The Enormous Profit Opportunity in Momentum Investing

"The trend is your friend."

That old market saw is gaining popularity, according to money manager Bill Nygren, who told me during a recent conversation that "there are probably more investors today who use positive price momentum as an important part of their buy or hold criteria."

This observation, of course, raises three questions:

1. Why is this so?
2. Why is this significant?
3. What is the enormous profit opportunity that it creates?

We'll get to all three in short order, but let's start at the top.

Why is this so?
Folks are investing in stocks and funds with shorter time horizons than ever before. The average holding period for a stock has fallen to less than one year, according to NYSE data. Mutual fund investors have a similarly short time horizon. As Nygren knows all too well, "Investors are ready to fire a manager if they underperform for two or three quarters in a row."

That's a real penalty for institutions who get paid a percentage of assets under management, so "The response of the investment managers is to reduce the possibility for short-term underperformance ... and momentum criteria help do that."

Why is this significant?
According to our good friends at Wikipedia, momentum investing is nothing more than "buying stocks that have had high returns" and "selling those that have had poor returns." To put theory into practice, you'd buy these stocks:

And then short these stocks:

... and let the trends take you where they may.

If everybody is thinking that way, rising stocks will keep rising and falling stocks will keep falling -- creating an enormous momentum market not unlike that which corrected in 2000. That, according to Mr. Nygren, is what we've seen the past year.

This, however, cannot last forever.

And now for that enormous profit opportunity
The net effect here is that previously rising stocks are now overvalued and previously falling stocks are now undervalued -- the scenario that sets the stage for our enormous profit opportunity. As Nygren noted to me, "The farther prices move away from fair value in both directions, the bigger the opportunity for [the person] whose investment philosophy anticipates reversion to fair value."

That, in short, is why our team at Hidden Gems has started looking at Hansen Natural and lulelemon -- two stocks who valuations had previously been far too rich for our liking. Unlike the momentum investors -- whose ranks get larger by the day -- we like to recommend stocks when they're cheap, and our preferred holding period is more than a year. Ideally, we like stocks we can hold for the next decade or more.

So, in short
Recent market momentum has been particularly working against the small-cap companies we hold dear at Hidden Gems -- and that has us as excited as we've been about buying stocks since 2003.

If you want to read more about what we're recommending today, click here to try Hidden Gems free for 30 days. There is no obligation to subscribe.

This article was first published on Feb. 12, 2008. It has been updated.

Tim Hanson does not own shares of any company mentioned. Dell is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.