In a bull market, when valuations are expanding and the market is pricing in a better future, there’s no faster road to profit than buying momentum stocks. When a stock is on the move, there’s a good chance it will continue in the same direction, especially if the power of institutional buying is behind it.

"An object at rest tends to stay at rest and an object in motion tends to stay in motion with the same speed and in the same direction unless acted upon by an unbalanced force." - Isaac Newton

In this latest in The Strategy Map series, I'll be giving you an overview of momentum investing, and introduce two approaches to capturing its rewards - the active trader approach of buying breakout stocks, versus the more systematic approach of buying and holding portfolios of higher strength stocks.

Is “Big Mo” right for you?

Momentum investing isn’t for everyone. It requires a watchful mindset, and a willingness to prioritise technical analysis (price action and sentiment) over fundamental analysis (valuation and company accounts). While a value investor seeks to buy stocks cheap, often buying after declines, the momentum investor seeks to “buy high and sell higher”. If your belief system rests on a deep value margin of safety, you may find momentum investing challenging.

This is an active approach that requires regular dealing and a keen attention to risk management. It's common to use stop losses to protect capital, and cut positions as soon as trends reverse. If you don't have the ruthless streak, and prefer the idea of marrying compounding quality stocks for life, you will want to look away now.

Nonetheless understanding how to read the runes of price and volume action provides invaluable lessons for all investors. Let’s get to grips with this compelling approach to beating the market and put Newton's Law of Motion to work.

Background to Momentum Investing

One of my favourite stock market stories was told by the globe-trotting Hungarian-Canadian ballet dancer, Nicholas Darvas in his classic 1960 "How I made $2,000,000 in the stock market".

Darvas's book may be more than 60 years old, but his tale reads timelessly. He made every mistake in his early years, buying on tips, trying to play it safe, over-relying on fundamentals, until he realised through keen observation that price and volume action held the key to sustainable profits.

Stocks did not fly like balloons in any direction. As if attracted by a magnet, they had a defined upward or downward trend which, once established, tended to continue. Within this trend stocks moved in a series of frames, or what I began to call "boxes".

Darvas observed that stocks met upper resistance as they rise in price, but gained support on reversals. He’d buy breakouts at the top end of each box, use strict risk management, and try to reap the rewards. He'd sell "when the boxes started to go into reverse". His simple approach worked, especially when focusing on stocks in strong industries with improving earnings trends. The $2m he accumulated was all done while travelling the world performing ballet, with financial magazines delivered by airmail, and communication with his broker by telegram - so no one can make any excuses!

One anecdote does not make a law, but Darvas is not alone. There are many tales of the fortunes made by momentum traders - Jesse Livermore making billions in todays money through tape reading in the 1920s, Bill O'Neil becoming the youngest ever person to buy a seat on the New York Stock Exchange from breakout profits, while an experiment by famed commodity trader Richard Dennis turned 23 regular people into trend following immortals - the "Turtle Traders".

The quants have since proved emphatically that strong stocks consistently beat weak stocks. In 1993, Jegadeesh and Titman published a groundbreaking study titled “Returns to Buying Winners and Selling Losers”. They found that recent winning stocks continued to beat recent losers by an average of more than 12% per year. Eugene Fama, winner of the Nobel Prize for Economics, and the king of academic finance, initially rejected these ideas, but in 2008 finally conceded:

How do you screen for strong stocks?

We'll discuss the risks inherent in momentum investing later, but for now, let's go and find them. Screening the market for strong, momentum stocks is actually remarkably simple.

Screening for price strength

Most momentum investors will not even consider a stock for purchase unless its shares are already beating the market over some recent period. Here are a few ways of measuring strength.

1. Relative Price Strength: we compare the share price of a stock relative to that of the broader market. So a rule like "Relative Strength 1y > 10%" will return stocks that have beaten the local index (e.g. FTSE All Share in the UK) by 10% in the last 12 months. It’s best to use 6 month or 1 year Relative Strength as these have proven the most effective at predicting the next 6-12 months of returns. Any longer or shorter than that isn't predictive.
2. New 52 week highs: Buying sets of stocks at their 52 week highest prices has been shown to be even more effective than buying strong relative strength stocks. 52 weeks gives enough time for disappointed holders who bought at even higher prices in the past to have already sold. I use "Price vs. 52 Week High > -10%" to find stocks within 10% of their highs.
3. Price versus Moving Averages: if you want the trend to be your friend then the best place to start is to avoid buying shares that are trading below their 200 day (or 30 week) moving average share price. To find stocks above their 200 day moving average use the rule: "Price vs Moving Average 200d >0%". You can stack these rules to compare the price, 50 day and 200 day averages to discover rising trends.
4. Recent Volume Surge: as we'll shortly see, new breakouts should begin with increasing volume when the price moves to new highs. Volume is simply the number of shares traded that day (it's graphed under the share price chart) and it's a key indicator of demand for the share. You want to see increasing volume as a clue that the big institutional players have started accumulating the shares. Screen for "Recent Volume Surge >50%" to identify anomalous recent volume patterns.

