Frogs, momentum and investment

It's well known that momentum investing has paid off well. What's not so well known is why. Two recent papers provide two very different explanations.

Zhi Da at the University of Notre Dame says it's because investors have limited attention; they simply cannot monitor all news about all shares. This means that they don't pay enough notice to gradual small pieces of good news about particular stocks, and so they under-react to such news. They are like the (apocryphal) frog in a pan of water. It doesn't notice that it is gradually heating up, with the result that it fails to act and so scalds to death - except that the lack of action has happier consequences for investors than for the frog.

He tested this theory by measuring the gradualness of news, based simply upon shares' daily returns. And he found that stocks whose good news arrives gently and gradually earn stronger and longer momentum profits that stocks whose good news comes in a single lump.

There's a simple implication here. Investors should look out for shares which, over a few months, enjoy many days of modestly good returns. These are more likely to do well subsequently than stocks whose good performance is due to one piece of good news. Last month's big fall in De La Rue, after the hoped-for takeover by Oberthur fell through, shows that it's dangerous to trade on momentum that's based on just one story.

However, Lu Zhang at Ohio State University has a different explanation.

To see his point, consider a commodity stock (though the theory applies to any share). If commodity prices rise, it too could well rise because its growth options - the opportunity to drill a new well or open a new mine - have become more valuable. However, it is risky to exercise such options, because investment in exploiting resources is both expensive and dangerous: remember Deepwater Horizon. To compensate for such risks, the share's expected returns must rise. And because higher expected returns, on average, lead to higher actual returns, we get momentum.

Mr Zhang estimates that momentum profits disappear once you control for the fact that momentum stocks tend to have higher capital spending and sales in the following year.

These two explanations differ in one important respect. In Mr Zhang's story, momentum profits are a reward for taking a particular risk - that investment in growth options will go wrong. In Mr Da's story, though, momentum has offered something for nothing - it's been a way of exploiting investors' cognitive limitations.

This difference matters. If Mr Da is right, momentum profits might disappear as investors learn to pay attention to flows of small good news. For all we can tell, this might already have happened; perhaps momentum profits will cease from now on. However, if Mr Zhang is right, momentum profits should continue, on average, but only because they are a reward for taking risk.

So who is right? I'm not sure it's possible to tell right now. Sometimes the same facts are consistent with two different theories.

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