Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.
Humans are quirky things. If you sit one down in front of a black box that spits out random numbers, they'll likely see a pattern in them that doesn't really exist.
Our propensity to spot patterns in almost anything is one reason why I give short shrift to technical analysis. But the surprising universality and persistence of momentum investing is winning me over.
Money manager Clifford S. Asness, et al., reviews evidence for the phenomenon in a recent paper called Fact, Fiction and Momentum Investing. The paper is largely devoted to shooting down 10 myths about investing in stocks that have performed very well, or very poorly, compared to their peers.
Mr. Asness points to the existence of momentum as a well-established empirical fact. For instance, it has been found in 212 years of U.S. equity data and dates back to the Victorian age in the United Kingdom. It's also present in 40 other countries and in more than a dozen other asset classes. As a result, it likely represents an intrinsic feature of the markets.
The main measure of momentum that Mr. Asness focuses on in the paper is a stock's return over the past 12-month period, skipping the most recent month's return. Stocks that have gone up the most are said to have positive momentum and, on average, have a history of outperforming in the near future. Those with the worst returns have negative momentum and often continue to slip.
When managing money, Mr. Asness likes to combine both value and momentum attributes. While it's a common approach for quantitative investors, it's more unusual for old-fashioned stock pickers who tend to identify with one tribe or the other. The friction arises because, at the core, they represent very different investment philosophies.
The clash is obvious when both methods are at their purest.
Frugal value investors love bargains and gravitate to stocks trading at low prices compared to various measures of financial merit. They often scour the list of stocks hitting new lows for interesting situations. But stocks that have fallen the most also attract momentum investors, who like to short sell them in the expectation that they'll continue to decline.
At the other end of the spectrum, hot stocks are beloved by the momentum crowd. But many climb so high that they detach themselves from any sense of financial reality. Value investors look to such stocks as good short-sale candidates and hope to profit when they come back to earth.
Problem is, both sides have empirical evidence to back them up. Stocks that have underperformed over the last year have a tendency to continue to fall, which Mr. Asness highlights in his paper. On the other hand, stocks with sky-high multiples of earnings or book value similarly perform poorly most of the time.
But instead of clashing, a combination of the two approaches seems to work well over the long term.
For value investors, that might mean giving up on stocks hitting new lows and instead looking for cheap stocks that are already on the upswing. However, the idea of buying a stock that has already climbed significantly may seem preposterous to diehard bargain hunters.
Similarly, momentum investors may have to give up on the story stocks of the day that trade at outrageous multiples. However, the idea of passing over the Facebooks of the world might be too hard the bear.
In both cases, stock pickers have to confront instincts that have often taken years to develop and opt instead for techniques that are often scorned by their peers. It can be a bitter pill to swallow.
But even if you're not ready to take a walk on the momentum side, Mr. Asness's paper is still worth consideration.
Norman Rothery