Why I Don’t Invest in Momentum Stocks…Yet!

Why I Don’t Invest in Momentum Stocks…Yet!

October 30, 2015 Guest Posts, Momentum Investing, Value Investing
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Confirmation bias is the tendency to cling to research/ideas that confirm with what you already believe. This behavioral bias leads to overconfidence and can impede our search for the truth. So in the spirit of healthy debate and ensuring we consider different perspectives, we asked Stig Brodersen, of The Investor’s Podcast, to post his thoughts on momentum, which is against every fiber of his value-investing body.

Here are Stig’s thoughts:

After reading the DIY Financial Advisor, one thought stuck with me. Should I start investing in momentum stocks? Now, this is actually a big intellectual leap for me. I’ve sworn to a value investing strategy for years, and really thought that this was the strategy I would use for the rest of my life. Therefore, I never really thought much about other strategies, but this time, it was different.

This wasn’t a new strategy that was written by a random person I didn’t know. The author was Wesley Gray – whose work I’ve long read – and I knew that he was a tried and true value guy with the same approach to investing as me. Recently, I even had the chance to interview Wesley’s co-author Jack Vogel specifically about momentum stocks, where he’s conducted a lot of research.

Our discussion evolved around the returns from the time period from July 1, 1963 through December 2014 (returns are gross of any fees and transaction costs):

  50% Value / 50% MOM 100% Value 100% MOM S&P500
CAGR 17.72% 15.69% 18.86% 10.23%
Std. Dev. 16.46% 17.48% 24.79% 14.86%
Sharpe Ratio 0.69 0.65 0.63 0.4

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So in a way, the results should speak for themselves and I should start jumping into momentum stocks, right? We’re looking at more than 8% outperformance compared to the overall market, and more than 3% compared to the value investing portfolio.

Well, it turned out that it wasn’t so easy. As an avid reader of the Alpha Architect’s articles and blogs, the concept of momentum stocks includes very frequent rebalancing. To derive the very best performance, we’re talking about monthly rebalancing. It also includes the DIY Financial advisor that refers to an academic paper suggesting 0.2% in monthly costs, which add up to a whopping 2.4% extra costs for the momentum strategy. That said, even with the extra costs, the momentum strategy still beat the value investing strategy, so I was still left explaining to myself as to why I couldn’t execute on a momentum strategy.

Beyond my internal intellectual struggle with momentum was the fact that I couldn’t find many good value bargains, and with my expectations of a portfolio of value stocks to deliver meager returns at best at the current price levels, I felt I was painting myself into a corner. Perhaps it could all be boiled down to irrational emotions? As many other investors, I constantly feel myself being manipulated by my own emotions to NOT do the right thing, but rather what my gut told me to do.

Regardless, I simply can’t come around to momentum investing and the reasons below describe why this is the case.

My reasons not to invest in Momentum Stocks

After my interview with Jack Vogel was posted, Wesley Gray reached out to me and asked if I was interested in writing a piece about my hesitation concerning momentum stocks. He thought that it would spike a great debate – a debate I would love to participate in. While I do consider myself a value investor, I’m also very aware that I’m on the path to life-long learning and I both hope and expect my current belief to be constantly challenged. So here is my 4 main reasons (feel free to read: “Excuses”) for not investing in momentum stocks.

1) I like my portfolio to be backed by undervalued companies

As we all know, the core of value investing is to have my stock pick’s intrinsic value vastly exceed the current market price based on both stable earnings and a strong balance sheet. In other words, when I look at my portfolio, I like to see companies where I pay very little for my cash flows, and a balance sheet with little or no debt and flooded with cash. Strong tangible and intangibles assets backing the valuation make the portfolio even more attractive.

I’ve found this approach to be profitable, and I find it just as important to see a correction or a crash and the strong fundamentals relieves me from the stress other investors often experience.  I see a $100 bill that might cost $80 getting even cheaper and I see a great opportunity to load up on even more value stocks.

But how would I feel when my portfolio of momentum stocks drop in price? Will I see a portfolio of very expensive stocks where the price and value simply converge? Isn’t that the effect that all value investors expect to occur, and the whole reason why value investing is profitable?

2) I don’t know the true costs of trading momentum stocks

It’s hard to find the true costs of trading momentum stocks. Well, to be completely honest, it’s basically impossible to find the true costs of any investment strategy. How much do we actually pay in commissions and spreads? These costs are dependent on so many factors, including trading skill, terms with your broker, liquidity, portfolio requirements, opportunity costs, and many other non-transparent factors. As previously mentioned, a momentum strategy should preferably be rebalanced monthly and we know that frequently rebalancing – no matter how you put it – is very costly.

