A Hitchhiker’s Guide to Momentum Investing

There are many ways to invest in the stock market and one method becoming more widely accepted is momentum investing. There are numerous ways to measure momentum, such as Price-to-Book Ratio, Price-to-Cash flow, Earnings Growth and others. But ultimately we are judged by the difference between our purchase price and our sale price, or the current mark-to-market price if a position remains open. Therefore, the heart of a pure momentum strategy is solely price action. Indeed, the heart of any strategy, regardless of how much you want to dress it up, is price.

Catching price momentum is like a hitchhiker catching a ride. A hitchhiker solicits a ride by standing at the edge of the road; thumb out while facing the oncoming traffic. When looking to capture a ride, hitchhikers don’t know which car will stop or how far a ride will take them should a driver offer a lift. A hitchhiker simply goes with the flow but will only join a ride that is heading in the right direction.

Likewise, a momentum investor will tend to stand aligned with oncoming price action ready to buy as prices are rising and ready to exit when prices start falling. A momentum investor does not attempt to predict which stock will offer the next ride or how far the ride will take them. A momentum investor, like a hitchhiker, simply goes with the flow of the market: fully invested as the market rises in a sustained up-trend and reverting to cash in a sustained bear trend.

Figure 1: A Hitchhiker catches a market wave only after a low is made

A common misconception is that a momentum investing strategy ‘buys high, sells low’. Sceptics suggest that momentum investors are more likely to buy when everyone else is buying and sell when everyone else is selling, rather than follow the traditional laws that govern value investing whereby one ‘buys fear and sells greed’. This is inaccurate. By definition, what exactly is high? What is low? Regardless of the type of investor you are, the reality is we can never predict the absolute high or low. An investor can try to guess (or predict) when a high or low is achieved but a momentum investor will wait for confirmation.

The following chart of Austral Limited (ASB) shows the stock in a clear range spanning several years. Is the price considered high or low?

Figure 2: Austral Limited appears to be trading toward the top end of a range that had been in place for several years

Over the following 9 months the stock travelled from under $2.00 to over $4.50 in an extremely clean trend. When price moved through $2.00 it never looked back – it just kept going.  Awaiting a dip to buy the weakness would have been a very costly mistake.

Figure 3: Iluka Resources in August 2011 - is the price high or low?

Traditional logic says we need to buy into weakness usually with the intent of purchasing a quality asset at a cheap price and well below its valuation. Doing so however creates unknowns, specifically:

1.      Will the stock continue to travel lower?

2.      If so, how far lower will it go?

3.      How long before weakness reverses and prices start to rise?

There are definitive risks of these unknowns, yet they remain the acceptable call to action by the herd. One need not look too far to see damaging examples of stocks that kept travelling lower and lower, such as AMP, BOQ and CGC to name a few.

On the other hand, a momentum investor removes these unknowns by waiting for strength to return before entering. The following diagram shows how both types of investor have essentially bought in the same general region yet the momentum investor is less susceptible to the three traits above.

Figure 4: A value investor buys into weakness. A momentum investors awaits further strength before buying

Not every stock will trend all of the time, but there are generally enough stocks trending some of the time to present opportunities. In certain market conditions these rides, or trends, will be very long and extremely rewarding. In other market conditions they may be short and non-rewarding.

A momentum investor will take the good with the bad knowing that, over time, the good outweighs the bad by a significant margin due to the creation of a positive mathematical expectancy. Whilst momentum investing works reasonably well most of the time, like any strategy, investment or asset class, it will have periods where performance is lacklustre. It is important to stress that during these times the strategy is not broken and needn’t be discarded. This is a beginner’s trap and is a topic of discussion unto itself.

The most traditional investment strategies rely on picking the right stocks, or at least the right sector in which the stocks sit. A momentum investor, on the other hand, does not pick the stock, but rather the stock picks the momentum investor.  The stock must start trending higher before it becomes a buying candidate, as is shown in Figure 4. An extrapolation of this is that a momentum investor need not predict the next hot sector, because stocks in a sector that are moving will automatically rise to the top and be presented as a new trend opportunity.

A momentum investor does not mind what stocks are held, what they do as businesses, the fundamentals, the financial metrics or what the stock’s future outlook is. These are simply by-products of the underlying strategy itself. An investor using a momentum strategy creates what is known as an edge, or a positive mathematical expectancy, and it’s this edge that is a generator of profits. Rather than focus on selecting the next great stock or sector, a momentum investor’s sole focus is replicating their edge over the longer term.

Nick Radge 

Head of Trading and Research 

The Chartist

Nick has 35 years’ experience in the financial markets throughout the world. He has authored numerous books on trading and investing with Unholy Grails (2012) considered a required read on Momentum Investing. The Chartist offers bespoke advice on technical analysis and momentum strategies.