The popular adage when it comes to investing is “buy low and sell high”. Another way many investors approach their portfolios is to “sell the winners and buy the losers”, recycling capital from winning stock bets to average in on stocks that have not been successful. Whilst this sounds like a good strategy, in practice, and especially in Australian equities, doing the opposite has been a winning strategy – buying winners and selling losers has historically generated strong excess returns for investors in the Australian stock market. This is the basis of momentum investing.
For example, comparing a portfolio of high momentum stocks and a portfolio of high value stocks in Australia shows that the return to high momentum stocks is strong, and has historically outperformed the return from a portfolio of value stocks.
Source: Russell Investments, UBS
Russell Investments has strategic beliefs about a number of factors in equity markets and how we expect them to perform through time. Our belief on the momentum factor is that high momentum stocks will outperform low momentum stocks over a market cycle. Momentum stocks are typically defined by relatively strong price performance over the past 12 months, or relatively strong recent earnings. Stocks in the Australian market that are currently “high momentum” include Aristocrat Leisure, Boral, and Qantas. One way to explain the existence of the momentum premium through time is behavioural, in that investors tend to show herding behaviour and have a “fear of missing out” on stocks that have been appreciating in value.
Due to our belief in the momentum premium, our equity funds are generally exposed to an allocation of high momentum stocks through a market cycle in order to harvest this expected excess return stream. As can be expected when buying a portfolio of stocks that have performed well (and are generally expensive), momentum portfolios can be volatile and subject to “momentum crashes”. As such, it is important to dynamically manage allocations to these high momentum stocks. To do this, we look at three broad indicators. Whilst valuation is a key decision-making input for any investment decision, it is also important to consider where we are in the economic cycle as well as gauge market sentiment.
Source: Russell Investments, UBS
In order to measure where we are in the cycle and how this affects different segments of the market, we look across three categories of indicators in earnings, economic, and policy. Overall, we see these signals as currently neutral on momentum as we do not expect material change in the outlook for earnings in the market for the next 12 months, nor do we expect substantial changes in the economic and policy environment for Australia in the near term.
We currently see the aggregate value metrics on a portfolio of high momentum stocks as modestly attractive, across a combination of asset- and earnings-based measures relative to the market, as well as relative to each individual stock’s history. Comparing valuations relative to history helps us further understand how the market has historically priced different market segments. For example, a stock or sector may be expensive on a P/E (Price Earnings ratio) basis relative to the overall market at a point in time, however relative to its historical P/E range it may be cheap.
Sentiment signals are more technical in nature, and look at how the market’s behaviour can help us make informed timing decisions of when to enter and exit (or increase and decrease) positions. Currently, we see sentiment for momentum is slightly positive. Momentum stocks have started to perform well this year after being aggressively sold off in the second half of 2016, however on a 12-month basis (which is a key timeframe for sentiment), momentum stocks are not yet showing strong metrics. One positive sentiment signal is that there is a good amount of breadth amongst the recent performance of momentum stocks.
After the market’s rotation last year which saw momentum stocks dumped and left behind in favour of value stocks, we view the current market as an attractive entry point to begin incrementally adding back exposure to high momentum across our Australian equity funds.
it's easy to find these stocks, harder to stay in them. Invariably they come up on a chart as a parabolic increasing price chart such A2M, APX, BLA, QAN, SPL. Staying with the stock is hard because the slightest dip over a few days (daily) or 1 week (weekly chart) and you think the end of the run has arrived and get out, only to find the trend resumes. At some stage the trend flattens out or reverses rapidly and the stock returns to its old momentum levels and a quick exit is needed - not an easy decision.
An excellent example of a momentum play was FIG - price appreciated from 35 cents to a high of 93 cents in less than a year on profit guidance upgrades from management. The market came to expect upgrades and even larger upgrades. In the end there was just too much profit on the table for released escrow holders to resist and the expected retracement eventuated. You sometimes can get an exit when the chart rolls over and flattens out but wise to trim on the way up.
A trap with parabolic charts is that a stock may look like it is rocketing upwards (A2M) but when you use a log chart the curve can be much smoother. Google the definition of log views. An example is (ALL) where on a log view, price has risen steadily over 5 years and a rising trend line can be drawn along higher lows all that time. If price falls below the trend line it could be an indicator to sell. Buy on pullbacks to the trend line. If you buy too far above a trend line perhaps use a tighter stop.
With regard to Davids' comment, all strong runs will include setbacks as investors like the ones you describe liquidate their positions from fear of losing their gains or in the belief that the move is over. In order to stay with a strong move it's important to be able to determine whether these setbacks are meaningful in the context of the move itself and so you need to have a way of assessing just that. This can be done through a variety of means such as measuring the stocks volatility relative to its' price or only exiting after an 'x' % fall or a new 'x' day low. There are many ways but they're all aimed at separating signals from noise. Success comes from being able to ignore the noise but acting on signals without hesitation. Simple, but not easy.