DIY Financial Advisor points to the following research paper: “The Illusory Nature of Momentum Profits” for further investigation. The paper is highly critical about the momentum stock approach and abnormal returns the authors of the paper acknowledge exists. They directly state: “We conclude that the magnitude of the abnormal returns associated with these trading strategies creates an illusion of profit opportunity when, in fact, none exists.”

No one knows the future and while I think momentum stock will likely continue to outperform the market, as investors we must always remind ourselves that future returns are uncertain while costs are very certain.

3) James O’Shaughnessy got me thinking…

Recently I had the great honor to speak with legendary investor James O’Shaughnessy. I consider Jim to be a top authority on quantitative investing. I asked him about how different versions of his best-selling book, “What Works on Wall Street,” showed that different metrics interchangeably best outperformed the market. His response: “When you see a lot of academic research on an outperforming metric is conducted, expect to see that return diminish in the future.” You can find my full interview with James O’Shaughnessy here.

Now, this concern has obviously been raised before. We have always seen outperformance in the market for value metrics like a low P/E and P/B for instance, and the outperformance doesn’t seem to vanish even though the information is publicly available. The explanation for this is simple: Unless large pools of capital in equities markets, in aggregate, start to subscribe to a value investing method, the premium will continue to exist. We don’t expect that to happen anytime soon, because value investing is a strategy that is harder to sell to potential investors, and has long periods with underperformance.

My concern is not that all the big funds will start applying a momentum strategy. I simply don’t think they can find enough investors where the strategy appeals to them. However, I think that James O’Shaughnessy has a great point. While we didn’t talk specifically about momentum stocks, my concern is that too many small funds will start applying a price momentum strategy.

So how is this not as sustainable as value investing? The answer is that it might be. However, it seems to me that the overall premium is harder to erode simply because so many different value-investing metrics can be applied. You can easily find more than a dozen metrics including P/E, P/B, P/FCF, P/S, and EBIT/EV and while there is some overlap, it allows for many investable stocks that can outperform the markets.

A momentum strategy that is built around a previous price appreciation might simply be more vulnerable if my thesis is correct about fewer stocks being available when there is competition. To keep transaction costs low, a momentum strategy is forced only to focus on the biggest and most liquid companies – otherwise the spreads will simply dilute the returns too much.

A clear counter argument is that many more funds and individual investors follow a value approach, so why there is say, X times as many stocks available, X times as many people are buying the value stock up and the difference in performance is proportionally the same. That might be true, but in any case this adds an extra layer of uncertainty for me that I don’t feel I have with value investing.

4) I don’t expect a long bull market in the future

Yep… you heard me right. I’m putting on my tin foil hat and saying that the stock market is overvalued and it could crash. Whenever people come with predictions, I’m skeptical, and I hope you are too. That said, when I look at overall indicators like Schiller’s P/E, Tobin’s Q, and Total Market Cap to US GDP, I don’t like what I see. While the fourth and last reason as to why I don’t see myself investing in momentum stocks is by far my weakest argument, I’ve included it because I consider it especially interesting from a research stand point.

In the event of a bear market, it’s deemed most likely that value stocks do better than momentum whereas a momentum strategy typically does better in bull markets. DIY uses the boom and the bust of the Internet bubble from 1998-2001 to support the argument. Arguably, it’s a short period, but intuitively it makes sense to me, and I wouldn’t be surprised if a longer study made the preliminary conclusion more robust.

While I have no idea how equities perform in the short run, I’m not optimistic about a long period with a bull market starting anytime soon.

This would change my mind about momentum stocks

It might surprise you, but I think I could consistently follow a momentum strategy – at least in theory. To understand this surprising statement, I need to confess something embarrassing: I used to believe in the efficient market hypothesis. Yes, of all those poor business school students that we like to make fun of because they don’t knowany better… I was the worst! In my younger days, if you had told me that the planet was flat, I would have believed you just as much if you told me that the market didn’t price all securities correctly. It was not before I personally worked with stocks and studied the literature away from common text books that I realized markets aren’t always 100% efficient.

But why do I highlight my old belief in efficient markets? Well, I bring this up because as I gained more knowledge, I completely changed my paradigm towards stock investing. Perhaps, this is what I need to do with momentum stocks? Despite all of my concerns I’ll be the first to say that I find momentum stocks very appealing, and while I’m skeptic, I’m ready to be proven wrong.

