Value and Momentum Simplified: One Handsome Couple!

Hear how the two factors of Value and Momentum, used by Nobel Prize Winners French and Fama, often work together to improve profits and reduce risk in your investments.

Five actor Model
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2287202

Diversification and Risk
https://www.cfamontreal.org/static/uploaded/Files/PDF/Fiches%20CFA-EN/CFA_InfoSheet-5.pdf

AnalystKit.com

Mixing AI with tried-and-true calculations, to find you find the best stocks in a single click!

Chapters

• 0:56 Value Investing
• 1:53 Value Performance
• 3:32 Momentum Investing
• 4:21 Momentum Performance
• 5:30 Value and Momentum - Two Complements
• 6:35 Volatility and Performance Drain

Transcript

Ever feel like everyone else has some secret formula
for investing success?
Well, today, we're gonna do a deep dive into two concepts.
That might just be the real deal.
Value investing and momentum investing.
Now, I used to think investing was all about picking
the next hot stock, chasing those sky high returns.
But after getting burned a time or two, ouch,
I realized I needed a more strategic approach.
That's when I stumbled upon these concepts of value
and momentum, and let me tell you,
it's been a game changer.
So buckle up as we unpack these investing styles,
see what the research really says about their performance,
and find out why combining them might just be
the secret sauce for building a portfolio
that can weather any market storm.
I love your enthusiasm, and you're right.
There's often more to successful investing
than just chasing the latest trend.
Let's start with value investing.
Imagine you're at a classic car show,
and you spot a vintage sports car in pristine condition,
but it's priced like a rusty old pickup truck.
That's essentially what value investors look for
in the stock market.
Companies with strong fundamentals
that are undervalued by the market.
So it's like finding a hidden gem at a bargain price,
but how do you know if a stock is actually undervalued?
I mean, there must be a reason everyone else
isn't snatching it up, right?
That's where intrinsic value comes in.
Think of it as a company's true worth, the whole package,
considering its assets, earnings, brand potential,
and everything in between.
Experts use various methods to calculate this,
but the basic idea is to determine
if a stock's current price reflects its true potential.
Okay, so we're looking for a bargain,
a stock whose true worth is higher than its price tag,
but do value stocks actually perform well over time,
or is it a case of you get what you pay for?
Well, historically speaking,
they've shown some pretty impressive returns.
Research looking at stock performance from 1951 to 2016
found that value stocks significantly outperformed
their more expensive counterparts.
While pricey stocks averaged around a 6% return
and fairly priced stocks around 10%,
value stocks blew them both away
with an average annual return of about 15%.
15%, now that's what I'm talking about,
but hold on, I'm picturing myself explaining this
to a friend and they hit me with,
if it's such a good deal, why is the stock price so low?
What would I say to that?
That's a great question,
and it gets to the heart of why value investing
requires a bit of expertise in digging beneath the surface.
You see, sometimes a stock is undervalued for a reason.
Maybe the company's facing temporary challenges,
or the market has misjudged its potential,
but other times it's like finding that vintage sports car
being sold for a steal
because the seller doesn't realize what they have.
That's where the opportunity lies.
Okay, I'm starting to see why this is so important.
It's about seeing the potential
that others might be missing.
Exactly, and there's a concept called
the Securities Market Line, or SML for short,
which helps illustrate this even further.
Think of the SML as a benchmark for risk and return.
It tells us, theoretically,
how much return we should expect for a given level of risk.
So if a stock falls above the SML,
it means it's offering a better return for the risk, right?
You got it, and guess what?
Value stocks consistently outperform
what the SML would predict.
They're like those overachievers in school,
always exceeding expectations.
With value stocks, you're potentially earning more
without necessarily taking on more risk.
That sounds like a win-win for any investor.
But what about this momentum investing you mentioned?
It sounds a bit more fast paced.
You could say that if value investing
is about unearthing hidden gems,
momentum investing is like hopping on a speeding train.
You're looking for stocks already on an upward trajectory,
aiming to ride that wave of positive price movement.
Okay, I can see the appeal of that,
riding the wave, capturing the momentum.
It sounds almost exhilarating, but also a bit risky.
What if you jump on the train
just as it's about to derail?
That's the million dollar question with momentum investing.
It's all about timing and being able to identify
when a trend is likely to continue
and when it's about to reverse.
It's a more short-term approach compared to value investing,
which focuses on long-term potential.
So how do those momentum stocks actually perform
compared to their more stable counterparts?
Are we really talking about significant differences?
Let's delve into the numbers.
Looking back at the same period from 1951 to 2016,
momentum winners.
Those stocks riding high on an upward trend
returned about 16% on average.
In contrast, the momentum losers, those that lagged behind,
only managed around a 6% return.
A 10% difference.
Now that's what I call a potential performance boost,
but I have to ask,
isn't momentum investing inherently riskier?
No, what goes up must come down, right?
You're hitting on a crucial point.
Past performance is never a guarantee of future results,
