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Asking questions of momentum winners

Buying shares with price momentum would have outperformed other stock-picking strategies in the UK over the past decade but the output of our momentum screens is only a starting point for building our Alpha portfolios.
March 20, 2018

Buying shares with price momentum would have outperformed other stock-picking strategies in the UK over the past decade. That’s one way to interpret the findings of Dimson, Marsh and Staunton of the London Business School. Their research, published in a section of their Global Investment Returns Yearbook 2018, shows momentum inspired style-investing would have delivered average annualised returns of 13.5 per cent between 2008 and 2017.

Investors Chronicle’s own momentum systems provide affirmation. Since 2012 Algy Hall’s Great Expectations FTSE 350 screen, which is run annually in the magazine and online, has made total returns of 220 per cent, compared to 62 per cent for its parent index. As well as share price momentum, Algy’s methodology also screens for upgrades in profit forecasts and positive earnings growth expectations.

For IC Alpha, we are running new versions of the screen from the FTSE All Share, the FTSE All Small and Aim indices. The Alpha screens will be re-run every month to highlight when new companies meet their criteria.

Momentum as a starting point

One way to use the screens would be to buy all the stocks and sell those that fall out of the screen. Potential turnover is high but, thanks to the earnings upgrade requirements, hopefully less than if just price momentum was considered. It then remains to be seen whether the momentum factor continues the impressive returns seen since 2008.

The first point to this is that, although momentum has been a hugely significant return factor in the UK stock market, it does go through periods of serious underperformance. In 2009 for example, the LBS team’s Yearbook shows momentum would have lost over 25 per cent. There is also the possibility stock turnover in our monthly screens could turn out to be very high after all, making it prohibitively expensive to ape the screens in their entirety.

Another way to use the new Alpha momentum screens therefore, is as a starting point in researching companies with potential to carry on recent good performance.  Now, momentum is a beta phenomenon, we know that periodically it beats the market in aggregate. By cherry-picking stocks, we are using momentum as an indicator, not buying into the factor – that can only be done by backing the momentum field.  So, for our IC Alpha portfolios, we will use these screens to highlight which companies have done well, before questioning whether their positive performance is likely to continue. The screens can help this task by highlighting weaknesses we should examine.

Taking the FTSE All Share to start with, there are three companies that didn’t fail any of the tests. Perhaps more is to be learned, however, from the companies that failed at least one test.  The full list of screen rules can be read in Algy’s report but of the companies that failed one test, ten out of twelve did so because the positive earnings forecasts were for below 10 per cent growth in the company’s next financial year. Therefore, we should examine the profit challenges each of these companies might face before deciding which we’d include on a shortlist.

FTSE All Share momentum companies with forecast FY+2 Earnings growth below 10 per cent

Company (Ticker)

Last IC View

Evraz (LSE:EVR)

Hold, 3 March 2018

Huntsworth (LSE:HNT)

Buy, 6 March 2018

IG Group (LSE:IGG)

Hold, 24 Jan 2018

NMC Healthcare (LSE:NMC)

Buy, 7 Mar 2018

KAZ Minerals (LSE: KAZ)

Hold, 22 Feb 2018

Robert Walters (LSE:RWA)

Buy, 1 Mar 2018

Beazley (LSE:BEZ)

Hold, 1 Mar 2018

Spirax-Sarco (LSE:SPX)

Hold, 16 Mar 2018

XP Power (LSE:XPP)

Hold, 5 Mar 2018

Marshalls (LSE:MSLH)

Buy, 14 Mar 2018

 

The table shows the companies which failed the test and the last IC View on each. Six out of 10 have been moved to hold by the writers that cover them, citing reasons to be cautious about the prospects for continued profit growth. In some cases, this can be explained by political risk. Steel producer Evraz (LSE:EVR), for example, could fall foul of a new spirit of protectionism.

In other instances, there is exposure to factors such as commodity prices. The outlook for Kaz Minerals (LSE:KAZ), for example, is influenced by the copper price. Where there are cost pressures too, as in the case of Kaz, there is uncertainty whether the shares will maintain momentum.

Sometimes there can be reasons to doubt whether tailwinds will continue. Stripping out currency effects lessens the impressive 2017 profits of Spirax-Surco (LSE:SPX) and less favourable movements could reduce the earnings growth story going forward.

For some of these companies, there are further checks that can be made to provide reassurance, or not, that momentum can be sustained by more than just animal spirits. Operational gearing – the sensitivity of profit levels to changes in revenue (high fixed costs means more units need to be sold to make a profit) – is an issue for some firms, especially in cyclical industries, in maintaining earnings momentum.

Where companies have high fixed costs, therefore, it is especially important to look at how successful they are at growing sales and the speed at which inventory is turned over.  Most vital is how long it takes orders receivable to translate into cash in the bank, which by extension is in part reflected by the ratio of accounting profit converted into cash.    

It is always worth looking at free cash flow but this only tells part of the story as cash flow can be lumpy because companies are investing for growth – which is potentially good. NMC Healthcare (LSE:NMC) which Investors Chronicle rates as a Buy, is  taking on debt to expand, but if the momentum story is to continue it needs to make good on those investments. If the ratio of enterprise value (equity plus debt capital net of cash) to cash profits (EBITDA) starts to look stretched then the positive share price performance could run out of steam.

For our IC Alpha portfolios, we’ll want to avoid companies with negative momentum but we won’t necessarily be rushing in to buy the positive momentum stories either. In doing so, we may be exhibiting some of the portfolio management behaviours that in part explain the momentum effect. Some academics have argued that portfolio managers, worried about beating their benchmarks, have been overly cautious. Underreacting to good news stories has, according to Jegadeesh and Titman (1993) been a source of further upside for momentum stocks as investors who lagged behind at first, flock to catch up and push prices higher.

The fact remains that picking individual stocks on the back of momentum alone is a leap of faith, so we’ll want to do further research. We are yet to choose the UK equity picks for our IC Alpha portfolios and we will deliberate further on the companies flagged by the momentum screens. This caution across the market at large may help to explain why the momentum effect has been so enduring.