Fol­low the mo­men­tum

Finweek English Edition - - INVESTMENT -

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.

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