Ocado lays bare the problem with momentum investing

Once upon a time, the consensus among financial academics (along with many investors) was that markets were efficient. It’s easy to see why the theory had lots of fans. After all, the idea that prices follow a random walk – driven by the push and pull of buyers and sellers digesting new information – feels like a sound description of reality. When the facts change, so do buyers’ and sellers’ minds, and prices. Just because the constant absorption of new data gives the impression of price randomness doesn’t mean that it is random, or inefficient, or wrong.

In a reversal of Benjamin Graham’s famous adage, the efficient market hypothesis essentially argues that the stock market can be a weighing machine in the short term, too.

That, as they say, is the theory. However, since its peak acceptance period in the 1960s, evidence for the concept has been decidedly mixed. To many, the idea fails to give a proper account of the powerful roles that emotion, investor psychology, sentiment, market positioning and liquidity can all play. Moreover, the contrarians argue, the frequent occurrence of dramatic market swings reflects investors’ inability to efficiently price securities in the short term.

All of this matters a great deal in our quarterly Momentum Classics screen – the subject of this week’s stockpicking methodology – for the simple reason that if markets are perfectly efficient, then momentum does not exist.

That the opposite might be the case isn’t the same as saying that momentum investing can be easily harnessed, or that investors need to pay attention to the phenomenon. A 2022 paper written by a pair of academics from the US and China found that while momentum trading is common across the fund industry, evidence of “timing skill” was only modest among the average hedge fund, and non-existent among fund managers. The paper also found that on its own, “momentum trading does not translate into superior performance”.

The evidence from our own stock screen is a bit more positive. Our quarterly screen, which takes long or short positions in recent risers and fallers in the FTSE 100, aims to replicate the well-documented (though not fully understood) phenomenon. Over the past decade, a strategy of continually surfing those rising blue-chip waves would have generated a simple price return of 108 per cent, versus 20 per cent from the index itself.

That doesn’t mean beating the market is simple. In the 65 quarters we have tracked the screen, the FTSE 100 has risen 63 per cent of the time. By comparison, the 10 stocks that rose the most in the preceding three months (which we call the ‘longs’) went up 57 per cent of the time over the next quarter. The past quarter’s biggest fallers (the ‘shorts’) went up in 54 per cent of cases.

That last observation helps explain why shorting is so volatile. Since the screen’s inception, the shorts are down 8 per cent in simple terms, making them a somewhat muted hedge.

But over the past three years, a trader who periodically took short positions in the worst-performing FTSE 100 stocks identified by our quarterly momentum screen would have lost 43 per cent before dividends and borrowing costs. Buying (rather than betting against) these laggards would have been a more profitable strategy than backing the biggest risers, or the index itself. Given the long-term performance, however, there’s a greater weight of evidence to suggest the ‘shorts’ thrown up by our screen are best avoided.

Following this rule in the three months to 15 September would have been a wise move. Two UK retail plays identified by the screen – B&Q owner Kingfisher (KGF) and trainers hawker JD Sports Fashion (JD) – saw their share prices stall and decline, respectively, as doubts about the strength of consumer spending re-emerged in the face of a wet summer. Elsewhere, sell-offs in Mexican precious metals miner Fresnillo (FRES) and chemicals business Croda International (CRDA) offset better quarters for lumbering telecoms giant Vodafone (VOD) and wound care specialist ConvaTec (CTEC).

On the other side of the ledger was a stonking performance from Sage (SGE), which passed the £10bn market capitalisation threshold in the period. The enterprise software group’s 17.7 per cent price return in the quarter also ensured its place in this month’s pack of longs and helped lift an otherwise middling group of third-quarter momentum picks above the FTSE 100’s 1.1 per cent price rise.

Can Ocado maintain its run?

For any reader who still finds themselves drawn to the elegance of the efficient market hypothesis, this quarter’s number one ‘long’ – Ocado (OCDO) – provides food for thought.

Shares in the online supermarket, which climbed 78 per cent in the three months to 15 September, have been on a wild ride this year. After posting the biggest decline of any FTSE 100 constituent in the first quarter of 2023 (and making it our top ‘short’ in the three months to June in the process), the stock rallied hard shortly after our last momentum screen went to press, as market rumours swirled of an imminent takeover bid.

While nothing materialised, the subsequent publication of half-year numbers in July was enough to put another rocket under the shares. On the face of it, those results hardly resembled manna from heaven. But in the context of Ocado’s serial disappointments and concerns around cash burn, the recording of an adjusted cash profit and the maintenance of full-year guidance were seen as big pluses.

Judging by the decline in net short positions in the stock during June and July, it seems likely that those twin rallies were exacerbated by sharp unwinds in bets against the shares. Faced with a short squeeze, bears would have been forced to either close out their positions or post extra collateral by buying more Ocado shares, forcing up prices in the process.

Since then, however, the stock has remained highly volatile, gapping up or down on each broker upgrade or downgrade. The online-only grocer, whose sales growth is now largely driven by licensing its order-fulfilment technology to third-party food distributors, remains one of the most divisive investment cases in London.

In the first half of 2023, sales in the technology solutions division – whose international clients include Kroger in the US, Japan's Aeon and South Korea's Lotte – jumped 59 per cent to £198mn. But only two fulfilment centres went live in the half, while new centre openings in Australia were hit by delays. A clear roadmap to free cash flow generation remains somewhat elusive, which is a big issue with debt rising.

Is the Hail Mary moment just around the corner? My colleague Christopher Akers is doubtful, calling Ocado a “jam tomorrow business”. But our momentum screen needs only to see the (possibly irrational) exuberance in the shares maintained until the Christmas run-in. Until then, here’s hoping the trend remains our friend.