Follow the momentum
One of the beauties of investi ng i s t hat t here is an almost infinite number of strategies one can use and they can be tailored to f it almost all requirements, r i sk prof i l es or t i me frames. The f lip side of this is confusion about which is best and which to use. Frankly, I don’t think it is about best – they all have pros and cons and, further, you don’t have to restrict oneself to only one strategy. What is extremely crucial is to know exactly what strategy you are implementing and stick to it. Changing track halfway is never going to work, so you must have a clear idea of the strategy for both entry and exit – it must be clearly spelt out, written down and understood – and, most importantly, you must be comfortable with the selected strategy. The two main investing strategies are: growth (buying fast-growing stocks likely at high price-to- earnings multiples) and value (buying quality stocks when they are cheap). There are, of course, many more, such as cyclical strategy (buying the beaten down sectors), recovery (buyi ng t he beaten down stocks), momentum (buying the winners) and so on – the list is almost endless.
Personally, one of my favourite strategies that I have used for many years is a pure momentum strategy. Momentum trading is the idea of buying those shares going up and selling those going down – buy the winners and sell the losers. Issues such as value, cash f low, dividends RoE, and so on, don’t enter the equation.
Sounds simple, almost too simple. In fact an article in the Financial Times a couple of years back suggested that it really is this easy. The front-page article quoted a comprehensive study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, who stated that the results of a pure momentum strategy were “striking” and “remarkably persistent”. The study used data going back to the 1900s, and the theory was to buy the winners from the previous twelve months and the annual return was 15.2%, well ahead of the index which, returned 4.2% (this excluded costs and dividends).
Locally, the obvious pool is the Top40 index, and my strategy was to buy the f ive winning shares. The winners are simply those with the best return over the period, in other words, the price move plus a ny div i dends received over the period.
So with the entry rules in place at the end of the year (the calendar year or any t welve-month time frame) you merely buy the top five winners for the year and hold them for the next twelve months.
The risks to the portfolio are when to exit. The strategy says sell at the end of the year when you are about to enter the next year’s momentum portfolio, however, this scares many as essentially you don’t have a stop loss in place, however this strategy works and back testing other exit strategies has only decreased the annual return.
So, keeping it simple, you buy the winners f rom t he prev i ous t welve months and keep t hem for t he next t welve, switching into the next set of winners. Initially, this was a Top40-only portfolio, but I am testing it using the MidCap Index with six stocks instead of f ive, and so far the system is working here as well.
A last important point: the goal of this momentum method is to outperform the index, so even if the index is red but the system is less red you are out performing, and so far real testing shows it does indeed beat the benchmark index most times.
As an alternative, there is a moment um ETF f rom Absa ( NFEMOM) which has a different approach but still uses a momentum concept for the investment strategy.
Simon Brown is a Finweek contributor and heads justonelap.com, a free resource of f inancial information and investment education.