Trying to understand momentum from a value perspective

Momentum is one the concepts I really have some difficulties with. As a traditional value investor, one would basically ignore market movements and invest purely based on intrinsic value.

However if one looks at different reasearch papers, “momentum” seems to be an important indicator. For instance Tim du Toits latest research, momentum combined with value metrics created some astonishing results for the 1999-2011 period.

Also for example this article shows based on a back test that pure momentum trading strategies can produce theoretically 10 % p.a. outperformance.

Interestingly, the mentioned AQR US momentum fund isn’t really outperforming the indeces in real life. Bloomberg shows an underperformance of this momnetaum fund against all major US indices since inception in mid 2009.

Definition & application of momentum for grwoth stocks

I have been looking around a little bit, but there seem to be different definitions for “momentum”.

The more simple approaches seem to look at a trailing time period (1M, 6M, 1Y) and define momentum either as the best performance within a certain group of stocks (i.e. low P/B) or in general relative performance agains an index.

I have found this site where they give the following advice for “momentum growth stocks”:

One of the things to spot momentum stocks is the relative strength of the stock compared to the overall market over a specific timeframe. Most momentum investors seek at a stock which has outperformed at least 90% of all stocks over the past 12 months. When major indices declines, a great momentum stock exhibit strength by holding or even exceeding their highs. When the major indices rally, momentum stocks typically lead the rally and make new highs outpacing the market.

Potential momentum stocks should show in their balance sheet that they are growing at an accelerated rate.

Another factor is the Earnings per Share growth. At least a 15% year-over-year earnings per share growth is needed to qualify a momentum stock. Stocks with accelerating rates of EPS growth over previous quarters are also considered.

In addition, a positive forecast by at least some analysts regarding the Company’s earnings in necessary for identifying momentum stocks. Further, momentum investors also looks at whether the reported earnings exceeded the analysts forecasts compared to the last quarter.

A company can’t grow its earnings faster than its Return on Equity, which is the Company’s net income divided by the number of shares held by investors, without raising cash by borrowing or selling more shares. Many companies raise cash by issuing stock or borrowing, but both alternatives reduce earnings-per-share growth. For momentum investors, a potential stock should show an ROE of 17% or better.

This simple strategy at the moment is quite succesfull. If we look at two typical “MoMo” stocks Chipotle and LuluLemon we can see this in action. The “fundamental requirements” are clearly in place like this table shows:

EPS Growth   ROE  
  Chipotle Lululemon Chipotle Lululemon
2007 67% 292% 14% 41%
2008 11% 30% 13% 29%
2009 61% 34% 19% 30%
2010 42% 109% 24% 39%
2011 19% 49% 23% 37%

As one could expect, analysts go wild for both stocks and as for any respectable US comapny, earnings are ALWAYS above (carefully guided) expectations and of copurse both shares are in the top 10% performers.

And both stocks are still in their “parabolic” phase:

However, as my two “MoMo” short positions, Netflix and Green Mountain showed, once “Momentum” dissapears, those stocks can loose 50-80% of their value in the matter of a few days or weeks:

“Fundamentally”, momentum is usually explained the following way:

The capital market is not really efficient, so positive and negative information does not transform directly into securitiy prices but this takes some time.

However, in my opnion, there is also a “psychological” component for momentum:

Many investors prefer to see an immeadiate positive feedback on an investment decision. Even for myself, I tend to look more closely to daily or even intraday price movements when I just have bought a stock. With a “positive” momentum stock, there is a very high probability that the stock continuos to climb and you see direct positive feedback (and feel like an investing genius),

With a declining stock, on a short time horizon it is very likely to see a loss directly after buying the stock (and feel like an idiot for not waiting longer).

As an “intrinsic value” investor one should not care about the short term direction of stock prices, but never the less it still takes a lot of conviction to buy into a falling or underperforming stock.

The big question for me would be: Can momentum add value to an investment process based on intrinsic value ?

