by Stig Brodersen
15 OCT 2015
As many of you guys might know, I’ve been looking into quantitative investing recently. While Warren Buffett and conventional value investing is my background, I find it very fascinating with that concept that you can completely systematize your stock investing process and still be beating the market.
I haven’t taken the leap, and therefore I was thrilled to have a chance to speak to Alpha Architect CFO Jack Vogel. Jack Vogel has a Ph.D. in finance, and is an expert on how behavioral biases affect the value anomaly. What I really found interesting after speaking with him is that Jack is not only looking into value investing but he has also found that so-called momentum stocks outperform the market consistently.
WHAT ARE MOMENTUM STOCKS
So I’m going to answer this question by answering another. I know it might seem odd but bear with me for a second. If we examine why a value strategy outperforms the market? it is because you are buying stocks at a price below the intrinsic value and thereby waiting for the mean reversion to happen. This strategy has proven very successful over the years for multiple value investors including investment icons Warren Buffett, Mohnish Pabrai, and Guy Spier. As value investors also know, it might take years before the mean reversion occurs, which is where the momentum stock comes into play. When applying a momentum strategy you simply buy the latest stock that has appreciated most over the previous 12 months, ignoring the last month. In other words, you disregard the underlying asset and bet on the psychology of the stock market in the short run.
For a long-term value investor like me it sounds crazy. How can you ever ignore the underlying asset? Also, while you as a value investor surely are betting on the psychology of the stock market, it’s only in the sense that you can temporarily buy on the cheap and sell again when the price has risen. A momentum stock strategy is rather buying expensive stocks, selling them at an even higher price, and then cutting your losses when rebalancing.
If I hadn’t experienced working on a trading floor, I might have quickly moved away from momentum investing when I first heard about it. However, I have been betting on how commodity prices can trend away from the intrinsic value within minutes hundreds of times. I’m 100% sure there is something about playing the trend, but I’m also 100% sure that it’s hard to know when the party stops. It just seems like a very hard game to play.
One of the reasons that I discovered value investing was actually that I didn’t like playing the trend. It simply didn’t suit my temper. I would much rather invest $50 is something worth $100 and wait for the price and value to converge. It’s a lot less stressful it and seemed much more sustainable to me.
HOW HAS MOMENTUM COMPARED TO VALUE AND THE S&P500?
Here is a very interesting table that I have replicated from Jack Vogel’s new book DIY Financial Advisor.
I’ve got to be honest, when I saw this table my eyes almost popped. I was quite sure that this was too good to be true, and I had to look very closely at the data to investigate what was in fact being tested.
The time period was from July 1, 1963 through December 2014. To me it seemed like a very sufficient time period. The value stocks were rebalanced annually due to the cheapest EBIT/EV, which has been proven to be the most efficient single metric in the past. I’ve done so much research on this metric in particular that I wasn’t surprised about the superior return to the S&P500. Rather it validated the perception I already had. If you want to study the superiority of EBIT/EV also called the “Acquirer’s Multiple” I highly recommend, Deep Value, by my friend Toby Carlisle.
Before transitioning into my main critique, I also want to highlight that the study was not conducted based on small obscure companies that were not sufficiently liquid for being invested in. The study deals with huge companies in the 40th percentile for market capitalization on the New York Stock Exchange with a minimum market cap of $1.9B.
So, is this really too good to be true? The short answer, unfortunately, is “yes” but as we look closer I think you would still be surprised at the superior performance. First things first: This study has found the “raw return”, and not the returns that you will get as an investor. There’s nothing suspicious about it, but as investors we are all subject to different costs that will dilute our returns. Actually by simply buying a low cost ETF you will not get the same returns as the index because you are paying commissions, spreads, taxes, and management fees.
The costs structure is no different when it comes to momentum stocks, and in addition you can tune up costs. Since you are rebalancing every month, you have to set aside quite a few bucks for commissions. You will also be paying spreads, and let’s not forget about capital gains tax. As an investor you can mitigate some of that tax by holding the momentum stocks in a tax efficient vehicle like a 401(k) or an ETF, but for an ETF investor you would have to pay management fees.
