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Go With The Flow
Posted: Jun 25, 2008 08:32 AM by Will Ashworth
As the name implies, momentum investing seeks to go with the flow. If a stock is challenging 52-week highs, momentum players believe this is the time to invest, buying high and selling higher. It involves taking big risks in return for big returns. Sometimes, this type of investor guesses wrong and misses the rising tide leading to a loss. Quick strike momentum investing requires precision trades with little margin for error. It's a strategy that involves high turnover, leading to high fees, a large commitment of time monitoring investments looking for signs it's time to sell, and a process that works best with bull markets, which tend to produce this so-called herd mentality.
Bottom Fishing For Suckers
Richard Driehaus, the famous Chicago money manager who manages $4.5 billion for institutional and wealthy clients, is considered by many as the father of momentum investing. He believes that avoiding stocks with high short-term volatility only results in long-term risk and under performance. He argues that investing in volatile stocks, especially those at or near highs, is better than owning beaten down stocks and waiting forever for them to come back. Momentum investors believe that stocks performing well will continue to rise as long as the news doesn't change. (Learn more about momentum investing in Riding The Momentum Investing Wave.)
For a long time, research seemed to indicate that successful momentum investing was a result of taking advantage of market inefficiencies or irrational investor behavior. However, new evidence from Jacob Sagi of the Vanderbilt University Business School study suggests that the greatest profits for momentum investors comes from stocks with high price to book (P/B) ratios, high revenue volatility and higher than usual gross margins. In other words, investors take on greater than average risk with this strategy. To read about the findings, check out "The Myths Of Momentum Investing" (2007).
Momentum Investing Picks
| Company |
P/B |
Price as % of 52 week high/low |
Market Cap (millions) |
Ansoft
(Nasdaq:ANST) |
12.2 |
100 |
871.07 |
eResearch Technology
(Nasdaq:ERES) |
7.2 |
100 |
863.96 |
Sun Hydraulics
(Nasdaq:SNHY) |
6.41 |
90.14 |
644.75 |
American Ecology
(Nasdaq:ECOL) |
6.24 |
99.07 |
539.53 |
Monolithic Power Systems
(Nasdaq:MPWR) |
6.17 |
88.35 |
842.67 |
| True Religion Apparel (Nasdaq:TRLG) |
6.03 |
98.88 |
643.52 |
Forward Air
(Nasdaq:FWRD) |
5.98 |
91.11 |
1092.01 |
NVE Corp.
(Nasdaq:NVEC) |
5.34 |
77.48 |
168.26 |
DTS
(Nasdaq:DTSI) |
5.03 |
100 |
626.95 |
Netlogic Microsystems
(Nasdaq:NETL) |
4.57 |
88.23 |
811.12 |
| Data as of market close June 19, 2008 |
Sun Hydraulics
This fast growing Sarasota-based small cap designs and manufactures screw-in hydraulic cartridge valves and manifolds for industrial markets. Founded in 1970 and publicly traded since 1997, its first quarter sales were up 20%, its 20th consecutive quarter with double-digit sales growth. In terms of earnings, its compound annual growth rate is 23%, dating all the way back to 1972. If you look at the stock since going public in 1997, it treaded water around the $3 mark for five years and then took off like a shooting star, hitting above $40 in late May for an annual increase of 53%. When Sun got on a roll, its P/B was 1.39 (at the end of 2003). Today, it sits at 6.41. That's a clear sign of a momentum stock.
American Ecology
Boise-based American Ecology helps companies get rid of hazardous waste. It's so successful that Business Week ranked it 12th in its June issue of "Hot Growth" companies. Its first quarter numbers were good with sales up 19% and operating income 20% to $9.5 million, the best quarter in terms of operating income in company history. In the April 29, 2008 press release, it guided EPS to the top of its earlier February projections, which were between $1.17-1.23 per share. Its stock, like Sun Hydraulics', sat around for five years before igniting in 2002. Since then, it's been on a tear growing 57% a year. When will the trend end and revert to the mean? Maybe Richard Driehaus knows. (Read more on fundamental analysis of revenue in Understanding the Income statement.)
Conclusion
Momentum investing involves going with the flow, riding your winners until they stop going up. Money managers like Richard Driehaus use this strategy to operate momentum funds that seek to make money for clients by buying high and selling higher. It's working for Driehaus; maybe it will for you too.
By Will Ashworth
Will Ashworth lives and works in Toronto, Canada. He's worked in and around the financial services industry for much of his adult life. He loves investing and is passionate about helping others learn how to put their money to work.
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