"The trend is your friend." That's the theory behind momentum investing, which involves buying shares that are already rising. The strategy has paid off recently, with an average capital gain of around 60% over the last three years against just 12.4% for the FTSE 100. It's also thrashed other well-known strategies, such as buying stocks that look cheap based on fundamentals (down 4%), or seeking out those with high dividend yields (down 8.5%), according to Digitallook.com's Richard Leader. So can it continue?
Momentum investing is rooted in the tendency of investors to act in herds, all piling into the latest hot stock at once. This may not make much sense, but as John Maynard Keynes observed, "the market can remain irrational longer than you can remain solvent". So momentum investors argue that you should follow a price trend, rather than stand in front of it. One of the best-known systems for identifying momentum stocks is William O'Neal's 'CANSLIM' technique, outlined in his 1988 book,
(see below). Between 1998 and 2002, the approach generated a return of 350% and was praised by the American Association of Individual Investors as being great for "active investors seeking growth stocks", says Investmentu.com.
So, what can go wrong?
Momentum trades usually only work over short periods, so you need to catch a trend early. And when a big upward price trend reverses as is happening just now the approach is positively "dangerous", says Investmentu.com's chairman Dr Steve Sjuggerud. The strategy is based on sentiment once this turns, whether for dotcom shares, commodities or UK house prices, investors rapidly sell out of the sector involved and gains can quickly be wiped out. Then there are the costs. Regular monthly trading incurs dealing commission, stamp duty of 0.5% on purchases and capital-gains tax on profits above the allowance of £9,200. It's also a hassle to keep fiddling with a portfolio on a monthly basis.
The alternative: 'value investing'
Investors such as Benjamin Graham and Warren Buffett favour a 'bottom up' approach to weed out undervalued shares. The ideal candidate is often out of favour with the market (that's why it's cheap) and is bought for the very long-term. Classic signs of an undervalued stock include a low pe ratio, a low price-to-book ratio and, in the current climate where bankruptcy is possible, a low price-to-free cash flow ratio (free cash flow is operating cash flows adjusted for non-discretionary capital expenditure). A decent dividend yield helps. Indeed, some 'value' investors just look for the highest-yielding shares in the market, following strategies such as 'Dogs of the Dow'.
But does it work?
Not recently. Digitallook.com's figures indicate that a 'value' approach that chose stocks using minimum earnings per share (EPS) growth of 10% in the last year, a maximum price-to-book ratio of 1.5, and a maximum p/e ratio of 15, would have made just 3.6% over the last three years and lost 32% in the last year. A pure 'high-yield' strategy selecting shares with a dividend yield of at least 3% and cover of at least two times would have lost 28% in the last year, as shares in sectors such as banks, household goods and construction plunged. But take a longer view (which is the point of value approaches) and the results improve. From June 2003 to June 2007, a value approach would have returned 296% and high-yield 126%.
Which approach is best then?
Momentum investing can sometimes beat other approaches over short time-frames. But the effort, cost and risk involved make it unsuitable for most investors. Value-investing approaches may have been unrewarding over the last twelve months, but they have a solid long-term track record, have made the likes of Warren Buffett very rich, and will be the best ways to spot bargains particularly once the current bear market abates.
For investors who favour value but don't want to pick individual stocks, there's the Trojan Income Fund (see www.taml.co.uk or call 020-7499 4030), which returned 13.3% in the year to 17 July and yields 4.4%. Fund manager Francis Brooke uses a value-based approach to seek out firms with sturdy balance sheets, high dividend cover and well-established brands. The fund is currently ranked second in its peer group. MoneyWeek contributor Stephen Bland also runs an email investment service called The Dividend Letter, which is based on a high-yield approach.
'CANSLIM': what does it mean?
C = Current earnings per share. Rising by at least 25% a year when measured over recent quarters.
A = Annual earnings. Rising by at least 25% per year over the last three years.
N = New product (or service): this will fuel the company's future growth.
