Reprinted with permission from the American Association of Individual Investors, 625 N. Michigan Ave., Chicago, IL 60611; 800-428-2244; www.aaii.com. ©2013. Investing’s Odd Couple: Value and Momentum By Kevin Truitt

Article Highlights • Several research studies argue that value and momentum strategies work well together. • Diversifi cation benefi ts are achieved by combining the best elements of both strategies. • Characteristics to look for are low price-earnings ratios and bullish moving average formations.

For value investors, the stock actually converge to its intrinsic sweet spot in investing is being value. Investors are highly dependent able to buy an undervalued stock on other investors’ actions (buying a stock right before its value is recognized drives its price higher, all else equal). This core market dynamic is why Nel- by the market and just before its son looks for undervalued stocks that are just starting stock price begins to take off. to be bought by other investors, the latter evidenced by a But how can a value investor tell when a stock is in the stock’s positive technical/momentum considerations. He does sweet spot? The answer, according to Brian Nelson, president not believe it is enough for a stock just to be undervalued. of investment research company Valuentum Securities, is to When it takes too long for a stock’s value to be recognized identify stocks with good value that are just starting to exhibit by the market, both the power of compounding and the good technical/momentum characteristics. stock’s annualized rate of return are adversely affected. A Doing so helps an investor avoid: 30% return in nine months, for example, is far better than • value traps: stocks whose prices continue to fall—so- a 30% return over fi ve years. Investors who focus only on called “falling knives”—or stocks whose value will never value, growth or competitive-advantage analysis may not be be recognized by the market, using everything in their tool kit to maximize returns. • underperformance due to the opportunity cost associated The value school of investing has seen this happen before. with holding a stock with great potential, but whose value For a long time, “value investing” and “growth investing” takes an inordinate amount of time to be recognized by were mistakenly viewed as separate and incompatible styles the market and of investing. Legendary investor Warren Buffett debunked • speculative momentum or irrational high-yielding stocks this myth when he said, “Growth and value investing are whose technicals are unsupported by their fundamental joined at the hip. Value is the discounted present value of an valuation (“greater fool” stocks). investment’s future cash fl ow; growth is simply a calculation Many investors often base their investment decision on used to determine value.” Similarly, some value investors whether a stock is undervalued or overvalued or whether it have viewed value and momentum as being likewise incom- has excellent competitive advantages or other qualitative mea- patible investment strategies, even though there is a benefi t sures. Nelson believes this a great start but it’s an incomplete to combining them. assessment, as stocks can stay undervalued or overvalued for As a common example, value investors have tradition- decades (and some stocks may never converge to an estimated ally been conditioned not to accept technical/momentum intrinsic value). Only when there is buying or selling in the analysis. Price movement strategies have often been dismissed stock based on its overvalued or undervalued state does a as a self-fulfi lling prophecy, the belief that they only work

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because other investors are buying and Figure 1. Performance of Value, Momentum and Combination Strategies selling based on technical/momentum indicators. Nelson argues that this isn’t a balanced view of the markets. Value investing works sometimes because people buy or sell based on value prin- ciples, driving a stock higher or lower, respectively. An understanding of these market dynamics helps investors relate to the theory behind why stocks admired by both value (inclusive of growth) and technical/momentum investors can be attractive. The possibility of price-to- fair-value convergence for this cohort of stocks is enhanced.

