Be a Value Nerd or Follow the Momentum Herd?

Todd Kenyon and Eliot Penn both made great posts on the topic of defining growth and value, with Todd even calling himself a nerd. Truth is, I was once both a jock and a nerd - I competed in the ultimate nerd sport: cross country. Now, however, I'm just a nerd.

Without being redundant, growth and value are redundant. You can't value a stock without accounting for its growth. In fact, the most basic value measure: the P/E ratio, is really just short-hand for the DCF (discounted cash flow) formula. In its most simplistic format: P/E = 1/(r-g), with "g" being the growth rate. While the formula doesn't work when "g" exceeds the GDP growth rate (5-6%), it illustrates the point that value and growth are interdependent.

So why does the industry separate people into the two categories? For many reasons, but "growth" sometimes is a pseudonym for something else. Many, though certainly not all, growth investors are really momentum investors. Indeed, many individuals classified as "value" are actually closet momentum investors too. And momentum is a different animal altogether.

Momentum investors, if they subscribe to any theory, are part of a greater body of investors that subscribe to the "greater fool" theory. That is, I may be a fool for buying stock X, but if I can get someone else to buy it from me for more than I paid, then that someone else is the greater fool. In momentum theory, stocks are pieces of paper and valuation is not relevant (though some will use valuation overlays).

This is a zero sum game: somebody wins when somebody loses, which happens to be the way gambling works.

When a "material" news report hits the market, a stock goes up or down depending on the content of the report. The momentum crowd is trying to get in ahead of that trade. Sometimes they do fundamental work to try to anticipate positive earnings events; sometimes they use quantitative measures to measure earnings and/or news trends; sometimes they just try to dig up the information in advance of the announcement. Academic studies have shown that sometimes news travels slowly - management teams trickle out news, especially bad news, because they are incentivized to do that. Some momentum strategies try to take advantage of that finding.

It is possible to make money this way - I've seen it done - but it's not easy and it's very stressful. And when the market suddenly goes south, these guys often get creamed.

Most conventional mutual funds use some form of momentum investing. They have the resources and the access to do it, and often the managers are forced into it by the mutual fund environment and its focus on short-term returns.

Then again, there are also some people who will just buy anything that is growing.

There is another crowd that buys "stories." Stories are stocks that sound good in 30 seconds or less. Some new product, some unique way of doing things, yada yada yada. In my opinion, this is just another indirect variant on momentum, since stories and momentum are highly correlated. When I worked for a mutual fund, I was always told to come up with a story for my recommendations. Unfortunately, my stocks don't always sound pretty and my stories usually started with: "This stock sold off because ..."

Then there is the "trend is your friend" investor - one who buys stuff that's going up. This is also momentum.

Are there growth investors out there that are not momentum or greater fool investors? Yes, of course. Not all growth stocks are easy to value; some growth investors specialize in investing in early stage growth companies. They pay attention to value, they just don't focus on it because some companies can't be reliably valued.

Like intrinsic value investors, those kind of growth investors are few in number.

As a value investor, and one with a strong contrarian streak, I like the down and out companies. P/E's below 10 get my attention. But so do companies that are growing and sport higher multiples. So do companies without earnings and therefore no P/E ratio, which are often growth companies that "growth" investors hate. I've made money on stocks with P/E ratios ranging from 8 to 25 -- all the way to a negative 5.

This type of investing is not mathematically difficult. As Todd put it, it is psychologically difficult. Who wants to be the nerd that everybody picks on? Humans have strong herding instincts - we are hard-wired to do what everybody else is doing. We don't want to look bad. We don't want to "miss" something.

Unfortunately, when it comes to our wallets, we are our own worse enemies.

Comments

[jurp]

But, when using either method, be sure to have some sort of stop loss. e.g. F going from 40 (when Templeton bot it, to 15 then to ??, and now 9)