The momentum score of value stocks is on the rise as a result of the recovery of financials, energy and a strong performance of the basic materials sector. If value stocks become momentum stocks, this could give an extra boost to the style rotation that has started since November last year.
Morningstar’s Jeffrey Schumacher discussed momentum investing in a contribution to Investment Officer and Fondsnieuws.
Buying stocks low and selling high is a basic principle of any successful investment strategy. However, the way this is put into practice can vary greatly. One particular variant is momentum investing, where founder Richard Driehaus stated in principle that “far more money is made buying high and selling at even higher prices”.
Momentum investors differ from traditional fundamental investors in many respects. For example, momentum investors assess stock price performance rather than the operating performance of companies and the intrinsic value of shares. Momentum investors focus on those stocks that can continue their upward price movement, rather than focusing on stocks that have the potential to be undervalued relative to their intrinsic value. In addition, momentum investors generally have a shorter investment horizon than fundamental investors.
The trend is your friend
The purest form of momentum investing focuses on buying shares that have performed above average over a specific period, often the past three to twelve months, in the expectation that this positive trend (in the short term) will continue. The strategy thus buys the most recent winners in the expectation that these will also be the winners in the near future. “The trend is your friend” will therefore be set in stone for every momentum investor.
As with value investing, the momentum factor has also been widely debated in the academic world. Professors Narasimhan Jegadeesh of Emory University and Sheridan Titman of University of Texas provided academic proof of the success of momentum investing in 1993. Their research showed that a portfolio of stocks selected on the basis of performance in the previous six months - and then held for six months - produced an excess return of 12 per cent. This research also ensured that the traditional Fama-French three-factor model could later be extended with the momentum factor by finance researcher Mark Carhart in 1997.
Price momentum thus became an important factor, with various techniques and indicators developed in the school of technical analysis to measure the strength of price momentum. Information momentum, however, is another form of momentum that is developing. One can think of profit adjustments by analysts, but also of more sentiment driven factors. Natural Language Processing makes it possible, for example, to analyse annual reports, quarterly reports and all kinds of other news items or communications about a listed company and to distil the sentiment surrounding the company from this, for example by counting the number of words with a negative association and a positive association. The tone of the news coverage can influence the sentiment and thus the strength of the momentum factor.
Momentum value stocks
Momentum investing therefore also has common ground with behavioural sciences. Investing in shares that have risen in price in the expectation that they will continue to do so leans on the phenomenon of herd behaviour, something that is not strange to investors, but also not without danger. Confirmation bias, whereby more weight is given to trend-confirming news, and overconfidence bias, whereby investors become overconfident after achieving good performance, are other dangers that can threaten the success of momentum investing, as can higher portfolio turnover and the associated transaction costs.
In recent years, the momentum factor has been a reinforcing factor behind the rally in growth stocks that we have seen, from which work-from-home stocks have also benefited. Many momentum portfolios therefore include names such as Zoom, Apple, NVIDIA and Moderna. However, because momentum is often calculated on the basis of short-term price movements, the momentum factor can quickly shift to other sectors or regions when there is a break in the trend. This is currently happening as a result of the resurgence of value stocks. The momentum score of value funds is on the rise due to the price recovery of financials, energy and a strong performance of the basic materials sector. If value stocks become momentum stocks, this could further boost the style rotation that has started since November last year.