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What the Data Tells Us About Momentum Stocks: Are They Good Buys?

As a new investor, it can be really easy to get caught up into defining what sort of investor are you – growth? Value? Momentum? It can be confusing and all it does is add stress to the new investor but don’t worry, I’m here to decode the BS and breakdown if momentum stocks are good buys or not!

First off – what even is a momentum stock?

Investopedia defines Momentum Investing as “a strategy to capitalize on the continuance of an existing market trend. It involves going long stocks, futures or market ETFs showing upward-trending prices and short the respective assets with downward-trending prices.”  

In other words, you’re selling your laggards that haven’t performed very well and buying more of your companies that have performed extremely well.  At first glance, I can see two different mindsets to this:

1 – well, of course I want to get rid of my bad stocks and buy more of the good ones, right?

2 – wait, isn’t this the definition of buying high and selling low?

In a way, these are directly contradictory of one another and also the same thing.  As a value investor, sometimes it’s hard to see and understand other strategies, but the core of a momentum investor is that they’re trying to ride the momentum of a stock all the way up until that momentum slows down.

Trading Momentum: Is It Like Gambling?

In a way, it’s like you’re trying to get a hot hand at a casino.  You want to keep playing that hot hand until you eventually lose and then once you lose a hand, cash out.  Ride it up, get a “heat check” as you might hear in sports, and then cash out your winnings.

In theory, I actually like this sort of investing strategy a lot, but to me it seems more like trading than investing, right?  Maybe you disagree, but I think a really strong performing company like Apple or Visa is just that – a strong performing company.  I wouldn’t say that they have an abnormally high amount of momentum, per se, that is driving up the stock, so would that mean I wouldn’t invest? 

Does this mean that I only invest in companies for a short period of time while the momentum is high?  These are all questions that I had when I first was learning about momentum investing and I want to share my knowledge with you all!  So, let’s start with the basics – if I was to get into momentum investing, how would I even start?

There are multiple different strategies that you can implement if you want to partake in momentum investing.  Per the Corporate Finance Institute, the process for being a momentum investor can be summarized in three steps:   

  1. A trader uses technical indicators such as trend lines, moving averages, and specific momentum indicators such as the ADX to identify the existence of a trend.
  2. As the trend gains momentum – strengthens – the trader takes a market position in the direction of the trend (buying an uptrend; selling a downtrend).
  3. When the momentum of the trend shows signs of weakening, such as a divergence between price action and the movement of momentum indicators such as the MACD or RSI, the trader looks to exit their position (hopefully at a profit), prior to any actual trend reversal.

I think that the Perfect Trend System has an awesome post all about momentum stocks and how to invest in them and even includes an example of a stock screener, which I’ve shown below, that can help you to screen for multiple different factors in identifying a great performing momentum stock:

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For a brand new investor, I personally think that the best way for an investor to learn is to jump in and try to buy a certain stock that they’re familiar with as well as looking at an ETF to try to get some more overall exposure and create a genuine interest for that investor to continue wanting to learn more and more about the investing strategy. 

MTUM is an ETF that captures large and mid-cap stocks that are showing signs of high momentum that could be a great way for an investor to gain some momentum investing exposure.  Per iShares, MTUM charges an expense ratio of .15% which is pretty cheap when all things are considered.  As of 5/12/20, below are the Top 10 holdings of MTUM:

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Chances are, you have heard of a lot of these companies before!  So, my immediate #1 curiosity when looking at a stock or an ETF is to see how it has compared against the S&P 500.  To me, I view the S&P 500 as my benchmark for performance, so that’s what I will always measure things against just to make sure that I stay a rational investor.

MTUM has only been around as an ETF since 2013, but it has performed very, very well compared to the S&P 500:

The thing that really surprised me, outside of the return being more than double the S&P 500 since the inception of this ETF in May of 2013, is that every single year except for 2016 had a greater return than the S&P 500, and every year the return was at least 4% greater with the exception of 2018 and obviously 2016 as well.

Everything that I have heard about momentum stocks is that it’s a higher risk and higher reward than most stocks, so given the fact that we have been in a bull market for the last 10 years or so until coronavirus makes me wonder if these sorts of outperformance will continue to happen or if it’s just a trend. 

One thing that gives me a major peace of mind is that the two years where the S&P 500 had a negative return, in 2015 and 2018, MTUM outperformed the S&P 500 by an average of 4.6%!  That’s a big deal to me.  Although the history is really short, I am seeing that MTUM appears to have the ability to limit the downside risk and also have great upside. 

