This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.
As stocks approach a seasonally strong period between November and May, investors may be looking for ways to increase their exposure to stocks with growth potential. We believe one way to capture exposure to potentially rising stock prices is through the momentum factor.
Momentum investing involves buying an asset that has displayed strong past return performance — instead of buying low and selling high, this concept is designed to buy high and sell higher. Past performance is not a guarantee of future results. However, this strategy assumes that strong returning assets will continue to find strength and generate returns ahead of their peers, while weak returning assets will continue to lag and underperform their peers.
Momentum investing can provide exposure to stocks with earnings growth potential
Screening for the momentum factor includes examining stocks with the strongest returns over a prior period, say 12 months, or ranking stocks by performance against their peers through the tools of technical analysis. Although momentum investing uses price as a key determinate for stock selection, momentum-factor stocks typically have the characteristics of either strong expected or actual earnings growth. Why? Because over time, stock prices are driven by a company’s earnings – so the strong prices of momentum-factor stocks are often the result of strong earnings. Therefore, investors looking for growth potential may want to think about adding momentum stocks to their portfolios.
To prove the point, the table below displays the top five holdings in the PowerShares DWA Momentum Portfolio (PDP). The stocks included within PDP are chosen by their relative strength using point and figure analysis — which is a charting technique that plots a stock’s current price against its movements up and down. As a byproduct, the top five holdings exhibited strong earnings per share (EPS) growth relative to the S&P 500 Index. As seen in the table below, in the current fiscal year, the top five holdings are expected to see average EPS growth of 74.69% compared to 7.37% for the S&P 500 Index. In other words, the top five holdings of PDP are projected to show 10.13 times the EPS growth of the S&P 500 Index.
Earnings Per Share Trends for the Five Largest Holdings of the PowerShares DWA Momentum Portfolio
The pricing of earnings and macro conditions may impact the performance of momentum stocks
The linkage between momentum stocks and earnings growth helps explain performance under different market environments. Investors are willing to bid up share prices when the outlook for profits is favorable and the economic environment is conducive to earnings growth. However, shocks to the macro outlook such as credit events, an Ebola scare, or a sudden change in economic conditions can quickly cause the earnings outlook to shift and lead to a downward adjustment in the profit profile and price trend. The potential for macro adversity can quickly make investors less willing to embrace the outlook for earnings and boosts the correlation between stock prices.