Ride the momentum? Not quite
Sep 08 2013
The momentum effect on FMCG pharma, IT stocks may have run its course. Look for early signs of new momentum in other sectors
So, if you had invested in defensive sectors such as consumption-oriented stocks (FMCG), pharma or IT, you would have gained much more than, say, buying stocks that had become cheaper due to underperformance. In contrast, things have gone from bad to worse for those investors who have put money in worst-performing stocks/sectors (such as infrastructure, capital goods and real estate) since 2008.
Simply put, investors who ignored the ‘momentum effect’ in the consumption-related stocks, pharma and IT have lost out on the big rally in these sectors since 2011.
The BSE healthcare index shot up 69 per cent in 2009 and if you invested, say at the end of 2009 following the momentum strategy, you are still sitting on 82 per cent gains (as calculated at the end of September 6). Or take the BSE FMCG index, which gained over 40 per cent in 2009 and another 31 per cent in 2010, a point when you noticed the ‘momentum’. From 2010, the BSE FMCG is up 76 per cent! Or for that matter, the BSE IT index, which jumped 132 per cent in 2009. Even if you had bought the stock at the end of 2009, the investments would have swelled by 52 per cent!
For comparison, the benchmark Sensex is still trading below the high hit in early 2008.
Various well-known studies have shown the momentum effect across most developed markets, although many have brushed aside this as an anomaly. In fact, the momentum phenomenon defies explanation if you are a believer in efficient markets. Momentum is what is exactly in play right now in the Indian market, though many now reckon this may not last forever.
It is also called the ‘bandwagon effect’, as fund managers and investors tend to rush and add the winning stocks of the past three or six months to their portfolios, which sustains the momentum in prices.
A landmark study in 1993, conducted by Sheridan Titman at the University of Texas, and Narasimha Jegadeesh of the University of Illinois, found that maintaining a long position in past strong performers and shorting past weak performers could earn investors abnormally large returns over a six to 12-month timeframe. Since then, other research have produced similar conclusions, prompting various academics to suggest that pursuing a relative-strength strategy can produce returns anywhere between 0.5 per cent and 1.5 per cent a month.
In 2008, another research by Elroy Dimson, Paul Marsh and Mike Staunton of the London School of Business showed the momentum strategy has been consistently profitable over the past 108 years, and is not subsumed by other factors. “The momentum premium has been substantial not only across equities as a whole, but within size-based and value-based partitions of the market. Momentum remains an enduring enigma,” they said, after studying stock returns in the UK since 1900, as well as returns in markets spanning 17 countries.
“Momentum — the tendency for stock returns to trend in the same direction — has been a major puzzle,” they admitted.
Growth and value investors, too, are indirectly exposed to the momentum effect, with growth investors benefiting from momentum, and value investors suffering. Whatever their style, the momentum ‘story’ is thus of considerable relevance to the investment community, they pointed out.
According to AQR Capital Management, when applied to stock picking, momentum (like value or growth) is about relative performance among stocks, and not about overall trends in the market. It works irrespective of whether a market is in an upswing or downswing.
There are several theories to explain why this happens. One of the main reasons is that investors (as human beings) are prone to what behavioural economists and experimental psychologists call the disposition effect. Investors tend to sell winning investments prematurely to lock in gains, and hold on to losing investments too long in the hope of breaking even. The disposition effect creates an artificial headwind: when good news is announced, the price of an asset does not immediately rise to its value because of premature selling. Similarly, when bad news is announced, the price falls less because investors are reluctant to sell.
As per AQR Capital, another reason is that investors are susceptible to the bandwagon effect (also called over-reaction). Short-term traders may use recent performance as a signal to buy or sell. Longer-term investors look at recent performance to confirm their convictions. The interaction between these investors can create price run-ups or run-downs that can persist for many months until an eventual correction. Notable extreme examples include the technology bubble of the late 1990s and the energy rally of 2007-2008 in the United States.
In India, let’s take Hero MotoCorp, the best performing stock of 2008 in India, a year when benchmark stock indices collapsed more than 50 per cent. The stock, which gained 15.29 per cent in 2008, rose another 111 per cent in 2009 and 16 per cent in 2010 before slipping four per cent in 2011, gaining nearly four per cent in 2012 and staying nearly flat so far this year. Or let’s take HUL, the second top performer of 2008 with 14.74 per cent gain. The year 2009 was a bit ordinary with 5.63 per cent gain, followed by 17.98 per cent, 30.25 per cent, 30.39 per cent and 15.79 per cent returns, respectively, in the years that followed.
Gaurav Mehta, strategist at Ambit Capital, said though recent performance of consumer, pharma and technology stocks shows effects of ‘momentum’, it was not good enough reason to hold on to these stocks or turn back on stocks that are attractive in terms of fundamentals/valuation.
He said the momentum effect on the defensive stocks looks good from a shorter timeframe of three to four years, but this may not play out in a longer horizon, for instance 10 years. He said the consumer stocks rose in 2004 and 2005, before underperforming in 2006 and 2007. Similarly, infrastructure, power and real estate stocks rose during the boom years of 2006 up to early 2008, but have fallen since then.
Private banks such as Axis Bank and Yes Bank had a good run till recently, before correcting significantly, causing severe pain to investors. “Momentum cannot replace the comfort of valuation and picking good quality stocks,” he said, adding that the government’s commitment to bringing down fiscal deficit means significantly lower spending from here on, impacting consumption. “In some cases, valuation (in the consumption-based stocks) has reached stratospheric levels,” he cautioned. There could be ‘de-rating’ of these stocks.
On the other hand, the revival in the economy, coupled with the RBI’s possible monetary easing policy may revive large segments of the economy, triggering a recovery in several sectors. For investors with a two-year time horizon, this may be the time to look at opportunities in stocks that are at attractive valuations, he reckoned.
Dhruva Chatterji, senior investment consultant at Morningstar India, reckoned ‘momentum’ suited short-term traders while the strategy was risky for long-term investors. For one, momentum will be noticed only after a certain period (may be towards the fag end of the rally), making it a risky bet. “Momentum may work for short-term traders. But a fundamental approach is better for long-term investors,” he opined.
Echoed Pankaj Pandey, head of research at ICICIdirect: “I don’t think buying momentum stocks is a sustainable strategy. It may work in the short term.”
In terms of valuation too, the so-called momentum sectors have become expensive, Pandey said, pointing out that the FMCG index was trading at a one-year earnings multiple of 21 times at the start of the year; now it has gone up to 30 times. These companies have seen an expansion in earnings and double-digit bottom line growth. On the other hand, the metal index was trading at 10 times earnings, which is now at eight times. This is because there is a good amount of decline in earnings, he explained.
He said before the start of the year, the outlook for the information technology/software sector was not good, but it has done quite handsomely due to the fall of the rupee versus the dollar and the revival in developed markets, led by the United States.
To conclude, as the London Business School research said, in well-functioning markets, it should not be possible to make money from the naïve strategy of simply buying winners and selling losers. Yet there is extensive evidence, across time and markets, that momentum profits have been large and pervasive.
In the Indian context, it may be too late to catch the momentum in the small pockets of our stock market viz., FMCG, pharma and IT. It may be better to look for early signs of new momentum in other stocks/sectors as such momentum has collapsed in the past, like in the case of the capital goods, realty rallies in 2006 and 2007, respectively.
So, let’s wait for the new momentum and catch it early. The rally in FMCG, pharma and IT are sour grapes by now. zz