Research Says Combine Value With Momentum Source: Research paper by Clifford S. Asness, Tobias J. Moskowitz and Lasse H. Pedersen, Several research studies—most “Value and Momentum Everywhere,” February 2009. notably a study done by Cliff Asness of AQR Capital, Tobias Moskowitz of the University of Chicago and Lasse H. that generally a value investor can expect Why These Styles Pedersen at the New York University to outperform the market by about 3% Complement Each Other in their paper “Value and Momentum to 4% a year, while a momentum inves- Everywhere”—make the argument that tor is likely to outperform the market Figure 1 shows that the 50/50 value and momentum strategies work by about 4% to 5% per year. He goes combination portfolio of value and well together. In their research, Asness, on to point out that combining value momentum produces better cumulative et al. show that over time combining and momentum strategies outperforms long-term returns and better risk-adjust- value and momentum strategies across on average by 5% per year. This may ed long-term performance. The logical diverse markets and asset classes results not look like much of an advantage question though is, why? The answer in signifi cantly higher risk-adjusted rates over using either value or momentum that Moskowitz offers in his article of returns. alone, but portfolio volatility is reduced “A Better Bet” is that while value and Modern portfolio theory indicates by about 50%. momentum appear to be at odds with that when you combine assets that are Figure 1 is from the Asness, et al. one another, it is this very opposition to not perfectly correlated, or move in op- study and shows the cumulative returns one another that accounts for the reason posite directions, both portfolio volatility and Sharpe ratios for the period from they seemingly work so well together. and overall risk are reduced. By applying January 1975 through July 2, 2007, for He explains that momentum investing this same sort of thinking to combining each of the three strategies. The blue works well in the short term—a year the best elements of two seemingly in- Value line represents the returns of or less—while value investing focuses compatible investment strategies—value a long-short portfolio. This portfolio on the long term. Combining value and and momentum—Asness, Moskowitz was long stocks with good value char- technical/momentum characteristics is and Pedersen found that an investor can acteristics (a high ratio of book value also a long-term proposition, as it is garner signifi cant benefi ts of diversifi ca- to market value, or the inverse of the conditioned on price-to-fair value con- tion by combining the best elements of price-to-book ratio) and shorted stocks vergence (the value premise). value and momentum strategies. In their with poor value characteristics (a low The example Moskowitz gives is that research, Asness, et al. found “that value ratio of book value to market value). during the technology boom of the mid- (momentum) in one asset class is posi- The Momentum green line is a long- 1990s momentum investors produced tively correlated with value (momentum) short portfolio that is long stocks that much better returns than value inves- in other asset classes, and value and mo- have performed well recently and short tors, who stayed away from technology mentum are negatively correlated within those stocks with poor momentum char- stocks. But when the technology stocks and across asset classes.” acteristics. The red Combo line shows crashed and burned, value investors gen- Moskowitz in his October 2012 cumulative return over this period for erated better returns because they were article “A Better Bet,” published by the a portfolio that is a 50/50 combination invested in a completely different group University of Chicago, makes the point of value and momentum. of stocks. He suggests that a strategy

July 2013 13 Figure 2. Valuentum Best Ideas Portfolio median for industry peers. Though an individual investor could simply use a low relative price-earnings ratio and a low PEG ratio to identify stocks with good value characteristics, including a DCF model will provide a more com- prehensive valuation analysis. Academic research and Nelson’s research also suggest that value metrics such as a high book-to-market-value ratio (the inverse of the price-to-book ratio) or a low EV/EBITDA ratio are useful indicators for an investor to focus on. Enterprise value (EV) is the cumulative value of market capi- talization, short-term debt, long-term debt, minority interest and preferred equity less cash. Earnings before inter- est, taxes, depreciation and amortization Source: Valuentum Securities. (EBITDA) is often used as a proxy for cash fl ow. The EV/EBITDA ratio is the that combined value and momentum in combined long-short value and momen- valuation ratio a would-be buyer might a situation like this would have allowed tum strategy and recommended applying assign to the entire company. an investor to profi t from these market it to a large number of stocks, such a Nelson’s methodology also utilizes extremes without being exposed to the strategy is not practical for the individual a relative value approach and considers probability of a major loss. investor. Nelson, however, has an idea a stock to be undervalued if it has a The conclusion of the Asness, et for a similar strategy that individual price-earnings ratio and price-earnings- al. study is that the negative correlation investors could follow. to-growth (PEG) ratio below average between value and momentum strate- In much the same way that Hall for its industry peers. This relative value gies coupled with their high expected of Fame baseball player Ted Williams approach is coupled with the low price- returns make a simple strategy of equally wrote about pitches being in his strike to-book ratio or low PEG ratio metrics weighting a portfolio with value and zone, Nelson believes it is the cohort to provide a more comprehensive valu- momentum stocks a powerful strategy of good value and good momentum ation analysis. Based on his research, it that produces higher cumulative long- stocks on the long side and poor value appears that a high book-to-market value term rates of return than either value and poor momentum stocks on the ratio (a low price-to-book ratio), a low or momentum alone (across every asset short side that are the major drivers of EV/EBITDA multiple, a low relative class). The Asness study also points out the outperformance when value and price-earnings ratio and a low PEG ratio that combining value and momentum momentum strategies are combined. are useful value signals that an individual results in a signifi cantly higher Sharpe To ferret out those stocks that are likely investor can use to identify stocks with ratio than either a value or momentum to be in the investor’s strike zone, his good value characteristics. strategy alone and makes the portfolio methodology utilizes certain value and less volatile across markets and time momentum signals. Momentum Signals periods. [The Sharpe ratio measures how There is a considerable amount of much return a strategy generates rela- Value Signals academic research suggesting that rela- tive to the level of risk it incurs. Higher To identify stocks that appear to be tive returns can signal whether future Sharpe ratios imply a strategy produces undervalued, Nelson primarily utilizes a price performance will be above or be- more return for each unit of risk. To three-stage discounted cash fl ow (DCF) low the market’s return, particularly over learn more about the Sharpe ratio, see model. This model is used to estimate a the next six to 12 months. (Examples “Interpreting the Sharpe Ratio” in the company’s intrinsic value by calculating include “Momentum” by Narasimhan May 2013 AAII Journal.] the present value of future expected Jegadeesh and Sheridan Titman, 2001, cash fl ows. He also utilizes a relative and “Momentum Strategies” by Louis How Investors Can value approach. A stock is considered to K. C. Chan, et al, 1996). Eugene Fama at Combine the Strategies be undervalued if it has a low price-to- the University of Chicago, was quoted in earnings ratio and a low price-earnings- the Financial Analyst Journal last year as Though Asness, et al. used a 50/50 to-growth (PEG) ratio compared to the saying, “Of all the potential embarrass-

