Choose Value and Momentum

 | Apr 04, 2014 | 2:00 PM EDT  | Comments
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Stock quotes in this article:

tsla

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gmcr

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ua

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luv

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glw

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stz

Here is a simple truth: The money in the stock market is made out on the edges. Momentum strategies do work, as do deep-value strategies. Everything else in the middle tends to become a quasi-index strategy that usually underperforms once you subtract fees, slippage and other fractional and frictional costs. The only exception to this that I can find is buying high quality companies with high capital returns in a full-blown crash and holding them for several years.

But everyone thinks that the momentum stocks are the really popular ones that get all the headlines. When I run a simple momentum screen for stocks that outperformed over the last year and led the way in the last quarter, I find that not too many of the headliners make the grade. Of the larger companies exhibiting strong momentum in the current market, only Tesla (TSLA), Green Mountain Coffee Roasters (GMCR) and Under Armor (UA) make the top 50 list. The top of the list is full of companies such as Southwest Airlines (LUV), Corning (GLW) and Constellation Brands (STZ). Those are hardly the high-tech whiz kids most people are buying and trading.

The question of holding period is another way that most would-be momentum investors make huge mistakes. A paper produced at Duke University entitled, "Use of Momentum in trading across Industry Sectors" found that the shorter holding periods of momentum stocks suffered from short-term reversion and high transaction costs. The longer holding period of three to 12 months worked best, with six months being optimal. Most of the momentum traders I have met are trading for two and three week returns and use stops that are guaranteed to cause excess slippage and commissions. A rebalance every six months of a momentum portfolio would seem to offer a much better opportunity to earn the returns associated with this approach.

Holding periods over a year long bring you into the land of value investing. Anyone buying a deep-value stock expecting to earn a high return in 12 months or less is making the same mistake a momentum investor who expect a two-week return makes. It simply is not going to work that way most of the time. Once in a great while you get a quick return because of a sudden earnings improvement or resource conversion event, but that is far from normal. Most of the money I made in the stock market last year came from stocks that I purchased in 2011 or earlier.

Instead of tracking moving averages and looking for breakouts, most investors would see better returns by spitting their portfolio between value and momentum and rebalancing every couple of years. If you are a value guy like me, then manage this part of the portfolio yourself and hire a great momentum manager to run that part of the portfolio. If you are a bit more action oriented, then manage the momentum side yourself and hire a great value manager for that portion of your portfolio. When there is a 2008 type event and blue-chips are trading at irrational multiples of earnings and asset, take half out of each and buy a bunch of high quality stocks to hold until we see the next bubble of optimism.

At times, I outperform my momentum investor friends but in strong markets, they tend to blow me away. Over the long run, however, the numbers end up looking pretty similar -- they are both well above the market rate of return. We ignore the middle and focus our efforts on the edges of the market and it works very well. Interestingly, the only time we will have portfolio overlap is during a severe correction because that's when the high quality stocks become cheap and tend to show momentum relative to a declining market.

It is all well and good to be dogmatic and pick sides in the stock market debate. It is even better to be open-minded and increase your overall rate of return.

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