The Value of Momentum

Commonly held beliefs suggest that once an investment strategy starts approaching the level of being an assured path to success, it is bound to falter. The reasoning behind this is that if the secret to amassing substantial wealth becomes widespread knowledge, the efficacy of the strategy could diminish.

However, amidst this skepticism, a strategy with a history of success has not only endured, but flourished for decades, consistently proving itself as a reasonably dependable money-making approach. This strategy is known as momentum investing, and it revolves around the idea that recent stock market winners will continue their winning streak in the short term, while recent losers will continue to lag. This approach is also referred to as relative strength investing.

In the world of academia, momentum investing gained substantial attention with a ground-breaking study published in 1993 in the Journal of Finance by Narasimhan Jegadeesh and Sheridan Titman, who were both associated with UCLA Anderson at the time. Their research documented the substantial outperformance of strategies involving buying recent top-performing stocks and selling recent underperformers. This outperformance was particularly pronounced within a three- to 12-month timeframe on either side. To elucidate, a stock's relative performance over the previous three to 12 months often predicted its performance over the following three to 12 months. By evaluating various combinations of past and future returns within these timeframes, the authors discovered that such strategies were, on average, remarkably profitable. For instance, constructing a portfolio based on the previous six-month returns of stocks and holding them for an additional six months resulted in an extra monthly return of approximately 1% beyond the expected average. Over time, this return premium, when compared to the market's return, could translate into a significant and lucrative advantage.

Momentum in stock investing is the tendency of a stock's price to keep overperforming (or underperforming) for the near future. The presence of momentum has always been accepted by practitioners and traders, but only in the last two decades or so has been studied and now accepted by academicians as well.

While we can easily get lost in the jargon of trading, essentially technical analysis is momentum strategy. Technical analysis holds that the securities price and volume is all the basic information we need to predict how the price will go in the future. Technical analysts look at many different statistics and patterns based on past price and volume to understand what the securities price will do in the future and to decide if they should buy or sell the security.

This can be contrasted with fundamental analysis, which holds that investors should study the financial characteristics of securities and value them rationally. Value and growth investing are subsets of fundamental analysis. Value investors hold that prices frequently deviate from the security's intrinsic value. Growth investors hold that the growth in a company's revenue and profits are the most important thing. Many investors like Warren Buffett (Trades, Portfolio) hold that growth investing is similar to value as consideration of growth is key to valuing a security.

Rather than holding that fundamental and technical analysis are two solitudes which do not meet, I think it makes more sense to use some parts of both fundamental and technical/momentum analysis in our overall assessment of stocks. Certainly over the long term, fundamental factors are more important, while over the short term (three to 12 months), technical factors (which are rooted in behavior) become more important. In the medium term, both disciplines come into play.

GuruFocus has bought the two investing disciplines, the fundamental and technical/momentum schools, in coming out with the innovative methodology called the GF Score. The GF Score calculates a composite score based on profitability, growth and financial strength, which are themselves made up of fundamental factors, and combines it with momentum, which is a technical factor, and comes out with a composite GF Value based on a proprietary methodology combining fundamental factors and analyst estimates. So, in my opinion, given the preponderance of fundamental factors, the GF Score is 80% fundamental and 20% technical.

Examine the iShares Edge MSCI USA Momentum Factor ETF (MTUM, Financial). The exchange-traded fund over the majority of the past 10 years has outperformed the S&P 500. Structured to follow the MSCI USA Momentum Index, this fund includes the most high-performing large- and mid-cap stocks in the U.S. market. The ETF invests in the large and midcap-cap U.S. equities with the strongest six-month and 12-month price performance, excluding the last month, and standardizing for volatility. Company fundamentals hold minimal significance; the sole criterion for inclusion in the index (and subsequently the fund) is being a market frontrunner. Lately, the ETF has faltered, showing the limitations of following a pure momentum strategy all the time over a business cycle.

We may ask, why does momentum work? Since it flies against the face of the dominant efficient market hypothesis, which holds that all relevant information about a security gets incorporated in the price efficiently and it is not possible for an investor to consistently outperform the market by exploiting information or making investment decisions based on past price movements. In practice, most financial professionals acknowledge that while markets may not always be perfectly efficient, the degree of efficiency can vary across different market segments and time periods. As a result, investors employ a range of strategies, including passive indexing and active management, depending on their beliefs about market efficiency and their investment goals.

Ultimately, momentum works because it exploits the lack of perfect market efficiency by us humans. It is the human tendency to either overreact or underreact to new information. In the case of "positive surprises," investors often underreact and while the stock may go up following positive news, it does not go up by as much as it should have, if we were perfectly rational entities. The same can be said for "negative surprises" when we underreact. It should be emphasized that momentum investment has been shown to work only in the short term (i.e., three to 12 months) and the momentum effect dissipates over the longer term. Also in the very short term (less than three months), momentum is subject to reversal (i.e., a stock reverses its initial trajectory and tracks back as technical traders seek to exploit this phenomena).

Value investors, of course, watch for overreaction by the market, particularly negative overreactions, and try to pick up securities which are trading much below intrinsic value. However, value investors typically work over longer timeframes over months and years rather than the three-to-12-month window for momentum investors.

Swing trading is often considered a momentum-based strategy, particularly if conducted over months rather than days or weeks. Swing trading involves capturing short- to medium-term price movements in financial markets. Traders who use this strategy aim to identify and capitalize on momentum shifts in asset prices, taking advantage of trends that can last from a few days to a few weeks. Momentum trading strategies, in general, involve capitalizing on the continuation of existing price trends. In the context of swing trading, traders look for stocks, currencies, commodities or other financial instruments that exhibit strong price momentum in a particular direction. They enter positions with the expectation that the price trend will continue for a period sufficient to generate a profit, but they do not necessarily aim to hold these positions for the long term.

Based on my reading and limited experience with momentum, I offer the following empirical suggestions to put the strategy into practice in stock investing.

1. Wait for at least three months to see if the stock has momentum in either positive or negative direction before opening a position. This is because in the short term, the initial burst of momentum often reverses.
2. Do not use momentum strategies in the longer term as, over the longer term, it is the fundamental factors which drive performance and the momentum effect tends to dissipate in periods longer than 12 months.
3. Combine fundamental factors with momentum. For example, if you are a long-only investor, look for securities that your research says are undervalued and are experiencing positive momentum and avoid securities that are experiencing negative momentum.
4. Momentum strategy works well when applied systematically as part of a portfolio. Avoid all or or nothing bets on one or two stocks. I would recommend that your momentum strategy should at least have five stocks.
5. The most important lesson from momentum is nothing lasts forever. Momentum is a powerful force, but so is reversion to the mean. That means investors who want to bet on momentum should do so carefully and remember not to overstay their welcome.

Using the GuruFocus All-in-One Screener, I backtested a strategy with the following criteria: five U.S. stocks with market cap more than 1 billion, have a low momentum rank of less than 3 and a GF Value of significantly undervalued or possible value trap and three-month better relative performance to S&P of more than 10%. The screener chosse stock in descending order of three-month relative performance and rebalanced every 12 months. Essentially, I was looking for undervalued, low momentum, beaten-down stocks that had experienced a large change in momentum over the last three months. The resulting performance of the picks are as follows:

The momentum strategy outperformed the Russell 2000 by over 550%. (Note that I was restricted to the time period as GuruFocus had introduced GF Value only since 2020 onwards.)

Of course, this is a theoretical exercise over a single time period and has to taken with a grain of salt, but it does indicate that combining value criteria with momentum in an investing strategy has merit.