Introduction
Investors often debate between two distinct stock-picking strategies: momentum investing and value investing. Both approaches have strong empirical support and have been used by legendary investors, yet they rely on fundamentally different principles. In this article, I’ll break down both strategies, compare their strengths and weaknesses, and provide real-world examples with calculations to illustrate their potential impact on an investment portfolio.
What is Momentum Investing?
Momentum investing is based on the idea that stocks that have performed well in the past will continue to do so in the near future. Investors who follow this strategy buy stocks with strong recent performance and sell those that have underperformed.
How Momentum is Measured
Momentum is typically measured using past returns over different time frames, such as 3-month, 6-month, or 12-month performance. One commonly used formula for momentum is
M_t = P_t - P_{t-n}where:
- M_t = Momentum at time t
- P_t = Current price
- P_{t-n} = Price n periods ago
A positive momentum score suggests an upward trend, while a negative score indicates a downward trend.
Example of Momentum Investing
Let’s consider an investor analyzing two stocks over a 6-month period:
| Stock | Price 6 Months Ago | Current Price | Momentum |
|---|---|---|---|
| AAPL | $150 | $180 | $30 |
| MSFT | $280 | $270 | -$10 |
In this case, Apple (AAPL) shows positive momentum, while Microsoft (MSFT) has negative momentum. A momentum investor would prefer AAPL over MSFT.
Academic Support for Momentum
Studies, such as those by Jegadeesh and Titman (1993), demonstrate that momentum investing generates excess returns over time. Their research found that stocks with strong past returns over 3 to 12 months tend to outperform the market in the following months.
What is Value Investing?
Value investing is the practice of finding stocks that are undervalued relative to their intrinsic worth. This approach was pioneered by Benjamin Graham and later popularized by Warren Buffett.
Key Metrics in Value Investing
Investors use financial ratios to assess whether a stock is undervalued. Common valuation metrics include:
- Price-to-Earnings (P/E) Ratio:
Price-to-Book (P/B) Ratio:
P/B = \frac{Market\ Price}{Book\ Value\ per\ Share}Discounted Cash Flow (DCF) Model:
V = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}where:
- V = Intrinsic value
- CF_t = Expected cash flows at time t
- r = Discount rate
Example of Value Investing
Let’s analyze two stocks:
| Stock | P/E Ratio | P/B Ratio | Intrinsic Value (DCF) | Market Price |
|---|---|---|---|---|
| JNJ | 15 | 2.5 | $180 | $160 |
| TSLA | 50 | 15 | $500 | $800 |
A value investor would prefer JNJ since it is trading below its intrinsic value, while TSLA appears overvalued.
Academic Support for Value Investing
Fama and French (1992) demonstrated that value stocks (low P/E, low P/B) tend to outperform growth stocks over the long term. Warren Buffett’s success also validates the effectiveness of this strategy.
Momentum vs. Value: A Comparative Analysis
| Factor | Momentum Investing | Value Investing |
|---|---|---|
| Strategy | Buy winners, sell losers | Buy undervalued stocks, hold long-term |
| Risk Level | Higher | Lower |
| Holding Period | Short to medium-term | Long-term |
| Best Market Condition | Bull market | Bear market recovery |
| Key Metrics | Past price performance | P/E, P/B, DCF |
| Drawback | Can reverse suddenly | Requires patience |
Both strategies have strengths. Momentum investing performs well in rising markets, while value investing excels in recession recoveries.
Can Momentum and Value Be Combined?
Interestingly, combining both strategies can create a balanced portfolio. Studies suggest that a blend of momentum and value can reduce risk while maintaining strong returns.
For example, a portfolio could consist of:
- 50% high-momentum stocks (recent winners)
- 50% undervalued stocks (long-term potential)
A historical analysis by Asness, Moskowitz, and Pedersen (2013) found that a combined strategy delivered superior risk-adjusted returns compared to either strategy alone.
Conclusion
Momentum and value investing offer two distinct paths to market success. Momentum capitalizes on short-term trends, while value focuses on long-term fundamental strength. Investors can choose based on their risk tolerance and investment horizon—or even combine both for optimal diversification.
While neither strategy guarantees success, understanding their principles and applying them wisely can enhance an investor’s ability to navigate the stock market. Whether chasing momentum or hunting for value, the key is discipline, research, and patience.
