Include Momentum Stocks To Boost Portfolio Returns
Buy low and sell high is the mantra that we have been taught by experts in the stock market – something that we have been chanting and practising regularly in order to make profits in the market. While this is an ideal strategy to make profits there are some who believe in ‘buying high and selling higher’ strategy. Investment professionals call it ‘momentum investing’. Momentum investing is a popular investing strategy adopted by investors and traders and there is enough evidence available that suggests marketbeating returns are possible to achieve by adopting this strategy that bets on trending stocks.
Defining Momentum Investing Momentum investing strategy is different in a way that it believes in ‘buy high sell higher’ strategy, thus contradicting the much popular strategy of ‘buy low and sell high’. Richard Driehaus is one of the earliest proponents of momentum investing strategy who successfully adopted this strategy to run his funds. His investment philosophy was always based on the belief that more money could be made by buying high rather than ‘buying under-priced stocks and waiting for the market to re-evaluate them.
Driehaus successfully explored options of selling the losers and letting the winners ride while re-investing the money from the losers in other companies that showed promise and are trending. The techniques used by Driehaus slowly but surely became the basics of what is now called momentum investing. Driehaus believed strong earnings surprises, upward earnings revisions, and both accelerating and sustained earnings growth is what pushes the stock prices higher.
Momentum investors have much to gain from this philosophy that ensures position will be taken in quality stocks with earnings momentum only. Sustained earnings growth is an essential factor while identifying momentum stocks under this approach. For longterm momentum investors the momentum in earnings growth is the most important factor while making stock selection.
However, for a majority of momentum investors it is the momentum in price that matters the most as the time horizon for traders can be much shorter. Says Vikrant Akolkar, who is a momentum trader and investor: “For any strategy to work, discipline is required, more so for a momentum trader and investor as the margin for error is minimal and one has to act swiftly to book profits in such a strategy. Also, what is important is that the investor and the trader have to place confidence in their own strategy. Practically it matters a lot.”
Generating Market-Beating Returns
To understand if the momentum investing strategy can generate marketbeating returns, we observed the data for BSE 500 constituents for the past 10 years. With an objective to understand if the winner continues to win and whether it makes more sense to buy winners rather than underperformers the data is collected for top performers and worst performers of BSE 500 constituents for the chosen period.
The average return of the winner (top 20 BSE 500 constituents in H1) stocks in the H1 (January 1 to June 30) for the last 10 years is 99.27% while that of losers (worst 20 BSE 500 constituents) is (-) 33% in the similar period. Assuming an investor was to invest fresh money adopting a momentum investing strategy, he or she will prefer to invest in those stocks that have done well recently. Hypothetically, let’s say a momentum investor chooses to invest in all 20 winner stocks at BSE constituents by mid-year and holds these stocks for the next six months, the average returns gained over 10 years by adopting such a strategy would have been 21.43% per annum. The returns earned would have been as low as 7.17% had the investor purchased the underperforming stocks at BSE constituents. This goes to show the extra returns generated simply by buying those shares that have done well recently. This explains how momentum investing strategy can prove to be a market-beating strategy.
Reasons for Momentum
There have been several studies attempting to identify why the momentum exists. Some of the observations are as follows:
1. Stocks where past returns accumulate gradually exhibit more momentum than stocks where returns are accumulated in a lumpy fashion.
2. Momentum arises principally in optimistic periods because investors under-react to bad news.
3. Momentum is also caused because several investors use overly simplified models to evaluate stocks. There is always a chance that an investor who believes in a particular model uses this model to make persistent forecast errors. More relevant information is missed out by the decision-making tools and hence the momentum continues in underlying stocks as investors invest ignoring pertinent information on markets and underlying stocks.
4. Momentum is also caused in the underlying due to overreaction to information because the traders often continue with their directional bets even when the pertinent news is fully incorporated into stock prices.
Identifying Momentum Stocks
If you believe that the trend is your truest friend in the equity markets, chances are you are a momentum investor already. While the merits of adopting momentum investing strategy are known, it is observed that most investors do not have
a clue on identifying momentum stocks. Not every investor is armed with technical analysis skills. In such conditions where the investor is not conversant with charts and technical analysis, how can he or she identify momentum stocks?
