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The Enormous Profit Opportunity in Momentum Investing

By Tim Hanson - Updated Nov 11, 2016 at 7:16PM

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"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, begs 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 five stocks:

Stock

Trailing 3-Month Return

Canadian Solar

67%

NVR (NYSE: NVR)

33%

Old Dominion Freight Line

29%

J. Crew Group

22%

Shengdatech (Nasdaq: SDTH)

53%

Data through 1/31/08, courtesy of Capital IQ, a division of Standard & Poor's.

And then short these five stocks:

Stock

Trailing 3-Month Return

Cisco Systems (Nasdaq: CSCO)

(26%)

Motorola (NYSE: MOT)

(39%)

Sadia

(22%)

Under Armour (NYSE: UA)

(35%)

Washington Mutual (NYSE: WM)

(28%)

Data through 1/31/08, courtesy of Capital IQ.

... 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 ... with large-cap tech and telecom rising and financials falling farther down.

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 Nygren is bullish on Washington Mutual, and why our team at Hidden Gems just named Sadia a best buy and started researching Under Armour. 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.

Tim Hanson does not own shares of any company mentioned. Sadia is a Motley Fool Hidden Gems recommendation. Under Armour is a Rule Breakers pick. Washington Mutual is an Income Investor selection. The Fool has a disclosure policy.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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Stocks Mentioned

Cisco Systems, Inc. Stock Quote
Cisco Systems, Inc.
CSCO
$56.15 (2.04%) $1.12
Under Armour, Inc. Stock Quote
Under Armour, Inc.
UAA
$23.50 (2.67%) $0.61
Motorola Solutions, Inc. Stock Quote
Motorola Solutions, Inc.
MSI
$252.52 (2.67%) $6.57
WMIH Corp. Stock Quote
WMIH Corp.
WAMUQ

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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