Which is better – momentum or value investing?

The theory behind momentum investing is to buy shares that are already rising. Value investing involves buying unloved shares cheaply for the long-term. So which strategy should you follow?

"The trend is your friend." That's the theory behind momentum investing, which involves buying shares that are already rising. The strategy has paid off recently, with an average capital gain of around 60% over the last three years against just 12.4% for the FTSE 100. It's also thrashed other well-known strategies, such as buying stocks that look cheap based on fundamentals (down 4%), or seeking out those with high dividend yields (down 8.5%), according to Digitallook.com's Richard Leader. So can it continue?

Momentum investing is rooted in the tendency of investors to act in herds, all piling into the latest hot stock at once. This may not make much sense, but as John Maynard Keynes observed, "the market can remain irrational longer than you can remain solvent". So momentum investors argue that you should follow a price trend, rather than stand in front of it. One of the best-known systems for identifying momentum stocks is William O'Neal's 'CANSLIM' technique, outlined in his 1988 book,

How to Make Money in Stocks

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(see below). Between 1998 and 2002, the approach generated a return of 350% and was praised by the American Association of Individual Investors as being great for "active investors seeking growth stocks", says Investmentu.com.

So, what can go wrong?

Momentum trades usually only work over short periods, so you need to catch a trend early. And when a big upward price trend reverses as is happening just now the approach is positively "dangerous", says Investmentu.com's chairman Dr Steve Sjuggerud. The strategy is based on sentiment once this turns, whether for dotcom shares, commodities or UK house prices, investors rapidly sell out of the sector involved and gains can quickly be wiped out. Then there are the costs. Regular monthly trading incurs dealing commission, stamp duty of 0.5% on purchases and capital-gains tax on profits above the allowance of £9,200. It's also a hassle to keep fiddling with a portfolio on a monthly basis.

The alternative: 'value investing'

Investors such as Benjamin Graham and Warren Buffett favour a 'bottom up' approach to weed out undervalued shares. The ideal candidate is often out of favour with the market (that's why it's cheap) and is bought for the very long-term. Classic signs of an undervalued stock include a low pe ratio, a low price-to-book ratio and, in the current climate where bankruptcy is possible, a low price-to-free cash flow ratio (free cash flow is operating cash flows adjusted for non-discretionary capital expenditure). A decent dividend yield helps. Indeed, some 'value' investors just look for the highest-yielding shares in the market, following strategies such as 'Dogs of the Dow'.

But does it work?

Not recently. Digitallook.com's figures indicate that a 'value' approach that chose stocks using minimum earnings per share (EPS) growth of 10% in the last year, a maximum price-to-book ratio of 1.5, and a maximum p/e ratio of 15, would have made just 3.6% over the last three years and lost 32% in the last year. A pure 'high-yield' strategy selecting shares with a dividend yield of at least 3% and cover of at least two times would have lost 28% in the last year, as shares in sectors such as banks, household goods and construction plunged. But take a longer view (which is the point of value approaches) and the results improve. From June 2003 to June 2007, a value approach would have returned 296% and high-yield 126%.

Which approach is best then?

Momentum investing can sometimes beat other approaches over short time-frames. But the effort, cost and risk involved make it unsuitable for most investors. Value-investing approaches may have been unrewarding over the last twelve months, but they have a solid long-term track record, have made the likes of Warren Buffett very rich, and will be the best ways to spot bargains particularly once the current bear market abates.

For investors who favour value but don't want to pick individual stocks, there's the Trojan Income Fund (see www.taml.co.uk or call 020-7499 4030), which returned 13.3% in the year to 17 July and yields 4.4%. Fund manager Francis Brooke uses a value-based approach to seek out firms with sturdy balance sheets, high dividend cover and well-established brands. The fund is currently ranked second in its peer group. MoneyWeek contributor Stephen Bland also runs an email investment service called The Dividend Letter, which is based on a high-yield approach.

'CANSLIM': what does it mean?

C = Current earnings per share. Rising by at least 25% a year when measured over recent quarters.

A = Annual earnings. Rising by at least 25% per year over the last three years.

N = New product (or service): this will fuel the company's future growth.

S = Shares outstanding. Ideally as few as possible. The fewer there are, the faster they will grow.

L = Leader or laggard? A stock's relative price strength should be at least 80 (so for a US-listed stock that means it has recently outperformed at least 80% of the S&P 500).

I = Institutional investors. Evidence that they are buying the stock is reflected in large volumes.

M = Major markets. The broader market (i.e. the S&P500 or Dow Jones in the US) should be trending higher since most stocks follow the market's overall direction.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.