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Momentum investing: Use the Force, Luke

A lot of academic research suggests a momentum investing strategy outperforms the market. John Harrington attempts to concoct a lazy person's momentum investing system.

Star Wars troopers
Taking the hard work out of stock-picking ... use the Force

Regular readers of the Stockpot column might recall the late, unlamented “Bombed Out but Bouncing Back” (BOBB) portfolio that was based on momentum investing.

The virtual portfolio’s disastrous performance offered me plenty of opportunities to be more than a bit sniffy about the concept of momentum investing – buying shares that have gone up a lot in price (relative to their peers) in the hope they will continue to outperform – but there is plenty of academic research to suggest that the strategy has merit.

The system is also fairly easy to implement and does not require any of that hard grind value investors go through, poring over the profit & loss accounts of companies trying to work out which ones are undervalued.

All an investor has to do is pick a universe of stocks – say, companies with a market capitalisation of more than £1bn – and a time-period over which to determine the best performers – say, six months or a year – and then pick a cut-off point to determine how many shares to buy.

Having whittled the list down to five or ten stocks or whatever, the investor then invests an equal amount in each and then repeats the process at regular intervals – say, every two or three months – to rebalance the portfolio.

For some, the concept of backing winners makes a lot of sense; it’s certainly a well-followed idea in sports betting, although obviously the circumstances are slightly different, as bookmakers can adjust the odds in their favour to such an extent that backing Manchester City to beat, say, lowly Wigan Athletic, is barely worth the risk.

For others, the whole idea of backing a stock that has already shot up (say) 40% in the last three months provokes the agony of wondering whether they have missed the boat.

Apparently, in many cases, the “missed the boat” fear is a losing mentality (says the man who decided he had missed the boat when Google’s share price doubled in its first year as a floated company to US$100; it now trades at US$1,160, or thereabouts).

Hit or myth?

According to a paper published in May 2014 by Clifford Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz, US equity data spanning more than 200 years supports the idea that a momentum-based investment strategy is, more often than not, a successful one.

“Some of this evidence predates academic research in financial economics, suggesting that the momentum premium has been a part of markets since their very existence, well before researchers studied them as a science,” the authors wrote.

“However, as momentum strategies have grown in popularity, so have myths around them. Some of the most common myths are that momentum is too “small and sporadic” a factor, works mostly on the short-side, works well only among small stocks and doesn’t survive trading costs. Furthermore, some argue that momentum is best used as a ‘screen’, not as a regular factor in an investment process. Others will go so far as to say that momentum investing is like a game of ‘hot potato’, implying that it isn’t a serious investment strategy, with no theory or reasonable explanation to back it up,” they wrote.

The fact that the authors referred to these as myths tells you which side of the momentum argument they are on.

If you are truly interested in their myth-busting treatise on momentum investing, it is available on the internet.

In our ill-fated experiment with the BOBB portfolio, we possibly tried to get a bit too cute (or greedy) by restricting our universe to “bombed out” stocks that had fallen 33% or more over the last year but which had been on a rising trend over more recent time periods (five days, 10 days, one month).

If we had adhered to a recognised momentum investing strategy, we’d actually have been shorting those stocks that had lost 33% or more over the last year, irrespective of the recent trend.

Back the winners until they stop winning

As it is relatively simple to do – or it will be the way we do it - it is, perhaps, time to give the old “momentum investing” strategy a proper try. To make it a bit more interesting I am going to draw on three separate groups of stocks, and see which ones do the best.

The three groups are:

  • Stocks with a market capitalisation of less than £100mln – the tiddlers
  • Stocks with a market capitalisation of between £100mln and £1bn – the middlers
  • Stocks with a market cap of more than £1bn – the … er … biglers.

Now comes the tricky part: setting the “whittling down” parameters and deciding how often to rebalance the portfolio.

Following the “keep it simple, stupid” (KISS) principle and avoiding getting involved in the reading of tea leaves, throwing of knuckle-bones, groping through sheep’s entrails and the deciphering of runes that is technical analysis, I have decided simply to pick ten stocks from each universe that have risen the most over the last year, invest an equal amount in each and then rebalance the portfolio every two months (i.e. run the screen again, dumping those that fall out of the top ten and reinvesting the proceeds in the new entrants).

