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What Role Does Momentum Play in Value Investing?

April 25, 2012 | About:
If value investing is a proven and profitable strategy and momentum trading is also a market beating technique, can we simply combine the two approaches to enhance our gain even further? Is it possible to target quality value stocks while trading momentum at the same time or will the two strategies work against each other? In order to test this concept we first need to understand how momentum relates to value investing.

Momentum Investing

Momentum is a real phenomenon in which stocks that have previously beat the market continue to outperform their peers. Typically, an investor screening for momentum would look for stocks that outperformed the market over the last quarter, 6 months or year and then hold for the following 12 months. One research paper, Size, Value and Momentum in International Stock Returns, reports an average 0.62% excess gain between high and low ranked momentum stocks globally. This "past performance dictates future performance" technique worked in every country but Japan. Yet the paper failed to consider the exclusive relationship between value and momentum.

Yet, how well does strong relative price performance fit with value investing?

Momentum and Value

Momentum investing may at times be at odds with value investing. Why is this so? Because if share price appreciation exceeds fundamental growth you will have decreasing intrinsic value ratios. If earnings double but share prices triple, your price to earnings ratio will jump 50%. On the other hand, if earnings triple but share prices double, your ratio just compressed by 33% giving you even deeper value despite a large run-up in share price. Therefore, momentum and value may at times have aligned goals, but you should check valuations first.

Momentum and Dividends

Another challenge of momentum investing is that it often only considers price appreciation and not total return which will include dividends. If you own a dividend stock that pays a 10% yield, it is unlikely that the share price will be among the top performers. Thus, momentum screening by price alone will award an extra bonus to companies not paying dividends. Some analysts have used total return momentum techniques discussed later.

Interesting Momentum Facts

Before we build a simple system using momentum and value, we need to consider a couple momentum findings. The first is that momentum often reverses direction after a few years. If you pick a strong outperforming stock today, be aware that the trend may change to the downside in a few years (or sooner depending on past performance).

The second finding that is of great concern to value investors, is that stocks which greatly under-performed the market over the past year generally continue to do so the following year. Again, this trend often reverses after two or three years – which is important if you are bottom fishing for a reversal.

Armed some basic knowledge of momentum principles, what are some approaches we can take to enhance our value investing?

Momentum Meets Value

Many analysts have successfully married these two disciplines. Note how O’Shaugnessy’s strategies have performed over the past decade when combining value metrics with price momentum with decent results.

Screenshot compliments of AAII.com

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To give you an idea of firms picked up in the Tiny Titans strategy, consider the following picks generated March 31:

  • Coffee Holding Co. (JVA) – Price to sales 0.32 and forward P/E 8.35. Prices have declined 22% since this stock was recommended.
  • Great Wolf Resorts (WOLF) – Price to sales 0.83. Price to book 1.74. Not yet profitable. Prices are up 37% in less than a month.
  • Cybex International (CYBI) – Price to sales 0.36. Trailing P/E 1.26 and forward P/E 4.67. PEG ratio 0.70. Prices up 17% since being recommended less than a month ago.
Quantitative strategists David Blitz and Pim Van Vliet likewise used a simple two step approach by investing in asset classes with strong earning yields and high momentum. Between 1986 and 2007 this approach outperformed by 11.9% annually (or 9% annually when comparing deep value/high momentum to low value/ low momentum).

In addition to this, Mebane T. Faber used a momentum-like approach that incorporated dividends in the paper Relative Strength Strategies for Investing which resulted in outperforming a buy and hold strategy by up to 6% annually between the years 1973 and 2009. Unfortunately their techniques did not include value metrics and they did not separate high-yielding dividend stocks to compare these vs. non-dividend paying firms.

My personal research has met with mixed results when combining value and momentum. In some instances it helps, at other times it hurts performance. There is, however, one specific strategy that has some value metrics that really moves when adding a momentum strategy.

Where Momentum Really Flies

Momentum really finds its wings when targeting smaller firms that have a strong comprehensive ranking in value, growth and earnings quality. Consider the Under $15 Small-Caps model that I created for Portfolio Café.

Over the trailing 10 years with monthly rebalancing, the Under $15 Small-Caps model has generated 12.87% annual returns. I then add in basic momentum filters that exclude any underperforming stock over the past year, six months or quarter. The result? The annual returns almost triple with this one small adjustment with a compound annual return of 34%. Of course at Portfolio Café we also add in a market timing component which boosts that return by half as much again.

Diagram below compliments of Portfolio123.com

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The lesson learned? While momentum is a real phenomenon that can profitably be used in certain strategies, you cannot take a ‘once size fits all’ approach when investing. While one technique might generate excess returns when used in isolation, we must weigh the underlying investment principle carefully before making an "all-star" strategy crammed full of our best ideas. Value investing can be combined with momentum investing for additional gain, but you better know what you are doing – otherwise you might kill the goose laying the golden eggs.

About the author:

KHemmerling
Quantitative investor seeking consistenty returns through sophisticated systematic investing techniques.

Visit KHemmerling's Website


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