One proven investment strategy for maximizing returns is buying undervalued stock, this is commonly referred to as value investing. While value players seek the unpolished, overlooked and undervalued stocks, momentum investors jump on a rising…
One proven investment strategy for maximizing returns is buying undervalued stock, this is commonly referred to as value investing.
While value players seek the unpolished, overlooked and undervalued stocks, momentum investors jump on a rising stock to ride out the wins. One strategy isn’t necessarily better than another, but each style enjoys its day in the sun.
“Value and momentum investing are complimentary styles that continually chase each other in a cycle of never-ending ups and downs,” says Christopher Carosa, president at Carosa Stanton Asset Management in Mendon, New York. “Historically, momentum investing thrives as markets top off and value investing does better as markets bottom out.”
It’s no surprise that the momentum party lights are dimming as the current bull market tires, Carosa says.
One way to measure momentum stocks versus value stocks is to compare returns of momentum and value indexes.
The MSCI USA Momentum Index captures the returns of large- and mid-cap stocks of the U.S. market and emphasizes stocks with a high-price momentum. At the end of November 2018, the three-month, one-year, year-to-date and three-year annualized returns of this index were -7.70, 6.68, 6.57 and 15.56 percent, respectively.
In contrast, the MSCI USA Value Index tracks large and mid-cap U.S. securities with a value style. The index uses the following three screening variables: book value to price, 12-month forward earnings to price and dividend yield.
The three-month, one-year, year-to-date and three-year annualized returns for this value index at the end of November 2018 were -1.07, 3.53, 2.23 and 10.71 percent, respectively.
Since 2015, momentum index returns outperformed the value index. But that changed in November 2018.
During the period between September and November 2018, the value index beat the momentum measure by more than 6 percentage points with momentum losing 7.7 percent, netting a 1.07 percent drop.
While value investing is outperforming momentum now, there’s much uncertainty in the financial markets. With a cloudy investing future, it might be too soon to cancel the momentum investing party.
Naushad Virji, CEO at ShariaPortfolio in Lake Mary, Florida says that the momentum drift was fueled by the corporate tax cuts and lower energy costs.
Low interest rates boosted corporate growth and stock prices, since funds could be borrowed cheaply for companies to expand. Currently, these expansive factors are waning as talks of a looming recession creep into the economic conversation.
Despite the short-term shift toward value investing, experts are divided as to whether this is the right time for this strategy.
“I don’t believe that business fundamentals have changed, as evidenced by the total market cap to gross national product ratio, also used by Warren Buffett,” Virji says.
The current ratio of TMC, which adds up the total market capitalization for all U.S. firms, to GNP, the total market value of goods and services produced domestically and overseas by residents of a country, is about 132 percent. Experts say that this ratio the market remains overvalued.
“We believe that the ratio would need to drop further before one can be confident that they are getting a good bargain on their investment,” he says.
Despite the 2.4 percent decline in the S&P 500 this year, stocks remain expensive compared with historical norms.
More fodder for the momentum stock fire includes the effect of a potential trade war between U.S. and China and companies’ concerns about future profitability after taxes and tariffs are imposed, Virji says.
With overvalued stocks in abundance and despite momentum stocks decline, there’s a dearth of value stocks available in the U.S.
Undervalued International Funds
Steven Jon Kaplan, CEO of New York-based True Contrarian Investments, says the best undervalued funds are from outside the U.S. He points to VanEck Vectors India Small-Cap ETF (ticker: SCIF), which mirrors the MVIS India Small-Cap Index, as an example of an undervalued international fund. SCIF carries a 38 percent year-to-date loss.
Other international sector funds that might maximize returns include small-cap China fund, Xtrackers Harvest CSI 500 CHN A SmCp ETF ( ASHS) with a 33.42 percent year-to-date loss.
Kaplan also favors other country sector funds, such as iShares MSCI South Africa ETF ( EZA), iShares MSCI Poland ETF ( EPOL) and iShares MSCI United Kingdom ETF ( EWU), to name a few.
Martin Jarzebowski, vice president and portfolio manager at Federated Investors expects the value-oriented energy and consumer discretionary sectors to outperform, initiating a shift to underpriced sectors. Jarzebowski says the beginnings of a reversion to the mean signals an improvement in value stocks.
Despite recent market shifts, a few investing experts recommend a wait-and-see approach.
“Even though value is set to outperform in the short term, due to the sharp market downturn, it is unlikely that the classic value factor will return to its long-term outperformance until the next economic cycle actually starts,” says Nathan Rex, chief investment officer at Eigenvector Capital.
The consensus is that the momentum trend is waning, while value investing is set to rise. But experts recommend investors to take a wait-and-see approach before switching their investment style from momentum to value.