Can investors ride the Contrarian momentum wave to beat the market?

In Martin Scorsese's 2014 film, The Wolf of Wall Street, Jordan Belfort (Leonardo DiCaprio) is taught an important secret of Wall Street elite: the aim of the game is to “move the money from your client's pocket into your pocket.”

Although based on true events, the film is, of course, fictional but it captures the core challenge that investors struggle against. Brokers do not always have our best interests at heart.

They are often hired by big corporations who want to raise money on the stock market. Towards this end, brokers produce research notes which encourage investment in client corporations. This research is often positive, but biassed and not objective. It’s rare for brokers to recommend selling a stock. Investors will often find themselves asking, ‘When do I sell?’

So what’s an investor to do?

Investors may choose to sell a stock when it becomes fully valued. But what does that mean in practice? Valuation is not a precise science. It is often subjective. There is not always a clear price which indicates a selling point. ‘Should I sell at £1.50, or wait for £1.55?’— these are questions that often trouble investors and burn up precious mental energy, especially when managing a diversified portfolio.

At some point we have to draw an arbitrary line in the sand, if anything to save ourselves from becoming like Buridan's Ass…

For readers who may not be familiar with the parable, the paradox of Buridan's Ass is as follows…

A thirsty donkey stands halfway between two buckets, each containing the exact same amount of water. As the donkey contemplates which one to choose, its indecision puts it at risk of dying from thirst. It would be better off making a simple, arbitrary choice. This parable is relevant for stock market investors: while we deliberate on whether to sell, we risk the share price moving against us. We also risk missing out on better opportunities.

How can we prevent ourselves from becoming the stock market equivalent of Buridan's donkey?

My colleague, Mark Simpson, offers a rules-based remedy with clear guidance on when to get out of a position. We have tested the performance of his framework by constructing model portfolios using a set of clear-cut rules and shown that the strategy can materially outperform the market.

Between 2013 and 2024 the average performance of a portfolio constructed using these rules was 102%, compared to a 32% rise from the FTSE 100 in the same time frame.

How to ride the Contrarian momentum wave…

Mark suggested that we should become StockRank Surfers. Readers will likely prefer being likened to surfers rather than donkeys—after all, who doesn’t want to conquer the waves of the market? A typical StockRank surf will looks like this:

• Paddle: At this stage, an investor is analysing a high quality company that may be undervalued. It is likely to show up as a high QV stock – a Contrarian stock – but momentum will be low as the investor is pushing against the current.

• Turn: Once the surfer has paddled past the crashing waves, they can position themselves to catch the rising wave. At this stage, the investee company will have a high ValueRank and momentum will be low, although beginning to pick up.

• Ride: Since value and momentum often move in opposite directions, the ValueRank will decline as price momentum begins to accelerate. At the same time, the stock will trend higher as momentum takes over. Surfers can stand up and enjoy the ride.

• Dismount: The surfer is now tempted to ride the wave for as long as they can. However, the wave will eventually close out, crashing down in one last unpredictable surge. If the surfer remains on the wave at that moment, they will wipe out. Instead, if the surfer can jump off before that moment, before they hit the white water.

The strategy can be summarised, as follows:

1. Start riding the wave when momentum is low and value is high.

2. Hold the stock as the price gains momentum. We are effectively riding the momentum wave of Contrarian stocks.

3. Eventually dismount as momentum slows down.

… towards a systemic surfing strategy

By introducing a series of quantitative rules, we can turn Mark’s approach into a systemic strategy…

Bull signals

• Momentum Rank <= 25, AND

• ValueRank >= 75, AND

• QualityRank >= 60

Admittedly, some of the cut-offs might seem arbitrary. For example, readers may wonder why I chose to focus only on stocks with a MomentumRank of 25 or lower. Other investors might prefer targeting stocks in the bottom decile, with ranks below 10.