Don’t forget that Stockopedia’s Momentum Rank can be used as an all-weather approach to finding strong momentum shares. This composite field incorporates some of the measures above into a Price Momentum Rank, but also assesses the sentiment around the share by including a weighting to Earnings Momentum (whether the brokers are increasing their forecasts and whether the company is beating those forecasts). To use the Momentum Rank - remember it’s scaled between zero (weak) and 100 (strong). To find the best 10% ranked stocks in the market, use “Momentum Rank > 90”.

Here’s an example stock screen of “Price Momentum Basics” that you can review and copy.

Screening for earnings strength

Many of the advocates of this style of investing - from Darvas, to Bill O’Neil and Mark Minervini - stress the importance of ensuring that price moves are backed up by genuine accelerations in earnings and sales power. This helps avoid the danger of investing in "momentum traps" - temporarily overhyped shares, without any substance backing their story.

Screen for stocks that have improving earnings or sales growth - especially in the most recent reporting period. Even better if they have news saying they are trading “ahead of expectations”. The key is to build a watchlist of "leading stocks in leading sectors".

• Earnings Per Share Growth Rate and Sales Growth Rate: you can screen for these as well as a variety of other growth measures. It’s great to see an acceleration in earnings growth more recently - so do try the Interim Earnings Growth Rates.
• Earnings Surprise this is a useful measure to find companies whose actual sales and earnings have beaten the forecasts of the analyst in the City or Wall Street.

Most momentum investors come to realise that the most promising momentum stocks often trade at a premium valuation to the market. Bill O'Neil once did a study of hundreds of the greatest stock market winners and discovered they all began their biggest moves on high P/E Ratios. From 1953 to 1985 they began at an average P/E of 20, whereas in the internet bubble this was 36+.

How to identify and buy “breakout momentum” stocks

For a breakout momentum investor, the key is knowing when to buy and when to sell. So we'll seek to answer those questions now. I'm going to lean heavily on Stan Weinstein's excellent work in "Secrets for Profiting in Bull and Bear Markets", as the lessons he tells have broad application not just for momentum investors, but anybody seeking lower risk entry and exit points in shares.

Step 1: Stage Analysis

Weinstein identified four stages in a typical, long-term share price lifecycle. These stages can repeat again and again in shares, and are sketched out below.

• Stage 1: Basing - this is a period of consolidation often after a significant decline. The share price languishes sideways around its 30 week moving average price (30 week MA), bobbing up and down between support and resistance.
• Stage 2: Advancing - the stock breaks out of the base on increasing volume, and above the 30 Week MA. This is a period of accumulation by institutions and intelligent traders. This is the ideal time to buy - either on initial breakout, or on the first pullback. The 30 Week MA moves into an uptrend. As the uptrend continues, any shakeouts and temporary drawdowns will remain above the 30 Week MA. There can be multiple bases on the way up.
• Stage 3: Topping - the 30 Week MA starts to flatten out after Stage 2 runs its course. The share price dips below the MA and share price volatility is often at its highest in the whole sequence. This is a key area of risk and is a sign of increasing distribution of shares by insiders and institutions. Sometimes the share price can stabilise to prepare for another Stage 2 but often not.
• Stage 4: Declining - this is the capitulation phase. The stock eventually breaks sharply below the 30 Week MA, not necessarily on increased volume. It then stays below its 30 Week MA on its journey down towards another basing area. This is the time of maximum risk. It’s when you most want to be out.

Ultimately, momentum investors seek to participate strongly in Stage 2 stocks - whether by buying the initial breakout from Stage 1, or later breakouts in Stage 2. These are the shares beating the market, and showing strong relative strength. The aim is to have sold out of the stock before or at the start of Stage 4 before any significant losses.

