The Underlying Dynamics of Momentum Investing

Momentum investing is based on the premise that past price performance is a good indicator of future price performance. Stocks with the highest relative strength over the past 3-12 months often remain among the best price performers over the next 3-12 months. The central idea behind this investment approach is to find an already existing price trend and a proper point of entry.

The stock market is a forward looking mechanism that constantly tries to discount collective expectations about the near-term future.  Prices change when expectations change. Expectations change under the pressure of external factors, which I call catalysts. Catalysts represent new information that alters perceptions of value and boosts risk appetite, which have the potential to start a process of major re-pricing (new trend).

At the foundation of every major price trend there is either an improvement in fundamentals or (as it is in most cases) rising expectations for future improvement in fundamentals. From a bird’s eye view major changes in expectations for fundamentals are based on new social trends, business cycle, economic cycle or new regulations – all of them are sustainable sources of change and don’t just disappear overnight. This is what makes the existence of trends possible.

At the beginning of a new trend many market participants adjust slowly to new reality due to:

–         Naturally ingrained conservatism. Many don’t change their mind when new facts start to appear and wait for additional confirmation before they act. Some wait for price confirmation as an evidence that other market participants have interpreted the new information in a similar way. Others wait for volume confirmation as prove of institutional involvement. The logic behind such thinking is that when institutions buy, they leave traces and if they don’t get involved, a new trend cannot be sustainable;

–         Market participants are using different sources of information, take different time to analyze it and might come to totally opposing conclusions based on dissimilar investing/trading styles and time frames of operation;

–         Disposition effect. Many market participants are looking for instant reward and feel fear against realizing losses. They are quick to sell winners and reluctant to sell losers, which essentially leads to slow reaction and under-discounting of new information.

The sustainability of surprises makes the existence of trends possible. In any given year, the best performing stocks are the ones that manage to surprise the most and most often. Every genuine surprise is a catalyst that changes perceptions of value and boosts prices.  Several consecutive surprises in a row are needed to convince enough market participants that the underlying dynamics of the new trend are not going away any time soon. At this point the stock becomes an institutional darling and discounting becomes pro-active.

The common denominator between price and the underlying fundamentals is that they are both cyclical. The difference is that when institutions get involved, price volatility increases much faster than fundamentals’ volatility as the market tries to take into account any potential future surprises. The best case scenario, all the potential good news is getting discounted proactively. Investors like to discount both extremes. From overly conservative at the beginning of a new trend, they gradually become overly optimistic and overreact. Overreaction could be explained by dissecting the following three concepts:

–         Herd mentality. Institutions have an incentive to buy the best performing stocks over the past quarter or two in order to sugarcoat statements to current and prospective investors. The real growth names are rare and everyone would like to claim in their prospects that they own them. This is what makes the stocks with the highest 3-9 months RS even stronger.

–         Blind obedience to perceived authority results in a false sense of security. Investors often outsource their due diligence to people who are considered experts in their areas. While it is true that experts are more knowledgeable, have more experience and probably access to better sources of information, their incentives are not entirely clear. For example, analysts’ statements have huge impact on the market despite the fact that many of them have been proven to be lagging indicators. Their price projections are often based on: 1) the assumption that the existing earnings trend will continue infinitely and 2) simplified models that assume normal distribution of market moves in a complicated world full with outliers and fat tails. This often leads to projecting and discounting of an unsustainable scenario of growth.

–         Bandwagon effect. Short-term traders may use the recent performance as a signal to buy or sell. Longer-term investors look at recent performance to confirm their convictions. The interactions between those participants might create price run-ups or –downs that can persist for many months until an eventual correction. Everyone is watching what the others are doing assuming that they know more (something). Price is considered as the ultimate sign that fundamentals are improving and will improve in the near future.

Finding a great trend is not difficult (at least in hindsight). Riding it and having a proper exit plan in place is the hard part. It is said that the difference between a great momentum investor and a good momentum investor is that the former knows how to time his exit properly.

