A big quarter for blue-chip momentum

This might not sound feasible. The ongoing banking crisis has served to highlight the unruly ways human fear can quickly lead to unforeseeable consequences.

But despite appearances, human behaviour isn’t totally random. In a 2010 study of millions of mobile phone records, a team of network scientists led by the physicist Albert-László Barabási found about 93 per cent of individuals’ travel patterns were entirely predictable.

Such insights also help explain why governments and companies place a lot of confidence in the power of behavioural nudges and marketing to influence the decisions of consumers and citizens.

Why might any of this matter to stockpickers? After all, on a long enough horizon, the impact of human behaviour on share prices tends to come out in the wash, as company cash flows assert their gravitational pull on valuations and prices.

In the short term, however, sentiment can play a big role.

When it comes to shares, the clearest example of this is the phenomenon known as momentum investing. As traders are fond of saying, “momentum is your friend”, by which they mean following the market’s lead is often a smart strategy for banking further short-term gains.

While a demonstrable feature of the way liquid assets are priced, it is hard to reconcile the apparent existence of momentum with the concept of efficient markets, which states that a company’s market price accurately reflects all the information known about it. Why, for example, do share prices often continue to rise for days after the disclosure of a positive development?

The truth is that no-one is quite sure why momentum seems to work. Indeed, second-guessing other investors’ slow digestion of publicly available information is just one theory. Momentum might also be explained by the tendency (or expectation) of good news to beget good news (and vice versa).

But work it does, at least when the UK’s most widely followed stock index is concerned.

Since 2007, our Momentum Classics screen has tracked the FTSE 100’s biggest risers and fallers every three months. Over those 63 quarters, two observations are apparent. The first is that the index usually goes up – approximately 62 per cent of the time – while the 10 stocks which rose the most in the preceding three months (which we call the ‘longs’) climb about 56 per cent of the time over the next quarter. Incidentally, this is only a little more than the past quarter’s biggest fallers (the ‘shorts’).

But it is the second observation which matters to long-term returns. While the FTSE 100’s growth has been more reliable in any given quarter, the longs’ greater volatility has been more than compensated for by their average gains, which have produced an index-trouncing performance. In simple price terms, the FTSE 100 is up around 9.8 per cent over 16 years, while a strategy of continually reinvesting in the index’s 10 best-performers every three months would have yielded closer to 244 per cent (excluding what would be some chunky dealing costs).

Doing the same with the ‘shorts’ would have generated a negative price return of 10.2 per cent, also before trading costs, suggesting blue-chip momentum is a factor that swings both ways.

The long-term trend was neatly demonstrated in the opening quarter of 2023. Thanks to double digit share price rises from four of the December screen’s 10 longs – including a huge re-rating in Rolls-Royce (RR) – those stocks with strong momentum saw a 9.5 per cent average increase in the three months to 15 March.

The shorts, meanwhile, tracked the broader market. Aside from a hefty decline in beaten-up North Sea driller Harbour Energy (HBR), which dropped out of the FTSE 100 in the period, there were no major blow-ups. Still, on balance, steering clear of the mini-portfolio’s selections would have been a smart call.

The latest movements mean the 10-year headline return from the screen’s longs stays above 100 per cent, despite the magnifying effect of a pedestrian performance between 2013 and 2016.

Interestingly, those returns have been almost entirely banked since early 2020’s pandemic-battered markets resulted in massive declines in the value of both the longs and shorts (see chart). Our screen suggests a UK large-cap investor who stuck with positive momentum over three volatile years could have doubled her money. As a result – and despite the FTSE 100’s recent recovery to its pre-pandemic watermark – the dispersion of momentum-driven returns over three years is now wider than it has ever been.

March madness

While shares often rally or drop sharply for idiosyncratic or company-specific reasons, the herd-like nature of markets also creates patterns across sectors. This quarter’s 10 longs for example (see table), have a distinct weighting to retail names, including JD Sports Fashion (JD), Primark-owner Associated British Foods (ABF), B&Q-owner Kingfisher (KGF) and Next (NXT).

A further two UK blue-chips – construction giant CRH (CRH) and gambling group Flutter Entertainment (FLTR) – have seen bullish investor sentiment further charged by plans to list their shares on US stock exchanges.

One wonders if the past three months’ share price declines at miners Glencore (GLEN), Anglo American (AAL) or Fresnillo (FRES) might tempt their boards to consider a New York listing, given US investors’ famed risk tolerance and the distinctly non-British focus of their operations. Investors in Entain (ENT), the sixth biggest FTSE 100 faller over three months, might also be wondering how to parlay its fast-growing American joint venture into a premium rating for the group. Investor hopes of another takeover tilt from US partner MGM Resorts (US:MGM) were quashed last month after the latter ruled out a bid, meaning the near-term horizon offers the Ladbrokes owner little beyond the potentially ominous conclusion of the UK Gambling Review.

If the white paper proves better than the industry fears, we might expect Entain to join the long list of blue-chip stocks which flip from one of the worst to best performers (or vice versa) on a quarter-to-quarter basis. This quarter, Fresnillo makes the switch from long to short, while Scottish Mortgage Investment Trust (SMT) keeps its place on the list of shorts for the third time in five quarters.

BT (BT.A), the one company in this quarter’s selection to jump from short to long, remains an important litmus test of investor sentiment toward UK plc. Last week, it received a big boost from the Budget, which rolled forward 2021’s so-called super-deduction tax that allows companies to write off their capital investments. Full expensing, as the policy is now known, is more or less the state's flagship corporate investment policy. Though it is designed to attract large business spending over the next three years, its continuation effectively gifts BT another leg-up in its planned rollout of superfast broadband networks.

Whether the policy’s expected effects on BT’s future cash flows and income will be the driving force in the share price over the next three months is anyone's guess. The narrative might be overtaken by Ofcom’s review of the group’s pricing framework for optical fibre contracts, and lingering doubts about the telecoms group's quasi-monopolistic ambitions. We'll have to wait and see. But as the cheapest of this quarter’s longs, at least some of the downside appears baked in.