The High Risk High Gain Strategy
Momemtum stocks are the ones that are currently in favour by investors. Karan Bhojwani and Nikita Singh explain how one can identify momentum stocks even as DSIJ team identifies top momentum stocks to invest in at this juncture.
Mihir Das is a 36-year-old marketing professional from Mumbai. After having worked for over 10 years in the marketing domain, he had invested a decent corpus of his savings in fixed deposits (FDS) of his bank. Now his FDS were about to mature and at maturity he was going to get a decent lump sum amount. He wished to invest the amount in the stock market. However, he faced a major challenge when looking for a stock to buy as there are more than 2,000 stocks listed on the Indian stock exchanges. Even when an investor/trader focuses on a small universe of stocks, such as the 500 in All Ordinaries, there is still a larger array of choices than most investors can deal with and this is an issue not quite restricted only to Mihir Das, but many other investors/traders face similar dilemma when they think about investing or trading. There are a large number of trains at the platform to reach the destination, yet which is the correct one to board is the big question mark!
Given the large number of alternatives, it is not surprising that investors tend to concentrate on stocks that are every now and then featured on television or in the financial press. As most people do not have an objective process for choosing stocks, more often than not, they purchase stocks going by the news stories and other random recommendations and endorsements by friends, relatives and colleagues. However, following these random recommendations and endorsements usually result in erosion of your wealth. If you want to be successful in the stock market, you need to select stocks using an investing style. This is a distinctive way of picking stocks that gives you objective rules for selecting which stocks to buy and which ones to sell.
Having an investing style will make you a better investor than having no style at all. This is because of the fact that styles are logical and with tens of thousands of investors following their own styles, their concerted actions do cause stocks to climb up and down. If you do not follow any style, your odds for success will be thin.
All the great investors have an investing style. The secret to fruitful investing is figuring out and adopting a strategy which suits your style and in return make money, and using it over and over again. Obviously, your style may evolve over time and as conditions change. All things considered, you should never pick stocks randomly or based on impulse.
FOLLOWING ARE SOME OF THE BEST/WIDELY USED INVESTING STYLES:
3. Dividend Yield
1. Value Investing: Value investing is an orthodox investing style. This involves researching companies and finding those with strong fundamentals that market participants have not yet noticed or appreciated. Value investors look for cheaply valued stocks and buy them at depressed prices. The idea is to invest in stocks that offer great value and, as a result, there is less chance of you losing money. In simple terms, value investors are bargain hunters who are willing to play for the long haul, more like a test match cricket!
2. Growth Investing: As defined by Wikipedia, growth investing is a style of investment strategy focused on capital appreciation. Those who follow this style, known as growth investors, invest in companies that exhibit signs of aboveaverage growth, even if the share price appears expensive in terms of various statistical metrics such as price-toearnings ratio or price-to-book ratio.
3. Dividend: Dividend investing aims to pick companies that provide a steady stream of income in the form of dividend. Investors following dividend style investing buy stocks for income rather than for share price appreciation. The key factor to consider is the dividend yield, which is the dividend per share divided by the share price. These investors usually buy large, well-known companies because they tend to have track record of stable and reliable earnings. This is essential given that income investors may rely on the dividends paid out of company’s earnings.
4. Momentum: Contrary to conventional wisdom of buying low and selling high, momentum investing is a strategy which involves buying stocks that have gone up over the period of last few trading sessions, weeks or months, with an intention to sell it at an even higher price and making a quick buck. Momentum investors are looking for quick returns. They want to invest in stocks with the most rapid share price gains. The idea is that a rising share price will continue rising – in other words that winners will keep on winning. In simple terms, momentum investing is like a T20 match.
Best traders and investors concentrate on one of the above categories for investment or trading purpose. Warren Buffett, for instance, arguably the greatest investor of all time, is a ‘value investor’. On the other hand, Martin Zweig and Louis Navellier are two examples of successful fund managers who concentrate principally on strong growth stocks. Investors who pursue
‘momentum stocks’ include Richard
Driehaus, the founding father of momentum investing, and the legend Jesse Livermore.