Step 2: When to buy

Weinstein identifies that "Investors" (holding for 12 months+) will want to be buying at the end of Stage 1 when the stock first breaks out. In practice this can be challenging, but stocks often stay in Stage 2 for up to 5 intermediate "bases" all of which can provide good entry points for traders, although the risk increases the higher the stock goes. The key is identifying stocks with extremely strong volume surges, as it's an indicator of strong, possibly institutional demand.

The initial breakout is prone to failure, and can lead to losses. Buying on the first pullback after the breakout is a less risky time to enter. The odds are more substantially in your favour, but you can miss out on some of the most propulsive winners if you wait. Buying the initial breakout is only recommended when there are significant confirming catalysts (fundamental or otherwise).

"Traders" (who hold for shorter periods) are likely to wait until there is already a confirmed "Stage 2" trend. They will wait for the first base after the trend has started before participating. Stocks in stage 2 can base multiple times before topping, and often all are tradeable, but risk heightens on the way up. Don't participate if the moving average has levelled off as it may signify Stage 3.

Mark Minervini only ever buys stage 2 stocks - he suggested a stage 2 trend filter which we've mostly replicated in this Minervini-esque stock screen that you can review and copy. Minervini has become known for his Volatility Contraction Pattern (VCP), which is essentially a wedging pattern between support and resistance in a base. It's illustrated above as a wedge pattern where the support line rises towards resistance. This is a good indicator that selling pressure is dissipating, and buyers are soaking up the supply.

Step 3. Risk Management - Stop Losses and Diversification

Firstly, every good breakout trader uses stop losses. Stop losses are loathed by Buffett-esque investors, because they believe if you know the company well enough, any drop in price is a chance to buy more. But momentum investors use stop losses as a form of insurance - it's a premium paid to protect starting capital.

Never let small losses turn into large losses. A 10% loss requires an 11% gain to return to parity, but a 50% loss requires a 100% gain for parity.

Weinstein recommends placing protective stop losses at the most recent support line below the breakout point. This is fairly loose, but respects the natural volatility of the share. Minervini never lets a loss be more than 8%, but he tends to trade larger, more liquid stocks that trade tightly. If you are dealing in small caps you would need to set wider stops. Just remember to keep losses small.

Secondly, many of the proponents of the breakout momentum style encourage you to “concentrate your eggs in one basket and watch that basket like a hawk”. This is a risky, low-diversification approach, but can pay off handsomely in bull markets if you manage your exits carefully. As this style aims for leading stocks in leading groups there can often be sector concentration - so beware. Even if you are highly attentive, it’s sensible to diversify across sectors, and own a range of stocks. Minervini, O’Neil and Darvas might promote 5-8 stock portfolios, but you know the risks. There’s plenty of stories out there of overly concentrated portfolios not working out. Once again, any attachment to shares can be fatal. Be ruthless.

Step 4. When to sell

The basis of all momentum and trend following profits is to run winners and cut losses. You can buy many more losers than winners, but still show big profits, if the profits on a few of your winners are huge. So how do you run your winners, but still have sell discipline to protect the profits?

Weinstein recommends raising your sell stops as the price moves upwards on its trend. This is essentially a trailing stop loss, but is best set manually. Here's how it works.

• After the initial breakout, there is typically a pullback towards the 30 week moving average line.
• Once that pullback is over, and the stock sets new high, raise the sell stop beneath the previous pullback under the 30 Week MA line.
• Repeat the process again and again on the different bases on the way up, as long as the 30 Week MA continues its uptrend.
• As soon as the 30 Week MA flattens, Weinstein recommends changing the approach. Now set your stops beneath the support lines under the share price charts.

While this sounds like a lot of work, this process will only need to be done a few times over the course of a year or two of uptrend in a strong name.

Mark Minervini was highly influenced by Weinstein, but as his process puts him into the biggest winners in bull markets, he often has to deal with "buying climaxes" - where stocks have parabolic runs. In these scenarios it can be best to sell into the strength, as the likelihood of rapid reversal is high. If a stock gets 70% above it's 30 Week MA, it's a good sign of a pending climax top.

What is particularly powerful about these selling approaches is that attentive momentum investors end up selling individual positions on weakness early in bear markets. They are rarely exposed to the deep drawdowns that occur in fully-invested portfolios.

The passive approach to implement a “trending momentum” portfolio

It’s quite possible that you don’t want to spend your days actively looking at the markets for breakout stocks, but still want to build momentum into an investment approach. Well there is a more passive way of putting its power to work for you. That’s by using a rules-based, systematic approach. In the interests of brevity (this is a long piece), I am not going to go into as much depth, but will cover some basics.

