Momentum: what it is and why it works
Momentum investing, i.e. investments that benefit from momentum, has been a persistent and well-established phenomenon in stock markets for some time.
In this text, we will explore three types of momentum and show how they can be used to help optimize stock returns while limiting downside risk.
Let’s start with price momentum
Several academic studies have shown that stocks that have performed well in terms of price tend to keep going well into the future… while those that have underperformed tend to continue to do so.
One way to apply this concept is through cross-sectional momentum. This looks at a stock’s performance relative to its peers and can be used to predict its future relative performance.
In this case, we take the stocks within a defined group and track their price returns over the subsequent 12 months.
The top 10% of the best performing stocks represent the winner portfolio – as a group, these stocks tend to continue to perform well.
The bottom 10% of the worst performing stocks are the loser portfolio – which as a group tends to continue to underperform.
Another concept – time series momentum – looks at how a stock performs in relation to its own price history. This can be used to assess developing trends or reversals in the share price and can be measured by a moving average. When a stock moves above a defined moving average, it can signal a new sustained upward trend.
When the stock price breaks below the moving average, it may signal a new downward trend.
Now let’s take a step back and look at why price momentum works.
The first explanation is based on investor behavior – in this case, entrenchment.
Researchers have found that investors change their beliefs too slowly when new information radically changes the value of a stock. Investors tend to anchor their value assessment to past prices rather than the new information.
This can lead to a share being offered on a delayed basis as investors eventually incorporate the new information into the share price.
The second explanation stems from an investor’s need to be compensated for risk.
When used on its own, the price momentum is interrupted by rare but pronounced drawdowns. This is known as crash risk and the positive excess return associated with momentum investing is compensation for this risk.
Is there any way to capture the powerful upside of price momentum while mitigating the downside risk? We believe it exists, but it requires a closer look at a company’s operations.
An important measure of operating momentum is earnings momentum, which can be tracked by measuring the degree to which a company beats earnings per share estimates.
For example, we can sort by the stocks with the strongest earnings momentum based on the positive earnings surprise.
Why is it important? Research has suggested that using earnings momentum can help avoid speculative bubbles and crashes associated with using only price momentum.
Operating momentum is also evident in measurable areas of a company’s basic performance such as:
Sales growth and gross margin expansion
Other metrics are less immediately quantifiable, but can help provide a more complete picture of underlying changes in a company’s fundamentals, such as
Addressable market size Pricing power and competitive positioning
What happens when you combine price and operating momentum? Combining these two actions results in what we call confirmed momentum.
Operating momentum itself may point to improving fundamentals that are not recognized in terms of price estimation.
Price momentum by itself, without underlying fundamental strength, may not be sustainable if it is largely influenced by speculative activity.
Confirmed momentum looks at the strength and persistence of a share price – and whether it is supported by robust and improving operating metrics.
This can allow managers to capture gains from higher growth stocks as they move up in price, while mitigating losses as the market consolidates.
The selection advantage of using this integrated approach is evident by looking at two stocks.
First, GameStop, had good price momentum…
… but set up for a crash as fundamentals did not improve in the same way.
Nvidia, on the other hand, experienced an upswing in its share price …
… while its foundations were improved. This is an example of confirmed momentum.
We believe that the combined dimensions of price and operating momentum described here can help investment managers achieve strong performance while reducing risk.
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