Value investing, momentum investing, and growth investing: what is the difference, and why are investors changing their approach right now?
There have been lots of stories in the financial media over the last week about the fact that investors are fundamentally changing their investment strategies from strategies that chase returns (aka find the best performing stocks over the last six months and only invest in those) to strategies that actually analyze the underlying stock’s attributes and make choices based on those.
As an analogy, investors aren’t looking to date the hottest guy who’s had a girlfriend for the last six months and is newly single (Mr.Momentum). Instead, they’re trying to find a guy who has a really solid personality and will slowly and steadily grow in the relationship (Mr.Value).
For some charting evidence and a bit more commentary, this is what my colleague Dan Russo, CMT, wrote two days ago about what we’re seeing:
The Big Story This Week
The major story in markets this week, thus far, has been the rotation out of Growth stocks and into Value stocks. We can see here in this chart of the Russell 3000 Growth relative to Russell 3000 Value, that Growth has dropped from all time highs vs Value and is now testing the rising 200-day moving average. The move lower follows a negative divergence between price and the RSI, which is now oversold.
Under the surface, investors are moving capital into the areas of the market that have been underperforming, especially Energy and Financials. The latter is also being helped by the recent rise in yields.
These shifts in investors’ sentiments are hard to predict, which is why we advocate for having a strong risk management process.
While Dan Russo paints this picture through the context of Growth instead of Momentum, Growth and Momentum are closely related.
What are Momentum, Growth, and Value Investing?
Think of it this way: Value investing requires looking under the hood of the car to see whether the seller’s asking price is appropriate. Is the price that they are seeking proportionate to the performance that the car is giving now? If the answer to that question is “no,” then a value investor won’t buy the car. When you look for a cheap car, make sure you consider its performance and features. If you just look for cheap, you can fall into a value trap, as some cars that truly are super cheap are cheap for a reason. On the other hand, it’s OK to pay a big price – if you’re getting a great car.
Growth investing requires deeper analysis of what you’re buying. In the stock market, this involves a focus on the future potential growth in earnings. When it comes to cars, it means asking if this is a truly great car. Might it even achieve classic status and inspire others to stare enviously as you drive by? If you believe you’re getting something great, whether a car or shares of a business, pay more to reflect what you’re getting.
So how does Momentum investing relate to this? Well, Momentum is that amazingly sleek and fast Ferrari. Not only does its historical chart look pretty sexy on the surface, but you believe it will continue to run quickly in the future. With a Ferrari, the appearance of the car is more important than the underlying mechanics and handling.
While Momentum investing seems like an easy strategy to do well in, it can actually be really difficult, because investors don’t know when a stock will suddenly stop going up (and they all do). However, historically speaking, there have been times where Momentum investing has outperformed Value investing significantly. Following the masses isn’t always a bad idea.
The last one to one and a half years has been exactly such an environment. There has been a lot of uncertainty leading to prices shooting up and down in very unpredictable manners. We’ve had unforeseen news events driving the prices of stocks. The effect of this on human behavior results in a rush toward Momentum investing: people are buying stocks that are priced for perfection, and willing to pay any price for them because they are the names people know and trust. This is what my colleague Marc Gerstein, calls “paying for growth at any price.” This is fine if you ultimately get perfection. But if you don’t get that . . . . oh well, you know (or are likely to soon find out).
From my personal perspective, I don’t like to pay a price that requires the best of all possible worlds to actually materialize. The Chaikin Power Gauge, for the last year and a half has been in line with this. However, my refusal to pay for perfection caused me to lose out to Mr. Momentum. (I guess I should probably get back on the dating apps…)
What This Means for the Chaikin Power Gauge
The switching of the market from rewarding Momentum investing to rewarding Value investing should bode extremely well for the Power Gauge. The Chaikin Power Gauge is a 20-factor model that combines Value investing, Momentum, Sentiment, Growth, and Quality factors in a quantifiable way that mimics how traders use the information before making investment decisions. The model is unique in that it isn’t strictly a Value model or strictly a Momentum model, but that it blends all of the styles together. That said, the model does have some preferences toward some of the styles, specifically Value investing.
Value Factors- There are 4 Value factors in the Power Gauge that combine to make Value one of the bigger styles in the model. While we lean toward Value, this leaning still constitutes less than the majority of the total weight. The Value factors in the model are: Price to Book, Price to Sales, Free Cash Flow, and Projected P/E. Since three of the four factors are in the Financials Component (which is weighted the most heavily), it is logical that this is the most significantly weighted style in the Power Gauge. Not only does Value investing make logical sense (no one prefers to overpay for anything), its success is backed up by historical data (below).
The charts below show give a sense of how the market has been reacting to different styles over the last ~20 years (Jan 1999-Sept 2019). These are not Power Gauge-specific items. These are broad generic style-based models Marc Gerstein created for use on Portfolio123.com, details of which can be seen here.
The best way to read the chart is to judge how the top bar (top 20% scored stocks) performed against the bottom bar (bottom 20%). It is done in this way because the difference between these two values tells you how you would have done if you had bought the best and sold the worst, which is what most investors look to do. These charts tell you what has happened over time, not all the time, as our CEO Carlton Neel likes to say. This is a significant distinction to make because, as mentioned earlier, there are times where Momentum or Growth outperform Value investing.
As you can see from this generalistic approach, Value has outperformed all of the other styles by far. Given the significant weighting of it in the Chaikin Power Gauge, if this shift from Momentum toward Value investing persists into the future, it should help the Power Gauge show in the best possible light!