Intuitively I would say that extremely negative momentum could be a warning sign for a “value trap”. On the other hand, I can also see the argument for stocks where after a long decline some fundamental changes are occuring.

One of the stocks I have been tracking for a long time is Sto AG. Sto in the 90ties was one of the typical construction related stocks. After the reunification, prices of construction and construction related stocks exploded. However in the mid 90ties the boom went bust and construction stocks suffered. In the 2000s, then Sto could participate in the boom for energy saving, multiplying its earnings sevral times.

I did a very crude check on Sto with regard to relative performance: I compared annual returns with the dax since 1992 ( I diddn’t get earlier numbers). The result is quite surprising:

P/E EPS Last price 12m change DAX 12m Change Delta
1992 11.9 1.51 17.985      
1993 20.7 1.47 30.523 69.7% 46.7% 23.0%
1994 13.2 2.58 33.901 11.1% -7.1% 18.1%
1995 12.8 2.51 32.098 -5.3% 7.3% -12.6%
1996 18.0 1.83 32.915 2.5% 27.8% -25.2%
1997 14.1 2.12 29.927 -9.1% 47.1% -56.2%
1998 16.8 1.11 18.618 -37.8% 17.7% -55.5%
1999 12.0 1.69 20.32 9.1% 39.1% -30.0%
2000 13.2 1.39 18.342 -9.7% -7.5% -2.2%
2001 13.1 1.17 15.285 -16.7% -19.8% 3.1%
2002 7.6 1.27 9.71 -36.5% -43.9% 7.5%
2003 15.0 0.96 14.386 48.2% 37.1% 11.1%
2004 10.3 1.46 14.97 4.1% 7.3% -3.3%
2005 8.3 2.41 20.05 33.9% 27.1% 6.9%
2006 3.9 7.35 28.591 42.6% 22.0% 20.6%
2007 6.7 7.29 48.855 70.9% 22.3% 48.6%
2008 5.3 8.05 42.794 -12.4% -40.4% 28.0%
2009 7.1 8.60 61.057 42.7% 23.8% 18.8%
2010 10.3 8.98 92.17 51.0% 16.1% 34.9%

One can clearly see that once “negative momentum” occured in 1995, four subsequent years with strong underperformance followed. Sto shareholders basically missed the whole 90ties boom.

Then again the same happened in 2006: Once Sto really started to outperform, 4 more years of outperformance followed.

Another example: KSB

When we look at the same type of crude analysis, we see a less clear picture at KSB:

P/E EPS Last price 12m change DAX 12m Change Delta
1992 10.2 19.32 196.847      
1993 40.1 5.74 230.081 16.9% 46.7% -29.8%
1994 41.8 4.59 191.734 -16.7% -7.1% -9.6%
1995 #N/A N/A -18.82 121.687 -36.5% 7.3% -43.8%
1996 #N/A N/A -5.71 123.733 1.7% 27.8% -26.1%
1997 18.2 11.35 206.562 66.9% 47.1% 19.8%
1998 9.5 17.82 169.238 -18.1% 17.7% -35.8%
1999 18.9 5.92 112 -33.8% 39.1% -72.9%
2000 14.2 5.8354 82.98 -25.9% -7.5% -18.4%
2001 15.0 5.32 80 -3.6% -19.8% 16.2%
2002 8.4 8.65 73.09 -8.6% -43.9% 35.3%
2003 19.4 7 136 86.1% 37.1% 49.0%
2004 27.1 4.67 126.5 -7.0% 7.3% -14.3%
2005 25.9 5.85 151.43 19.7% 27.1% -7.4%
2006 13.4 27.99 375 147.6% 22.0% 125.7%
2007 10.3 43.86 450.06 20.0% 22.3% -2.3%
2008 5.1 70.17 360 -20.0% -40.4% 20.4%
2009 6.7 61.32 409 13.6% 23.8% -10.2%
2010 14.0 44.09 618 51.1% 16.1% 35.0%
2011 11.0623 40.95 453 -26.7% -14.7% -12.0%

For the first 4 years, momentum would have worked but in 1997, momentum would have failed us. However in the subsequent years momentum might have worked OK, although one would have missed the big jump in 2006.

