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The value of a momentum approach to investing

Like warring political factions, value and momentum investors rarely mingle and can be scornful of each other’s methods

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After a struggle full of rancour and bitterness, the battle for the White House ended last week in a surprising win for the Republicans. While investing tends to be a more sedate endeavour, the stakes are high and it has its own set of opposing camps.

A great chasm exists between value investors and momentum investors. The former like to hide behind huge corporate walls and deep moats while the latter take direction from the mob and go along for the ride. As a result, they inhabit very different corners of the market.

Like warring political factions, value and momentum investors rarely mingle and can be scornful of each other's methods. But the argument for considering both is made by money managers Wesley R. Gray and Jack R. Vogel in their new book Quantitative Momentum.

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They argue that value and momentum investors rely on similar behavioural factors that operate on different time scales. That is, investors become too pessimistic about the prospects for value stocks that trade at low prices compared with their fundamentals. Similarly, they are too pessimistic when it comes to the outlook for momentum stocks that have climbed dramatically over the past year.

They point out that both value investors and momentum investors can benefit by taking a page from each other's playbook. A portfolio that contains both value stocks and momentum stocks tends to perform well and is less volatile. Mixed portfolios also suffer from fewer periods of poor performance compared to the market than either pure value or pure momentum portfolios.

Messrs. Gray and Vogel have written a fascinating primer on momentum for numerate practitioners. They highlight their arguments with graphs and tables while exploring different momentum variants. They also examine some of the practical difficulties that investors face when putting momentum portfolios together.

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The heart of the work revolves around the 12-2 measure of momentum, which is popular in academic circles. It means they measure a stock's return over the previous year while ignoring its return over the past month.

A stock's performance in the most recent month is discarded because stocks with strong one-month gains tend to underperform the market over the next month. However, stocks with strong 12-2 gains tend to continue to do well over the next several months. To make matters more complicated, the tendency flips again when returns over the past several years are examined with strong long-term performers going on to post weak results.

They report that a portfolio containing the 10 per cent of mid-cap to large-cap U.S. stocks with the top 12-2 returns, rebalanced quarterly, gained an average of 5.6 percentage points more than the S&P 500 annually from 1927 through 2014, not including fees.

Messrs. Gray and Vogel also tweak the simple 12-2 model in several ways. For instance, they impose a "quality momentum" filter, which favours stocks that have climbed in a relatively smooth fashion while punishing those that jumped suddenly. They also pay attention to seasonality and rebalance quarterly in the month prior to the end of each calendar quarter.

Currently, a large number of Canadian resource stocks pass the simple 12-2 momentum test due to strong rebounds from lows set near the start of the year. For instance, Teck Resources fits the bill. It jumped 481 per cent since I eyed it last year when it was a long-term reversal candidate. (As an aside, the list of stocks mentioned last December gained an average of 103 per cent over the subsequent 11 months, not including dividends.) Just keep in mind, the 12-2 momentum effect usually lasts for only a few months.

While momentum might sound deceptively easy, it can be psychologically difficult for frugal bargain hunters to buy stocks simply because they've gone up dramatically over the past year. But, even if you don't want to adopt momentum, it is good to understand the views of other market participants. The world would be a wiser place if more people took a similar approach to politics.

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Norman Rothery is the value investor for Strategy Lab. Globe Unlimited subscribers can read more in the series at tgam.ca/strategy-lab.

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About the Author

Norman Rothery, Ph.D., CFA, is the founder of StingyInvestor.com and has been catering to value investors since 1995. He publishes the Rothery Report, a value stock newsletter. Norm obtained a Ph.D. in atomic physics from York University before following his passion for investing. More

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