Quick gains, but equally quick losses: How to make the most from momentum investing

The debate between value and growth investing gains traction during every bull market. The fundamental difference between the two is ‘the mindset.’

Growth investors scout for brighter business prospects. A higher top line generally leads to higher profitability and hence the up-move in stock prices.

On the other hand, value investors look for assets that may not lead to immediate profitability. Value unlocking generally happens through corporate actions such as bonus issues, rights issues, mergers & demergers. There are ample examples of demerged companies generating more shareholder wealth than their parent or holding companies.

Momentum investing is most probably related to growth investing. This is so because India is a growing economy. In such developing economies, investors generally tend to assign higher valuation multiples to growing companies. Expansion of valuation multiples leads to movement in the underlying prices.

Fundamental value-unlocking events are relatively rare in the market. For this reason, it is difficult to find value opportunities that also have momentum.

In this article, we will discuss the pros and cons of momentum investing. We will conclude by looking at a framework for momentum investing.

Pros of momentum investing:

1. Gives an opportunity to turn investments quickly into profits. Works best for investors who do not want to rely too much on the uncertainties of a long-term approach.

2. In an environment of shrinking business cycles, it is difficult to take a long-term view of how businesses will respond to change. The rapid evolution of technology offers regular opportunities to momentum investors to churn their capital from one company to another

3. Understanding a business as an outsider is difficult. Company insiders have access to richer information and there is always an information asymmetry. Momentum investing gives you the opportunity to make hay in the stock markets without having to understand a business in depth.

Cons of momentum investing:

1. Momentum investing has similarities with the game of musical chairs. One needs to ensure that they can exit their positions (find a chair to sit) before the music stops.

2. The stock markets are notorious for price manipulation. A set of individuals gets their interests aligned and decides to drive up prices of stocks. Such rallies often end painfully for investors who indiscriminately chase momentum. At the top of the cycle, operators/insiders exit their positions and when the music stops, smaller investors are left with stocks that are substantially lower than their purchase price.

3. Spotting stocks that have momentum may not always give stocks that are fundamentally strong. If you fail to exit your positions at the right time, you wouldn’t have the confidence to hold these companies in your portfolio during volatile times.

4. Such an approach requires higher involvement in the markets – not just in terms of time, but also in terms of higher transaction charges to the government and brokers.

5. If you ask any elderly person, there are high chances that they would dissuade you from ever investing in the stock markets. In my experience, many such individuals lost their hard-earned money and patience trying to indiscriminately chase momentum.

A framework for momentum investing: Frequent entries and exits from your stocks require great mental strength. In the short term, the stock markets naturally are volatile. Watching your hard-earned money go down the drain is no easy feeling. Similarly, it is not easy to control the exuberance when you make quick money from stocks. Such an emotional outburst is not good and is generally inversely related with profitability.

Having a set of rules or framework helps in controlling the emotional aspect of momentum investing. Here are a few pointers on how one could make a framework:

1. Use technical analysis extensively. A momentum-based approach essentially means you are interested in the price rise of your stocks. The entire science of technical analysis is based on price movements. Mastering the indicators and oscillators is a must for succeeding in the momentum game.

2. Try not to bring in the fundamental angle into your analysis. There is a school of thought called ‘techno-fundamental’ analysis. Studying fundamentals can help in ensuring that you can sit on your positions in case of extreme volatility. However, it is not always a guarantee that you would get a momentum-based opportunity in fundamentally strong companies.

3. Sectoral movements provide a very good view of how market participants are thinking.

Pharmaceutical stocks gave handsome gains during the peak of the Covid-19 pandemic. Similarly, as the nation unlocks, tourism stocks are making a smart bounce-back. If you spot momentum in a couple of stocks within a sector, it makes sense to take positions in a few of those stocks.

They say everything is fair in love and war. In our context, I would say any approach (growth, value, momentum, contrarian) is fair in the stock markets provided it consistently makes money for you and suits your personality. I hope this article will help in chalking out a framework for yourself.

Abhinit Kulkarni, Founder and CIO, Tequity Investing