My choice was somewhat arbitrary—you have to set a threshold somewhere—but I also wanted the portfolio to be diversified. If the rules are too restrictive, the number of qualifying shares is too small. When I applied cut-offs of 25 and 75, the portfolio typically included over 100 stocks.

Bear signals

• MomentumRank drops by 33 or more points within a single month; OR

• MomentumRank falls for three consecutive months.

Again, these rules might seem arbitrary, but by establishing clear guidelines, we can at least take action and avoid getting stuck in endless deliberation…

Q&A: Portfolio construction

• How did you identify investment candidates? A stock became a ‘holding candidate’ if it had the bull signal described earlier. A stock retained ‘candidate’ status until it had either of the two bear signals defined above. Let’s use LON:AAL as an example. In December 2015, the company had high quality (65), high value (94) and low momentum (21). This was the bull signal. The stock retained ‘candidate’ status until early 2017, when the MomentumRank dropped for three consecutive months.

• What happened on rebalance day? On the rebalance day, we filtered the UK market for stocks that met the ‘candidate’ criteria. All stocks with ‘candidate’ status were added to the portfolio on an equal-weighted basis. We dropped stocks that had lost their ‘candidate’ status since the prior rebalance day. The backtest simulation tracked the same portfolio of stocks from one rebalance to the next, without changes in between.

• How often did you rebalance? The portfolio was rebalanced every two years, with the backtest simulation starting in spring 2013, then rebalancing in 2015, 2017, and so on.

• How did you decide the rebalancing period? We rebalanced biennially because the strategy follows a 'Contrarian' approach, targeting companies with high value and quality characteristics. This approach typically involves longer holding periods—at least one year (see below)—to allow the investment thesis to play out.

• What about rebalancing more frequently? The backtest simulation suggests that investors would have gained very little by rebalancing their portfolio more frequently. Indeed, rebalancing quarterly only outperformed a biennial rebalance by 5%. Given this small difference in returns, why would investors want to incur the extra transaction costs that come with more frequent rebalancing?

Example holdings

The tracked portfolio usually contained more than 100 stocks. Let's take a closer look at one or two of those holdings.

Evoke

The table shows why Evoke (LON:EVOK) (formerly 888 Holdings) qualified for the surfer strategy.

1. In early 2020, value was high and momentum was low.

2. Momentum eventually started to slow one year later.

3. Momentum dropped to 94 in January 2021.

4. Momentum dropped further to 90 in February 2021.

5. The rank dropped even further, to 87 in March 2021.

As such, the MomentumRank fell for three consecutive months.

We would have bought in January 2020 (at around 135p) and sold in early 2021 (above 300p). Notice that we would sell as momentum starts to tail off…

Anglo American 

Anglo American (LON:AAL)  qualified for the Surfer Strategy between December 2015 and January 2017. During that period, the stock went from £3 to comfortably above £10. We would have sold in February 2017, while momentum was still high (above 90) but falling nevertheless – from 99.9 (December 2016) to 99.6 (January 2017) to 96.5 (February 2017).

It is worth noting that between January and July 2017, Anglo American dropped from around £13 to £9. By ruthlessly following a rules-based approach, investors would have gotten out before the momentum crash. Such is the advantage of arbitrary rules. They remove the need for excessive deliberation and save us from unnecessary frustration.

Rules over narrative

There is another advantage of following a simple rules-based approach. We have a system that can be scaled across multiple stocks and across multiple industries. Evoke is a betting company that owns brands like William Hill. Anglo American is a mining company. To implement the Surfer Strategy, we don't need to be experts on licensing in the betting industry. We do not need to fully understand the nuances of copper supply and demand. Sure, that context helps, but we can gather key insights from just a few metrics, like the ValueRank and the MomentumRank.

Readers who are interested in the Surfer approach will likely be wondering about the next steps. The first step is to identify investment opportunities using a rules-based system. This is where a screener tool can be beneficial. The following criteria can be applied to focus on stocks that exhibit the characteristics of a Surfer Stock.