Ten soaring blue chips

Movements in the FTSE 100, from which the screen’s selections are drawn on a quarterly basis, have been especially jumpy. The index spent the first couple of weeks of the period selling off. Then, starting midway through July and continuing well into August, we saw a summer rally. That ended abruptly at the start of September, as a slew of bearish economic data grounded positive sentiment.

The net result was a 1 per cent rise in the UK’s blue-chip index. At least, that was the result in sterling terms. Priced in dollars, the market fell 4 per cent, compared with quarterly rises in both the MSCI World and S&P 500. In fact, so weak was the pound’s performance against the greenback in the period that US shares appeared to jump 10 per cent when seen through the lens of a sterling-denominated portfolio. International stocks’ late June down-leg is also much less visible from this perspective.

Of course, headline swings in momentum often disguise bigger price movements at the individual stock level. Such movements have been key to the long-term success of our ‘buy-the-trend’ screen.

For those not familiar with momentum investing, it operates on a simple and proven principle: that recent share price performance often points to the continuance of that trend. Our screen seeks to exploit this dynamic by identifying the FTSE 100’s 10 biggest risers and fallers in the preceding three months, and betting on the trend carrying on by going long or short. Over the past decade, the longs have returned 129 per cent before dividends, compared with 23 per cent from the index itself. Selling the shorts would have avoided a 1 per cent cumulative simple share price fall.

This quarter, the screen didn’t quite fit the long-term trend. While a majority (seven out of 10) of the shorts fell, posting an average decline of 0.4 per cent in the three months to 15 September, the longs declined by 0.7 per cent – despite a rise in the majority of June’s picks.

Exclude from the ‘shorts’ cohort the antivirus software developer Avast, whose shares rallied after the company’s takeover by US rival NortonLifeLock (US:NLOK) received surprise approval from the Competition & Markets Authority, and the average decline would have been 6 per cent. Likewise, the performance of the longs looks much smarter if you remove industrial turnaround specialist Melrose Industries (MRO), which experienced another sharp reversal in market confidence. This quarter, the stock flips from long to short.

Of course, we can’t exclude stocks in hindsight. Nor, in the interests of quantitative rigour, should we. The big defect in momentum investing is that peaks and troughs are impossible to spot, but this is something we must live with and (hopefully) ride out over time.

3-MONTH PERFORMANCE

With commodities prices more subdued in recent months, this quarter’s picks are both less weighted to resources stocks, and more eclectic from a sector perspective. With a couple of exceptions – namely lender NatWest (NWG) and discount clothing retailer Frasers (FRAS) – the longs are also more highly-rated businesses with a general bent toward scalable software platform businesses.

That might reflect a realisation among some investors that large caps with growth stories are still worth paying up for, despite the damage inflation and rising interest rates are doing to the real value of long-term cash flow assumptions. This theme is neatly encapsulated by the past quarter’s biggest riser, engineering software group Aveva (AVV), which is on the cusp of a buyout by its majority shareholder, Schneider Electric (FR:SU).

Other bid activity in the space, including a surprise offer for former FTSE 100 constituent Micro Focus International (MCRO), the £1.25bn acquisition of Aim-listed NHS software provider Emis (EMIS) and the takeover of Avast, may serve to put some support under what counts for the UK’s technology sector. But investor enthusiasm is a fickle thing right now, meaning today’s speculative bullishness can quickly fade on tomorrow’s central bank hint at a steeper pace of monetary tightening.

Unlike most of the stock screens that appear in these pages, our Momentum Classics screen tracks share price performance (so-called capital returns) only, meaning dividends are absent from the equation. That might seem like an oversight, given the importance of shareholder distributions and compounding to the FTSE 100’s investment case. But factoring in the reinvestment of those payments gets a little bit complicated when it comes to quarterly reshuffles. The long-term evidence also suggests it is price performance, rather than total returns, that has a bigger sway over the success of backing rising or falling stocks.

