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.
Historically, momentum investing has worked best when asset returns show low correlation. When prices have moved up and down together, the momentum factor has not shown outperformance.1
Momentum stocks are more risky
Investors embracing momentum stocks should expect higher volatility. Because momentum stocks tend to see stronger expected earnings growth than the average stock, volatility for momentum stocks should be relatively higher than broad market averages. Big movements in earnings open up the chance for both positive and negative surprises. Potentially, there is more that can go right or wrong for a company with rapidly growing earnings than a company that has a more stable earnings profile. To illustrate this point, since its inception in March 2007, PDP has had a beta of 1.07 to the S&P 500 Index. Its volatility is also higher at 19.26% compared to 16.53% for the S&P 500 Index (based on standard deviation of index returns).2
Concluding thoughts
It is important to note that momentum investing is sophisticated and complex, so investors should always discuss with a financial advisor before deciding when to use momentum investing. After consultation with an advisor, investors may want to explore using the momentum factor as a way to gain exposure to growth potential. Companies experiencing strong upward price momentum could be experiencing strong earnings growth. However, investors should realize that momentum investing has worked best when the market is discriminating between good and bad stocks, and remember that momentum stocks usually carry greater risk.
The prerequisite for momentum investing rests in the ability of the investor to gather price history so an asset’s price strength can be measured. ETFs can provide an investor access to momentum investing across asset classes and make implementation of a momentum based strategy easy to execute. Those who would like to know more about momentum investing can explore the PowerShares DWA Momentum-based ETF solutions:
1. Source: Ned Davis, Fama/French Library, Invesco PowerShares. Based on an examination of the average monthly return of momentum factor stocks by quintile of stock market correlation (median correlation of S&P 500 stocks to the S&P 500 Index.)
2. Source: Bloomberg LP as of Oct. 28, 2014