One of the simplest ways to identify momentum stocks is to compile a list of stocks from a particular sector or market capitalisation (large-caps, mid-caps or small-caps) which are trading in the 10% range of their respective 52-week highs. This way the investors and traders will be able to easily identify those stocks that are reflecting price momentum. There are investors who are more risk-averse and usually hate investing in markets that are making new highs. What these risk-averse investors miss is the ample evidence that shows how markets making new highs have a tendency of making even higher highs. Momentum investing needs investors to deal with higher degree of volatility than most other strategies. In fact, momentum investing attempts to capitalise on market volatility.
It is important to catch the trend at its early stages and that is where the ability to read charts or technical analysis comes handy. The probability of winning in markets using momentum strategy improves drastically by adopting the following steps:
1. Stock selection using technical analysis.
2. Identify how many stocks (number of stocks) or indices are touching their respective life highs or 52-week highs.
3. Devise entry strategy – it is important to have a plan.
4. Devise an exit strategy. You should know at what point you will take profits and at what point will you exit with loss.
5. Use advance tools deftly to consistently book profits in the market.
Technical Analysis and Momentum Investing
Rate of Change (RoC), Moving Average Converge Divergence (MACD), Relative Strength Index (RSI), Know Sure Thing (KST) and Average Direction Index (ADX) are some of the common indicators used to identify momentum in stocks. For stock selection and studying the overall trend of the markets deft use
of these momentum indicators can be very profitable. Says Manav Chopra, CMT-Head of Research, Indiabulls Ventures Ltd., “There are multiple parameters one needs to quantify and ideally one should look to take positions in the prevailing trend to capture the momentum stock. I prefer a top-down approach where higher weight is given to weekly and monthly time-frame and their price structure. To identify bullish momentum stocks one needs confirmation of the bullish trend in the larger time-frame and can include criteria of price above previous weeks’ highs, RSI greater than or equal to 60, and MACD above the trigger line. These scans would eliminate a lot of noise and would list strong trending stocks in the bullish trend with momentum, which is also confirmed by price action and momentum indicators.”
Extreme Swings and Momentum Investing
Extreme swings are something that can be used wisely by momentum investors. Extreme swings are actually quite rare events in stock markets, but when an investor spots them it is important that he or she follows the trend as they indicate the emergence of a new trend. Extreme swings usually signal dramatic shifts in psychology and that some unbelievable exuberance is shaping a reversal in the primary trend. Extreme swings usually develop only if there is a prolonged pre-existent downtrend or an uptrend.
Sacchitanand Uttekar DVP–Technical (Equity), Tradebulls Securities
Momentum is nothing but speed or velocity or rate of change in a stock’s price performance gauged with respect to time consumed. A simple rule of thumb to gauge whether the stock is gaining momentum is to compare the stock’s current price movement relatively to its past normal behaviour. Ideally, momentum occurs when a significant rate of change is witnessed in the ongoing direction of the stock’s price due to the impact created by its related news or information hitting the public domain. A rapid shift in traders’ sentiment gets triggered as volatility spikes, which adds fuel to the fire and sets the momentum for that particular stock. Momentum traders like to jump on the stock which is moving in one direction with the hope that it would continue to do so for a brief period of time.
Hence, momentum stocks are the ones where the existing thrust witnessed in the current price of the stock is expected to amplify further in a shorter duration of time with an expectation of a significant change in price to be witnessed in a short period of time. The principle rule for picking up stocks purely lies in the intention of the traders. Buy high to sell higher or sell low to buy lower are the two schemes which a momentum trader adheres to. Therefore, the best way to identify such stocks for trading is by focusing on stocks which have witnessed significant jump in price in the recent history of the stock prices’ performance. Some traditional techniques followed are consolidation breakouts, pattern failures, moving average confluence, etc. which distort the ongoing behaviour of the stock’s price movement and provide a fresh pedigree for the stock’s movement.
Volumes and price average movement captured by its various averages are the key gauges to select such stocks which fall under the category of this trading style. The stocks falling under this category do witness unprecedented volatility which is primarily caused due to change in expectation. Another crude way especially used by derivative traders is to observe the shifts in open interest additions in fix time intervals and the rapid change in their positioning by option writers which tend to set the mood for building momentum. The impact of such observations is highly reliable as traders get the opportunity to position themselves at the early stages of the ripple effect which eventually turns into a tide.