Nor, it should be highlighted, does the screen factor in the notional dealing costs of rebalancing each quarter. This all matters, because research into momentum strategies shows costs hurt returns. Shorting can be especially costly, once commissions and borrowing charges are factored in.

The net result is a less-than perfect proxy of real-world momentum performance, even allowing for the fact that the screen and its results are not intended to be oven-ready portfolios. Again, this is something we will just have to live with. For now, we take a closer look at one of the longs.

NatWest

NatWest’s (NWG) appearance in September’s list of upwardly mobile FTSE 100 stocks marks the third quarter in a row that a UK-listed bank has made the cut. Even as the spectre of recession looms large on the economic horizon, a combination of rising interest rates, gradually expanding net interest margins and higher near-term projections for income have created a positive feedback loop for earnings forecasts and investor attention.

Sometimes, simple stories are powerful drivers of momentum. It may be that investors do not want to hold NatWest for the long haul. A forward earnings multiple of seven would suggest that the market is sceptical of the quality of the company’s earnings. But as far as carry trades go, banks like NatWest have a powerful story to tell, which is that higher borrowing costs are likely to persist so long as inflation remains elevated.

That dynamic is especially pronounced when rates are rising quickly. Because lenders are usually able to earn more from borrowers than they pay out to depositors, further rate rises translate to both wider margins and higher income. Combine that by holding down operating expenses – as NatWest managed to do in the first half of 2022 – and operational gearing starts to kick in in a big way. Consensus earnings forecasts for this year have roughly doubled to 33p a share since February, and according to analysts are on course to hit 41p in 2023 as the yield on one-year UK gilts rapidly heads toward 3 per cent.

The threat to this rosy scenario is quite how much risk is buried in the bank’s asset pile. Just how painful a collapse in UK house prices might prove is unquantifiable, though the country’s second-largest mortgage provider is unlikely to escape unscathed. A larger risk might come from distress in the corporate loan book, should a recession lead to a spike in bankruptcies and breaches in borrower covenants.

Fortunately for NatWest, loan impairment rates remain very low and capital buffers remain high, despite a generous programme of shareholder distributions. I would be surprised if the shares have suffered when we come to review their performance in December.  

RS Group

Over the long haul, a stock’s inclusion in either the FTSE 100 or the FTSE 250 shouldn’t make much of a difference. But when companies are promoted to (or relegated from) the premier index, the effect can be magnified, for the simple reason that tracker funds are forced to buy or sell shares in the constituent.

This somewhat idiosyncratic instance of momentum investing may have been a factor in the 21 per cent jump in the shares of Frasers in the third quarter, after the group catapulted into the big league in time for Mike Ashley to bid adieu. It also likely contributed to a rally in the shares of RS Group (RS1) at the end of 2021, when the electronics products distributor re-joined the FTSE 100 after a two-decade absence.

Shares in RS, which for the duration of its life outside the index was known as Electrocomponents, have been enjoying something of a rebound in recent months, after selling off in line with stuttering market sentiment in the first half of the year.

The latest noises from the company suggest those fears were badly overcooked. In July, the group said full-year market forecasts for both sales and profits, which had already been climbing, were likely to be beaten as cross-selling synergies and robust global client demand translated into sustained like-for-like growth. “While we remain alert to a difficult macroeconomic environment and increasing inflationary pressures, we have an improved pricing model, strong cost controls, tight inventory commitments and profitable growth initiatives,” commented chief executive Lindsley Ruth.

A month later, Ruth and his team cemented that bullishness by agreeing to buy Risoul, a leading distributor of industrial and automation product and service solutions in Mexico, in an all-cash $275mn (£228mn) deal.

Encouraged by what they’ve seen and RS’s apparent resistance to supply chain issues, analysts have continued to push estimates higher. The group is now expected to post EPS of 57p in the 12 months to March 2023, an inflation-busting year-on-year rise of 16 per cent. The shares are still a quarter below last November’s all-time high, but they are now almost a third cheaper on a forward price/earnings basis than they were a year ago.

*13 Jun to 15 Sep. Source: FactSet