Valuing Momentum: A Fundamentalist Coming To Terms With Momentum - Part 1
Alpha Theory clients have been asking how can momentum be incorporated into Alpha Theory’s model. In this article, Cameron Hight dives into the data and determines if this is a good idea.
“When events change, I change my mind. What do you do?”
– Paul Samuelson, Nobel Laureate Economist
Alpha Theory clients are value investors. Value investors, in general, like to keep things simple. They like to buy quality, underpriced securities and sell the opposite. The idea of momentum as a positive factor is an anathema to value investor thinking.
I’m a value investor. I originally wanted to keep Alpha Theory pure of subjective influences like “conviction level” but changed my mind after reading “Zen and the Art of Motorcycle Maintenance” and “The Checklist Manifesto”. Now we have checklists which combine subjective and objective elements into a Confidence Score that impacts position size. It’s a major improvement to Alpha Theory.
Momentum is the next step in Alpha Theory’s evolution. After being asked enough times by clients to investigate how we could incorporate momentum into Alpha Theory’s model, I started doing due diligence to determine if this was a good thing to add. It is.
We first analyzed historical Alpha Theory client data. We analyzed the performance of positions after they went down by 10%, 20%, 30%, etc.
Returns were negative no matter how we cut it after a stock had taken at least a 10% loss. A position that underperforms the market by 10% loses another 3% to the market over the next 3 months and over 7% over the next 3 years. A stock that goes down 50% more than the market underperforms the market by 5% over the next 3 months and over 17% over the next 3 years! I didn’t believe the data. So, we ran it against stocks in our clients’ portfolios that went up 10%, 20%, 30%, etc.
The same phenomenon appears in the opposite direction. Our clients would have been better off selling losers and adding to winners. That’s contrary to Alpha Theory’s model which is mean-reverting and has created positive alpha over time for clients trading around positions. Something didn’t foot.
Looking into the data, the mean-reverting trading suggested by Alpha Theory was positive because stocks didn’t travel in straight paths. As they oscillated, positive alpha was created. In addition, clients reassess their valuation work after a stock goes up or down, which would allow the position to adjust with new information.
After examining our internal data, I searched for external research to confirm or refute our findings. Momentum is a well-researched phenomenon and the conclusions largely support the case that it is a positive, sustainable factor in stock returns (there is also research showing momentum’s positive influence for other asset classes as well).
In our next post, we’ll discuss Cliff Asness’ paper on momentum and what it means for Alpha Theory and value investing.