As we have seen when it comes to investment, there are dozens-if not hundreds-of investment styles. But in this cover story, we are going to talk about one of the most exciting investing strategies: ‘Momentum Investing’.
WHAT IS MOMENTUM INVESTING?
In a nutshell, momentum investing is based on the belief that stocks which have performed better relative to its peers will on average continue to outperform and stocks that have underperformed relatively will tend to continue to underperform. There is a famous quote by William J. O’neil: “What seems too high and risky to the majority generally goes higher, and what seems low and cheap generally goes lower.” Momentum investors are not afraid of jumping onto the bandwagon and invest in the most popular stocks of that time. When the realty stocks prices were reaching new highs in mid-2000s, irrespective of the amount of debt on the books or despite any strong fundamentals of these companies, the stocks continued to surge higher. Following the rule of momentum investing, momentum investors follow a trend. They believe what’s moving higher is likely to move higher and they bought realty stocks. But by the end of 2007 and the beginning of 2008, the momentum of these realty stocks was seen to be petering away and prices began to change direction, momentum investors took the cue and sold the shares. In this case, there were two types of momentum investors, one who had a proper entry and exit plan, and the second who got stuck right at the top and kept on holding to the stocks in hope that the stock price would bounce back to the cost price. That, of course, did not happen and some stock prices even crashed from three digits to single digit. Hence, momentum investing is a skilful strategy that involves timing the entry and exit and monitoring the position on a regular basis.
IDENTIFYING MOMENTUM STOCKS
There are a number of methodologies available in which an investor can measure momentum. Some investors use a combination of statistical and technical analysis to identify entry and exit points and find out which stocks currently offer the best opportunity for rapid appreciation. Below are some of the methodologies to identify momentum stocks.
Quite often we see there are a few stocks which are in the spotlight and have a tendency to outperform when there is some trend movement in the stock market, while the majority falls behind or keeps trading inside the range. However, looking at the outperformance of the stock, we tend to draw the conclusion that this is an expensive stock as it has had a mad run-up, only to find later that it has continued to move higher. Now the big question that arises is: how to identify such stocks? There is the concept of ‘Relative Strength’ that comes into play when the decision regarding the selection of stock or sector has to be done. Relative strength is a measure of share price momentum. It is used to identify stocks that have done well in the past, on the assumption they will continue to do well in the future. Stocks with high relative strength will be rising faster than the market and other stocks.
Higher Trading Volume:
One of the widely used strategies in momentum investing is following the volume. Ever since trading/investing began, investors have used volume to get a read on where the stocks are headed. The volume represents the number of shares bought and sold on any given day. Understanding volume can provide insight into stock’s behaviour to help you determine its overall strength or weakness. In momentum investing, trader/investor focuses on stocks that are moving significantly in one direction on high volumes. In general, a price change on relatively low volume for a particular stock suggests an aberration or manipulation, whereas a price change on high volumes is considered a genuine move. This is because a high volume gives an indication that smart money is actively participating in the move. The basic theory is that if price and volume are moving in the same direction, the trend of the stock price will continue.
Standard deviation is defined by Investopedia as a measure of the dispersion of a set of data from its mean. The more the data is spread apart, the higher the deviation. In simple term, standard deviation is a measure to know how much an investment deviates from its average. For example, if ₹50 is the standard deviation for a stock whose average price is ₹400 and if the stock is currently trading at ₹550, this tells momentum investor two important things. One, the stock is very volatile and two, it has a lot of positive momentum since it is currently trading three standard deviations above its average.
Moving average is a simple technical analysis tool which helps trader to spot the direction. All moving averages are called lagging indicators, which means the actual trend changes before the moving averages generate a signal. Due to this lag, many of the traders ignore this system, but this does not make moving averages totally unproductive. Moving averages smoothen prices and provide investors/traders with a cleaner price plot, which makes it easier to identify the general trend. This strategy employs two moving averages to define the trading bias. The bias is bullish when the shorter moving average moves above the longer moving average and the bias is bearish when the shorter moving average moves below the longer moving average.
