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The Best of Both Worlds Combining Momentum and Value Strategies

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The Best of Both Worlds Combining Momentum and Value Strategies The Best of Both Worlds Combining Momentum and Value Strategies Marvin I. Kline, CFA Managing Director, Value Portfolio Manager Deborah G. George Managing Director, Client Service January 2012 There is substantial evidence that both momentum and value strategies have historically generated above-average returns over time1. Importantly, the excess return that these strategies deliver is negatively correlated therefore using both strategies in one portfolio can lower risk and improve portfolio efficiency2. Additionally, investors are more likely to stick with a portfolio that utilizes strategies that rarely move together. In this paper we will present some of the research produced by academicians and practitioners on the effectiveness of momentum and value strategies. Moreover, we will provide real world evidence of the effectiveness of combining these strategies into a single portfolio. At Logan Capital our Growth team manages growth portfolios that use momentum as one factor in a multi-step process and our Value team manages value portfolios using a high dividend yield strategy. Both strategies have a long history of outperforming their respective benchmarks. By combining these two strategies into one portfolio, Logan Capital’s Core portfolio has a consistent record generating significantly higher returns than the S&P 500 and superior risk adjusted performance. 1 Asness, C. 1997. “The Interaction of Value and Momentum Strategies”, Financial Analyst Journal, March/April (1997) 2 “Momentum Investing Finally Accessible for Individual Investors” by T J Moskowitz. Investments and Wealth Monitor. 1 Momentum Investing Momentum investing is a strategy based on research that has shown that high price-momentum stocks outperform low price-momentum stocks3. In general, stocks that have recently performed the best over a period of time (often measured over 12 months excluding the most recent month) continue to do well over subsequent periods, and stocks that have performed the worst continue to perform poorly. The robustness of momentum strategies has been supported by numerous academic and practitioners’ studies that have been published since the early 1990’s4. One recent study (by Tobias Markowitz)5 summarized in the chart below was based on a universe of U.S. stocks6 sorted annually into price-momentum quintiles covering data from 1927-2008. The chart shows that the stocks with the best year-over-year price momentum (P5) outperformed the stocks with the worst price momentum (P1) in the following year, both on an absolute basis and relative to the overall market. The same study showed that price momentum has worked both for large cap and small cap stocks. For the thirty year period December 1979 through December 2009, large cap momentum stocks outperformed the Russell 1000 Index by about 2% per year and small cap momentum stocks outperformed the Russell 2000 by 3.7% per year. 3 Jegadeesh, N. and S. Titman. 1993. Returns to Buying Winners and Selling Losers: Implications for stock market efficiency. The Journal of Finance 48, 65-91.; “The Case for Momentum Investing” AQR Capital Management Summer 2009 4 “The Case for Momentum Investing” AQR Capital Management Summer 2009 5 “Momentum Investing Finally Accessible for Individual Investors” by T J Moskowitz. Investments and Wealth Monitor. 6 The universe is all publicly traded stocks in the U.S. with beginning of month share prices of at least $5, and excludes REITS, ADRs, and non-common shares. 2 While the evidence that high momentum stocks outperform is persuasive, there is no agreement among researchers as to why momentum strategies work. For example, among those financial theorists who believe in the Efficient Market Hypothesis, the higher returns for high momentum strategies means that they are associated with an additional unique risk factor, which has not yet been identified. Taking a different tack, some Behavioral Economists believe that investors may react slowly to new information, and that it takes time for new information to be incorporated into stock prices. Another possible behavioral explanation is the idea of ‘herding’, which means investors buy more of a stock because they are following the crowd. Herd followers buy a stock simply because it is already going up, which further increases the stock price, which attracts more buyers7. While there is no general agreement as to why price momentum has been a successful investing strategy, its success has withstood the test of time. Value Investing The value premium is one of the most consistent sources of excess return in equity markets. The value premium refers to the excess return that the value investor can earn by investing in “cheap” stocks. Academic research on value investing goes back to the 1970’s. In an often-cited seminal academic paper published in 1994, entitled “Contrarian Investment, Exploration and Risk”, the authors (Lakonishok, Shleifer, and Vishny) concluded that “value stocks” consistently