What is momentum investing?

Momentum investing is the right stock in the right industry at the right price.  Industries that are receiving a great deal of media attention based on investor driven momentum which then feeds on the media attention until it most likely burns itself out.

Momentum investing in any stock, industry, or sector is driven by a combination of factors but one thing and only one thing creates actual momentum and that is simply a matter of supply and demand.

Hence the slogan "buy high, sell higher."

Momentum investing is not for everyone. It’s risky, requires close attention and ironclad discipline.

“The investor of today does not profit from yesterday's growth.” - Warren Buffett

When market orders to buy any stock outweigh sell orders that stock will rise rapidly. When whole groups of stocks rise in this fashion they are being subjected to Momentum Investing. Even in a Bear Market stocks can and do rise rapidly. Momentum Investing can be a great way to capitalize on this phenomenon for savvy investors.

Some examples of momentum investing:

Some recent examples of momentum investing include:

• Technology stocks
• Oil stocks
• Stem Cell stocks
• Anti-Terrorism and Anti Bio-warfare stocks
• Defense stocks

When the momentum or buzz gets going all the stocks in that industry get buzzed and go up together. Momentum doesn't generally discriminate based on management, cash flow or EPS.  Companies must been seen as having products to change the way the world works. There must be a mystique to the technology - enough so a few gurus can emerge to explain it. 

Traditional ways of valuating stocks don't work for momentum investing hot stocks.  Current financial results tell you nothing about the company's potential.  Momentum stocks are emotion. No one can write logically about emotion.

The lessons of momentum investing:

1. Let the stock run. Don't sell the stock after it goes up 50%. The biggest mistake everyone makes is selling too early.
2. Watch like a hawk for disappointments. If the company exceeds Wall Street's estimates (of revenues or losses) by the requisite tiny amount, the stock will keep soaring. If it misses by even the tiniest amount, investors will pound the stock into the ground. Get out when the going gets rough.
3. Constantly search for new momentums.

Momentum winners for the 90's have included Microsoft (MSFT), Cisco (CSCO), EMC, General Electric (GE),  and more recently the Internet stocks like Google which have introduced the concept of top-line momentum, even if earnings are scant or only a distant prospect.

One problem is that many who consider themselves momentum investors, do not honor their own mental stops, and fall in love with the momentum stocks even after they have lost it. Not only did the investor love the momentum, but they back filled logic as to why technology would power the market forever.

This is a style that is not about falling in love, it is about making money.

Momentum investing Basics:

What do momentum investors look for? Three things, typically: a strong price chart, rapid earnings growth and recent positive changes in earnings-growth forecasts. Generally, momentum types don’t spend much time scrutinizing fundamentals 

Momentum investing is not a buy-and-hold strategy. Momentum investors typically hold a stock for a few months. However, they monitor their holdings daily and sometimes sell much sooner.

The downside of this investment style occurs when a company breaks its positive trend of performance or even underachieves market estimates. The decline can be quick and very painful as “momentum” investors frantically exit the stock

The result is that, whenever there is a whiff of bad news, numerous previous buyers scramble to get out before the barn door shuts. In this type of environment, stocks become highly illiquid and prices become discontinuous. When the upward momentum ceases, concentrated selling quickly accelerates, as momentum investors attempt to be among the first to get out. This not only drives prices lower but also leads to margin calls, and thus more selling.

As momentum investors see a rising trend, they all join in, driving prices even higher. It may seem like a winning strategy, with the promise of high upside and limited downside -- a bet one apparently cannot lose. But the risk of this strategy is that, while momentum investors can all pile in at the same time, they cannot all escape (sell) at the same time unless markets are both highly liquid (large blocks can be sold quickly and at the same price) and continuous (prices do not gap sharply downward with no opportunity to sell).

Relative strength:

This may sound counterintuitive, but research shows that stocks that have already outperformed the market over the past 12 months are likely to continue their winning ways, at least in the short term. Limiting your picks to strong 12-month performers is crucial to momentum strategies, and relative strength is the tool of choice for gauging performance 

Relative strength, or RS, measures how a stock has performed compared to the overall market over a specified timeframe. For example, a 12-month relative strength of 75 means that a stock has outperformed 75% of all stocks, in terms of price performance, over the past 12 months.

Earnings momentum:

Now that we’ve pinpointed stocks with strong price charts, we’ll check the earnings-momentum side of the equation.

Earnings momentum starts with strong quarterly year-over-year earnings growth. You could use the most recent reported quarter’s figure, but I prefer the current quarter’s forecast growth, because it better reflects current expectations. In either case, fast growth is the name of the game, and 15% year-over-year EPS growth is about the minimum to qualify a momentum stock.

Finally, in the earnings department, momentum investors look for a positive earnings surprise in the last reported quarter, meaning that the reported earnings exceeded the consensus forecasts. This requirement is well-founded because a variety of studies found that stocks with recent positive surprises outperform the overall market.

Revenue and revenue growth:

The parameters above are sufficient to define momentum stocks in the classic sense. But stocks meeting those requirements alone will include disasters waiting to happen. So we’ll add some fundamental requirements to filter out some of these time bombs.

Few companies can make money without selling something to somebody. Establishing a minimum annual sales (revenue) volume weeds out stocks that don’t have solid businesses. Most publicly traded corporations sell products and/or services totaling well into the hundreds of millions of dollars annually. I set the limit at $40 million annually, which equates to $10 million per quarter.

Avoid stocks trading below $5.

Very low trading volumes signal lack of interest, just the opposite of what momentum investors need. Need minimum trading volume at 20,000 shares, which most momentum candidates should meet handily.

When to sell using momentum investing?

Momentum investing was one of the major fads of the past decade, fueled by the red-hot performance of technology and dot-com stocks. The prices of these stocks seemed to rise for no good reason, despite lack of earnings -- or sometimes even the prospect of earnings. No historical valuation models could justify the prices achieved by many of these stocks. Unfortunately, momentum investing, like many other investment strategies, is basically a strategy that seems to work until it no longer does. In other words, the strategy may work for some period of time, but by its very nature, it contains the seeds of its own destruction 

Momentum stocks get hammered when something goes wrong. Consequently, momentum investors must act quickly at the first sign of trouble.

Note that momentum is a relatively short effect, the biggest gains were over the next year, following on from that momentum doesn't seem to affect the stock after a year, the result is that "momentum" investors frequently need a very high turnover in their portfolios to take advantage of the effect. Most momentum funds I know of do indeed have portfolio turnovers of 100% or more, which only adds to their expenses and takes away from returns.