That’s true, but boring. What’s interesting is why so many professionals in the investment community are so pleased to see momentum investors fall on their faces. The short answer: the investment style flouts some of Wall Street’s most revered principles. It has such a bad reputation that few managers will admit to using it. “It’s almost like calling someone a dirty name,” says Susan Paluch, a managing editor of Morning-star Investor, a monthly newsletter. And yet it worked amazingly well. As momentum funds kept topping the charts over the last decade, investors flocked to them. Assets at 20th Century, a Kansas City, Mo., fund complex that’s considered the granddaddy of momentum investing, ballooned 248 percent, to $27.5 billion, in just five years. Success attracted closet momentum players, too. “With so much money coming in, a lot of managers frolicked in our part of the market,” says Pilgrim. Does this newly disgraced investment technique deserve a place in your portfolio? Let’s look at all the bad things people are saying about momentum investing.
It’s speculative: This insult is like slapping a fund manager’s face with a glove and challenging him to a duel. In plain language it means: you’re pouring money into the market brainlessly. And to traditionalists, that’s what momentum investing looks like. Momentum players don’t care about what a company makes, its dominance of an industry or its expansion plans. To them all companies are generic–what matters is how fast earnings grow and how fast a stock price rises. Not only are momentum investors willing to buy companies they know nothing about; they are willing to pay prices that would give convulsions to Graham and Dodd, the high priests of stock valuation. “Momentum investing is a great oxymoron because it’s not really investing,” Bill Fleckenstein, president of his own investment firm in Seattle, says with a sniff.
Reality check: Ask yourself, what is “real” investing? Legions of Wall Streeters with Ferraris in their six-ear garages would like you to believe it’s a science. But it’s not. No matter how much number-crunching and brainpower goes into a stock purchase, it’s still a bet that the price will go up-otherwise known as speculation. Momentum investors’ system of speculation may offend the old guard’s sensibilities, but it’s getting hard to call it a flash-in-the-pan technique. The best practitioners, like Pilgrim, have been using it for 25 years. His PBHG Growth has earned an average 21.3 percent over the last 10 years-6 percentage points over the hard-to-beat Standard & Poor’s 500 Index. A momentum index devised by Morningstar, a fund-information company in Chicago, showed that these go-go funds averaged 18 percent returns over the 14 years ending in 1995, 3 percentage points better than the average fund. “It’s a legitimate style,” says Don Phillips, president of Morningstar. “To say it doesn’t have a place at the table is to ignore the evidence.”
It only works because everyone is doing it: This is the greater-fool theory, which suggests that momentum investing has a lot in common with a Ponzi scheme. A few years of smart returns attract new believers into the cult. The initiates all clamor for the same small, fast-growing stocks, which boosts their prices further, begetting yet more stellar returns. All the while, hot money from small investors is flooding into the funds. But when the music stops, say critics, investors’ mass bailout triggers a death spiral as fund managers sell losing stocks to raise cash. Take a look at Garrett Van Wagoner, a 41-year-old who’s widely seen as a momentum investor, although he denies it. His Emerging Growth fund earned 30.3 percent in the first 31 days of its existence last year. During the next 30 days, more than $600 million sought out Van Wagoner in his 11th-floor San Francisco office. In the third quarter he began losing money. During the last six months investors have yanked out nearly a quarter of the fund’s assets. This year he’s still losing money. The fund’s down nearly 22 percent.
Reality check: Does anyone remember the Nifty Fifty in the 1970s, oil stocks in the 1980s or Iomega last year? Stock-market history is littered with examples of investors going to extremes. Momentum investing has no corner on excess-it’s just the latest example. But falling out of fashion doesn’t mean a stock or investment style will never make money again. In fact, the best thing to know about an oversubscribed fad is that its fall to earth is just as exaggerated as its climb to glory. Momentum-style stocks may not be a screaming buy yet, but 20th Century’s Fogle says they are the cheapest they have been in the last 20 years.
Where has the hot money fled? Index funds. Full of big, stable companies like those in the Standard & Poor’s 500, index funds seem as far from the perils of momentum investing as you can get. But they may be where the next train wreck occurs. Why? Since the S&P is the yardstick to beat in mutual-fund performance, even non-index fund managers tweak their portfolios to resemble it when it’s on a roll-as it has been for the past two years. But if the S&P 500 chokes, managers will stampede out of those look-alike stocks to make their portfolios look as unlike the index as possible.
There’s no risk control: Momentum players indulge in so many risky practices, the argument goes, they should be charged with reckless endangerment. Their thirst for hyper-growth leads them into the most volatile sectors, such as technology and health, and the least stable companies, tiny and unrested. Their insensitivity to steep stock prices allows them not only to load up on such companies but also to spend fundholders’ money irresponsibly. All of which means there’s not even the flimsiest of safety nets when a momentum stock gets knocked over. “The selling has been merciless,” says Giftrust’s Fogle. He got out of Centennial Technologies, a computer-component maker, just before it was delisted from the New York Stock Exchange in late February for filing fraudulent accounting statements. But plenty of momentum players didn’t escape. In contrast, managers who hew to value-style investing are usually protected from such free falls because they won’t buy a stock unless they can get it at discount.
Reality check: The critics are right. Momentum managers are using the diciest investment style in the riskiest corner of the stock market and are fueled by the jumpiest money. Does that mean you should reject them? If you’re a one-fund investor, definitely. And if you can’t stand being knee deep in losses for a year or more, stay away. If you’re going to use these funds, it’s up to you to provide the risk control. Have mutual-fund buyers been doing that? Probably not. They loaded up on momentum funds at twice the rate they invested in the average stock fund during the five years ending in 1995. The perfect way to limit risk: pair a momentum player with her opposite-a value manager, who buys stocks on the cheap.
That strategy won’t allow you to jump on the bandwagon when everyone disses momentum players and glorifies value and index funds. But you’ll be entertained another way: by profiting from all of Wall Street’s excesses all of the time.