Relative Strength Index (RSI):
Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a wellestablished momentum-based oscillator which is used to measure the speed (velocity) as well as change (magnitude) of directional price movements that give a clear measure of the strength of a trend. In other words, the momentum measures the speed and the magnitudinal change in price movements. The RSI of a stock with a strong uptrend momentum or bull phase tends to remain in the range of 40 to 90 with the 40-50 zones acting as a support. During a downtrend or bear market, the RSI tends to stay between the range of 10 to 60, with the 50-60 zone acting as resistance points.
The Rate of Change (ROC):
The Rate of Change indicator (ROC) is often referred to as a purely momentum oscillator. As the name suggests, ROC oscillator measures the rate of change in price, based on the look-back period. The ROC calculation compares the current price with the price “n” period ago. The ROC indicator measures the current price with the price for the defined period. The ROC oscillator moves around the 0-line from positive to negative or from negative to positive, depending on the momentum. When the momentum increases, the ROC oscillator moves from the negative to positive, that is, above the 0-line, and when momentum decreases, the ROC oscillator moves from positive to negative, that is below the 0-line. Apart from the above mentioned methods, there are a wide-collection of technical tools used to assist the momentum-based approach, including chart reading, support and resistance levels, oscillators, and so forth. In the modern world where there are large number of screeners, softwares and information is easily accessible, the task for trader is to select the best tool or a combination of tools that complement one another and provide a means to study the market in a reliable manner and offer well-defined entry and exit points. For a majority of investors following momentum investing, the primary analysis starts with defining the condition of the trend in the price. By and large, momentum is robust at the initial phase of a trend and fragile at the concluding phase just preceding a trend reversal. To draw an analogy, this is similar to the way a ball travels faster when leaving your hand and progressively reduces its velocity of ascent before it reaches its pinnacle, from where it reverses its direction and falls back to earth.
MOMENTUM INVESTING MAY BE IDEAL FOR YOU IF:
1. You are an aggressive investor with a high tolerance of risk. In straightforward terms, it implies you are an experienced investor or a young investor having adequate time to recoup any misfortune.
2. You are disciplined and can adhere to your strategy despite volatility in few stocks.
3. You follow a proper ‘stop-loss’ strategy because the hottest stocks tend to fall much faster than the market when conditions turn the other way around.
4. You should not be emotionally attached to any stock and you have to be good at getting out of bad investment quickly.
5. Since momentum investors focus on the fastest growing stocks in the strongest sectors of the market, when the stock or sector loses momentum, they move on to the next big thing to avoid being caught in a sharp correction. Hence, a momentum
portfolio requires constant attention as you may want to make changes to your portfolio more often than a value, income or low beta investor.
BEST TIME FOR MOMENTUM INVESTING:
There are a number of investment strategies followed by investors across the globe and it is a proven fact that different styles of investing work in different market phases or cycles. It is critical to understand that momentum investing is no different; the effectiveness of a momentum strategy depends on the phase in which the stock market cycle is.
History suggests that the best time to use a momentum strategy is when stocks are moving in an uptrend, which is generally mid to late cycle in a bull market. Likewise, the strategy could be replicated in a bear market if the downtrend in the stock market is prolonged. Momentum techniques generally witness a drawdown or whipsaw near the market tops and bottoms as there is generally a move in the stocks that leads the market to these points in the cycle.
Generally speaking, the widely used philosophy in the stock market is to ‘buy low and sell high’ and equity investors are advised to stay invested for a good enough time to ensure that they get good returns. This is because the risk inherent in equities is reduced over time and the possibility of earning higher returns increases. However, from the way the stock market has been moving up with gusto, it seems that some of the investors are impatient and are looking to make quick bucks by adopting momentum investing style. Though this strategy may be profitable at times, it can also provide a rollercoaster ride. However, to be able to make money consistently through this style of investing, one needs to have a disciplined approach because momentum investor will have to make fast risk management decisions based on limited information when the momentum changes or the market turns its course. The momentum investor surely needs a lot of self-belief.
It is seen that momentum investing is in spotlight during the bull market phase because the profits can be incredible. However, once the bull phase peters away and the stock market cycle moves to the consolidation or corrective phase, the vast majority of momentum chasers go back to their old strategy. Hence, it is important to understand your risk profile and follow an investing style that suits you the best.