How much does the cost add up to? This will be individual for each investor since we all pay different commissions to our broker, some investors will not be penalized similarly by the spread, and we don’t pay the same in tax etc. Studies show that you have to pay approximately 2.4% in costs for rebalancing if you hold your investment in an ETF. Still after subtracting the costs, momentum stocks still seem to historically outperform both value and S&P500.
IS MOMENTUM INVESTING SUSTAINABLE?
For all investment strategies that have proven superior in the past we have to ask why it has happened, and whether it may continue. As a long time value investor I’ve been asked countless times if value investing will also outperform in the future. The answer to that question is a confident “Yes”. One of the major reasons for this is that the people that are really moving the markets like fund managers in mutual funds and ETFs can’t afford to have a bad year. Some of them can’t even afford to have a bad quarter if they want to keep their job. Since value investing is very volatile in the short run, fund managers in general never follow a value investing strategy even in situations where they know it works. Ironically, this is the same reason why value investing outperforms in the long run.
In this regard value investors and momentum investors share the same fate. Momentum stocks are too very volatile, and may have long periods with underperformance. It’s therefore hard to imagine the majority following a momentum strategy – again: who wants to buy expensive and hope to sell it even higher?
So you might be thinking: “Isn’t momentum stocks the same as growth investing?” At least that is what I thought when I first read about it. Surprisingly it’s not. Though it varies dependent on the time period, it’s typically only between 20-30% of the same stocks. The premium of momentum stocks quickly disappear if you don’t rebalance every month. By rebalancing only once a year, you are historically looking to achieve a 1.48% superior return compared to 7.84%? for a 1-month hold.
What you are really betting on here is the well-known phenomenon that most investors sell their winners too fast to lock in a gain, and the same investors hold on too long on their losers, because they don’t want to realize a loss. But back to the original question: Is momentum investing sustainable? For once I don’t think that people in general will ever use a purely quantitative style of investing. It’s simply not coherent with human nature. I also think that the big funds will never apply this strategy, simply because most investors are not looking for quantitative investing, nor do they have the required long term perspective. Unless something dramatically happens to the way we are wired I don’t think this will change anytime soon. I’m tempted to say that this strategy is sustainable. That said I’m really thrown off about a strategy that is not being backed by cheap securities that are looking to revert to the mean. That is obviously just the premise of momentum investing, or any other strategy that is different than what I currently do. – Maybe I’m just stuck in my ways as a value investor but I don’t know if I am ready to deviate from that yet.
WOULD YOU INVEST IN MOMENTUM STOCKS, STIG?
If you have read my previous blog posts you have likely found that I’m not fast to pull the trigger on something new. I’ve read enough about investing to always be highly critical of any strategy that is beating the market – and momentum investing is no different. Basically, I need to understand the strategy a lot better.
I don’t like the high cost momentum strategy generates from rebalancing. I’ve learned from bitter experience that costs in investing are always certain while the superior returns are harder to achieve. One thing that I do like is the thought of a portfolio with both value and momentum stocks. Historically, momentum stocks have done better in periods where value stocks usually do poorly, and vice versa. Perhaps the best example of this is in the years before the dot com bubble burst in 2000, momentum stocks did very well. However, after the crash you would do a lot better in value stocks.
It’s not so much that I worry about the volatility. As I wrote in my latest blog post the returns are much more important to me. The reason I’m hesitant is not really that I doubt the study or the conclusions. It’s rather that I feel more confident with undervalued high quality assets backing my stocks, and a combination of the strategies might provide me with a higher return and still provide the certainty of quality assets and a strategy that I fully trust.
But when I come to think about it, I’m not sure why I doubt the strategy so much. After all, as a value investor you continuously exploit that fearful and greedy human behavior in mispriced stocks. How is that essentially different from a momentum strategy?
P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.