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Opinion

Podcast: Momentum- The Anomaly that Persists (Episode-6)

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Host Deepak Shenoy (CEO) interviewing Prashanth Krishna (Trading, Momentum Portfolio) on the Momentum Strategy and why it’s the anomaly that persists.

Capitalmind offers the Momentum Portfolio as part of Capitalmind Premium (subscription service) in Wealth and as part of our Wealth Management Service.

What’s the definition of momentum?

Stocks moving in one direction continue to do so. Speculation? No, Momentum is a factor identifying a stock that is going up and that continues to do so. As part of Momentum, we are not asking why – we’re just identifying when this trend is happening and when it’s stopped. Same exercise on the way down as well.

We are betting on the trend of the market, not taking a contrarian view.

Why does momentum work?

We have research going back decades (generally in the US and other developed markets) that clearly shows that momentum works. We can show the persistence and impact of momentum but the reasons aren’t very convincing (Rory Suterhland anecdote on knowing something works but not having the exact reason why).  One of the best reasons I’ve come across attributes this to behavioral factors. Investors underestimate at beginning and over-estimate at the end. 

Another is asymmetric information – if you know or have figured out something about a stock you will start to acquire more and more shares. As information trickles in, people will jump on the bandwagon and others will replicate. The stock goes from under-information to over-participation driven by FOMO and greed.

Isaac Newton story about the South Sea Company, He got in, made 100%, got out, but jumped in once again on peer pressure and then eventually lost everything.

How long do you hold a stock for and what are the portfolio construction strategy, diversification criteria?

We don’t buy for life like Buffett. The average holding period is a couple of months. We know something about the stock but simply not enough to make long term hold decisions.

Price is the key, price action is the trigger for our investment and exit choices. We don’t want a low liquidity stock. We would rather not have a high volatility stock either that keeps hitting upper and/or lower circuits. The best fit is a stock that goes up steadily without making waves. So avoid the parabolic rise? Yes, HEG is an example that after it hit all time hights it was subject to indefinite growth style justifications. You can’t start with momentum and then transition to fundamentals.

25-30 stocks is an optimal choice. Even a 50% fall in Vakrangee where couldn’t get out.only caused a drop of 1-2% of your overall capital which is still manageable.

How do you re-balance?

Re-balancing is meaningful – selling and buying has costs, taxes and slippage. Monthly is a sensible level. Let it ride for a month unless there is extreme news. At the next month, re-visit is the stock still worth holding.

What do you do in times like these (months leading up to Aug 2019) when there’s not enough momentum?

In Bear runs like the current environment, we stay in cash if we can’t find 30 stocks.  If we only find 20 stocks (instead of 30), we have 33% in cash. 

Momentum is often viewed as a negative because of the dangers of manipulation (promoters and operators driving prices). Since you don’t have filters that can track manipulation – how do you deal with this?

Manipulation happens at every level, at accounting, price, balance sheet – even an analysis of fundamentals have risk from misleading or false financial statements. Manipulation is easier in a low volume stock. If you filter on high volume, it’s tougher to get caught in a pump and dump.  Between filters and diversification, we avoid mistakes or avoid mistakes that we can’t recover from. In Vakrangee – we rode the stock on the way up and then down as well! Once the lower circuit hits, you can’t exit no matter what your back test claims.

Do you get time to exit?

We’re scared of parabolic charts – they become waterfall when the stock comes down. The lower circuits often kick in (unless it’s an F&O stock) so it’s not easy to get out. Fortunately, momentum normally exhausts over time so it gives you down to exit.  It’s the series of small waterfalls kills an investor in a stock.

Pitfalls or things to watch out for?

How will you build your version of Momentum? If you’re not looking at volume filters – that’s a big risk.  What’s the universe? Momentum today would be say 50% in large and 50% mid cap. Outside of a wholescale fraud, you should have regular market risk. When there’s a drawdown, will you have the conviction to exit the stock like your model tells you to or will you be loss averse? Alpha comes from behavior rather than the genius of the strategy. Have faith in the strategy. The biggest failure point is us. 

What are the returns like?

Return of this strategy is linked to the market. This isn’t a contrarian portfolio, In a bear market you don’t do great either. Above Nifty returns are achievable based on the track record. During the bull market days you could easily hit the higher end of this range and the numbers looked abnormally great in the short term. However, draw downs are similar to Nifty.

Your portfolio make-up changes from small to mid caps in the bull runs to larger companies in the bear market. You’ll know this is working when Momentum falls in line with Nifty even on the downside but has beats it during the upside.

This has played out in foreign markets as well?

Yes, in US like markets we have some data going back nearly a century and this very much works. Low volatility strategies don’t always prosper but Momentum is an anomaly the persists. Just buying small cap stocks looks great in bull markets but risk adjusted doesn’t really do better than large cap. Momentum gives alpha even after adjusting for risk.


Next Steps:

If you’re interested in learning and doing this yourself Capitalmind Premium articles on Momentum (we have a smallcase) https://www.capitalmind.in/momentum-portfolio/

And if you would like us to invest for you, we offer the Momentum to our Capitalmind Wealth customers (Wealth Management/PMS) as well.