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Key Characteristics for Finding Good Value and Momentum

• Price-earnings ratio belo w the industry or sector median 50-day) are above the longer-term 200-day moving • Price-earnings-to-growth (PEG) ratio below 1.0 and average below the industry median • The current price is at least 75% of the stock’s 52- • EV/EBITDA* ratio below or equal to 10.0 week high • Increasing relative strength over past 52 weeks, 26 *EV/EBITDA is enterprise value (total market capital- weeks, 13 weeks and 4 weeks ization plus total debt) divided by earnings before interest, taxes, • The shorter-term moving averages (5-day, 20-day, or depreciation and amortization. ments to market effi ciency, momentum his or her entry and exit points on the this 24-month period. is the primary one.” most undervalued stocks. A combina- In trying to identify stocks with tion of the two strategies can be used Conclusion good momentum characteristics, Nelson to help weed out the value traps and generally uses four factors. The fi rst “dead-money” ideas to bolster overall The research studies by Asness and are moving averages, with an emphasis returns. Such a strategy doesn’t require others provide evidence that combining on situations where the shorter-term value investors to abandon what they’re value and momentum strategies offer in- moving average crosses a medium- or currently doing, but rather simply over- vestors the opportunity to achieve higher longer-term moving average from below lays a timeliness assessment to augment rates of return with lower risk than would (a bullish signal). The second is the performance. Focusing on the very be achieved with either strategy individu- money fl ow index (MFI), which is an best (timely) opportunities in the tra- ally. Nelson’s research adds to these stud- oscillator that uses price and volume ditional value portfolio can result in an ies by highlighting the fact that the results to measure buying and selling pressure. even more concentrated, low turnover of combining value and momentum Chartists often look for an overbought portfolio, which can result in less tax strategies are very likely driven by focus- signal, above 80, and an oversold signal, and less transaction costs and better ing on a subset or cohort of stocks that below 20, to indicate unsustainable long-term performance. For Nelson, possess good value and good momentum near-term price extremes. The third is most turnover occurs as a result of a characteristics. Nelson believes individual the accumulation/distribution ratio. A value trigger, meaning the stock is no investors can profi t from this research by heavy accumulation (buying) or distribu- longer undervalued, as opposed to a focusing on such stocks. tion (selling) week can signal the future momentum trigger, such as a negative Currently it does not appear that the near-term direction of the fi rm’s share assessment of a stock’s moving averages. strategy of combining good value and price as investment dollars continue to good momentum has gained enough move in or out of the stock in the days Testing the Strategy popularity to reduce its benefi ts. (Too and weeks ahead and drives the stock The effi cacy and usefulness of any much focus on any single anomaly price up or down, respectively. The fi nal investment strategy are the returns it tends to reduce or eliminate the excess indicator is upside/downside volume. produces in the real world. Figure 2 returns.) One reason why is that value in- The level and trend of the upside/ shows the results that were achieved vestors have been conditioned to ignore downside (U/D) volume ratio indicates with a model portfolio constructed by technical/momentum analysis, while whether institutional participation has Nelson. The cumulative return for the many chartists do not pay signifi cant been bullish or bearish recently. model portfolio from May 2011 to May attention, if any, to valuation multiples. 2013 was 55.9% versus 30.2% for the Until combining value and momentum Low, Not High, Turnover exchange-traded fund S&P 500 Index becomes more widely used, it is pos- The biggest benefi t of a combined (SPY). Valuentum’s stock strategy out- sible that combining low valuation and value-momentum strategy is that the performed the S&P 500 Index (SPY) upward price momentum will be a useful approach allows an investor to improve by close to 26 percentage points during strategy for individual investors. 

Kevin Truitt earned an MBA in corporate fi nance from the DePaul University’s Kellstadt Graduate School of Business. He has over 15 years of commercial banking experience at First Chicago, BMO Harris and National City Bank. Kevin currently serves on the Chicago AAII chapter’s board of directors. Find out more at www.aaii.com/authors/kevin-truitt.

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