Momentum Investing: Finding The Market’s Top Performing Stocks

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Each day across business websites and news networks we’re bombarded with the “day’s best performing stocks.” These may be companies being acquired, those with upside earnings surprises or maybe even companies of whose stocks are deep value stocks that are heavily shorted and are seeing signs of life. Whatever it may be, the largest one-day price moves get a lot of attention, but there is a better measure of price strength that investors should be paying attention to—price momentum over time.

It seems counterintuitive to many investors to buy the stocks that have gone up the most,  but this sits at the heart of momentum investing.

Momentum investing was first documented in the 1993 research paper, “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” published by Narasimhan Jegadeesh and Sheridan Titman. The authors found that “strategies which buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3- to 12-month holding periods. We find that the profitability of these strategies are not due to their systematic risk or to delayed stock price reactions to common factors.” Since its initial discovery, momentum has continued to be researched by academics and implemented by practitioners.

What Drives Momentum

There is some debate as to why momentum works, but generally momentum can be split into two different camps centered around investor overreaction and underreaction.

  • Overreaction: Momentum driven by overreaction is centered around the idea that stock prices can drift away from their intrinsic values. Delayed overreaction to stock-specific news; herding behavior; and investors’ willingness to chase the best performing stocks. These explanations are based on investor overreaction.
  • Underreaction: Momentum driven by underreaction is centered around the idea that stock prices can drift towards their intrinsic values. Underreaction to stock-specific news or holding on to losers to avoid admitting mistakes while quickly selling winners to show success are two behavioral biases that contribute to investor underreaction. 

There’s a third idea behind momentum which is called reflexivity. It works something like this: a company’s stock goes up for one reason or another, which allows it to either buy other companies, raise additional capital or hire the best employees and talent with attractive stock-based compensation programs. As a result, the company may benefit from these capital allocation decisions or by recruiting the best talent, thus resulting in an improved business and a continually improving stock price.

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The reality is some high momentum stocks are exhibiting strength due to overreaction, some are driven by underreaction and sometimes reflexivity is at play between the stock and the underlying business. As is often the case in investing, it can be difficult to pinpoint the exact reason a stock is outperforming.

Measuring Momentum

When it comes to measuring the momentum in a stock, it’s important to note that not all momentum indicators are created equal. As the original Jegadeesh & Titman research discovered, momentum tends to work best when used over periods of time from 3 to 12 months. In the stock selection models we run on Validea, there are two different momentum statistics that appear most of the time.

1) Intermediate-term momentum, which is generally defined as the 12 Minus One Month Momentum. The measure does exactly what it says it does in that it calculates a stock’s momentum by taking the 12 month return and  excluding the most recent month. Once we calculate this for each stock in our universe, we can then rank all stocks to find the top percentile of stocks that have the best returns using this formula.

2) Relative Strength is the other metric some may be familiar with. All relative strength does is takes the returns of all stocks over the past year and ranks them using a score from 1 to 100. The higher the relative strength, the better the stock looks from a momentum standpoint.

Another important factor to consider is the consistency of momentum. Taking an analogy from the book Quantitative Momentum written by Wesley Gray, Ph.D. and Jack Vogel, Ph.D., the authors give the example of a frog in a pot of boiling water. If you drop a frog in a pot of already hot water, it will jump out, but if you put a frog in room temperature water and slowly bring it to a boil the frog ultimately realizes its fate. Relating this to momentum, those stocks with gradual momentum get less attention from investors compared to those stocks that see huge gains. As a result, there tends to be an underreaction from investors as a whole to those stocks with continuous, or gradual, momentum, which is an important factor that allows many of them to continue to produce strong returns going forward.

A Long-Term Test of Momentum

In their book, Gray and Vogel developed and tested a strategy that rewarded high momentum stocks (using 12 minus 1 momentum momentum) with more return consistency. From 1927-2014, their Quantitative Momentum model produced an annualized return of 15.8% compared to 9.9% for the S&P 500. The strategy displayed a higher degree of variability in terms of standard deviation but the Sharpe ratio, which is a measure that looks at both returns and risk, was 0.60 vs. 0.41 for the S&P 500. The chart below shows the cumulative performance of the strategy tested in the book.

Downsides of Momentum

Of course, no investment strategy is foolproof, and momentum, just like many other factors, can go through periods of underperformance relative to the market. There are other risks with momentum as well. First and foremost, momentum can be subject to crashes and struggle during market regime changes when the leadership in the market flips suddenly. For instance, in the late 1990s during the dot com boom with internet and technology companies, or even in 2007/2008 with financials, both of these groups of stocks were showing strong relative performance only be decimated in the bear markets that followed.

Momentum strategies can also be plagued by higher turnover and higher direct and indirect transaction costs of trading.

And perhaps the most difficult part of momentum investing is investor’s ability to fully understand what drives momentum in the first place. Investors who lack an understanding of a strategy are far less likely to stick with it over time and during the periods of underperformance when they occur.

Understanding the downsides and risk of any investment strategy is equally important to understanding why it works. Momentum is no different.

Ten Top Momentum Names Right Now

Using my model inspired by Gray and Vogel, here are the top scoring momentum stocks in the Validea stock universe. All these stocks have seen massive price movements over the past year as reflected by the 12 Minus One Month Momentum and high relative strength figures.

Given how far the market has come from March of last year, it’s not surprising to see stocks with these types of returns. Of course, as momentum ebbs and flows across sectors, stocks and industries it’s important to have a systematic way to stay on top of those changes—something I routinely do in the models I run.

Bottom line, investors can benefit by using momentum screens such as this one, but it’s important to be aware of both the positives and negatives as you incorporate momentum into your own investment research process.