Welcome to Finance and Fury. This episode is about what is momentum investing and can this be the best investment strategy in a world where fundamentals mean nothing?
Over the past few years – value managers – or those that try to estimate the fair value of a company and base their purchasing decisions around this have struggled to provide alpha – Alpha is the returns above the benchmark – or the index – and those active managers trying to provide value through buying undervalued companies – or those that have had short term losses – so their prices are below their fair valuations – have failed to see the rebound in prices expected from following this strategy So returns have been minimal One alternative strategy which has provided better returns over the past few year on average has seemed to be buy those companies not based around fundamentals but with momentum – i.e. what others are buying and hold these for a while to ride the wave up
What is momentum investing - is a system of buying shares that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period –
Seems antithetical to the age old saying of buy low and sell high – as here you are looking at a strategy that is selling low or buying high – based around the returns over a 3 – 12-month time frame – Now – there is no single consensus that exists about the validity of this strategy – but recently it has been a viable strategy for a handful of shares – At large - economists have trouble reconciling this phenomenon – I am someone in this same boat – For standard market theory - when using something like the efficient-market hypothesis – momentum strategies shouldn’t be able to provide much in the way of alpha – however there are two main hypotheses have been used to explain this effect in terms of an efficient market - The first - it is assumed that momentum investors bear significant risk for assuming this strategy, and, therefore, the high returns are a compensation for the risk – in other words – more risk, more reward However – at the same time - Momentum strategies often involve disproportionately trading in shares that have a high bid-ask spreads – everyone is trying to get into them so the buyers have to buy above a price what they may otherwise wish so it is important to take transactions costs into account when evaluating momentum profitability The second theory assumes that momentum investors are exploiting behavioural shortcomings in other investors, such as investor herding, investor overreaction and confirmation bias - Hence – from this theory – there is a greater downside – that through buying into a share that has risen significantly over the past 3-12 months may result in greater long-term losses – Reminder – that there are plenty examples of this – A2M is one – others in the market – but those companies that seem to be having a massive rise in prices (which does result in returns) off speculation – what can eventually fall apart Looking back in time – the history - Richard Driehaus is sometimes considered the father of momentum investing – similar to how Benjamin graham is considered the grandfather of value investing but the strategy can be traced back before Driehaus – and in the previous market participants view - this strategy takes exception with the old stock market adage of buying low and selling high. According to Driehaus, "far more money is made buying high and selling at even higher prices." There are some reasons as to why momentum may become more of a viable strategy to trade moving forward Over the years though – technology has improved – so has the availability to trade – In the past – going back 30 years, especially before the internet – only professional investors, or those with access to brokers or other professional investors guiding the way could generally buy shares – and back then – with these gate keepers leading the way - buying a company with a negative -100X PE may be considered crazy - But from the late 2000s - computer and networking speeds increase each year, there were many sub-variants of momentum investing being deployed in the markets by computer driven models – not only from within broker models but from without – as access to trading became available to everyone Some of these operate on a very small-time scale, such as high-frequency trading, which often execute dozens or even hundreds of trades per second So not only is it that more people can now buy shares – but computers and algorithmic trading can occur – for an AI – they may not care about fundamentals at all – if the price growth is there through momentum – they will jump in as well – pushing up prices further So this increase in access and technology may have given a rise to momentum investing – essentially every one has access to jumping on any bandwagon of shares Although this is a re-emergence of an investing style that was prevalent in the 1990s – just a side note - that ETFs for this style of momentum investing began trading in 2015 So a lot of shares that are in the top of an index – or in a index in general – have a ride up as people are buying the index – if you buy the VAS – you are buying 10% of CSL – so if 10,000 people buy VAS – all putting down a few thousand – at an average of $5k – that is an easy $5m to the market cap But on top of this – momentum specific ETFs are now available But there are some studies conducted on the specific advantage of following a trend - Looking back at the historical precedence that point towards to value of momentum investing – few studies looking at this strategy give average returns of 1% per month for the following 3–12 