outperformed “glamour” companies8 (which are generally fast growing companies) by wide margins for the period 1968 through 1994. In this study stocks were sorted into the value or glamour (i.e., “growth”) category based on price-to-book (“P/B”), price-to-cash flow (“P/CF”), and price-to-earnings (“P/E”) ratios. Stocks that had low P/B, low P/CF or low P/E ratios were classified as value stocks and those stocks that had high values for the same ratios were classified as glamour (growth) stocks. Using the same methodology, the Brandes Institute extended this research through 20109. Brandes also concluded that value stocks outperformed glamour stocks over the long term, both in the U.S. and globally. An additional factor which some value managers use for stock selection is dividend yield. An abundance of research studies10 have concluded that high dividend yield stocks outperform both low dividend yield stocks and the market over time. Based on this research some value managers limit their investable universe only to stocks which have above-market yields. As discussed further in this paper, high dividend yield strategies work well among stocks with low momentum. 7 “Momentum-A Contrarian Case for Following the Herd” by J Hancock, GMO White Paper, March 2010 8 Lakonishok, Josef, Andrei Shleifer, and Robert W. Vishny.1994 “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance, vol. 49, no. 5 (December)):1541-78 9 “Value vs. Growth a Global Phenomenon”, The Brandes Institute, December 2010 10 Siegel, J. Stocks for the Long Run: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies, 4th edition. 2007; Patel, P, CFA, Yao, S, Carlson, R, CFA, Banerji, A. Global Dividends-Short and Long Term. Equity Reserch Quantitative Analysis, Credit Suisse, November 2009. 3 How to explain the value premium? Once again for those who believe in the Efficient Market Hypothesis, the higher returns for value strategies means that value strategies should have higher risk. However, as shown in the table below both the large cap value index and small cap value index had higher returns and lower risk (standard deviation) than their respective growth indexes. From 1979-2011, large cap value outperformed large growth by 1.4% per year, and small cap value outperformed small growth by 4.0% per year. Value: Higher Return, Lower Risk January 1979 - December 2011 Return Standard Deviation Russell 1000 Growth 10.4% 17.8% Russell 1000 Value 11.8% 15.1% Russell 2000 Growth 9.0% 23.5% Russell 2000 Value 13.0% 17.8% Since risk measured by standard deviation does not explain the outperformance of value stocks, believers in efficient markets again suggest the higher returns are associated with an additional unique risk factor which has not been identified, while Behavioral Economists offer the theory that value investing works because investors are uncomfortable buying cheap stocks (likely because they may have been recent losers) and for this reason, they earn a return premium11. Combining Value and Momentum in the Real World Empirically, value and momentum are proven strategies that have unique attributes. Momentum and value each deliver excess returns, but because these returns are negatively correlated, the combination can provide higher risk adjusted performance12. Does combining value and momentum outperform in the real world? In this regard our own investment record suggests that the combination results in outperformance. At Logan Capital two independent investment teams manage our growth and value portfolios. Each team utilizes investment strategies that are consistent with their investment style. Logan’s Growth team uses a multifactor ranking algorithm as an idea generator for possible buy candidates, which are then analyzed both fundamentally and technically. Although 65% of this ranking algorithm is earnings driven, price momentum is also recognized as an important factor which helps to identify growth stocks that are more likely to outperform, and is weighted at 20% in the growth model. Given that the ranking algorithm is just one part of a multi-step discipline, Logan Growth cannot be considered a “pure” price momentum strategy. However, when we sampled Logan growth portfolios from different time periods we found that the stocks in the portfolio tended to skew toward the top third of the universe ranked by price momentum13. 11 Asness, C. 1997. “The Interaction of Value and Momentum Strategies”, Financial Analyst Journal, March/April (1997) 12 Asness, C, Moskowitz, T and Pedersen, L Heje, “Value and momentum everywhere” National Bureau of Economic Research Working Papers (2000) 13 In addition, the Logan Growth strategy has a correlation coefficient of 0.88 to the AQR Large Cap Momentum Index from October 1995 to December 2011 as calculated by Zephyr StyleADVISOR. 4 Logan’s Value team utilizes a large cap high dividend yield strategy. The Value team screens for large cap stocks that have strong fundamentals, then sorts those stocks by dividend yield. Those with the highest dividend yields are candidates for purchase. The Value team does not use high or low price momentum as one of its screening factors.
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