Over the weekend, in addition to reviewing all the 13F filings, I spent some time testing a new idea of mine. Recently, I spoke with Gary Antonacci about his research on dual momentum. Last week, I saw Antonacci, along with Wesley Gray of Alpha Architect, talk about the value and momentum anomalies and one of the ideas presented was that if you carefully controlled costs and worked only with the cheapest or highest momentum stocks, more frequent rebalancing should produce higher returns.
While I have found that to be the case in studies I have done, it is the cost control that can be tricky. I decided to try and wrap some concepts together and see if I could produce a model that trades less frequently and still produces higher returns.
I know value works and I am aware that momentum also works pretty well. Therefore, I decided to blend the concepts together using Antonacci's dual momentum theory with a minor twist and applied it to my recent screen of Benjamin Graham's "P/E below 7" he talked about in a 1976 Journal of Finance article.
To pass the screen, a stock had to have a price-to-earnings ratio of less than 7, positive price performance over the past 12 months and be outperforming the market. It worked pretty well, but you still needed to rebalance fairly frequently to obtain the maximum results. There was a wide performance gap between rebalancing monthly, quarterly and annually.
However, when I changed the fundamental factor to price-to-book value, some magic started to happen. Using the dual momentum factors and price-to-book with a one-year holding period beats the market pretty solidly over one-, three-, five-, 10- and 15-year timeframes. I ran a rolling back test over all one-year holding periods for the past 15 years and the returns remained consistently high.
There was positive bear market performance in the rolling back test and the only extended periods it lagged were if you started your dual momentum and value portfolio any week in the first eight months of 2008. When that disastrous little period was over, the model goes right back to a long string of outperformance.
One reason for the outperformance is that this model portfolio sidesteps disaster. The portfolio owned no tech names in 2000, no banks in 2007 and no energy in 2014 and 2015. Because the performance has to be positive over the past year, it does not get caught owning stocks that have simply gone down less than the market.
The dual momentum and value portfolio also has the gentle timing effect of other value portfolios. There are a lot more stocks to buy when markets have gone down a bit then when prices rise. Right now, there are about 80% as many stocks as the average over the past 15 years and about one-third the amount during the bear market buying opportunity periods. It is worth noting that there are currently no energy stocks in this model portfolio.
Of course I cannot go more than an hour or two without talking about community bank stocks. Most of the time this model loves banks, especially the community banks. In normal times, it owns a lot of community banks but when there are little to no small bank stocks it is time to step aside. When that happens, most banks are trading over book value and activists and bank stock specialists are starting to cash in. These stocks will lose relative strength and we are likely to be on the verge of some type of extended market decline or economically weak period. Currently, the portfolio is a little more than 50% in community banks.
When I lowered the price-to-book thresholds of 80% and 90%, performance actually deteriorated a bit. You need to own those stocks that were starting to move up from lower valuations to get the most performance, so those that were currently at 95% of book and heading to 150% or 200% of book were a huge part of the model's success.
Adding other fundamental factors also hurt performance. It seems that momentum in conjunction with value adds its own brand of margin of safety. For a cheap stock to be beating the market and have positive returns over the past year odds are that institutions and hedge funds have carefully vetted the shares and are applying what Louis Navellier calls "buying pressure."
There are some very challenging and thought-provoking conclusions and ideas drawn from my little study. Next, we will look at some of the stocks that currently qualify for a dual momentum and value portfolio.