Perhaps my discussion about value investing vs. momentum investing with Alpha Architect CIO Jack Vogel was the first step into changing my paradigm. Perhaps it will be your first step too?

About the Author: Stig Brodersenstig-brodersen

Stig holds a master’s degree in Finance, has studied Business Analysis at Harvard University, and he’s the co-founder of the The Investors Podcast educational site. During graduate school Stig co-founded a consultancy firm, providing clients with legal and financial advice relating to personal finance. Upon graduation Stig sold his shares in the firm to become a commodities trader in one of Europe’s leading energy trading companies. Now, Stig works as a college professor teaching a variety of courses including financial accounting, investment and economics. Stig also owns the investment company Stig Brodersen Holding.

Stig’s the author of The Warren Buffett Accounting Book, The 100 Page Summary of The Intelligent Investor, and The 100 Page Summary of Security Analysis.

 

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Eric Darnel

    Thank you for confirming my bias against the idea of momentum investing! Buying something because it has gotten more expensive is hard for me to be comfortable with.

  • it is definitely less intuitive than value investing!

  • Chris

    I think the fact that an obviously very smart guy/investor finds momentum uncomfortable will be the reason why the anomaly will persist . i guess value investing use to be more uncomfortable before Buffet became mainstream and all the academic papers were published !

  • Tim Brennan

    The initial fundamental screening required to identify true value opportunities certainly provides the investor with an added layer of confidence. Intuitively though, the behavioral tendencies that drive momentum are very similar to those that create the value anomaly.

    I have much more conviction in the reliability of the factors themselves than I do in the underlying investments. As long as there’s human involvement, it’s hard to imagine a time when both value and momentum won’t present opportunities for disciplined investors. Yogi Berra would say something like, “Humans are always going to be human.”…and there’s nothing more intuitive than that! 😉

  • IlyaKipnis

    Eh…I’d seriously disagree with Mr. Brodersen’s assessments, the rebalancing shenanigans aside (seeing 30% of your paycheck go up in smoke every pay period is a constant source of cursing…). I come from the exact opposite vantage point, which is why I’m long QVAL and IVAL, since proper value investing just seems like absolute wizardry to me. I mean, you have a sea of different metrics, a zillion little companies to keep track of, and it just seems that there’s a hundred-and-one ways to royally screw things up, and unto my few attempts at having attempted to create a value backtest using Quandl’s data, they’ve all been woefully disappointing.

    Regarding momentum, however, it’s not as simple as he makes it out to be in terms of “oh, all funds applying a price momentum strategy”. I mean first off, how does one measure momentum? Cumulative rolling return over a set period? AKA a price change between two points? A moving average difference of some sort? An average of multiple momentum settings? (EG 3, 6, 12 month?). Maybe some sort of volatility-adjusted difference between the price and a moving average? What about the trade-off between your measurement’s smoothness (so you don’t get false signals), and its responsiveness to market action? You get one at the cost of the other. EG, you can have a very smooth 500 day moving average, which tells you nothing due to its lag, and the price action itself, which also tells you relatively little because of its noisiness. How do you strike a good trade-off? How do you measure what constitutes a good trade-off?

    Using a static data set, it’s fairly trivial–select the settings that minimizes the sum of in-sample and out-of-sample error (bias and variance), but with finance, there’s also an element of time to that. Over what period do you measure the smoothness of your indicator (variance in daily changes), and over what period do you measure the responsiveness (the absolute difference or squared difference of the price minus your indicator)? What weight do you assign to both of those components?

    This is a reason that there are so many CTAs, after all.

  • Doug

    As a person who’s read Security Analysis (1940 edition), The Intelligent Investor and all of the Berkshire Hathaway annual letters (and who has owned BRK.b since about 2005), I’m in a similar spot as the author. Hard to wrap my brain around the concept. But…I’m slowly coming around to it. One big sticking point remains, though…

    Taxes.

    While I have some capacity in an IRA to shift some assets to this method, I think a lot of people out there need to really think hard about the effect of taxes before jumping into momentum (or any other strategy that frequently rebalances). The ETF vehicle helps mitigate this effect, but I suspect the tax drag from momentum would be higher than value.

  • Michael Milburn

    As to persistence, from my personal behavioral standpoint, momentum is more difficult to follow than value. I look at some of the momentum tickers and get sick. Additionally, I wonder if momentum is anywhere nearly as popular as value among funds. Wes has also pointed out the drawdowns with momentum are killer (moreso than value), killing hope for adherents at various intervals.

