If you’re an investor in momentum stocks, 2014 probably has been a kick to the teeth.
The popular momentum stocks of last year, such as social media darlings Facebook (FB) and LinkedIn (LNKD) and other tech stocks like Netflix (NFLX) and Tesla Motors (TSLA) are all down 15% to 30% from their March highs. Meanwhile, Twitter (TWTR) — the biggest IPO story of 2013 — is down by more than half from its December highs.
And all of this in a year where the market is slightly positive.
A word of advice here: Don’t throw out the baby with the bathwater. As a strategy, momentum investing — which can be loosely defined as buying stocks that have performed particularly well over the past six to 12 months — has proven its mettle over time.
As with value investing, research has shown that a strategy of screening stocks based on simple momentum criteria can, in fact, outperform the broader market (The Economist wrote a good summary piece a few years ago).
But let me stop you before you run out and attempt to buy TWTR on a dip.
While momentum stocks do pan out, the strategy’s performance still is directly tied to the price you pay. And at 23 times sales (and massive shareholder dilution via stock-based compensation to boot), Twitter is still a ridiculously expensive stock.
Patrick O’Shaughnessy of O’Shaughnessy Asset Management wrote an excellent piece in which he found…
“Since 1963, a strategy that buys the top group (best 10% of the market) of stocks by 6-month total return, has delivered a 14.4% annual return, which is roughly 4.5% better than the S&P 500.“
But the outperformance gets a lot less impressive when the stocks in question are expensive based on simple metrics like the price earnings ratio.
Take a look at the following table from O’Shaughnessy’s article.
In other words, momentum stocks that are cheap based on P/E ratio outperform momentum stocks that are expensive. And it’s not by a small margin. The cheapest high-momentum stocks returned 18.5% per year, whereas the most expensive high-momentum stocks returns 11.6%.
Value investing works. Momentum stocks work. But combining the two works best of all.
Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.