Transcript
Momentum investing has been a persistent and well-established phenomenon in equity markets for some time.
In this video, we’ll explore three types of momentum and show how they can be used to help optimize equity returns while limiting downside risk.
Let’s start with price momentum.
Numerous academic studies have shown that, stocks that have performed well in terms of price tend to continue doing well into the future …
while those that have underperformed will tend to continue to do so.
One way to apply this concept is through cross-sectional momentum. This looks at a stock’s performance versus its peers and can be used to help forecast its future relative performance.
In this case, we take the stocks within a defined group and track their price return over the trailing 12 months.
The top 10% of the best-performing stocks represent the winner portfolio—as a group, those stocks tend to keep performing well.
The bottom 10% of the worst-performing stocks comprise the loser portfolio--which as a group tend to continue to perform poorly.
Another concept - time-series momentum – looks at how a stock is performing relative to its own price history. This can be used to assess evolving trends or reversals in the stock price and can be measured through a moving average. When a stock moves above a defined moving average, it may signal a new sustained uptrend.
When the stock price breaks below the moving average, it may flag a new downward trend.
Now, let’s take a step back and look at why price momentum works.
The first explanation is based on investor behavior—in this case, anchoring.
Researchers have found that investors change their beliefs too slowly when new information radically alters the value of a stock. Investors tend to anchor their value assessment to past prices rather than the new information.
This can lead to a stock being bid up on a delayed basis as investors eventually incorporate the new information into the share price.
The second explanation stems from an investor’s need to be compensated for risk.
When used on its own, price momentum is punctuated by infrequent but pronounced drawdowns. This is known as crash risk and the positive excess returns associated with momentum investing are compensation for this risk.
Is there a way to capture the powerful upside of price momentum while mitigating the downside risk? We think there is, but it requires looking more closely at a company’s operations.
One important measure of operating momentum is earnings momentum, which can be tracked by measuring the degree to which a company beats earnings per share estimates.
For example, we can sort for the stocks with the strongest earnings momentum based on the positive earnings surprise.
Why is that important? Research has suggested that the use of earnings momentum could help avoid speculative bubbles and the crashes associated with using only price momentum.
Operating momentum is also evident in measurable areas of a company’s fundamental performance such as:
Sales growth and Gross margin expansion
Other measures are less immediately quantifiable, but can help provide a more complete picture of underlying changes in a company’s fundamentals, like
Addressable market size Pricing power and Competitive positioning
What happens when you combine price and operating momentum? Joining those two measures results in what we call confirmed momentum.
Operating momentum on its own can point to improving fundamentals that are not recognized in terms of price appreciation..
Price momentum on its own, without underlying fundamental strength, may not be sustainable If it is largely influenced by speculative activity.
Confirmed momentum looks at the strength and persistence of a stock price--and whether it is supported by robust, and improving, operating metrics.
This can enable managers to capture gains from higher-growth stocks when they are
moving up in price, while mitigating losses when the market is consolidating.
The selection benefit of using this integrated approach is evident by looking at two stocks. The
first, GameStop, had great price momentum…
... but was setting up for a crash because fundamentals were not similarly improving.
Nvidia, on the other hand, experienced a rise in its share price …
… while its fundamentals were improving. That’s an example of confirmed momentum.
We think the combined dimensions of price and operating momentum described here can help investment managers achieve strong performance while mitigating risk.
Of course, there's more to the momentum story. Visit LordAbbett.com, or contact your Lord Abbett representative, for additional information.