Martin J. Pring
"It is of paramount importance to use momentum analysis in conjunction with some kind of trend-reversal signal in the price series itself."
PROCTER & GAMBLE HYGIENE & HEALTH CARE
BSE CODE : 500459 Face Value : Rs.10 CMP :Rs.11780.90 Target : Rs.13800
Procter & Gamble Hygiene & Health Care Ltd. is currently trading at Rs.11,790. Its 52-week high and low are at Rs.12,090 and Rs.8,714 made on September 23, 2019 and October 11, 2018, respectively. Considering the weekly time-frame, the stock had recently given breakout of an ascending triangle pattern as on the weekend of September 20, 2019. This breakout was confirmed by the above 50-day average volumes. Additionally, the stock formed a sizeable bullish candle on the breakout week, which adds strength to the breakout. The major trend of the stock is bullish as it is trading above its weekly pivot and above its long-short-term moving averages.
This is in terms of the 20-week, 50-week, 100-week and 200- week EMAs and these moving averages are exactly in an ascending order, which suggests that the trend is strong. From the momentum indicators’ perspective, the 14-period weekly RSI is currently quoting at 68.40 and it is in a super-bullish zone. Interestingly, the 14-period RSI is never been below 50 mark in the past 10 years on a monthly chart. The weekly stochastic oscillator is also suggesting some bullish strength as %K is above the %D. Considering all the above factors, we feel PGHH could be a good bet on momentum for target of Rs.13,800, followed by Rs.14,500 with a stop-loss of Rs.9,900.
POLYCAB INDIA LTD.
BSE CODE : 542652 Face Value : Rs.10 CMP :Rs.685.05 Target : Rs.800
Polycab India Ltd. is currently trading at Rs.691.15. Its 52-week high and low stand at Rs.699 and Rs.525.05 made on September 23, 2019 and August 22, 2018, respectively. Considering the daily time-frame, the stock had recently given breakout of downward sloping trendline along with strong volume. With this trendline breakout, the stock has also managed to close above its previous pivot level.
Currently, the stock is trading above its 20-day EMA (605.10), 50-day EMA (618.90) and 100-day EMA (610.30), which indicates a short-medium-term uptrend. The leading indicator of 14-period daily RSI is currently trading at 74.40 and it has moved above its recent swing high, which is bullish.
The fast stochastic line is also trading above its slow stochastic line. The daily MACD stays bullish as it is trading above its zero line and signal line. Moreover, the daily ADX is very strong at 36.14. The -DI is much below the +DI and ADX is above the -DI. This shows the strong momentum in the stock.
Hence, all the indicator setups suggest that a bullish move is on the cards soon. Buy this stock at its current market price with a stop-loss of Rs.610. The target is open towards Rs.800, followed by Rs.850.
(Closing price as of Sept 24, 2019)
Momentum investing is a time-tested investment strategy and can work especially when the market is dominated by bulls. When the markets are in the grip of bears, adopting a momentum investing strategy can be a challenge investors and traders. No doubt the risks are magnified when momentum strategy is adopted; however, the risk in the strategy can be minimised drastically by adopting the most suitable risk management tactics. Appropriate use of technical analysis is the key in identifying momen-tum stocks and focusing on earnings’ momentum can fetch rich dividends for investors who are willing to hold the position much longer.
The Indian equity market has experienced a record 8-9 years of earnings downgrades and there is a feeling amongst the market participants that there is a need for deeper structural reforms in the country.
What the recent tax reform, touted to be the first structural reform in Modi 2.0, has done is to push Indian equities in an ‘extreme swings’ mode. The unprecedented unprecedented tax cut makes the erstwhile untenable P/E multiple for Indian markets look far more tolerable and attractive for foreign institutional investors.
Also, the premium for Indian markets over the emerging markets is below the historical average, in spite of the current extreme bullish swing. In all likelihood, the momentum may continue in the same direction as the extreme swing we are witnessing right now in Indian markets. Momentum investors need to simply stick to basics and follow the predefined trading system or investment process to profit from the sudden change in the market moods.
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