months when back testing data This finding has been confirmed by many other academic studies, some even going back to the 19th century But it is important to note – that turnover tends to be high for momentum strategies – or in other worlds high levels of buying and selling the investing – so it isn’t a buy and hold strategy if it is to work out well as these studies have anticipated So this high level of turnover has the potential to reduce the net returns of a momentum strategy This can go even further – as if you account for transaction costs as well as capital gains taxes – these can wipe out momentum profits There is another empirical study of this strategy covering over a century of data showed just how consistently well it performs – this was done by London Business School researchers Dimson, Marshand Staunton – looked back at market performance since 1900 - They constructed investment portfolios by selecting 20 top performing shares in the previous 12 months from among UK’s 100 largest publicly trading firms, and compared their performance to portfolios of 20 worst performers, re-calculating the portfolios every month. They found that lowest-performing stocks would have turned £1 invested in 1900 into £49 by 2009. By contrast, the top performers would have turned £1 into £2.3 million, a 10.3% difference in compound annual rate of return This is all well and good when back testing data – as you know what the best performing shares have been In a 2014 study called 'fact, fiction, and momentum investing' - 10 issues with regards to momentum investing, including transaction costs were identified – don’t have time to cover this fully -if you are interested would suggest going and checking this out - Does point out some downsides – such as the performance of momentum shares – epically that occur with occasional as large market crashes One example of this is in 2009, momentum style shares experienced a crash of -73.42% in three months from the initial crash – This downside risk of momentum can be reduced with a so called 'residual momentum' strategy in which only the stock specific part of momentum is used – where you buy a specific share that has momentum whilst allocating the rest of your portfolio based around fundamentalsA momentum strategy can also be applied across industries and across markets to individual specific shares -
Lets look at one example of this – and maybe the best example of the past few years – Tesla – I have been sceptical of TSLAs price rise over the years – that is because there has been little in term of fundamentals to give rise to these price increases They get positive cashflows from selling government credits – there is also a lot of speculation that they will make up a decent chunk of the car market share in the future - But - tsla and the power of momentum investing have proven to be a great investment – requiring no actual thought but simply following a trend – the more you think about it – the more TSLA looks like a sell – or a short sell when framing this decision based around fundamentals – but simply buying into this trend as part of a momentum strategy wouldn’t have provided a dependent return – but again – the fundamentals aren’t there to justify their current prices - In comparison - Last week Tesla’s market cap was siting at around $606 billion USD – this now has surpassed that of Toyota, General Motors, Daimler, VolksWagen, BMW, Honda and Ford combined – which are sitting at around $578.2 billion Obviously – TSLA should produce more cars and revenues than all of the above – but - Where does Tesla rank compared to other auto companies – VW, Toyota, Daimler – top 3 – top two around 10.5m cars each year – TLS made 380k cars a year This yet again underscores the power of market trends and the momentum investing strategy Comparing the returns over the past 10 years – the S&P500 has had a cumulative return of around 300% Overall though – car manufacturers have lagged this return If you invested $1 in Toyota – you would have $2 today – Ford – investment would be $0.5 – the others are about even – Investing in TSLA would have given you $120 – which is a huge return in comparison But when comparing a purchase into TSLA versus Toyota - Tesla’s valuation would be hard to justify these returns based around any rational basis – however - the undeniable reality is that Tesla has massively outperformed it peers – a trend that’s held throughout the past decade
Looking at the power of momentum investing – which is the power of a trend
There is a recurring theme within markets – in particular with some companies and their performances - that markets move in trends When trends get going - they can blow out any notions about rational valuation So Momentum investing, a variant of trend following, seeks to systematically pick such ascendant stocks and hold them for as long as they outperform. The benefit of a trend follower and momentum investor is that you don’t need exert yourself to determine the right valuations at which to buy or sell assets the market through the trend communicate to us which assets are in favour and which are not It may seem very simplistic - but with CBs having injecting liquidity and cash rates being so low – there is evidence supporting this approach Momentum investing can work – but it – requires some specific selection - if you systematically picked the best performing shares and invested in them regardless of what you thought about the companies in question, their valuation, products or management teams – that is momentum investing
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