Don’t be afraid of momentum strategies - MoneySense

Don’t be afraid of momentum strategies

Momentum strategies may be more volatile, but the strong returns may be worth the ride


go-1200For everyday investors, some of the more popular types of stock portfolio strategies focus on either low volatility stocks, dividends, cash flow and value. Since these types of strategies are usually easy to understand, implementable, and can achieve the goals of growing a portfolio and minimizing risk, they are appropriate for many investors.

More aggressive-type strategies like momentum are often dismissed due to the risks and caveats associated with them. However, while it is true that momentum-based strategies come with traits such as increased volatility and higher turnover, they may have a place for a wide range of investors.

What are momentum strategies?

Momentum strategies involve investing in stocks that have displayed a recent short term positive trend in a certain quality such as price, earnings, profitability, etc. For the most part, momentum concentrates on price trends and they do not look at the stock’s business, industry or competitiveness. The theory behind momentum investing is to capture a continuing trend that stocks with increasing prices will continue to rise. Research studies have shown that momentum investing can achieve significant profits.

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The criteria

I used Morningstar CPMS* to create a momentum-based strategy mainly focused around short term price increases with a restriction of stocks having at least a market cap of $250 million to exclude the smaller cap stocks. Smaller cap stocks tend to be more difficult to trade due to lower trading volume. I also added a return on equity factor which seems to add positive performance when combined with price momentum.

The factors used in the strategy are:

  • Price return from 3 months ago
  • Price return from 6 months ago
  • Price return from 12 months ago
  • High return on equity
  • Market cap of at least $250 million

The results

I back-tested the strategy from December 2006 to July 2017, using an initial investment of $50,000. During this process, a maximum of 15 stocks were purchased and equally weighted. Quarterly, the portfolio would be replaced with the best 15 stocks based on the strategy’s criteria. After assumed trading costs of $9.99 per transaction, the strategy produced an annualized total return of 17.8% over the period while the S&P/TSX Composite Total Return index advanced 4.5%, resulting in an outperformance of 13.3%. The investment of $50,000 grew to over $282,000 in just over 10 years. You can find a list of the 15 stocks that are currently in this strategy below. 

A word of warning

While these results are impressive, they do come with some stipulations. Standard deviation of returns (a measure of volatility) for the strategy was 23.6% vs. 13.1% for the S&P/TSX Composite. This essentially says the strategy will not work all the time and will experience greater swings in portfolio value vs. the index. Turnover was a whopping annual 272%, which means you would make a significant number of trades at the end of each quarter. And although the 17.8% return is after deducting for trading fees, you should also consider the amount of time and effort required for this amount of active trading. Furthermore, this test assumed trading with closing day prices and only at the last business day of each quarter. In reality, you will likely trade at a different price.

Does it work for you?

Momentum strategies come with a lot of baggage in the form of trading costs and volatility. However, in one sense, momentum can be quite simple. In this strategy, you only trade at the end of each quarter. Also, momentum strategies usually do not look at a stock’s business, industry, competitiveness, etc. which would take more time to analyze.

Before implementing a momentum strategy, you should seriously analyze and consider if you are comfortable with the baggage involved. If you are, the strong returns may be worth the ride.

Rank Company Market Cap ($mil) Return on Equity Price change from 3 months ago Price change from 6 months ago Price change from 12 months ago
1 Tembec Inc. (TMB) $456.0 68.5% 2.0% 51.0% 360.6%
2 Theratechnologies Inc. (TH) $575.8 -12.4% 8.7% 70.7% 206.3%
3 Shopify Inc. (SHOP) $10,982.2 -1.2% 3.1% 63.0% 136.4%
4 Air Canada (AC) $6,496.9 100.6% 34.4% 78.8% 167.0%
5 BRP Inc (DOO) $1,259.1 301.9% 26.3% 59.5% 70.3%
6 Colliers Intl Group (CIGI) $2,327.3 51.3% -14.4% -7.2% 15.0%
7 Tucows Inc. (TC) $698.3 42.1% -15.0% 9.5% 83.6%
8 Yangarra Resources (YGR) $255.0 4.7% 0.6% 25.9% 163.3%
9 Sleep Country Canada (ZZZ) $1,280.1 20.7% -12.8% 16.2% 9.1%
10 Cascades Inc. (CAS) $1,361.1 7.2% -12.4% 8.5% 28.8%
11 5N Plus Inc. (VNP) $273.0 11.6% 5.8% 81.7% 81.7%
12 SunOpta, Inc. (SOY) $951.3 -0.3% -12.8% 15.9% 26.4%
13 Sabina Gold & Silver (SBB) $497.3 -0.4% 19.5% 60.1% 82.6%
14 Sandvine Corporation (SVC) $539.6 5.9% 12.6% 52.8% 18.8%
15 Ballard Power Systems (BLDP) $613.1 -6.1% -6.2% 38.3% 27.7%

* Morningstar CPMS includes all stocks in the TSX Composite Index and the BMO Small Cap index. It also includes other stocks based on request with at least 3 analysts of coverage and 5 quarters of earnings. Currently the universe has 699 stocks in Canada.

Michael Pe, CFA is an Institutional Product Specialist at Morningstar Research Inc.