Let’s go back in time 30 years. Remember those “Taste great / less filling” Miller Lite beer commercials from the mid-1980s? You could roughly divide the world’s beer-drinking population into two rival factions: Those that insisted that Miller Lite tasted great… and those that insisted it was less filling. I’m pretty sure people lost their lives fighting over this in bars.
Personally, I find Miller Lite neither tastes particularly great, nor is it particularly easy on my stomach. As a native Texan, my heart will always belong to Shiner Bock.
But I digress. As with Miller Lite fans, you can roughly divide the investing world into two camps: Those who favor value strategies and those that favor momentum strategies – i.e. following the trends to find the most gains.
Both camps will insist that the academic research – and real world experience – prove that “their way” beats the market over time. And they’re both absolutely right. Simple value screens like Joel Greenblatt’s “Magic Formula” have beaten the market by a wide margin, and research has shown that a strategy of screening stocks based on simple momentum criteria also beats the market over time.
So if value works… and momentum works… what would it look like if we combined the two?
Quantitative investing guru Patrick O’Shaughnessy wrote an excellent piece last year in which he parses the universe of stocks into value and momentum buckets. Take a look at the following table, taken from O’Shaughnessy’s article.
The bottom row of the table represents the top 20% of stocks with the most momentum. The returns get gradually better as you move down the value scale. In other words, momentum stocks that are cheap outperform momentum stocks that are expensive. And it’s not by a small margin. The cheapest high-momentum stocks returned 18.5% per year, whereas the most expensive high-momentum stocks returned 11.6%.
And viewing it through a value lens tells the same story. The right-most column represents the cheapest stocks in the sample using a composite of value metrics. All value-stock buckets performed well. But as you move down the column, the returns get a lot better.
In other words, cheap stocks that have recently shown momentum perform better than cheap stocks that haven’t!
All in all, value investing works. But so does momentum investing. And combining the two works best of all.
Editor, Dent 401k Advisor