What are some of the leads that might hint a potential danger to a great price trend:

–         When the consensus opinion says that the only thing a stock can do is go higher, be careful. If everyone owns it, there are not many buyers left. There are always plenty of sellers as market participants, who operate on shorter time frames, are quick to sell their winning positions and lock in profits. Tops are formed when a stock runs out of buyers;

–          Eventually the Wall Street printing press catches up with market’s demand by 1) issuing more shares of existing companies that are currently growing in an impressive pace and 2) underwriting IPOs of companies in currently popular industries. Don’t forget that investment banks are in the business of printing and marketing securities that are currently in demand;

–         The appearance of negative earnings surprise or not positive enough one. When expectations are high and a stock is priced for perfection (another expression for projecting unsustainable growth), even the slightest disappointment leads to a sell off;

–         Risk appetite vaporizes due to a macro event;

A Look at Value Investing

I have no doubt  that value investing is based on inherently sound principles and it could be a source of consistent profits over time. I am not sure if it is a style suitable for everyone. It requires an amazing patience, an iron will to overcome naturally ingrained biases and a strong stomach to get over temporary setbacks. This is the good news for those willing to devote to this investment style. If everyone was practicing it, it would not be so profitable.

On the surface value investing looks like shopping. If an $80 shirt is suddenly on sale for $40, you got yourself a deal. Capital markets are actually quite different than consumer markets. There is a big difference between shopping for a shirt and buying a financial asset. If you are an end consumer, you buy a shirt in order to wear it. You have no intention to make money out of it by re-selling it or renting it out. You purchase a financial asset with a plan to profit from it by playing one of two roles:

– a retailer, who buys with the intention to sell for a gain later or

– an investor, who buys for the income in terms of capital gain and dividends.

In capital markets price volatility is much higher than fundamentals’ volatility. Stocks that drop from $80 to $40 look like a bargain, but they may continue to look cheap all the way to $20. The fact that an asset seems attractively priced doesn’t mean that it can’t go even lower. In theory such huge discrepancy between value and price should not exist as arbitrageurs should offset the extremes. In practice such an event occurs much more often than most investors are willing to admit. The job of a value investor is to figure out: why is the price down and why the market is not seeing the existing value? Is the reason behind the sell off fundamental or emotional?

Value investors base their market approach on the assumption that the economy and  investors’ confidence are cyclical. They realize that in short-term perspective prices are heavily impacted by risk appetite, not by net asset value, cash flows or growth prospects. Occasionally emotions and biases become the main driving force of  investors’ decision making. Experienced value investors know that recessions happen often enough to offer great buying opportunities and economic recoveries always follow. When they do, risk appetite comes back and prices rise.

Essentially value investors make a  bet on the human nature – after all it hasn’t changed since the beginning of time. Market often acts irrationally as people forget all logic and become slave to their emotions. When people are in capital preservation mode, suddenly the return OF capital becomes more important than the return ON capital and investors rush for the exits at all cost. At this point there is not enough liquidity to meet the supply and prices might fall quickly. A patient value investor, who is also a good risk manager will come and will start to nimble, gradually building a position that he will sell later at much higher prices, probably to the same people who sold to him when they were scared.

I distinguish three basic approaches to value investing:

– very conservative: they don’t care about future cash flows and discount rates, because they realize that they cannot be forecasted with good enough precision. There is one important question to be asked -If I pay the current market price,  am I going to make money in case this business liquidates tomorrow? They calculate the market value of all liquid assets; give a good 50-70% discount to the current book value of the inventory and fixed assets, assume that intangible assets’ value is zero, subtract from all that the debt and if the remaining sum is still higher than the current market cap, they’ve found an investment candidate deserving further investigation. If this company survives, its fixed assets are likely to costs much more than they were accounted for. Such positive development would be considered a bonus. Now you may wonder, why would a company sells below its net liquid assets value? There are times when emotions reign supreme, when the return of capital becomes more important than the return on capital and investors want out at any price. Such times create opportunities for patient investors with deep pockets.

– pay fair price for good businesses: recessions occur frequently enough to offer favorable entries in good businesses and the stock market eventually always come back due to the cyclical nature of the economy and investors’ risk appetite. The important question here is – is the company going to survive the economic turmoil. If yes, when the economy starts to recover, the market will recognize the value and prices come back to pre-recession levels or higher.

