How to beat the market: Rolls-Royce among seven momentum stock picks

Of all the thoroughly tested ways to beat the market, “momentum” is the one that researchers have found to be most ubiquitous. Pointy-headed academics have even christened it “the premier anomaly”.

Momentum investing involves buying shares that are rising strongly in the hope there is more to come.

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This can feel counterintuitive and uncomfortable. If a share price has already gone up a lot, it can feel like the opportunity has been missed and even that a reversal is warranted.

As we’ll see, there is good reason for some nervousness, but studies show that over time it pays to back recent winners because of their tendency to keep winning.

A by-the-numbers momentum investment strategy that I tracked for a decade while writing for Investors Chronicle magazine managed to beat the market by 262%. It is one of four strategies covered in my book Four Ways to Beat the Market.

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We’ll find out more about the specifics of that approach and the UK stocks it is currently highlighting later, but first, why does momentum investing work in the first place?

Why it works

There are two key ideas that help explain why momentum is so widely observed in financial markets. These ideas are somewhat contradictory, and that also helps illustrate the pros and cons of this form of investing.

One of the most important principles that helps us understand momentum is what’s termed the wisdom of crowds. This is a fascinating phenomenon whereby the average judgement of large groups of people has been found to normally be far better than the judgement of any individual in the group.

The stock market is effectively a collective judgement machine. It arrives at prices for shares based on what a large group of well-informed individuals are prepared to sell and buy them for. As such, share prices should contain a huge amount of information about the true value of an investment.

However, things are complicated by the fact that share prices are moving targets. They move in reaction to new information, which arrives all the time.

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Information from companies often seeps out slowly but with a consistent narrative, be it good or bad. So, the movement of share prices should provide investors with valuable clues about ongoing positive or negative developments.

There is a further complication when considering how the wisdom of crowds works in stock markets. This is the second important idea that can help us understand why momentum investing works. It is something that can result in the so-called “madness of crowds”.

The stock market is not an ideal environment for the wisdom of crowds. That’s because every judgement from the crowd needs to be made independently of each other to get an optimal outcome. Because all investors can see share prices and share price movements, and thereby see the collective judgement of the crowd, judgments are not independent.

The message from share price movements – the crowd watching the crowd – creates a form of social influence on judgements, just a five-star review on Amazon is likely to add to a product’s appeal. This means the signal from share prices gets mixed with noise.

This phenomenon exaggerates the momentum effect. That’s all part of the momentum investing game. But sometimes the noise can get much louder than the signal. At the extremes, this results in the madness of crowds. This is a key factor used to explain market bubbles, from tulip mania to the dot.com boom.

When madness takes over

From a long-term perspective, the pedigree of momentum is very impressive.

One of the most exhaustive studies produced on momentum was released in 2008 by Elroy Dimson, Paul Marsh and Mike Staunton, of London Business School. It covered the performance of stocks, bonds, cash and foreign exchange in 17 major markets since 1900. The authors identified momentum as being a prevalent predictor of returns everywhere!

My own momentum stock screen, which I ran for Investors Chronicle magazine while I worked there between 2011 and 2021 produced outperformance of 262% over the decade I monitored it.

Stock screens work by highlighting shares in companies that display financial characteristics associated with a desired type of investment opportunity. We’ll look at the specifics in more detail shortly.

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But the journey to outperformance by momentum strategies tends to be far from smooth. My screen is no exception. It experienced a dramatic peak-to-trough fall of 54% during the 2020 Covid crash.

The timing of the smash-down is not a surprise. Historically, momentum tends to do particularly well during the late stages of bull markets when the economy is normally overheating. It does badly, often extremely badly, when markets fall abruptly.

Big setbacks for momentum are usually associated with a sharp change in sentiment towards a dominant theme that has been driving markets. Whipsaw reversals are worst when the stories attracting investors lack substance, as was the case during the dot.com boom, and more recently, the heady markets of the pandemic.

Taking the edge off

There is another crowd-sourced form of intel that can help investors dampen the risk whipsaw reversals. This is based on tracking trends in consensus broker forecasts.

A consensus forecast is the average forecast for a company’s future financial performance from all the professional analysts that follow it.

It sounds counterintuitive, but for momentum strategies, the key value in these forecasts is their propensity to be wrong. The fact analyst forecasts are often wrong is not due to a lack of intelligence, information, or application. It is best regarded as a reflection of the simple fact that the future is unpredictable.

Because forecasts are often wrong, they frequently need to be revised up or down. What is really interesting is that sometimes clear upgrade or downgrade trends develop, which point to the ongoing positive or negative developments at a company.

Pulling it all together

My screen that outperformed the market over a decade simply marries the signal from broker forecast revisions with the signal from shares prices. In so doing, it aims to check that the stories investors are flocking to have some substance based on improving underlying fundamentals.

The screen also avoids loss-making companies and looks for good forecast earnings growth as well as upgrades.

Coupling share price and forecast momentum has the potential to limit damage and harness greater upside. Based on annual portfolio reshuffles, my screen that employed this tactic produced a total return over 10 years from 2011 to 2021, while I tracked it for Investors Chronicle magazine, of 371% compared with 109% from the FTSE 350, which is the index it picked stocks from. Factoring notional fees of 1.5% a year for the reshuffles, the return drops to 305%.

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Despite the impressive numbers, as the big peak-to-trough fall experienced by the screen demonstrates, using forecast upgrades alongside price movements is no silver bullet in dealing with the risks of momentum investing. As with any screen, this momentum screen should be regarded as a way to generate ideas for further research rather than a way to create an off-the-shelf portfolio.

My book Four Ways to Beat the Market, published by Harriman House, provides more detail on how this screen works, how to research the ideas it highlights, and how to adapt criteria to cope with changing market conditions. It also covers three other market-beating strategies.

Here’s what the screen looks for along with the FTSE 350 stocks it is highlighting right now. I’ve also highlighted the tests I feel are core to the screen, while the others can be relaxed to try to achieve more results.

Share price momentum 

• Share price performance better than the index over three months. CORE TEST
• Share price performance better than the index over one month. 
• Share price performance better than the index over six months. 
• Share price performance at least double that of the index over the past year. 

Earnings momentum 

• EPS forecasts for next financial year upgraded by at least 10% over the preceding 12 months. CORE TEST
• EPS forecasts for the financial year after next upgraded by at least 10% over the preceding 12 months. CORE TEST
• EPS growth of 10% or more forecast for the next financial year. 
• EPS growth of 10% or more forecast for the financial year after next.  ​​​

Source: FactSet. Data as 13 Dec 2023. Price/earnings ratio and dividend yield based on 12-month forecasts. Past performance is not a guide to future performance.

Algy Hall is an award-winning journalist and author of Four Ways to Beat the Market which can be bought by ii readers from all good book shops including Amazon.