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Believe it or not – momentum is doing well

My blue-chip momentum screen has substantially outgunned the index over the past three months – a case of don't believe everything you hear, or the exception that proves the rule?
December 11, 2018

Around this time of year, there tends to be no shortage of broad-based prognoses about the state of the market. However, broad overviews do not always tally with individual investor experiences. A case in point can be found in the performance for my blue-chip momentum screen over the past three months.

The consensus view seems to be that 'momentum' as a style has been trashed over recent months. However over the last quarter, the 10 FTSE 100 momentum picks from my screen, which simply backs the best-performing shares of the previous three months, has done substantially better than the index. Their average 1.2 per cent share-price fall compares with a negative 6.6 per cent from the FTSE 100 itself. Perhaps better fitting with the consensus view is the fact that the 10 'loser' shares picked last year actually did a bit better than the 'winners', dropping just 0.6 per cent.

Final-quarter perfomance

LongsShorts
NameShare price (15 Sep - 10 Dec 2018)NameShare price (15 Sep - 10 Dec 2018)
Sky29%Fresnillo1.5%
Whitbread-2.2%Antofagasta-0.7%
Rolls-Royce-18%Glencore-7.9%
Shire1.1%TUI AG-20%
Reckitt Benckiser-4.7%Randgold Resources43%
London Stock Exchange-18%easyJet-22%
Admiral0.6%SSE-0.1%
Unilever-0.1%Paddy Power Betfair-2.6%
Hargreaves Lansdown-15%Associated British Foods2.5%
BT15%Rio Tinto-0.5%
Average-1.2%Average-0.6%
FTSE 100-6.6%FTSE 100-6.6%

Source: S&P Capital IQ

Does any of this mean the consensus view that momentum strategies have been in trouble is wrong? In my opinion, definitely not. Rather it demonstrates how significant the specific implementation of strategies and timing can be in determining performance. Even though strategies such as momentum are often discussed as an amorphous whole, individually they can be very different. And while my version of 'momentum' has performed well recently, this is far more likely to be down to luck rather than any superiority of design.

A key reason for the relatively good performance is likely to come down to the period over which the screen assesses momentum. This is relatively short at three months. This means the screen managed to capture some of the recent market trends at the last review date on 15 September, even though the recent sell-off only really began in October. What’s more, it benefited from tagging on to ongoing takeover situations which played out relatively well – Sky in particular.

My reason for choosing a three-month period to assess momentum is based on an excellent 2008 ABN Amro-commissioned study by academics Elroy Dimson, Paul Marsh and Mike Staunton that considered the long-term performance of momentum strategies alongside issues associated with estimated costs and the frequency of portfolio reshuffles.

When it comes to tracking the performance of this screen my method is far less real-worldy than that used with other screens. Dividends are ignored and so are costs. That's very significant because the cost of implementing a momentum strategy is regarded as a key real-world challenge. So, even more than most of the screens monitored by this column, the results published here are considered chiefly as a source of ideas for further research rather than an off-the-shelf portfolio. Meanwhile, the performance numbers are best regarded as chiefly of interest in seeing the widely documented momentum 'factor' at work in the field. The table below shows the results from the screen alongside graphs for the one-year, five-year and since-inception performance of the screen.

Long-term performance table

Capital return ignoring costs
 LongFTSE 100Short
Since Jun 2007 (inception)146%-2.1%13%
5-yr37%1.7%47%
3-yr42%11%55%
1-yr-0.1%-10.5%-5.2%

 

Sources: Datastream, S&P Capital IQ

There is a recovery flavour to the long momentum picks for the coming quarter. I've taken a look at the two top picks below and details of all long and short picks can be found in the accompanying table.

 

Long
NameTIDMPriceMarket Cap3mth MomNTM PEDY*
BTLSE:BT.A253p£24.9bn11.3%106.1%
Micro Focus InternationalLSE:MCRO1,466p£6.2bn11.2%105.0%
PearsonLSE:PSON912p£7bn10.3%161.9%
United UtilitiesLSE:UU.763p£5.2bn7.8%145.2%
AstraZenecaLSE:AZN5,927p£75.1bn6.5%203.7%
Smith & NephewLSE:SN.1,475p£12.9bn6.0%191.9%
DiageoLSE:DGE2,785p£67.6bn4.8%-2.3%
National GridLSE:NG.829p£28.2bn3.8%145.5%
FresnilloLSE:FRES801p£5.9bn3.0%184.0%
Anglo AmericanLSE:AAL1,608p£20.4bn2.8%95.3%
Short
NameTIDMPriceMarket Cap3mth MomNTM PEDY*
Royal MailLSE:RMG304p£3.0bn-38.9%117.9%
DS SmithLSE:SMDS309p£4.2bn-37.0%84.8%
GVCLSE:GVC669p£3.9bn-36.5%94.8%
Smurfit KappaLSE:SKG1,997p£5.3bn-35.9%--
Standard Life AberdeenLSE:SLA236p£5.9bn-35.6%-10%
AshteadLSE:AHT1,625p£7.8bn-31.9%92.0%
Melrose IndustriesLSE:MRO155p£7.5bn-30.7%1642.7%
WPPLSE:WPP816p£10.3bn-28.0%87.4%
BAE SystemsLSE:BA.450p£14.4bn-27.5%104.8%
British American TobaccoLSE:BATS2,664p£56.6bn-26.5%97.3%

Source: S&P Capita IQ

 

BT

Sentiment towards BT (BT.A) has been poor for some time, but over the last three months the market has begun to price in a potential recovery, with sentiment boosted by better-than-expected first-half results.

