What is stock price momentum and why is it important if you want high returns

If you have read even a few of our blog posts, I am sure you have read something about stock price momentum and why it is important to include if you want great returns.

What is all this focus on momentum you may be thinking?

 

What is momentum?

Before I tell you how I stumbled onto momentum let’s start by defining momentum.

Momentum is the tendency of the share price movement to continue past performance. This means that the price development over a 6 month or 12-month period tends to continue in future.

 

How is it momentum calculated?

Momentum is easy to calculate as it is simply the share price change over a period.

For example, six-month momentum is the share price today divided by the share price six months ago (€120/€100 = 1.2). Similarly, 12-month momentum is the share price today divided by the share price 12 months ago.

 

I also did not believe in momentum, until

As a classic value investor, I did not pay any attention to momentum.

In fact, the lower the share price fell (lower momentum) the happier I became as it meant I could buy at an even lower valuation.

 

Click here to start using momentum in your portfolio Now!

 

Then it all changed

This all changed with the research report I wrote with a friend called Quantitative Value Investing in Europe: What Works for Achieving Alpha.

In the report we set out to find the best investment strategy over the 12-year period from June 1999 to June 2011.

 

Momentum in all the top places

In the report the top strategy which returned 1157% as well as the next nine best strategies, which returned an average of 850.3%, momentum formed a part of all the strategies.

 

This is what convinced me

The best performance of all the strategies with momentum convinced me to make it a big part of the way we find investment ideas.

I am sure if we did not do the study ourselves (running the analysis, analysing the numbers, and writing the report) we would not have believed it. I certainly would not have.

 

Why does it work?

Why does momentum work you may be thinking?

To tell you the truth, in spite of all the studies that found that momentum works, none of the researchers are sure as to why.

 

What researchers suspect?

What some researchers think is that it has something to do with risk premia (investors should be rewarded with higher returns if they buy more risky companies). And they see high momentum companies as higher risk.

 

More common explanations

But the most common explanations researchers mentioned has got to do with behavioural investment factors such as (click link to see the definition):

 

Not likely to disappear

Because these behavioural biases are hard wired into the human brain, they are unlikely to disappear, which may explain why momentum profits have persisted over hundreds of years of testing and will continue to persist in future.

 

Click here to start using momentum in your portfolio Now!

 

If you only look at momentum

If you only look at momentum what researchers found was that stock prices continue their most recent performance (up or down) over the short term (up to a year).

However, over the long term 3 to 5 years this trend turns around with winners (high momentum companies) underperforming and losers (low momentum companies). This is because high momentum companies with high share prices get overvalued and these companies then underperform over the long term as undervalued companies (losers) get revalued.

 

You must combine value with momentum

That is why, when selecting companies for the Quant Value newsletter (and for my own portfolio) we look at momentum as well as valuation. We want to exclude overvalued companies and only select ideas which are still undervalued but have already started increasing and still has a lot of room to do so.

 

Another reason

Another reason why we include valuation with momentum is because if you only use momentum, it can be a very volatile (large profits and losses) investment strategy. This is because of momentum reversal, also called a momentum crash. It happens when high momentum companies decline substantially in price, as happened in 2008 and 2009.

This can ruin your returns!

Another reason why we combine momentum with value it to make sure we build in a margin of safety in the investment ideas we select for the Quant Value newsletter.

This lowers the impact a momentum crash will have on returns as it avoids overvalued companies.

 

More momentum info

If you want to find out more about momentum, click on the following links:

 

Click here to start using momentum in your portfolio Now!