2014 has been a kick to the teeth for investors in momentum stocks. The popular names of last year, such as social media darlings Facebook (FB) and LinkedIn (LNKD) and new technology stocks like Netflix(NFLX) and Tesla Motors (TSLA) are all down 15%-30% from their March highs. And Twitter (TWTR), the biggest IPO story of last year, is down by more than half from its December highs. And all of this in a year where the market is slightly positive.
A word of advice here: Don’t throw out the baby with the bathwater. As a strategy, momentum investing—which can be loosely defined as buying stocks that have performed particularly well over the past 6-12 months—has proven its mettle over time. As with value investing, research has shown that a strategy of screening stocks based on simple momentum criteria can, in fact, outperform the broader market (The Economist wrote a good summary piece a few years ago).
But let me stop you before you run out and attempt to buy Twitter on a dip. While momentum investing works, its performance is still directly tied to the price you pay. And at 23 times sales (and massive shareholder dilution via stock-based compensation to boot) Twitter is still a ridiculously expensive stock.
Patrick O’Shaughnessy of O’Shaughnessy Asset Management wrote an excellent piece in which he found that, since 1963, a strategy that buys the top group (best 10% of the market) of stocks by 6-month total return, has delivered a 14.4% annual return, roughly 4.5% better than the S&P 500. But the outperformance gets a lot less impressive when the stocks in question are expensive based on simple metrics like the price earnings ratio.
Take a look at the following table, taken from O’Shaughnessy’s article.
The bottom row of the table represents the top 20% of all stocks by momentum. The returns get gradually better as you move down the value scale. In other words, momentum stocks that are cheap based on P/E ratio outperform momentum stocks that are expensive. And it’s not by a small margin. The cheapest high-momentum stocks returned 18.5% per year, whereas the most expensive high-momentum stocks returns 11.6%.
What should we take away from this? Value investing works. Momentum investing works. And combining value and momentum works best of all.
