There's a genuine puzzlement in academic circles at momentum's ability to deliver market-beating returns. In fact, momentum investing has earned the nickname the 'premier anomaly' due to its uncanny knack of beating the market. But there are a number of sound reasons that can be given for the existence of this anomaly.
For one thing, as most seasoned investors know from experience, the market rarely captures the full significance of corporate news in one swoop. On the one hand, despite the clatter of brains constantly analysing events, it generally takes the market a bit of time to fully appreciate the significance of events. But it is also often in a listed company's best interests to play its cards reasonably close to its chest. Companies that over-egg investor expectations tend to be harshly punished if things go even slightly wrong. Most canny managers of healthy public companies who want to impress shareholders know that it's best to under-promise and over-deliver, even if behind the scenes they are preparing for a brighter future than analysts' perceive.
And a tactic of keeping expectations safely inside the realms of achievability leaves scope for a continual trickle of broker upgrades to fuel share price appreciation.
The trickle effect is also evident when trading and share prices are heading south. This is why it is often said that profit warnings come in threes. For example, a public company is obliged to issue a warning when it becomes clear that forecasts will be missed by 10 per cent or more. However, usually trading continues to deteriorate, which means it's not long before the company has to warn again, except in the rare event that the problems have been quantifiable at the time of issuing the first statement. And it's normally evidence that things have gone badly wrong when management are prepared to throw in the towel and announce a major overhaul, which is often the subject of the third warning issued by a troubled company.
Momentum is also an understandable concept based on the time it takes for a stock to build a fanbase after a strong investment theme emerges. While an eagled-eye or lucky analyst or investor may alight on a good investment story early on, support for a good investment idea is usually slow to build. However, as support builds, prices rise, which attracts more investor and analyst attention, which in turn leads to more demand for the shares, pushing up the price and attracting even more interest.
It's essentially herd mentality. When there is a good investment case for a share and its price is rising fast, the market has a knack of being able to justify the valuation being applied to it even if it were thought outlandish only a few months earlier. During the dot-com boom, a lack of earnings and, in some cases, revenue to justify valuations didn't stop brokers setting stratospheric target prices for shares. The effect on the way down reverses as despairing analysts and investors stop watching falling stocks.
Themes are also very prevalent in deciding the constituents of a momentum portfolio. As demonstrated by recent popular market themes, such as emerging market 'decoupling' and commodity super-cycles, these ideas can persist for a long time and inflate parts of the market far more than most investors would dare hope when the arguments were first formulated.
Other factors that aid momentum include the tendency for funds to compare their performance to that of large-cap indexes which encourages them to hold shares in those indexes. This tends to mean that there is more money available to invest in larger stocks, so when share price rises cause a company to move up into a new index, there is more buying by funds which can cause additional outperformance. Likewise, a stock that loses ground and falls out of an index is likely to come under further selling pressure. Some investment styles also explicitly embrace momentum strategies and others, such as growth investing, tend to support momentum by chasing earnings growth which should be reflected in share price rises.
