As I have stepped up my research efforts the past few years, I have included a lot of work on momentum. Although private equity-style, deep value investing and community banks are my preferred investment areas, when putting together a Grand Unified Theory of Investing -- such as I am attempting this week -- it is necessary to consider other avenues and approaches. All the academic research I have read and the hunt and peck number crunching I have conducted make it very clear that momentum investing does work. Although value outperforms in the long run, in the short term it is momentum that outperforms.
More importantly, it is not correlated with value strategies and, especially in the second half of a bull market when value is matching or lagging market returns, momentum tends to be outperforming by a wide margin. The trade-off is that in the early stage of a bad market, momentum is simply horrid. Combining the two approaches has been shown to raise returns and lower volatility because of this lack of correlation.
When developing a momentum strategy for the Grand Unified Theory, I relied on a great deal of idea piracy. I stole from Louis Navellier, Richard Driehaus, Gary Antonacci and Cliff Asness to come up with an approach to momentum investing that works and does not require an investor to watch every tick and trade during the day. At the end of the day, I do believe that fundamentals drive the price, so I added earnings momentum to the price momentum criteria to select my stocks.
The system is simple. We look for stocks that have 25% or more earnings growth over the trailing 12 month. Then we filter the list down to those have dual momentum and are outperforming the market over the past year and exceeding the market's rate of return by 20% over the past three months. Now we buy those 25 stocks that have the highest earnings growth in the most recent quarter. The portfolio is rebalanced monthly, so it is best to use a low-cost broker. A tax-deferred account works better than a taxable one for this strategy.
It does not produce the portfolio you might think. The classic market darlings like Action Alerts PLUS charity portfolio holding Facebook (FB), Growth Seeker portfolio name Amazon.com (AMZN) and Netflix (NFLX) occasionally pop up in the screen, but not all that often. As we started 2015, the highest ranked stock included companies like Macquarie Infrastructure (MIC), G-III Apparel Group (GIII), Springleaf Holdings (LEAF), Healthcare Trust of America (HTA) and Sun Communities (SUI). These are not exactly what most investors think of as momentum names, but as the year started they were right in the sweet spot, with strong earnings growth and price momentum.
If you started a momentum portfolio today, one of the names would be what you might expect if you spent a lot of time watching the financial news networks. One of the top ranked stocks today would be Primo Water (PRMW). Primo sells home water dispensers and water. They are available at retail locations like Wal-Mart (WMT), Lowes (LOW), Target (TGT) and at several grocery chains. I had never heard of this company, as in my world water serves as the base ingredient for coffee and iced tea and I think tap water works just fine. However, when I went to the Primo web site, it is the #1 water dispenser in the U.S. and there are no fewer than 10 retail locations selling the product within 10 miles of my house. Earnings were up 107% last quarter, driving the stock to the top of my momentum list. It is worth noting that institutions own less than 50% of the company, so if it starts attracting attention from Wall Street, the recent strength could be accelerated.
The largest company on the list is Reynolds American (RAI). While in today's world we tend not to think of tobacco companies as growth stocks, the acquisition of Lorillard is paying off for Reynolds. It also just sold the rights to the Natural American Spirit cigarette brand to Japan Tobacco for about $5 billion that helps strengthen the balance sheet. It has a strong presence on the fast growing market for e-cigarettes and vaping systems, which should help it keep growing in the future. The company reported a more than 200% earnings pop last quarter, and the stock has been moving higher in a tough market this year.
If you are going to have a Grand Unified Theory of Investing, you have to include momentum investing. However, you can design a momentum strategy that is not the same thing that everyone else is doing, and gain stronger results by combining both price and earnings momentum.