Combining Momentum and Value Investing Strategies

Includes: DIA, QQQ, SPY
by: Dan Knight

There was an interesting article in the Wall Street Journal; click this link, wsj. It stated that Momentum strategies, buying stocks that have been up recently, have been trouncing Value strategies, buying those  which are relatively cheap.

The magnitude was staggering, +71% for "Mo" vs -54% for Value, and it compared this environment to the tech bubble in regards to commodities. Additionally, there was an 18 year chart showing the annualized performance difference between Momentum and Value, with a big spike up favoring Mo during the tech bubble, and a subsequent plumment, favoring Value during the bubble pop.

For nearly 3 years now, Momentum has been outperforming Value, and the article's implication is that a reversal may be near. However, I have analyzed this relationship for years, and since 1970, the advantage of one style over the other can range from a few months to several years, with perhaps a 3 year average advantage. So yes, Momentum is about at the average duration of outperformance, and it could continue, but Value is looking relatively "cheaper" than normal.

I have long advocated a combination of Value and Momentum characteristics in my stock selection and portfolios. Over the last 30 years, Value and Momentum have been highly negatively correlated, roughly -0.5, and thus excellent diversifiers. A simple equal weighted combination of the two styles finds stocks that are cheap but with good relative strength, and this combined value plus momentum strategy outperforms both single style strategies overall and roughly 60% of the time.

So, going forward, if you are a Momentum investor, start looking for the cheapest stocks that are still outperforming, and if you favor Value, find your favorites that have the best relative strength and enjoy the style diversification and likely superior returns. Timing the styles is very tough, so combine them and reap the benefits.