Valuation vs. Momentum

by: Value Expectations

In August 2009, The Applied Finance Group (NYSE:AFG) explored the relationship between Valuation and Momentum variables. (The original article can be found here.) We wrote about an interesting observation of the S&P 500's performance between 9/1998 and 6/2009. We showed that strategies built around Valuation or Momentum variables had periods of outperformance and underperformance, but combining these variables led to fairly consistent outperformance, as well as better overall performance than the individual variables alone. The table below highlights S&P 500 returns for Valuation (AFG’s Percent to Target variable), Momentum (AFG’s EM Momentum variable), and Combination strategies.

Table 1: S&P 500 Performance: 9/25/1998 – 6/26/2009

This strategy performed so well in the S&P 500 for more than the last decade, it would be wise to implement the knowledge gained into a stock picking methodology. To explore this further, we will now turn to our international research database to show how this strategy works at the country level. At this point, we have data for 26 countries, with nearly 10,000 companies and nearly twenty years of data. The following three data tables contain the performance for our Valuation, Momentum, and Combined strategies internationally.

Table 2: International Valuation Performance: 12/31/1991 – 10/31/2009 (Percent to Target)

Table 3: International Momentum Performance: 12/31/1991 – 10/31/2009 (EM Momentum)

Table 4: International Combination Performance: 12/31/1991 – 10/31/2009

Individual Country returns are equal-weighted, monthly turnover, cumulative returns from 12/31/1991 – 10/31/2009.
Portfolio Construction:
Percent to Target: Top Half by Sector vs. Bottom Half by Sector
EM Momentum: Positive Momentum vs. Negative Momentum
*United States start date: 2/29/1992
*Greece, Luxembourg, Australia, Taiwan, and New Zealand start date: 12/31/1995
World returns are calculated by taking individual country returns, then market-cap weighting each country by sum of market cap in US dollars.

Some interesting observations can be found here. First, Valuation has been a stronger predictive variable than Momentum within the S&P 500, but looking at entire country universes that relationship is inverted. Also, we can see the strength of international diversification through our Batting Average metric. Batting Average is a measure of the percentage of months where the “Buy” portfolio outperforms the overall universe and the “Sell” portfolio underperforms the overall universe. Valuation alone has a “Buy” Batting Average of 67% worldwide; Momentum alone has a “Buy” Batting Average of 79% worldwide. We can see that the combined strategy's Batting Average improves to 81% for “Buys” and 84% for “Sells”. This is further driven from individual country research, where average Batting Averages are 61% for “Buys” and 63% for “Sells” for the Valuation/Momentum hybrid. To help clarify that, note that over the last 18 years diversification through valuation and momentum variables, as well as across countries, leads to outperformance over 80% of the time.

Let’s take a look at annual and quarterly performance across the entire world.

Table 5: Annual International Research: 12/31/1991 – 10/31/2009

Table 6: Quarterly International Research: 12/31/1991 – 10/31/2009

These data tables begin to really highlight the benefit of a Valuation/Momentum hybrid strategy. Over the past 18 years, we only observe one year of underperformance, and over the past 72 quarters, we only observe seven quarters of underperformance. (Note that four of these quarters happened over a 15 month span from 1991 Q1 through 2001 Q1.)

This ultimately begs several questions, including “where do we go from here,” as well as, “how can I apply this to my portfolio?” Our internal research on implied sales growth points to an understanding of US equities as being reasonably fair-valued, with a nearly 5-6% growth rate currently imbedded into stock in the S&P 500. Despite this fairly-valued label on our current market environment, it is clear that due to the dramatic price fluctuations over the last year and a half, the market will still need time to sort out reasonable valuation levels for many individual stocks, and we predict that this will be captured through our Percent to Target metric. Along with this “stock-pickers” environment, we also have a tremendous amount of macro-economic uncertainty as equity markets anticipate news on banking regulation, health care, and a variety of other economic concerns. We predict that this will be captured through our EM Momentum metric.

Try constructing a model portfolio or screen based on Valuation and Momentum. Add your other screening criteria that are necessary for your investment style. See if any of the names are currently in your holdings, or if any of the names have been on your watchlist. As an example, we constructed the following list of stock ideas from the S&P 500, using AFG metrics. Each stock is the most attractive in its AFG sector when ranking Percent to Target and EM Momentum.

Table 7: Valuation/Momentum Buy Ideas: 1/22/2010

Regardless of overall market performance this year, we believe that these variables will help you achieve benchmark outperformance. Good luck.

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Disclosure: none