A few other important factors to look at:

As you likely assumed, the monthly average return of MTUM is much better than the S&P 500, but so is the median.  I love using the median as a way to remove some of the outliers and it’s reassuring to see that the outperformance is a similar amount of the average, meaning that there aren’t any huge outliers that impact the performance of the two indexes.

The worst month also is significantly better than the S&P 500, but the best month is worse than the S&P 500 by a similar amount.  I don’t place a ton of emphasis into the best and worst months but it’s nice to see the bookends throughout time.

From an ETF perspective, and only comparing ETFs, it’s hard for me to not have an interest in MTUM.  But we’re here for individual stocks, right?  I mean, I am supportive of ETFs but there are dangers that an ETF can be overweighed by a few different stocks, just like how an S&P 500 ETF is currently, or even in the screenshot that is shown above. 

I mean, the Top 5 stocks make up nearly 25% of that ETF, so that’s when it can make a lot of sense just to pick individual stocks and control your own destiny!

Another popular indicator for momentum investing is the Relative Strength Index, or the RSI, and that’s actually another thing that you can find on a stock screener like Finviz.com:

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In general, the RSI is a number that ranges from 0 – 100 where anything below 30 signifies that the stock is oversold and anything above a 70 means that the stock is overbought.  A lot of day traders will use this as an indicator for when a good time is to get in and buy stocks, but it is also something that can be applied to momentum investing.

I recently was listening to The Investor’s Podcast and they had on Wesley Gray on a previous episode and I thought it was extremely interesting in how he really described Momentum Investing in that there is proof that a blend of Momentum and Value Investing is the best portfolio strategy that you can have. 

Wes Gray is the CEO of Alpha Architect and they have a ton of great information on their website including a couple of ETFs, both on the value and on the momentum side of the business.  The Investors Podcast referenced that he is a huge data geek and loves back testing all of his theories, so I can assure you that once I get more time and look into his website, I will be sure to follow-up with another blog post about Alpha Architect!

Buying Low on a Rebound

What he said really made a ton of sense to me – value investing is when a stock is beaten down and you think that it’s worth more than the public does and then momentum investing is when a stock is breaking out and the price performance has been performing extremely strong.

Value stocks typically have a low P/E while growth stocks will have a high P/E and with momentum, the E doesn’t matter at all – all that matters are the pricing performance!

It seems weird to me, a true value investor, but the proof of the ETF performance is in the pudding, and that’s what I was able to show above.

The issue with momentum investing for the common investor is that it takes a lot more time and effort than what we might be accustomed to putting in, and to be honest, it also somewhat crosses the line of market timing in my mind.  Now, I have previously written about how I do have some short-term investments, so this certainly could fall into that, but I need to do a lot more research and maybe even some dabbling into momentum investing before I can truly report back on how I feel about it!

Something that Wesley Gray said on the podcast was that you need to be rebalancing your portfolio at least once/quarter if not even more often than that.  That terrifies me as an investor that has a majority of my funds in a normal brokerage account due to the large amounts of capital gains that I might need to pay.  Paying taxes is something that I ALWAYS want to avoid, and after reading Richard Kiyosaki’s opinion of taxes in Rich Dad, Poor Dad, I want to avoid them even more.

Along with the taxes comes the time issue of rebalancing and constantly looking for new stocks.  While I personally love looking at new stocks, knowing that this was something that I absolutely had to do to make sure my portfolio was going to survive terrifies me with me just not having as much time as it might potentially require.

Value Investing vs Momentum Investing

I know I keep referencing Wesley Gray, but the man had a ton of great knowledge and his analogy for investing was great – value investing is like driving on the highway, going 60 MPH in a 65 MPH zone, letting everyone pass you.  You’re going to get there, and it won’t be flashy, but you will get there. 

Momentum investing, on the other hand, is like going in the fast lane and as soon as you see a car in front of you, you swerve and change lanes and if you don’t, you’re going to crash.

While that does sound really fun, that also is terrifying lol.  Maybe this is something that I will dabble in a little bit later in my life, but for now I think that the ETF has a proven history of success so that could be a great way for a less experienced investor to gain exposure to Momentum Investing while still leaving the major “move making” up to the professionals. 

And guess what – an ETF will allow you the ability to not have to buy and sell in and out of stocks on a constant basis, therefore keeping those capital gains tax out of your tax filing!

I’m not going to lie – I am super intrigued by Momentum Investing, so fully expect a follow-up from me on this.  I’ll let you know how much money I have made, or most likely, lost!