I am perpetually mystified by the pervasive insistence by investment professionals that ‘value’ dominates ‘momentum’. This debate really comes down to the age-old question of whether any one person (or team of analysts) can consistently identify ‘cheap’ companies which the market, in its collective wisdom, has neglected. More broadly, this debate is about whether any one expert, or team of experts, can consistently forecast the future better than ‘the crowd’ can through its collective actions. This is a key plank of adherents to Behavioural Economcs; lots more on this subject here, here and here.
- Active investing works: I present 2 different screens which add significant value over time relative to buy and hold.
- Investors are biased to systematically overemphasize the importance of a ‘value’ approach while under-emphasizing the power price momentum.
- Outstanding investment results have been achieved by combining two very different, but independently effective approaches.
“Due to its significant overall outperformance, we believe utilizing a trust-worthy valuation metric is of utmost importance in stock screening.”
What makes this claim outrageous is that the article then goes on to present two tables, which I have attached below for discussion:
Source: The Applied Finance Group
Source: The Applied Finance Group
Please attend to the numbers in the top red boxes in both tables. Table 1. shows the relative performance of stocks which screen in the top half (TH) of AFG’s valuation metrics (i.e. cheap stocks) versus stocks which screen in the bottom half (BH). Note that high ranking value stocks (TH) outperform low ranking stocks (BH) by 7.9% per year from 2001 through 2009, using AFG’s proprietary ranking methodology. Note also that this screen did a pretty good job on a ‘per trade’ basis: in terms of ‘Batting Average”, 67% of TH stocks outperformed, and 68% of their BH stocks underperformed in each selection period. This is pretty good stuff!
Now look at the top red box in Table 2., which shows the relative performance of stocks which screen in the top half (TH) of all stocks according to a simple momentum screen versus stocks that screen in the bottom half. You can see that high ranking momentum stocks (TH) outperformed low ranking stocks by 11.1% per year from 2001 through 2009. The batting average is also fantastic, with 80% of top ranked stocks outperforming and 79% of low ranked stocks underperforming in each selection period.
What gives? The authors assert that, “…long-term valuation is the main driver of stock performance”. However we can plainly see that, with 18 years of data on almost 7000 global stocks, momentum substantially dominates value as a selection criteria, with 11% returns versus 8% respectively.
This is not uncommon. The dominant investment theories of our time are Modern Portfolio Theory and the Capital Asset Pricing Model. These models rely on a value-based framework to identify securities for investment, and to allocate efficiently among those securities. Substantially all of the capital that is invested by major institutions worldwide is allocated by according to these theories. Unfortunately, these theories assume that momentum effects can not exist, despite hundreds of years of evidence to the contrary. Fortunately, this leaves those of us who follow momentum-based strategies with a dramatic advantage. We largely ignore the basic tenets of CAPM, while we use MPT for efficient capital allocation, but with greatly modified parameters.
I promised to show you how two independently effective, but very different, approaches to investing can combine to deliver outstanding investment results. Courtesy of The Applied Finance Group, Table 3 shows the performance of stocks that have met both criteria: TH of value screen AND TH of momentum screen. By buying the TH of this combination screen and selling short the BH, and investor would have realized 20% returns from 1991 through 2009.
Now that is really powerful stuff.
Source: The Applied Finance Group