The momentum formula

"May the Momentum be with you." If legendary Jedi Obi-Wan Kenobi was a stock investor and not busy training Luke Skywalker in the world of Star Wars, this is the catchphrase he would use throughout his life. It makes sense, too. Momentum stocks have been a magnetic force. The Nifty 200 Momentum 30 index, which tracks 30 best market performers (adjusted for volatility) of the biggest 200 companies, powered 53 per cent returns in the last year, handily outstripping even the Nifty Small Cap 250, at 46 per cent. So, combine Momentum with our three traditional pillars - Growth, Quality and Valuation - your stock portfolio can be a real force to be reckoned with. Our Stock Ratings will do the job for you. We have included momentum in them to spot healthy businesses with share price gains to match. We have unearthed a list of top-ranked stocks based on the new framework. But before getting there, find out why adding momentum to the mix makes sense. Introducing momentum: Why it works and why it found a place in our Stock Ratings framework A three-word Gujarati saying "Bhaav Bhagwaan Che", which translates to "Price is God", captures the essence of momentum investing. For a momentum investor, price is everything and its past performance is an indicator of future performance. The strategy picks stocks that have rapidly moved higher in recent weeks and months. The idea is that the winners will keep winning. Some potential explanations for this belief point to behavioural inefficiencies: that investors initially tend to underreact to positive news, or are slow to acknowledge changes in a company's fundamentals. The news, thus, takes time to get reflected in stock prices. For example, prices tend to increase for weeks or months after a positive earnings surprise, as more investors gradually revise their expectations upward. What follows is investor herding as others take note of the strong performance and begin increasing their exposure, leading to more price gains. Likewise, a downtrend continues as investors begin to engage in panic selling even at the slightest hint of bad news. Their overreaction triggers a stampede out of the market. In both cases, a herd-like behaviour sustains prolonged gains or losses. Why we included momentum in our Stock Ratings Because momentum captures market opinion about a business and its prospects. Market opinion reflects investors' belief in the business, which is as important as other fundamentals for a stock to create wealth. The Street often refuses to reward companies that are fundamentally strong on paper. Bandhan Bank serves as a good example. In the last three years, it has lost nearly 28 per cent of its market value, even when it is highly rated on our Growth, Quality and Valuation Scores. This could mean the market lacks confidence in the stock's future potential. Or perhaps it is privy to something about the business that is not reflected in traditional metrics. Adding momentum to the mix addresses these gaps. It allows us to find companies that are not only healthy, basis their financial records but also recognised and rewarded by investors. Of course, one still needs to inspect companies using all the four metrics together to find out whether the underlying momentum has any substance, or if it's just a short-to-medium term reaction to a sliver of temporary good news. How do we calculate the Momentum Score? Our Momentum Score is calculated by analysing a stock's price performance over the last six to 12 months, adjusted for its volatility. We also compare its volatility to those of others in its market cap category. The calculation involves arriving at three ratios: Momentum Ratio: Measures price movement relative to volatility. A higher ratio is ideal; it suggests the price trend has been less volatile. Momentum Ratio Score: Compares the price trend of the stock against others in its market cap category, factoring in volatility. Weighted Average Score: Combines the 6-month and 12-month Momentum Ratio Score to arrive at the final score. Once the above parameter is calculated for each company, their Momentum Score is assessed by ranking the Weighted Average Scores relative to their respective market cap category. Data that backs the momentum advantage Before integrating momentum into our Stock Rating framework, we rigorously tested the strategy on historical data to ensure its effectiveness. Performance of top momentum stocks We created an equally-weighted portfolio of top momentum stocks with the highest Momentum Scores over the last 10 years. These were stocks in the top 10 percentile of each market cap category. The portfolio contained about 80 to 120 stocks every year. We rejigged the pool annually as the list of top momentum stocks was always changing. We found that a sum of Rs 10 lakh invested in this portfolio, at the beginning of April 2014, would generate a corpus of Rs 31 lakh in the subsequent five years, compared to just Rs 18 lakh in the case of BSE 500 index. At the end of 10 years, this outperformance was even more staggering. Check graph 'Momentum portfolio for the win'. Performance of our top-rated stocks after adding Momentum Score We constructed two equally-weighted portfolios for the last 10 years starting FY14. The first portfolio consisted of our top-rated stocks based on the old framework (four-and five-star rated stocks based on growth, quality and valuation). The second portfolio comprised top-rated stocks based on the new framework (four-and five-star rated stocks after adding Momentum Score). In every five-year period (except during FY18-23), the second portfolio outperformed both the BSE 500 benchmark index and the first portfolio. It outstripped the benchmark index 83 per cent of the time in the last decade! See graph 'How momentum adds extra muscle to long-term returns' The results from our backtesting confirmed our decision to include momentum in our rating system, as it consistently provided better outcomes than the previous three-pillar framework. We continue to believe 'fundamentals bhagwaan che' Momentum does not replace the existing parameters of Quality, Growth, and Valuation. Instead, it enhances them by providing a market-based signal that complements fundamental analysis. Here's how momentum integrates with our existing scores: Quality Score: High-quality companies with strong momentum signal not only solid fundamentals but also growing investor confidence. Growth Score: High-growth companies often attract market attention, and momentum signals that their growth is being reflected in their price. This alignment helps spot stocks where momentum is a result of underlying fundamental performance. Valuation Score: While some stocks may appear expensive based on traditional valuation metrics, momentum suggests that the market is willing to reward them for future potential. This helps avoid value traps and pick out fundamentally strong stocks that are also benefiting from positive m

This article was originally published on October 01, 2024.