Amplifying Momentum’s Alpha Potential

Amplifying Momentum’s Alpha Potential

By Justin Carbonneau (@jjcarbonneau) —

Momentum investing can sometimes be looked at as a more speculative type of investing since it involves buying stocks that have gone up the most, and a pure momentum approach has no regard for fundamentals. However, our data as well as the research of others, has shown that by combining momentum with other value, quality, growth and investment factors, you can potentially amplify the alpha found in momentum as the fundamental backdrop helps support the price strength.

Momentum investing involves buying stocks that are exhibiting price strength. Over the last year, we seen plenty of shifts in the stocks that are exhibiting strong momentum. Pre-covid much of the price strength was in large cap growth and technology, but starting in late spring and early summer the tide changed, and small caps, value and economically sensitive stocks, as well as energy names, started to show relative price strength, while more recently strength has shifted back to large cap tech. For many investors, getting exposure to the stocks that are performing well is paramount, but buying just based on price strength alone doesn’t seem like a fundamentally sound investment strategy for those who analyze and value company financials, stocks valuations and other important metrics.

Momentum + Fundamentals a Good One-Two Combo

What I thought I would do in this article is outline a few of strategies we follow here at Validea that combine momentum and fundamentals. This is a powerful one-two combination that investors can utilize in their investing process. As of this writing, the strategies that incorporate momentum are some of the very best performing models historically on our web site, so it’s worth taking note of how momentum is utilized in each of these.

Since 2003, one of the best performing models we track is our Small-Cap Growth Investor model based on the strategy outlined in The Motley Fool Investment Guide. This is one of the most comprehensive strategies on Validea with over 15 unique criteria, including a momentum variable. Specifically, the model wants to see companies that have a relative strength of 90 or higher. One of the interesting observations with this model is it’s been one of the more consistent outperformers out of the initial set of strategies we started tracking in 2003, and while its not certain what the exact reason for that is, my hunch is the momentum part of the strategy has helped the model find areas of the market that are strong and avoid those stocks with relative underperformance.

Another one of our top performing strategies is the Twin Momentum model, which is based on the academic paper, Twin Momentum: Fundamental Trends Matter. This strategy tends to make sense intuitively to investors since its looks at the trend (improvement) in fundamentals and price performance. There are two components to the model. First, fundamental momentum is determined using a combination of seven variables: earnings, return on equity, return on assets, accrual operating profitability to equity, cash operating profitability to assets, gross profit to assets and net payout ratio. Second, price momentum is determined using the most recent twelve-month period, excluding the latest month. Stocks then get a combined rank and those in the first or second percentile are candidates for the portfolio we track.

In the first edition of Jim O’Shaughnessy’s book, What Works on Wall Street, he found that in small-cap investing using momentum as one of the selection criteria helped produce the best long-term returns. Specifically, his Cornerstone Growth Model, which makes up 50% of the Growth/Value model we run on Validea based on O’Shaughnessy’s research, looks at a few simple criteria. First, it wants to see persistent earnings growth over the past five years and a reasonable price-to-sales ratio. If a company meets the first two criteria, it is then ranked on Relative Strength, which is a measure of performance over the past year. Those in the top 50 get the highest ranking from this model.

There are other models on Validea that utilize momentum as well. They include strategies we base on writings of Meb Faber and his Shareholder Yield approach, Patrick O’Shaughnessy’s research he outlined and we extracted and modeled from his book Millennial Money and a model that combines low volatility, or conservative stock selection with momentum developed by Pim van Vliet, a European Money Manager in his book High Returns From Low Risk.

There are different ways to look for momentum as the various models show, but ultimately these models are rewarding strong price performance, and perhaps more importantly avoiding those stocks that aren’t performing well.

Momentum’s Bottomline

This is not to say using momentum doesn’t come with risks. Momentum stocks can be susceptible to momentum crashes. Furthermore, markets where there are large turns in leadership can sometimes be problematic for momentum, as stocks are jockeying for a leadership role. But the models on Validea that use momentum as one of the factors and also look at fundamentals have been solid performers. Investors utilizing these approaches can be ensured that the stocks they are buying meet other fundamental tests of soundness, which can go a long way in giving an investor the confidence they need to believe and stick with a strategy over time.

Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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