How I Use Momentum In My Investment Process

22nd Oct '24 by Roland Head

13 comments 1942 reads

My recent third-quarter update on the performance of the rules-based SIF portfolio prompted some interesting questions from readers. One comment in particular caught my attention and prompted some reflection on my part:

I would be interested to hear from you as to which of your rules (or processes) do you feel might have played a strong part in your positive performance, and which might have been weaker contributors.

The rules referred to above are those in this screen: SIF Buying Screen

I use the results of this screen to select stocks to buy for the SIF Folio - you can read more about this project here.

I’ll highlight some of these trading rules shortly, but in short my aim is to identify reasonably-valued growth stocks with the potential to deliver near-term returns.

My reply to the subscriber comment above highlighted two of the main elements I think are responsible for the portfolio’s record of 8% annualised returns since April 2016:

applying a consistent strategy over a long period (8.5 years) and being willing to sit in cash when the screen isn’t flagging up any opportunities;
In terms of the rules themselves, what’s become more apparent to me over time is the importance and impact of positive momentum.

In the remainder of this article I’ll look at how I’ve tried to capture momentum in my screen and why I believe this has contributed to some of the portfolio’s strongest results.

I’ll also take a broader look at momentum in the context of the StockRanks.

How I capture momentum

Momentum describes the tendency of share prices and earnings estimates to trend in one direction for periods of time. Rising earnings estimates tend to lift share prices, while positive share price action often attracts additional buyers.

When I devised the rules for SIF, I knew that it was going to be a fairly active trading portfolio, not a long term buy-and-hold portfolio. This meant I needed to focus on finding factors that might indicate the potential for near-term gains.

In short, I believed these were likely to be:

Rising earnings per share
Potential for earnings upgrades
A reasonable valuation
Positive share price action, evidenced by recent index outperformance

Note: In case this sounds like the holy grail of investing,…

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SCI20

22nd Oct '24

Thanks Roland for an excellent article and one that resonates with me. My portfolio performance has flatlined for the last 2 years and is only now seeing the benefit of cutting losers, adding to positions showing strong momentum and of course a big dose of patience.

Epitychia

An interesting article, thank you.

Some investment styles move into favour while others move out of favour. Therefore it is a good idea to run several styles as a way of diversifying your portfolio, smoothing volatility and reducing losses. There are different ways of classifying styles, but one way is holding period. I suggest running these 3 styles would be one way to do this:

Short term, hold 6 months. Focussed on a momentum style, mid to large cap shares that have low transaction costs. Similar to SIF above.

Medium term, hold 12 months. Focussed on value/ momentum, small to mid cap firms with reasonable transaction costs. Similar to NAPS Ed Croft.

Long term, hold multi year. Focussed on quality and growth, strong business case, turnaround situations, special situations, out of favour sectors, potential multi-baggers, new technologies. Transaction costs and size not particularly relevant.

There are 'many ways to skin a cat', so it pays to use all of them.

LumpedOn

Roland - thanks for another thought provoking article. Over the last 9 months I have been really active in terms of reallocating capital towards stocks with strong momentum scores and cutting positions that have been range-bound for a while (we discussed our views on Computacenter (LON:CCC) here recently). Have to say it's been a mixed bag with results on Eurocell (LON:ECEL), Warpaint London (LON:W7L) and Taylor Wimpey (LON:TW.) , losses on Renold (LON:RNO) and McBride (LON:MCB), and a tragedy on Card Factory (LON:CARD).

I have been using a screen that looks at a combo of QG and VG scores linked to momentum, and I agree that a timeframe needs to be longer than expected for this kind of strategy.

My issue is that as a risk accepting, inherent gambler I still do better on specific situation picks and risks - Funding Circle Holdings (LON:FCH) is my best performer of the year at 40% gain since buying in July when its M score was just 40 (now 46) and I still hold. Last Friday I started on Future (LON:FUTR) and we'll see how that does in the coming weeks (at least it has a high M score) compared to the kind of decisions I used in the above.

So my point is that for me at least, rules based and data-driven decisions are all well and good, but my gambler's instincts and willingness to scan endlessly for special situations, and lump on big-style, still seems to win out. A frustrating outcome but I guess that's part of the fun of playing the markets.

Always appreciate your rules based stuff, thanks !

chrisgb

Thanks for the interesting article. I have a question. When you specify a stop loss of 25%, is that 25% down on the purchase price or 25% down on the highest price it reached while you own the stock?

iwright7

Rowland,

A fascinating take on Momentum and your belief that Momentum has contributed to some of your portfolio’s strongest results. Also you note that a high F-Score supports a rising share price. This dual effect has been shown in a little known research paper I came across just recently. It’s called: “Dissecting stock price momentum using financial statement (F Score) analysis’

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3127181

The authors conclude… For investment professionals, our findings suggest that a combined fundamentals (High F Score 7-9) / (High 6 month) momentum strategy is not only more profitable and less risky than a pure momentum strategy, but is also likely to be more implementable.…. The effect is remarkably robust in that it generates positive returns 88% of the time (37 of 42 years) and outperforms a pure momentum strategy 83% of the time (35 of 42 years).

I'll happily take those odds! Ian

Roland Head

Hi chrisgb,

The stop loss is for a drop of 25% from the purchase price. In other words, a running loss of 25% on the position.

Roland

Quest

Roland, Are your 8% Returns pre or post Capital Gains Tax?

cadmunkey

Good find iwright7, thanks for adding the link. Roland, I always like your articles, this is no different.

Cancun

Presumably tax free in a SIPP or ISA ? Why would one expect returns to be adjusted by CGT please? Am I missing something please ?

Peez Peez

In short, there are five powerful drivers for share price appreciation:

1) Revenues and profits growth momentum.

2) Operating margin expansion.

3) Multiple expansion.

4) Share price momentum.

5) Brokers' upgrade momentum.

In addition, 2 main rules on selling to preserve capital and keep losses small:

1) use a stop-loss and never let losses go beyond 25%.

2) Sell on the first sign of a profit warning.

Howard Adams

23rd Oct '24

Hi Roland

A really interesting follow up article from your recent review.

Many thanks

Howard

StrawberryDreams

Thanks for the insights.It's really interesting and very helpful to see people walk through and break down their strategies, successes and warts and all.Especially as i'm still trying to work out where i am most at home strategy wise.I tend to like the idea that i can 'flip-flop' strategies according to market conditions and how much time i want to spend working on investing and trading and where other commitments and hobbies take me (ie. less momentum to more value).And i definitely still tend to the stockpicking approach rather than a purely quant approach.However perhaps that's not the best idea.It's always great to hear about different approaches i can use as personally i can still find that it's easy to ignore better methods sometimes, as i can get so wedded to one idea of investing.

Threepeat

24th Oct '24

Thanks Roland, I had never really thought about the broader aspect of momentum, being a value & Income investor.

Made me think more widely

Thanks again

How I use momentum in my investment process

How I capture momentum

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Roland Head

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