S = Shares outstanding. Ideally as few as possible. The fewer there are, the faster they will grow.
L = Leader or laggard? A stock's relative price strength should be at least 80 (so for a US-listed stock that means it has recently outperformed at least 80% of the S&P 500).
I = Institutional investors. Evidence that they are buying the stock is reflected in large volumes.
M = Major markets. The broader market (i.e. the S&P500 or Dow Jones in the US) should be trending higher since most stocks follow the market's overall direction.
There are as many ways to make money in the stock market as there are investors. No single strategy is best for everyone, and no strategy is universally “right” or “wrong.” Some investors find that a value style works best.For others, a momentum, or growth, or quality, or index strategy is the right way to go.
In essence, momentum strategies perform when prices continue in the same direction while the value approach delivers when prices move in the opposite direction. For that reason, the approach to combine the two strategies helps to manage risk.
Value investing starts with determining a security's intrinsic value, buying it when the price is lower by a pre-determined margin, because eventually its price and value will merge. Momentum investing suggests that stocks whose prices have increased for a period of time will continue to increase.
The momentum strategy buys assets with the strongest past return (12-month or 1-month) and expects them to outperform assets with the lowest past return. Value strategy buys assets that are fundamentally cheap and intends to gain on the assets' reversion to their long-term means.
Momentum investing can work, but it may not be practical for all investors. As an individual investor, practicing momentum investing will most likely lead to overall portfolio losses.
Stocks with low price/earnings ratios historically have outperformed the overall market and provided investors with less downside risk than other equity investment strategies.
This is why Buffett recommends only purchasing stocks that you're willing to hold for 10 years. Taking on that attitude forces us to stop caring so much about the short term, and refocuses our efforts on predicting what will come after.
Value premiums have often shown up quickly and in large magnitudes. For example, in years when value outperformed growth, the average premium was nearly 15%. On average, value stocks have outperformed growth stocks by 4.4% annually in the US since 1927, as Exhibit 1 shows.
Historical data indicates that value stocks have provided stable long-term returns and outperformed growth stocks in certain periods. In contrast, growth stocks have shown potential for higher short-term returns but with more volatility and risks.
Some studies show that value investing has outperformed growth over extended periods of time on a value-adjusted basis. Value investors argue that a short-term focus can often push stock prices to low levels, which creates great buying opportunities for value investors.
Momentum trading strategies capitalize on the continuation of existing market trends by buying securities in an uptrend and selling them as they peak, embodying the 'buy high, sell higher' philosophy and often relying on technical indicators over fundamental analysis.
Momentum trading attempts to capitalize on market volatility. If buys and sells are not timed correctly, they may result in significant losses. Most momentum traders use stop loss or some other risk management technique to minimize losses in a losing trade.
The RSI is one of the most widely used momentum indicators. It shows the momentum of an asset's price and can be used to identify potentially overbought or oversold situations.
By concentrating on recent price shifts, momentum investors become more vulnerable to market noise and temporary price fluctuations. This heightened sensitivity can increase volatility and pose challenges in adhering to a long-term investment strategy.
The success of momentum can be explained by a variety of behavioral, market friction, and risk considerations. Under certain conditions, momentum will tend to not work, including post-decimalization, after bear markets, during periods of volatility, and when value stocks outperform.
A value investor seeks out above-average companies and invests in them. Therefore, the probable range of return for value investing is much higher. In other words, if you want the average performance of the market, you're better off buying an index fund right now and piling money into it over time.
The bottom line on momentum trading is that it is a higher-risk way to put money to work in the stock market. And it's certainly a form of trading, not investing. Momentum trading can be a good way to make money when things work out, but it can quickly result in big losses if things go the other way.
Whereas buy-and-hold investors tend to wait months, years, or even decades before seeing significant profits, successful momentum traders have the potential to turn out profits on a weekly or daily basis.
Momentum investing involves making long-term investments in assets showing an upward trend. The rationale behind this strategy: an established trend is likely to continue.
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