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, "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 that get paid a percentage of assets under management. "The response of the investment managers is to reduce the possibility for short-term underperformance ... and momentum criteria help do that," Nygren says.

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:

Data through July 7, courtesy of Capital IQ.

And then short these five stocks:

Data through July 7, 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 similar to the one that corrected in 2000. That, according to Nygren, is what we've seen the past year.

This, however, cannot last forever.

Now for that enormous profit opportunity
The net effect here is that those formerly rising stocks are now overvalued and the formerly falling stocks are undervalued -- the scenario that sets the stage for our enormous profit opportunity. As Nygren told 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 is no longer looking so hard at energy stocks, but has moved on to out-of-favor stocks such as Chipotle (which is hurt if people stop eating out). 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 about buying stocks as we've been 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. Chipotle is a Hidden Gems and Rule Breakers recommendation. Royal Caribbean and Unit are Stock Advisor picks. Thor is a Motley Fool Hidden Gems Pay Dirt selection. The Fool has a disclosure policy.