A simpler, more fully invested approach is based on my own No Admin Portfolio System (the NAPS). It can be implemented in only a few hours per year and has been remarkably effective over the last decade. The published NAPS Portfolio combines quality and value with momentum by using the StockRanks, but a momentum only approach has outperformed the combined style.

Some steps to implement are as follows:

• Twice per year (end March and end September in the study below):
  • Screen the market for the highest Momentum Rank stocks, and cut out the tiddlers (nothing less than a £10m market cap).
  • Select the 20 highest ranked stocks, ensuring no more than 4 per sector. This ensures sector diversification.
  • Buy an equal weight of all the stocks on the list. (If £100k in a portfolio, that’s £5k each)
• On each rebalancing date, repeat the process, but if any stocks are still the same as the original portfolio, sell or buy a proportion of the position to bring them back to equal weight.

Generally there are quality businesses in this portfolio that have good price strength as our momentum measure includes "earnings momentum". Here’s how such an approach has fared over recent years. More than a 16% annualised return over 8 years. The median size of the stocks across the portfolios was £2.3bn with an average yield of 2.2% and spread of 1.2%.

If you are looking for a good read on this style, do check out Andreas Clenow’s “Stocks on the Move”. He outlines a systematic approach to investing in US large-cap, momentum stocks that could be followed by any investor, albeit with a little calculation. Taking this approach doesn’t require any checking of news stories, fundamental analysis nor even chart reading. It’s a clean, price-only approach to the market.

The risks and limitations of Breakout Momentum strategies

First do no harm. Before you set out on this adventure and get too excited about every chart you see with the slightest uptick, please do read these caveats.

1. Most breakouts fail - you will find that you get stopped out a great deal if you try and buy every breakout. In bad, sideways or bear markets, this happens extensively. You need to learn to sit on the sidelines and wait for exceptional breakout opportunities and good markets. For traders who like action, this can be deeply infuriating. Don’t let your lust for action grind your capital away. Wait for the tide to turn!
2. Beware micro-cap breakouts - these stocks are most prone to gossip and manipulation. It's best to weed out higher-volatility shares like these using filters. Some investors short these breakouts very successfully - so be warned.
3. Be careful in late stage 2 breakouts - dealing with regret is tough for a momentum investor. You want to own the biggest movers, but due to missing the early moves you may feel a need to get involved in late action in a stock. This is a painful lesson.
4. Watch out for high PE Ratios - many of the market's biggest growth winners start their runs on nose-bleed PE ratios, especially in the US. It's a double edged sword, as reversals on earnings disappointments can be rapid and severe. Be vigilant.
5. Pick markets carefully - the US is a great market for the extreme breakout style due to its size, extraordinary corporate ambition, and high stock ownership. More value oriented markets like the UK may be better suited to more systematic momentum approaches.
6. Be careful at bull market tops - the indices follow the same Stage 1 to 4 pattern. Mark Minervini has illustrated the past bull market winners will often give back 70% or more of their gains when the market has topped - we've seen this time and again, but most recently in US tech stocks. So when the market enters Stage 4 - it’s best to avoid momentum.
7. Watch out at bear market bottoms - the highest relative strength stocks will likely be defensive stocks at the bottom of bear markets - like cash generative utilities, consumer defensives and healthcare stocks. While they won’t lose you money, they will lag any bull run. If you are investing in momentum at a bear market bottom, it’s best to use a breakout approach, rather than a systematic momentum approach, as you'll more likely pick the big winners.

This has been another extensive piece, and it's a real challenge to try to bring so much source material into a coherent 15-minute read. To be honest, these topics need books rather than articles. If you've read this far, I hope I've succeeded in giving value for your time. Please do comment below, and let me know your own experiences and anything important that the community ought to know that I've had to miss out - intentionally or not.

Recommended Reading

I do encourage you to continue your learning further in some of the following books. There are many more good reads, but here are a few essentials.

• Stan Weinstein - Secrets for Profiting in Bull and Bear Markets - the best book on charts.
• Nicholas Darvas - How I made $2000,000 in the stock market - fun read, good storyteller.
• Bill O'Neil - How to Make Money in Stocks - a bit of a sales pitch, but an enlightening read.
• Mark Minervini - Trade like a Stock Market Wizard - a market wizard shares his secrets.
• Andreas Clenow - Stocks on the Move - systematic momentum in US large caps.
• Wes Gray, Jack Vogel - Quantitative Momentum - for the geeks.