Two of the drawbacks – or “myths”, if you prefer – of rebalancing a portfolio every two months are the dealing costs and the bid/offer spread (the difference in price at which you sell and buy), so in this virtual portfolio I will be factoring in the bid/offer spread and an assumed £15 in dealing costs.

I’ll not be factoring in stamp duty because, as a former colleague of mine used to observe, “life’s too long” and I don't want to get to the end of it and realise I have spent 73 hours calculating stamp duty on an entirely fictitious portfolio.

So, we’re under starter’s orders … and we’re off!

The Tiddlers

Company

Ticker

% change (1 yr)

Relative Strength Index (66 periods)

50-day moving average

Offer price

Zoo Digital

LON:ZOO

740%

63.2

69.78p

89p

Rockrose Energy

LON:RRE

700%

89.9

196.42p

364p

N4 Pharma

LON:N4P

390%

57.5

21.97p

25p

Spectra Systems

LON:SPSC

340%

87.5

97.95p

120p

Elektron

LON:EKT

310%

74.6

22.63p

29.6p

Biome Technologies

LON:BIOM

290%

63.4

294.82p

380p

AorTech

LON:AOR

260%

55.4

46.87p

49p

One Media IP

LON:OMIP

210%

61.9

8.88p

9.75p

UniVision Engineering

LON:UVEL

190%

55.7

2.01p

2.4p

Weatherly International

LON:WTI

180%

54.7

1.88p

1.95p

 

The Middlers

Company

Ticker

% change (1 yr)

Relative Strength Index (66 periods)

50-day moving average

Offer price

Versarien

LON:VRS

400%

56.8

85.07p

88p

Yu Group

LON:YU

360%

68.9

1,048.7p

1,260p

Bluejay Mining

LON:JAY

220%

56.7

23.56p

26p

Asiamet Resources

LON:ARS

200%

58.4

10.27p

12.25p

Oxford Biomedica

LON:OXB

170%

60.9

11.02p

12.72p

Griffin Mining

LON:GFM

150%

59.6

126.86p

130p

LoopUp Group

LON:LOOP

140%

62.5

336.55p

388p

Silence Therapeutics

LON:SLN

120%

53.0

195.75p

206p

StatPro Group

LON:SOG

110%

62.7

164.17p

187p

TMT Investments

LON:TMT

110%

65.2

US$3.21

US$3.70

 

The Biglers

Company

Ticker

% change (1 yr)

Relative Strength Index (66 periods)

50-day moving average

Offer price

Blue Prism

LON:PRSM

240%

59.0

1,408.5p

1,690p

IQE

LON:IQE

200%

52.9

123.09p

144p

Keywords Studios

LON:KWD

170%

61.0

1,527.56p

1,834p

Plus500

LON:PLUS

160%

54.5

1,107.99p

1,116p

Ocado Group

LON:OCDO

120%

68.0

489.42p

596.6p

Hutchison China

LON:HCM

110%

54.8

5,120p

5,160p

Evraz

LON:EVR

110%

61.3

392.36p

447p

Kaz Minerals

LON:KAZ

94%

54.9

861.75p

895.4p

Softcat

LON:SCT

89%

68.1

546.48p

644p

NMC Health

LON:NMC

84%

57.6

3,282.64p

3,450p

 

I know I said I would not be going anywhere near technical analysis and all that voodoo stuff but for those of you that are au fait with that sort of thing, I have included the relative strength index (RSI) for each stock over 66 trading days and also a 50-day moving average.

The RSI was developed by Wells Wilder and is a “momentum oscillator” that measures the speed and change of price movements. Traditionally, an RSI of more than 70 indicates a stock is moving into “overbought” territory – it has moved too high, too quickly – whereas an RSI of less than 30 indicates a stock is oversold.

If we had nothing better to do all day than stare at screens and check on stock prices, we could trigger a sell whenever a stock moves above an RSI of 70 but we haven’t, so I have included it for information purposes, just to see whether those with a lower RSI have a better chance of surviving the next rebalancing in two months’ time than do those with a high RSI.

Similarly, we could trigger an automatic sell any time a stock’s bid price moves below its 50-day moving average, as this is considered a ‘sell’ signal in some circles. We’re not going to do that, but readers might find it informative to compare the stock’s current price with its 50-day moving average.

We'll revisit the three portfolios to see which is doing the best; logic would suggest that it will be the tiddlers, as they seem to generate bigger percentage changes over a year than the others but we shall see.

 

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