Let’s finally look at one of the “true hidden champions”, Fuchs Petrolub which I regret deeply not to have bought in the past:

P/E EPS Last price 12m change DAX 12m Change Delta
1992 23.0 0.10 2.414      
1993 27.3 0.13 3.46 43.3% 46.7% -3.4%
1994 23.3 0.17 3.848 11.2% -7.1% 18.3%
1995 34.2 0.08 2.869 -25.4% 7.3% -32.8%
1996 21.6 0.14 3.123 8.9% 27.8% -18.9%
1997 13.0 0.27 3.544 13.5% 47.1% -33.6%
1998 44.6 0.07 2.92 -17.6% 17.7% -35.3%
1999 9.2 0.22 2.03 -30.5% 39.1% -69.6%
2000 8.4 0.234 1.964 -3.3% -7.5% 4.3%
2001 19.9 0.1089 2.162 10.1% -19.8% 29.9%
2002 7.3 0.3207 2.327 7.6% -43.9% 51.6%
2003 11.6 0.4152 4.816 107.0% 37.1% 69.9%
2004 17.4 0.4919 8.564 77.8% 7.3% 70.5%
2005 11.3 0.9394 10.57 23.4% 27.1% -3.6%
2006 13.8 1.2413 17.163 62.4% 22.0% 40.4%
2007 13.5 1.5517 20.983 22.3% 22.3% 0.0%
2008 8.7 1.4867 12.943 -38.3% -40.4% 2.1%
2009 11.9 1.70 20.217 56.2% 23.8% 32.4%
2010 13.7 2.39 32.9 62.7% 16.1% 46.7%
2011 11.7637 2.56 30.115 -8.5% -14.7% 6.2%

Again we can see here longer stretches of under- and outperformance which clearly seem to imply some kind of momentum, persisting at least for some 4-5 years in this example.

Summary: Momentum is something which is is usually not connected to intrinsic value investing but with growth investing. However, some recent studies show that momentum also seems to be a factor in “value” stocks. A crude test with three examples from my long term “circle of comeptence” shows some anecdotical evidence for momentum in stock prices of “normal” companies and even “value companies”.

So this is definitely something to include in the investment process as additional aspect.

Edit: There is acutally a new Dilbert out referring to “momentum”:

8 comments

  • + very short term momentum is inversely correlated with market-adjusted stock returns. I.e. you have short term mean reversion going on

  • hi winter,

    i have to admit that so far i stayed “clear” of O’s. But I will have to expand my knowledge to those factors as well.

    mmi

  • As you might know, the concept of relative strenght also works in the opposite way: Over 5 years, a low RS is best. Trends tend to last for five years (or some years, at least more than one year). That’s what O’S showed.
    It is even possible to combine that with high RS in the medium term (7 months as the best time frame, or one year, but not much more): A still cheap stock, which underperformed over the last 5 years, and outperformed over the last 7 months.

    Or at least: Keep your hands off from the best performers over the last five years – because they will be underperformers in the future.

  • I think the people involved with all the history (SPAC Germany1) are the most inglorious (rat) pack you can find in germany.

    The value at the launch of the spac was 10€. Agreeing on a takeover value of more or less half that inital value 3 years after launch reflects badly the reputation the whole situation.

  • I love your blog and just wanted to point out an interesting situation that I think would be up your alley (in case you missed it). The buyout of 3w power (3W9.GR) by private equity firm nordic capital was blocked by bafin – very unusual but I think at this price it is in value territory (at least worth a look). it is likely to overshoot to the downside because it was generally illiquid and many merger arbitrage players are forced sellers. Thanks again for the work you do!

    • hi nyhedge,

      thank you for the comment. I had a quick look at 3W Power, but I would not touch the stock.

      Mostly because there is no real track record for the company and because of the people involved. I would rather look at the bond if it goes below 50%.

      MMI

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