Momentum investing is based on the assumption that stocks which have outperformed in the past will continue to do so. This persistence of higher return is known to be very often true. Several important studies show momentum can hold for long periods across different markets, timeframes, sectors and assets.
The reasons or justifications could be fundamental. For example, there could be a significant competitive advantage favouring a given stock. Or, some reason or several reasons why a given sector is doing well. But the justifications are often after the fact.
It might be useful to identify any underlying fundamental reasons because that could help the investor exit or modify strategy if there is a change in the fundamentals. But many momentum followers also hold that working out the underlying fundamental causes are unnecessary so long as the momentum itself is identified and the stock held at the right time.
Momentum is often confused with trend-following but they are not the same thing. A trend follower will enter assets only if the price line is consistently moving in a given direction. For example, a trend follower might look for a succession of higher highs (or lower lows), or a price line with a clearly positive (or clearly negative) slope.
A momentum follower will only look for net gains, exceeding a given benchmark such as a stock index, over a given period. Momentum stocks might have involved a steady uptrend, or a sequence of up and down trends, or random moves with some positive bias.
So, an uptrending stock might be a specific instance of a momentum stock but a momentum stock might not be trending. Trend following is easier to handle in terms of setting mechanical rules and stop-losses. Setting stops in a non-trending momentum stock is a more complicated process and the risks are probably higher.
If we look at the past year, one sector with very high momentum is clearly finance and banking. Another is automobiles. The Nifty has gained about 35 per cent in the past year, so take that as the benchmark return to beat. The Bank Nifty gained 75 per cent, while the CNX Auto Index gained 67 per cent in the same time. Both sectors, therefore, qualify as high-momentum.
In the case of both sectors, capital gains must be driven more by future expectations of better times than by current performance or past results. Banks struggled through the first half of the last financial year with low credit offtake and record levels of non-performing assets and record numbers of requests for loan restructuring. There were also periods in the current financial year when unit vehicle sales stagnated, or fell. However, automobile components did well.
Is it reasonable to expect momentum to be maintained in both sectors? It looks that way. Interest rates are set to come down. Banks see reduced costs and higher credit offtake volumes when interest rates reduce; the value of their portfolio of previous loans rises.
Automobiles and auto components are not only capital-intensive. These industries will also see reduction of key raw material costs such as plastics and metals, since international commodity prices are down. A drop in interest rates could also stimulate demand for automobiles, since most vehicles are sold via financing.
Banking and finance is the well-known "story" - both the issues and potential upsides are well-known and there is a lot of investment flowing into banking. Automobiles and auto-components have been less discussed. But these are probably as likely to be useful momentum targets.
The author is a technical and equity analyst
