Value investing vs momentum investing: watch out for the market's mood swings

Value investing and momentum investing strategies both exploit investors’ emotions. But, asks John Stepek, why is value looking so glum? 


Value and momentum strategies both exploit investors' emotions. But why is value looking so glum?

If the stockmarket were efficient, then over the long run no one could beat it. The good news for active investors is that it's not efficient it's made up of human beings, who make predictable misjudgements, creating opportunities for attentive investors to exploit. Two strategies (or "factors" see box below) with a long track record of outperforming are "value" and "momentum". A recent paper from US money manager O'Shaughnessy Asset Management (OSAM) delves deep into both factors, and concludes that they are both driven by the same thing investors' overreactions.

Subscribe to MoneyWeek

Become a smarter, better informed investor with MoneyWeek.

Value investors benefit from overreaction to the downside. A company does badly, and investors shun it, sending the share price to unjustifiably low levels. If you buy in cheaply, you can benefit when the market realises its error or as the OSAM paper puts it: "Relative to actual realised future earnings, the market imposes an excessive discount on value stocks." Between 1964 and 2017, if you had bought the cheapest fifth of US large caps (judged by the price/earnings ratio) each year, then you'd have made more than 13% annually, compared with 9.8% for the wider S&P 500.

Momentum investors, on the other hand, profit from overoptimism. Investors expect companies that have recently done well to do even better in the near future. OSAM notes that, again, between 1964 and 2017, if you had invested in the top fifth of large-caps judged by their share-price returns over the prior six months, you'd have made about 12.5% a year.

Advertisement - Article continues below

By temperament, MoneyWeek is more attuned to value investing (we like our investment case to be underpinned by fundamentals). However, the strategy has endured a long period of underperformance, to the point where a Wall Street Journal headline this week declared: "Value investors face existential crisis". However, in OSAM's view, the main issue is not that value is "broken" it's simply that an unusually large number of value stocks have proved to be value "traps" in the wake of the financial crisis. In other words, they've been cheap for a reason, and they haven't recovered which is key to value's performance.

This makes sense. Financial stocks most of which fall into the value category just now were at the heart of the 2008 crisis, and have taken an incredibly long time to recover (mainly because many of them would have gone bust were it not for the support of central banks). Meanwhile, another value stalwart the resources sector has been through a brutal bust in recent years. Yet many of these stocks should start to do better in an environment of rising interest rates and inflation. So don't give up on value yet.

I wish I knew what a factor was, but I'm too embarrassed to ask

In the jargon, a "factor" is a characteristic that has been shown to contribute to market outperformance. Research into factors was largely driven by academics trying to figure out why certain stocks tended to generate higher returns than theories about efficient markets would have predicted.

For example, widely accepted factors include size (the observation that small companies tend to beat large firms over time); value (cheap companies beat expensive ones); yield (high-yielding stocks do better than low-yielding ones); and momentum (stocks that go up just keep on going up). To be clear, these factors will not always beat the market over any given time period but looking at historical data over the long run, they have generated superior returns in many different global markets.

"Smart beta" is one trend in the investment industry that tries to exploit both the rapid growth in computing power and the growing sense of disillusionment with "active" fund managers. Smart-beta exchange-traded funds (ETFs) promise to use computer algorithms to construct and invest in indices based on various factors. So you might invest in a "momentum" ETF that continually rebalances into momentum stocks, or a "value" ETF that does the same for stocks viewed as cheap on certain measures.

One problem with the race to find new factors for smart beta to exploit is the risk of "data mining" if you look hard enough at historical data, you can find apparently meaningful patterns that are in fact simply statistical flukes. A 2017 paper by Kewei Hou and Lu Zhang of Ohio State University, and Chen Xue of the University of Cincinnati, found that the vast majority of 447 "anomalies" found by equity-market researchers were precisely that. However, it's fair to say that the best-established factors (such as those above) are widely accepted as true.



Share tips

Finding hidden treasure: value investing is back in fashion

Focusing on cheap stocks, historically a highly successful investment strategy, has been a disappointment over the past ten years. But the tide is sta…
28 Nov 2019
Investment strategy

How to be a value investor

Value investing is probably the purest form of contrarian investing out there. John Stepek explains what it is, and how to do it.
30 Jul 2019
Investment strategy

Value investing’s not dead yet

Rumours of the demise of value investing have been exaggerated. John Stepek looks at what could reinvigorate the strategy.
25 Jun 2019
Investment gurus

Martin Gilbert: most assets still look “reasonable” value

Only government bonds seem too expensive, says Martin Gilbert, vice chairman of Standard Life Aberdeen.
24 Jan 2020

Most Popular


Want to make money in 2020? Gold and silver are looking like a good bet

If you want to make money from investing, says Dominic Frisby, it’s simple: find a bull market and go long. And in 2020 gold and silver are in a bull …
22 Jan 2020
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
24 Jan 2020
Global Economy

The charts that matter: coronavirus – or a liquidity air pocket?

With the yield curve showing worrying signs of flatlining again. John Stepek wonders what's to blame and turns to the charts that matter most to the g…
25 Jan 2020
Investment strategy

The coronavirus is scary – but it's irrelevant to your investments

The spread of the coronavirus is causing alarm around the world. And, while it could be a serious short-term threat to human health, it’s not somethin…
24 Jan 2020