A strong performance by BT’s consumer division helped limit a first-half decline in adjusted sales to just 1 per cent, while cost-cutting helped prop up profits. The results, reported at the start of November, bolstered hopes that a restructuring strategy put in place earlier this year may be having the desired effect. The man who devised the strategy, Gavin Patterson, is soon to depart and the man who will take his place at the start of February, Philip Jansen, is something of a restructuring specialist.

There are hopes Mr Jansen will add extra zing to Mr Patterson’s plans. Two contentious areas where Mr Jansen may look to change strategy are the group's foray into sports broadcasting and Mr Patterson's decision not to spin off Openreach. The emergence of David Einhorn’s activist investment firm Greenlight Capital as a shareholder in October means the pressure will be on management to act.

The new boss may need to make some uncomfortable decisions in regard to potential asset write-downs and the dividend. A key issue for BT is cash flow given its stretched balance sheet and high investment requirements in coming years. This is of particular note given the company’s reputation as an income play and the £1.52bn cash cost associated with maintaining the dividend. While forecast 'normalised' free cash flow (FCF) does cover the dividend bill, the pesky reality of what is excluded from the normalised figure – cash costs related to BT’s £5bn pension deficit and upcoming investment in 5G – means real FCF is not expected to cover the dividend until 2021.

While Mr Patterson has earmarked some assets for disposal, which should bring in cash, there is a logic in arguing that shareholders would be better served if BT were to focus on paying down its £11.9bn net debt rather than paying out such large amounts. An interesting but contrarian situation.

 

Micro Focus International

Historically, Micro Focus has a reputation for juicing shareholder returns from a diverse range of mature software products, many of which have come into its ownership following acquisitions. However, the group’s $8.8m (£6.98m) acquisition of Hewlett Packard’s Enterprise division last year has not gone well.

Micro Focus's shares tanked in March when the company announced that sales were plummeting. Management expects a full-year sales decline of between 6 and 9 per cent. At the same time, cash collection has deteriorated sharply as problems have been encountered rolling out an IT system acquired with HP to manage operations across the group. A sharp increase in costs associated with the system roll-out are largely responsible for sharp increase in expected exceptional HP acquisition costs from $750m to $960m.

The problems have been reflected in a ballooning of the average number of days the group has to wait for reported sales to turn into cash (days of sales outstanding in the company’s parlance or 'DSO'). DSO has jumped from 65 at the end of October to 94 at the end of April. This was reflected in a $177m working capital outflow in the six months to the end of April. Before the HP acquisition DSO had been 49 – about half the April level.

As well as the change in IT systems, Micro Focus has encountered problems with loss of staff, disruption to relationships with HP clients, and poor sales execution. The pain has been particularly pronounced for the company’s licence sales, which will have an inevitable knock-on effect for maintenance revenues further down the line.

So, plenty of problems. The share price strength over the last three months represents hopes the issues are coming under control. Such hopes may seem at odds with the news the group is losing a finance director, Chris Kennedy, after less than a year. But Mr Kennedy’s reasons for leaving (to work with a former colleague at ITV) are better than those offered by some departing finance directors. His replacement, Brian McArthur-Muscroft – the person who will now be responsible for assessing the carrying value of the $4.9bn of goodwill associated with the HP deal – is considered a good fit for the job.

Importantly, a trading update released at the same time as the news of the finance director change, suggests the sales decline and IT situation may be stabilising. The statement also increased confidence that the licence-sale problems Micro Focus has been experiencing are specific to the company (ie, potentially fixable) rather than a reflection of new technology rapidly stealing its market share (ie, existential).

Meanwhile, cash flows remain on target and share buybacks have been extended, although cash collection remains bad. The company has also increased its cost-cutting targets and cash profit (Ebitda) margins should hit 37 per cent this year, compared with 32 per cent following the HP acquisition. The target is for a mid-40s margin by 2020. Meanwhile, the $2.5bn sale of Micro Focus’s SUSE open-source enterprise software business, announced in June and expected to complete early next year, should improve management’s focus on rectifying problems.

Recent experience aside, Micro Focus has a reputation for investing sensibly in product development and product-life extensions in a way that enhances shareholder returns while returning surplus capital to shareholders. The company expects the enlarged group to ultimately generate operating cash flows of $1bn a year and deliver shareholder returns of 15 to 20 per cent. Indeed, broker Numis forecasts 550p could be returned by the company over the next two years. Should investors see further progress, the shares’ low rating means there could be good upside from here. However, the risks are high, especially while cash collection remains poor and the potential for impairments lurks.