especially in the stock market.
While historical trends can be informative,
they can't predict the future.
So momentum investing is like that friend
who's always chasing the next big thing.
It's exciting, but unpredictable.
Exactly, and that's why it's essential
to approach momentum investing
with a healthy voice of caution and a well-defined strategy.
Now, this brings us to the really intriguing part.
What happens when we combine
these two seemingly contrasting approaches,
value and momentum?
That's what I've been waiting for.
It seems like they'd be at odds with each other.
How do you find stocks that are both undervalued
A and D on an upswing?
That's the beauty of it.
It's not necessarily about finding both qualities
in a single stock at the same time instead.
It's about building a portfolio
that includes both value stocks and momentum stocks,
allowing them to work together in a complimentary way.
Okay, I'm intrigued.
So how does this dynamic duo work in practice?
Picture this, you have a portfolio
with a mix of value and momentum stocks.
When the market takes a dip, as it inevitably does,
your value picks.
Those solid companies with strong fundamentals
can provide stability.
They're like the anchors in a storm.
Then as the market recovers and optimism returns,
your momentum stocks, those poised for growth,
can capture the upside and potentially boost your returns.
It's like they take turns shining,
each playing a crucial role
depending on the market conditions.
So you're not just diversifying
across different types of companies,
you're diversifying across different investing styles.
Precisely.
And this kind of diversification
isn't just about managing risk,
although that's a significant benefit.
It's also about potentially smoothing out those market bumps
and reducing the impact of volatility
on your portfolio's performance.
That makes a lot of sense.
And speaking of volatility,
didn't you mention something about how those market ups
and downs can eat away at your returns over time?
Absolutely.
The CFA Institute of Montreal did a study
on the impact of volatility
on long-term portfolio performance.
And the results were eye-opening.
Even small amounts of volatility
can have a significant impact.
Okay, give me an example.
How bad could it be?
They found that even a seemingly insignificant 1%
of volatility could result in a performance drain
of 0.0005%.
Now, that might not seem like much,
but imagine your portfolio is experiencing 20% volatility,
which is not uncommon,
especially during turbulent market periods.
I'm guessing that tiny drain becomes a much bigger issue.
Exactly.
At 20% volatility,
that performance drain skyrockets to a whopping 2%.
2%.
So even if I'm making decent returns,
those ups and downs could be silently chipping away
at my gains.
Precisely.
And that's another reason why this value-momentum
combination is so compelling.
By strategically combining these approaches,
you're not just aiming for higher returns,
but also trying to hold on to more of those returns
over the long haul by potentially smoothing out the ride.
Wow, 2%.
That's a huge hit just from the market going up and down.
That really puts things into perspective.
So we've got value investing,
digging for those hidden gems,
and we've got momentum investing,
riding the waves of market trends.
And then the magic happens when we combine them,
creating a portfolio that can weather those market storms
and protect our hard-earned returns.
It all sounds a little too good to be true.
Is there a catch?
You know, it's funny you should say that
because if combining value and momentum
can lead to both higher returns and lower risk,
you'd think everyone would be doing it.
Exactly.
What's the secret handshake?
How come this isn't common knowledge?
Well, there's no secret handshake, I promise.
But there are a few reasons why this approach
might not be as widespread as you'd expect.
Part of it might be behavioral, investors.
Even seasoned ones are susceptible to emotions.
We get caught up in the hype,
chasing the latest hot stock.
Or we panic when the market dips,
selling low instead of holding strong.
Ah, the classic emotional rollercoaster of investing.
Exactly.
And these emotional responses can make it challenging
to stick to a disciplined, long-term strategy
even when we know it's in our best interest.
Plus, finding the right balance between value and momentum,
tailoring it to your specific financial goals,
risk tolerance, and time horizon,
well, that takes research, analysis,
and often the guidance of a financial advisor
who understands these nuances.
So it's not exactly a set it and forget it kind of strategy.
It takes effort, research, and maybe a bit of expert help.
That's right.
But for those willing to put in the work,
the potential rewards can be significant.
And that's what I hope you take away
from this deep dive today.
Absolutely.
We've just scratched the surface here,
exploring the fascinating world
of value and momentum investing.
It's like we've uncovered a hidden treasure map,
and now it's up to us to go out and explore.
Exactly.
And who knows?
Maybe you'll uncover some hidden gems of your own
along the way.
To help you on your journey,
we'll be sure to include some additional resources
in the show notes, articles, research papers,
maybe even a few book recommendations
for those who really want to dive deep.
Excellent idea.
Knowledge is power, especially when it comes to investing.
Couldn't agree more.
And remember, this isn't financial advice,
but hopefully it's giving you some food for thought,
some new tools for your investing toolbox
as you continue to build a portfolio
that aligns with your unique goals and aspirations.
Here's to making smart, informed decisions
and achieving financial success.
Cheers to that.
And to all our listeners, happy investing.
We'll catch you in the next Deep Dive.