The Hindu Business Line : Momentum versus value investing

VALUE investing is a popular long-term investment style. From Warren Buffett to David Dreman and Bill Miller, value managers have outperformed the market in the long run. Here is a comparison between value investing and picking stocks based on technical analysis. Because of the contrasting investment styles, it appears that an optimal portfolio should contain a combination of value and momentum stocks based on the investor risk preferences.

The picking technique: Value funds pick stocks that are currently out of favour. These funds typically choose stocks with low price-earnings ratio or price-book ratio. Tata Engineering, for instance, may have been a value buy at Rs 80. A value manager would have added the stock to his portfolio, expecting the company to turn around. Sure enough, the company generated profits, and the stock zoomed to its all-time high of Rs 570 in 2003-04.

A momentum fund, for the purpose of this article, is one that uses technical analysis to pick stocks. These funds do not chase stocks that are currently winners and dump ones that are losers, as is the general perception. A momentum fund may have bought Tata Engineering at, say, Rs 200. Such funds buy stocks on price breakouts. Empirical evidence suggests that buying on price breakouts generates good returns in quick time.

So, how does a value manager compare with a momentum manager? Remember, the longer the stock is held in the portfolio, the higher the opportunity cost. A value fund incurs higher opportunity cost to generate higher returns. A momentum fund generates quicker but relatively lower returns.

Risk-return trade-off: Studies in the US have concluded that value funds outperform the market in the long run. But what is long run? Most value funds in the US performed poorly during the tech rally. These funds, however, outperformed the market by a long chalk in the subsequent year. The point is that the dismal performance of value funds during the tech rally would have hurt many long-term investors. After all, that year would have been long term for those who bought into the fund 5 or 10 years ago.

Herein lies the risk. The market does not allow stocks to wander far away from their perceived intrinsic value for too long. This makes stock picking difficult for a value manager. Besides, a stock may be trading at a low price-earnings ratio for some reason. Essentially, then, choosing the right value fund may be difficult for an investor. For a value manager who performed well in the past may not necessarily do so in the future.

The risk associated with momentum fund is of a different nature. The momentum manager may not have a fixed investment horizon for each stock.

The momentum manager may wait for the position to be stopped or for the price target to be achieved. This may take a short while or few months to a year. The risk in buying units in a momentum fund is that the portfolio could incur losses if the position is stopped.

Optimal portfolio: The contrasting style of value and momentum funds suggests that an investor can beneficially combine the two to create a portfolio that performs well in any market. The asset allocation process will be function of the risk preference and the investment horizon of each investor.

An investor with, say, 10-year horizon, may prefer to take 70 per cent exposure in value fund and 30 per cent in momentum fund. Those with a shorter horizon may prefer to allocate more assets to the momentum fund. For, such funds provide speedier returns.

The discerning investor can construct his own portfolio with appropriate measure of value and momentum stocks. Or as an alternative, an investor can buy into a value fund and construct his own portfolio of momentum stocks. After all, there are not many momentum funds to choose from at present.

(Feedback can be sent to bvenky@thehindu.co.in)

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