Momentum Stocks or Value Investing? Try Both.

by Charles Sizemore | May 20, 2014 10:31 am

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[1]) and LinkedIn (LNKD[2]) and other tech stocks like Netflix (NFLX[3]) and Tesla Motors (TSLA[4]) are all down 15% to 30% from their March highs. Meanwhile, Twitter (TWTR[5]) — 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[6] 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[7].

[8]The bottom row of the table represents the top 20% of all stocks by momentum. The returns get gradually better as you move down the value scale.

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%.

Bottom Line

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[9] 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[10] 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.

Source URL: https://investorplace.com/2014/05/momentum-stocks-value-investing/

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