– using reversed engineered DCF model. By taking into account the current price, a conservative (high) discount rate and current year’s operating cash flow, the projected growth is calculated. The main question here is – is the already embedded in the price growth sustainable based on historical reference? This approach provides a general estimate of that how overvalued or undervalued is a stock. It doesn’t provide a buy or a sell signal. Market can remain irrational for a long, long time.

The goal of value investors is not to beat the market benchmark every quarter or every year. There will be periods when they will underperform for 2-3 consecutive years, followed by times when they will be up 500-600%, which will more than offset any previous disappointments. To use a baseball analogy, they are looking for home runs, not doubles and triples.

Of course, value investors also make mistakes. As Warren Buffet likes to point out – “if I ever write a book about investing mistakes, it will be autobiographical”. The most often met mistakes in value investing are associated with the timing of an entry. Sometimes you have done your analysis, all the existing evidence points out that it is right, but the market may not agree with your thesis for years. In the meantime your capital is locked in a position that doesn’t produce cash flow and if you manage other people’s money – they might start to question your analysis. If you enter too early, you might experience significant losses. Are you able to tolerate them? If you manage other people’s money – are they able to tolerate them? Someone said that if you want to make 100% return you have to be willing to experience a drawdown of 20%. You can’t go down 20% with other people’s money. If you are too leveraged and start to get redemptions from scared customers, you will become a forced seller.

There is a saying that the difference between a great value investor and a good value investor is that the former knows how to time its entry properly. Timing is hard. Trying to build big position by timing the market is harder, because catching the absolute lowest point is a matter of luck. Even if by some accident you happen to catch it, the liquidity at the bottom is usually way too shallow. Correct timing  is not about catching the absolute bottom, it is about getting into a neglected stock that won’t remain neglected for too long.

Experienced value investors minimize the negative impact of timing by keeping plenty of cash and by gradually building new positions. Most of their investments could be essentially described as well in-the-money calls without an expiration date.

– ITM because there is margin of safety in the position (even if the underlying company is liquidated, what is left after debt payments will be higher than the market cap at which it was purchased);

– call options, because the potential reward could be tremendous (5-10 times the paid price  or even more);

– without expiration, because they keep plenty of cash reserves and aren’t leveraged; therefore they can’t become forced sellers before their thesis materializes.

The true value investor is a very rare bird that represents a very small part of the investors’ community; probably less than 1% of all involved in the stock markets. I have a huge respect for the people who have the mind to practice this contrarian investing approach. Their abnormal long-term profits are fully deserved. From psychological stand point everything is against them. It takes a special kind of character to overcome all biases wired in the human brain – our desire for instant gratification, our inability to feel financial pain for longer periods of time, our urge to jump from one market method to another when things are not going flawlessly. At this point of my life, I realize that I am still not patient enough, not able to stomach big drawdown in my portfolio, unwilling to go against the trend in order to be a good value investor. Maybe this will change with time.

P.S: over the weekend I will take a look at the underlying dynamics of momentum investing. I will present my view on why it works, how it works and when it works.

Niederhoffer on making errors

As a squash player, I was gifted. I had all the right things going for me. I practiced. I was very good with the racket, and I had tremendous anticipation. But I tended to play an errorless game by hitting a slice on my backhand, which took a lot of power off the ball. That wasn’t a disaster, but it was definitely a weakness in my game. My opponents always used to say that on a good day they could beat me, because they could hit more spectacular shots than me. But they never did. I went for about 10 years without losing a game, except to [the great Pakistani squash player] Sharif Kahn. He made about six, seven errors a game—but he also made eight or nine winners. I would make about zero errors per game but only one or two winners. He had the edge on me about 10-4, and I regret that I was never willing to accept the risky shots and confrontations, never willing to play a more error-full game.

In my market career, I took too many risks. In my squash career, I didn’t take enough.

I wish I had applied my squash methods to my speculating. I’d be a very wealthy man if I had.