Value vs Momentum

I’ve been in this business for a long time and this paper confirmssomething I’ve observed throughout my career:

There are two primary and distinct techniques of asset management: momentum and fair value.

  • Momentum investors (‘the trend is your friend’) ignore fundamental value and follow the money, buying when prices are rising and selling when they reverse.
  • Fair-value investors (‘a stock’s price is the present value of dividends’) disregard fund flows and trade securities based on their expected future cash flows.

This is basically what you find in the typical brokerage office (or at least the ones where I once held down a desk). The majority of the brokers I’ve encountered fell in the momentum camp – for pretty obvious reasons I think. If you get paid by the transaction, the economic incentive is to maximize the number of transactions. Momentum investing – or I think more accurately described as trading – is just brokers being human and responding to the incentives put before them. Momentum techniques require more and more frequent transactions to execute than value strategies and so – when done right – maximizes the broker’s income. And of course, when done well, the broker’s clients benefit too.

The rest of the brokers fall into the value camp. It is a smaller, usually – but not always – older and generally less attractive group but it exists in every brokerage office. They are not usually the big producers in the office. They are more likely to be doing research in their office than smiling and dialing (as we used to call it back in the old days before social media). These brokers are also responding to the incentive to maximize their income but just as in their investing they are taking a longer view. If their clients share that longer view and the value technique is employed well, these broker’s clients also benefit.

The linked article goes on to provide what I think is a very plausible explanation for the existence of the momentum and value anomalies which shouldn’t exist in an completely efficient market.

In our model, delegation is the key. For example, asset owners have imperfect knowledge of the ability of the fund managers they invest with. They are uncertain whether underperformance against the benchmark arises from the manager’s prudent avoidance of overpriced stocks or is a sign of incompetence. As shortfalls grow, investors conclude incompetence and react by transferring funds to outperforming managers. The investors’ gradual flows amplify the price changes that led to the initial underperformance and generate momentum. In this way, Bayesian updating can explain how some prices are pushed below fair value, simultaneously creating the well-documented value effect as well as momentum-trading opportunities.

I think the authors have missed a level of delegation that probably contributes to the effect. The brokers and other intermediaries who make investment recommendations to – or decisions for – many individual investors are prone to the same herding behavior as individual investors. So the momentum and value anomalies are amplified by a relatively small group of brokers, investment advisers, CFPs and other intermediaries.

The problem with both methods, of course, is the execution. Neither is easy that’s for sure. Trading or momentum investing is hard work. Damn hard. Getting in and out at the right time requires two consecutive correct decisions. Repeating that level of success over many trades is very, very difficult. And when you are wrong, the hit is quick and deep. Anyone who has ever owned a high flyer that missed an earnings estimate knows what I’m talking about. If you’ve got a broker with some gray hair, ask them sometime what it means for a broker to “blow up his book”.

Value investing is no easier. Finding stocks or markets that are truly undervalued is hard. Damn hard. Not only do you have to avoid the value traps – ask Bill Miller about value traps – you also have to be patient enough to wait until everyone else recognizes your brilliance and buys the unloved nugget you’ve uncovered. Every value investor has faced the decision of what to do with the stock or market that just keeps getting cheaper. Is something wrong with your analysis? Should you just dump it and take your lumps? Hindsight may be 20/20 but foresight needs trifocals.

The conclusion of the paper, by the way, is that an investor can lower the overall risk of their investments by combining the two strategies. Momentum and value strategies have low to negative correlations. At Alhambra, we endorse that approach by utilizing both strategic (passive) and tactical (active) strategies. It isn’t exactly the same as value and momentum but it is a very close substitute with the passive strategies standing in for value and the active strategies for momentum. Portfolios can be customized by varying the allocations to passive and active.

Individuals who want to execute a combined strategy need to find advisers who know how to execute both or hire multiple advisers matched to the proper strategy. You don’t want to hire a momentum adviser to execute a value strategy. You don’t want to hire an active manager to execute a passive strategy or vice versa. Know what kind of investor you’ve hired to execute your investment strategy.

I’m no longer a broker but I do have some gray hair, so by the way, to “blow up your book” in broker slang is to bet big on a stock, sector or market and be spectacularly wrong. It happens more often to the momentum guys because clients hate to see a stock take a big, quick hit. Do that a couple of times and clients start disappearing. Do that repeatedly and you’ve “blown up your book”. Time to start over and find some new clients. Value brokers can also blow up their book by betting big on a value trap of course but it is usually a longer, more drawn out process.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com

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