Two Ways To Improve The Momentum Strategy

Momentum investing worked very well in 2013, but it’s been awful in 2014. The momentum reversal has been one of the major headlines in an otherwise flat and quiet market year because the high-flying stocks from 2013, especially popular tech names like Tesla, have been crushed in recent months. Momentum investing works great over the long term but can suffer from short term reversals that are painful to live through.  Luckily, there are ways to significantly improve the momentum trading strategy—which would have side-stepped the momentum carnage of 2014 completely.

Momentum Works On Its Own

Momentum investing is popular because it has worked well across market history. I’ll define momentum in simple terms: total return over the past 6 months. Since 1963, a strategy that buys the top group (best 10% of the market) of stocks by 6-month total return, has delivered a 14.4% annual return, which is roughly 4.5% better than the S&P 500. But, to earn this excess return you have to live through a roller coaster ride. The annualized volatility of this strategy is 24.4%—almost 10% more than the market’s 15% annual volatility.

The weakness of a raw momentum strategy is that it will sometimes piles you into very expensive and/or low quality stocks. At the end of 2013, companies in the top 10% of the market by trailing 6 month return (which included lots of social media stocks, biotechs, and power companies) had valuations which were, on average, more expensive than 67% of the market[i]. Some of the most talked about names like Plug Power and Twitter were literally the most expensive stocks in the market. The best way to mitigate this issue is by insisting on valuation and quality—if you never buy the expensive, junk stocks, then the momentum strategy gets much better.

Improving the Momentum Strategy with Value

You may think that value and momentum are polar opposites, but they work remarkably well together. Think of the combination as cheap stocks that the market is just beginning to notice.  The combination of the two factors yields results more impressive than either of the two investing styles on their own. (Note: for value, I’ll use the simplest measure possible to make the point: price/earnings)

The cheapest 10% of stocks by P/E have historically delivered 16.3% per year, and the top momentum stocks have delivered 14.4%, but a combination of the two has yielded 18.5% per year (bottom right corner of the table below). What’s more, the volatility of this combined strategy comes way down: from 24.4% for raw momentum to 18.9% for value + momentum.

The table below breaks all stocks into a 5×5 panel by value and momentum (6m return and price/earnings). Stocks in the upper left have terrible value and terrible momentum. Stocks in the lower right have great momentum and great valuations. The combination of these concepts has been very powerful.

Annualized returns, 1963-2013

Annualized returns, 1963-2013

Quality Works Too

A second way to improve the momentum strategy is to focus on companies with higher quality earnings. The simplest way to define quality earnings is by looking at non-cash earnings. The fewer non-cash earnings (which come from accruals like accounts receivable), the better[ii].  Here is a similar 5×5 panel by quality and momentum. The effect is similar to value, but quality is a different factor and so a different take on qualifying the stocks you are willing to buy.

Annualized returns, 1963-2013

Annualized returns, 1963-2013

Don’t Fight the Tape, Unless…

Momentum investing works on its own—but there are ways to improve the strategy by following some trends and ignoring others. If you are trading momentum stocks, remember that the momentum effect has worked better amongst the cheapest and the highest quality names out there.  If value was a part of your momentum strategy, you’d wouldn’t have owned any of the stocks making headlines for the wrong reasons so far in 2014.

Some people are buying the dip, but most of these stocks remain very expensive. Investing based on factors like momentum is like all other investing: diversification improves and smoothens your returns.

 

[i] Value based on a combined measure of p/sales, p/earnings, ebitda/ev, yield

[ii] Earnings Quality defined as percentage change in total accruals