The idea for today's piece was triggered by a recent Tweet.
Posted by Alok Jain, a friend (I hope a face to face interaction and a few email exchanges qualifies me as one) and one of India's most popular momentum traders, it went something like this.
Not surprising, right? A momentum guy and an extremely successful one at that, tooting the horn of his own discipline.
To be honest, even I am a big fan of momentum investing. So what if my short tryst with momentum has been anything but successful.
--- Advertisement ---
FREE Event on Equitymaster's New Project
On May 17, we are holding a FREE event to reveal Equitymaster's Great Indian Wealth Project.
At this event, we'll reveal the details of your first stock for a potential Rs 7 crore in long-term wealth.
Seats for this event are filling up fast.
Since there are limited seats, we urge you to register at the earliest.
Click here for free sign-up
Maybe I am not as skilful as Alok and perhaps bad timing also played a part in my case.
Anyways, this article isn't about my brush with momentum. It's about the comparison between two of the most popular forms of investing aka momentum and value investing.
Of course, Alok Jain has given his verdict. He is also true about the countless research papers showing momentum's superiority over value investing.
However, momentum investing has one huge disadvantage. It needs a thriving stock market for it to work effortlessly.
Warren Buffett, who I believe has carried the torch for value investing for decades now, is often heard saying that he never attempts to make money on the stock market. He buys on the assumption that they could close the market the next day and not reopen it for five years.
This is another way of saying that behind every stock there is a business. Our goal should be to find out how the business is doing.
I think it will be fair to say that a momentum investor doesn't worry about how the business is doing. For him, its stock price on the bourses is supreme.
And if it is going higher and showing a definite trend, a momentum investor may get interested irrespective of whether the underlying health of the business is sound or not.
Thus, one can still be a value investor without there being a stock market. The same cannot be said about momentum investing though.
Another way of putting this distinction across is to highlight that for a value investor, most businesses have a certain intrinsic value. You should buy the business only if the stock is trading at a big discount to intrinsic value and sell if it is trading at a premium to it.
So, if a stock has an intrinsic value of Rs 100 per share, a value guy will buy it if it's trading at Rs 60 or lower and sell at 100.
A momentum investor on the other hand may get interested in the stock even at a price of Rs 120 or higher if he finds the trend favourable and may ignore the stock even at Rs 50 or lower if he finds the trend unfavourable.
Intrinsic value is of no meaning to a momentum investor.
As a matter of fact, as per Benjamin Graham, the very term momentum investor could well be an oxymoron. He liked to call investors who don't believe in value as speculators. And therefore, momentum investors are speculators as per him.
What makes the whole thing more complicated is that even for the best businesses, the concept of intrinsic value is an intelligent guesswork at best.
You can never be sure of a stock's intrinsic value and therefore, be always on tenterhooks if a stock spends a year or two sideways and shows no signs of reaching your estimation of its intrinsic value.
In fact, this is one of the main reasons investors get disillusioned with the whole concept of intrinsic value and start looking for other, less complicated forms of investing.
And this is where momentum investing comes to their rescue. Here, you don't have to track a stock's fundamentals nor estimate its intrinsic value.
All you are looking for is a stock showing a certain pattern on the chart and voila, you can go ahead and make your investment. If you are right, you are rewarded with strong gains in a short period of time and if you are wrong, you can always keep a stop loss and exit the trade before it makes a big dent in your portfolio.
Please note that I am not arguing the superiority of one form of investing over another. I think to each his own.
For me personally, I would like to invest with at least 85%-90% of my portfolio and keep the remaining 10%-15% for speculation or may be even less.
I sleep more comfortably at night knowing that I have a portfolio that's undervalued and where my stocks have a certain intrinsic value and are not at the mercy of charts and trends.
If you think momentum is the way to go for you, by all means, make momentum your calling. However, do have solid risk management in place so that a few wrong investments don't cost your dearly.
And by the way, I am also of the belief that there are certain markets that are conducive for value investing and others that are conducive for momentum.
I think value investing does well when the broader market goes from significantly undervalued to being fairly valued or slightly overvalued. Momentum on the other hand does well in a slightly overvalued to significantly overvalued market.
If historical valuations are anything to go by, we seem to be in an overvalued to significantly overvalued zone. Therefore, it may not be a bad idea to dip your toes into momentum style if your core holdings are value oriented.
As Graham says, speculation is not bad if you know the risks involved and you are doing it with your eyes open.
Besides, do not forget to limit the amount at risk and to separate it completely from your investment strategy.
Editor, Profit Hunter
Equitymaster Agora Research Private Limited (Research Analyst)
PS: Our co-head of research, Tanushree Banerjee, has identified a way for investors to potentially accumulate Rs 7 crore in wealth over the long-term. Read more about it here.