Momentum investing – and why price matters more than anything else

The recent fashion for momentum investing, with investors piling into expensive growth stocks, is nothing new, says Merryn Somerset Webb. And the dangers are the same, too.

Back in 1967 a man calling himself Adam Smith wrote a wonderful book called The Money Game. Smith – actually a professional investor called George Goodman writing under a pseudonym – devotes one chapter to what he called “The Cult of Performance”. 

In it, he describes the shift that took place in fund management in the 1960s. Before then, portfolio management was not an “Instrument of Personality”. Funds were instead run by a “Prudent Man” – the kind who “died with an estate that won the admiration of the lawyers for its order and efficiency”.  

His portfolio had around 200 stocks in it – the 200 biggest companies in the US. These made up two-thirds of the assets – bonds made up the rest. 

This was straightforward, formulaic stuff. If our man was to make a radical move, he might “reduce Steels from 3.3% to 2.9% and buy a little more Telephone” (Smith was an enthusiastic user of capital letters). 

Then something changed; where there hadn’t been much money, there was suddenly a great deal of money. 

Momentum investing takes off

In 1946, $1.3bn was invested in mutual funds. By 1967 that number was $37bn (plus another $150bn in pension funds). Seven times as many Americans held shares by the end of the 1960s as had during the height of the 1929 bubble. 

At the same time, a new group of managers arrived. These were “tigers” not remotely scarred by the horrors of 1929. They saw that the best capital gains weren’t coming from America’s big old companies, but newer growth companies – Xerox, Disney, Polaroid, Eastman-Kodak and IBM. The stage was set for The Cult of Performance.

Fund salesmen found people weren’t interested in “nice balanced diversified funds” any more. They wanted the funds that had gone up the most – and that they thought would continue to go up the most. Initially that mostly meant the Fidelity Trend Fund (up 56% in 1965) and the Dreyfus Fund (the first to run a real retail advertising campaign – featuring a real lion emerging from a subway station on Wall Street).

But soon the method was jammed with Instruments of Personality – Fidelity’s Gerry Tsai raised $274m in a day for his Manhattan performance fund against an original target of $25m – and everyone was getting into the growth game. 

Even the head of the supposedly conservative Ford Foundation was muttering about caution costing more than risk taking. Look at how the performance managers are doing, he said, and surely funds such as his should be changing direction: “The true test of performance in the handling of money is the record of achievement not the opinion of the respectable.” I imagine that in later years he filed this under things he wished he had never said in public.

“It may all go too far”, said Smith in 1967; the respectable “may be right”. It did and he was.

The performance stocks, which became known as the Nifty Fifty, went nuts, with price/earnings (p/e) ratios hitting 50-plus across the board; Polaroid was the winner on 94.8 at its peak. 

Then oil prices, inflation and interest rates all rose fast, the Bretton Woods system came to an end and it all came tumbling down. By 1974 Polaroid was down 91%. The Fidelity Trend Fund fell 23% in 1973 and 31% in 1974. 

The FAANG stocks take over where the Nifty Fifty left off

This will all sound familiar. Replace Fidelity with Baillie Gifford, performance with growth and Polaroid with Netflix and you will see the story is very much the same. 

This brings me neatly to what Ed Yardeni of Yardeni Research calls the MegaCap-8: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Netflix, Nvidia and Tesla. 

Until very recently this lot were treated just as the performance stocks were in the 1960s. They were where the growth was – you bought them and you held them forever. Price was irrelevant. 

In a low growth world you didn’t need prudent men, or those looking for what we used to call GARP (growth at a reasonable price). You needed those who would buy growth at any price (GAAP).  

Tesla peaked on a price/earnings ratio of 163 in August 2020, says Yardeni, while Amazon hit 85 and Netflix 66. It went too far. Then oil prices, inflation and interest rates began to rise – and here we are. 

Collectively, the MegaCap-8 lost 6.1% on Tuesday. They are now down 27% in the year to date (the S&P 500 is down 17%). The only one that has outperformed the S&P 500 (a low bar) is Apple (down 13.4%). The p/e ratios look slightly less mad: Tesla is on only (!) 53 times earnings and Nvidia on 32. Netflix has made its way down to 20 due to a 60% fall in its share price so far this year. 

The most important thing when investing is price

The lesson here isn’t exactly a new one, but it is worth keeping the Nifty Fifty and the MegaCap-8 in mind as you and your portfolio navigate the next few years. It is this: price matters. 

We have just been through a period in which I have constantly been told that we must pay up and up for growth and for quality – quality being shorthand for businesses with predictable earnings streams. But the past few months have made it clear that this only works if you have total clarity over the unfolding of the future. 

If you could have known for sure when you paid 80 times earnings for a stock that interest rates were to stay low forever, that its earnings would be just as you predicted and its growth all but permanent, it might have made sense. 

With the knowledge that the future is generally unguessable and that even great companies can be bad investments if bought in a bubble, might you not be better just buying the cheapest cash flows you can find? Do this, say analysts at Orbis, and with each passing year “your need for a crystal ball dissipates”.  

Let me end with some good news for those of you still determined to hold the Megas (just one-fifth of investors questioned by exchange-traded product provider GraniteShares say they have sold or cut their US tech investments).  

In the year before their stunning pandemic melt-up, the eight had a collective forward p/e of around 24 times earnings. It isn’t much higher than that now – just over 25 on Yardeni’s numbers – so things are looking a little more normal, if still quite expensive in historical terms. 

Two weeks ago Orbis, mainly a value investor, noted that on current valuations, with a p/e of around 20, Alphabet can now be considered a value stock (it is cheaper than the S&P 500 as a whole) or a growth stock – or perhaps even just a big US company offering a little GARP for the Prudent Man. 

• This article was first published in the Financial Time

Recommended

Sterling continues to slide after Friday’s mini-Budget
Currencies

Sterling continues to slide after Friday’s mini-Budget

The pound has continued to fall hard and is heading towards parity with the US dollar. Saloni Sardana explains why, and what it means for the UK, for …
26 Sep 2022
Beating inflation takes more luck than skill – but are we about to get lucky?
Inflation

Beating inflation takes more luck than skill – but are we about to get lucky?

The US Federal Reserve managed to beat inflation in the 1980s. But much of that was down to pure luck. Thankfully, says Merryn Somerset Webb, the Bank…
26 Sep 2022
Johann Rupert: the Warren Buffett of luxury goods
People

Johann Rupert: the Warren Buffett of luxury goods

Johann Rupert, the presiding boss of Swiss luxury group Richemont, has seen off a challenge to his authority by a hedge fund. But his trials are not o…
26 Sep 2022
The hidden cost of employee share schemes
Investment strategy

The hidden cost of employee share schemes

Paying employees in shares comes at a cost to investors – but it isn’t always easy to see how much, says Stephen Clapham.
26 Sep 2022

Most Popular

Could gold be the basis for a new global currency?
Gold

Could gold be the basis for a new global currency?

Gold has always been the most reliable form of money. Now collaboration between China and Russia could lead to a new gold-backed means of exchange – g…
22 Sep 2022
Share tips of the week – 23 September
Share tips

Share tips of the week – 23 September

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
23 Sep 2022
Paypal, bitcoin, and the weaponisation of money
Bitcoin & crypto

Paypal, bitcoin, and the weaponisation of money

Recent events have shown how both business and governments can “weaponise” money and shut down dissent. What to do? Buy bitcoin, says Dominic Frisby.
22 Sep 2022