  • Stig T. Brodersen

    Great point Tim. That would be my main reason to invest in momentum stocks too!

  • Steve

    I can certainly relate to the internal debate that can go on with value vs momentum….and that’s coming from the perspective of a dedicated “value AND momentum” investor (quite a long time before it was cool to be a multi-factor investor).

    Considering the two factors individually, here are my current thoughts:

    a) Forget the statistics(!) Depending on the author, various studies will show that price to book (for example) is statistically insignificant. Others will show that it is. Reading enough momentum papers will convince you that momentum IS the most robust anomaly (or ‘factor’) – and maybe it is (statistically). But on a, “does it beat the market?” basis…value (using simple price to book) beats the market everywhere (on a pure return basis…the kind of thing a real life investor cares about). Momentum, on the other hand, does not. My current thought / belief is simply that value is probably more of a fundamental of market / market behaviour…but momentum is pretty reliable too. If I could only have one factor alone to use…I would choose value, particularly if I was a global investor. That’s my practical answer.

    b) Momentum isn’t some weird, unexplainable factor (from a behavioural point of view). Nor is ‘quality’ for that matter, but that’s another topic. In my opinion, of course. With momentum, the same type of behaviour is seen with everything from social media to choosing restaurants (people prefer to go to a restaurant with lots of people looking like they are enjoying themselves) etc. It’s popularity, and consensus and confirmation etc. It’s normal human behaviour for fads and trends to occur.

    c) On a like for like basis (e.g. annual rebalance), value wins (or is at least no worse than) momentum….but momentum balanced annually still beats the market.

    d) Poor momentum value stocks is a bad bet. Even worse – poor momentum value stocks that were expensive (“growth”) stocks not too long ago…underperform the market. Obviously momentum means something, even to value stocks. A value investor should consider the ramifications of investing in ‘bottom decile’ momentum stocks…they would be a ‘short trade’ under a momentum strategy (which, we know, works).

    e) Momentum, just like value, can be assess from different angles. It’s not just rate of price change. Examples; the speed of the rate of change, the consistency of returns, the volatility of the returns, the relative price levels of the trend etc.

    I think the, “never the twain shall meet” of value vs momentum is interesting. I hope it doesn’t go away.

  • Thanks for saying what many of us have been thinking.

    “In the event of a bull market, it’s deemed most likely that value stocks do better than momentum whereas a momentum strategy typically does better in bull markets.”

    Which one does better in bear markets?

  • Jesse Koltes

    I thought I’d throw good old Graham into this conversation. In the intro to the original copy of Security Analysis he distinguishes between intelligent speculation and investment. I think its worth quoting him at length:

    “If the field of sound investment has suffered a severe contraction…it would seem natural to turn our attention to intelligent speculation, on the theory that a good speculation is undoubtedly superior to a poor investment. But here again we must recognize that the psychology of the speculator militates strongly against his success. For, by relation of cause and effect, he is most optimistic when prices are highest and most despondent when they are at bottom. Hence, only the exceptional speculator can prove consistently successful, and no one has a logical right to believe that he will succeed where most of his companions must fail. For this reason, training in speculation, however intelligent and thorough, is likely to prove a misfortune to the individual, since it may lead him into market activities which, starting in most cases with small successes, almost invariable end in major disaster” (page 12)

    I think “intelligent speculation” is a nice name for Momentum trading. My guess is that by departing from a sturdy value philosophy (even in a segregated account) an investor will start to erode the hard won behaviors of intelligent investing.

    Even rule based investing and speculation is only as good as one’s ability to follow rules.

  • jimhsu

    Value and momentum couldn’t seem more different, but the key similarity in my mind is this: They force you to do something that’s uncomfortable, painful, and just plain “wrong”. Buying things with terrible fundamentals, declining prices, and abysmal expectations (value); or buying things that clearly don’t deserve the price they have except for the fact that they are up (momentum). As I’ve said, the single biggest mistake investors make is value investing with a momentum timeframe, and momentum investing with a value timeframe.

  • Ray Sheedy

    Hi Stig,

    I have been a listener of your podcast from the beginning. Why not use a trending value strategy like James O’Shaughnessy features in his what works on Wall Street book. This way you are buying value stocks with the best momentum. Taxes and rebalancing will still be an issue. But at least the stocks are “cheap”.