Fast-moving stocks that are riding a momentum wave

Momentum strategies have delivered some of the strongest returns from equity markets over the past few years — certainly in the UK and Europe. In these kinds of bullish conditions, models that zero-in on 52-week highs, earnings forecast upgrades and earnings surprises have produced impressive results. An even more straightforward momentum strategy is to just look for stocks with the strongest price momentum in the market. It sounds simple, but it’s a strategy that’s proved to be consistently profitable.

As a reminder, momentum strategies are based on the idea that price trends persist — both up and down. It’s a powerful driver of stock market profits, which is why we model several momentum strategies at Stockopedia. It’s also why the MomentumRank is a key component of Stockopedia’s StockRank. A couple of months back I wrote about some of the behavioural ‘drivers’ that can make these strategies so effective.

One of the original Price Momentum strategies was actually a test devised by researchers Narasimhan Jegadeesh and Sheridan Titman. They were two of the very earliest academics to tackle the concept of momentum and their landmark studies used very straightforward techniques that still work well today.

The strategy focuses solely on a stock’s price strength relative to the rest of the market. Jegadeesh and Titman found that momentum often lagged for the first month after new news was issued about a stock. But then it accelerated over the subsequent three to 12 months.

In their paper they wrote: “The strategy we examine in most detail, which selects stocks based on their past 6-month returns and holds them for 6 months, realises a compounded excess return of 12.01% per year on average.”

This strategy is one of several momentum screens tracked by Stockopedia, and we’ve generally seen consistently robust returns from it over the past six years — with a 38.8 percent gain seen over the past 12 months alone. (Remember that those returns are based on quarterly rebalancing and ex-costs).

One problem with momentum — and one of the reasons some believe it exists at all — is that it collapses farthest and fastest when confidence dries up. You only need look at how the momentum trade crashed during the financial crisis 10 years ago to see the damage that can unfold.

On closer examination — using Stockopedia’s StockRank Styles and Risk Ratings — many of the fastest moving stocks in the market right now are classed as Highly Speculative or Speculative. These are precisely the sorts of shares that are at risk of rapid declines if, or when, they disappoint the market.

For that reason I have adjusted a version of the Price Momentum screen and filtered out those Highly Speculative and Speculative categories. That is no fail-safe for avoiding disappointment, but it is one way of perhaps tightening the rules of momentum screens to filter out lottery ticket-like Momentum Traps. You can find that version of the screen here.

Here is a selection of UK stocks currently passing these price momentum rules. By adjusting the screen to filter out the two highest risk categories, there’s more of a higher quality, small- to mid-cap trend in the results.

While the stocks on this list have all performed well over the past year, it’s worth reiterating the risks with pure momentum strategies. Trading on the behaviour of other investors means investing in shares that can end up on stretched valuations. If those companies slow down or if sentiment changes towards them, their share prices can crash.

For that reason, many momentum investors introduce quality or valuation filters to reinforce their strategies. But on its own, momentum has proved to be a powerful driver of market returns. It can be a useful pointer to the market’s strongest performing stocks and it has a performance track record that’s hard to ignore.

Originally published at www.stockopedia.com.

Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.