Why the trend can (often) be your friend
At Montgomery Investment Management, our philosophy is based on owning businesses with future cash flows that are expected to be large compared with their market value. Fundamental analysis is not the only way to think about equities, but it has a strong intuitive appeal, sound theoretical underpinnings, and has been applied to good effect by a number of very successful investors over the years.
Another approach in common use is technical analysis – the forecasting of future share prices based on observation of historical share prices. Fundamental investors tend to be dismissive of technical analysis, and it is certainly easier to make a list of notable (and rich) fundamental investors than it is a list of notable chartists. However, if we’re being completely honest, it is a bit of an over-simplification to say that one approach works and the other doesn’t.
The big challenge to fundamental investors’ claim to the high ground is price momentum. Numerous academic studies have shown that companies whose share prices have been rising over (typically) a 12-month period tend – on average – to outperform over a subsequent period. As far as I know there is no convincing evidence that future share prices can be successfully forecast by identifying complex patterns in past share prices, but this very simple idea of price trends has been shown to apply across different markets and different asset classes. In short, that old adage that “the trend is your friend” seems to have some basis in empirical truth.
There is no clear consensus on exactly why price momentum should work and, as fundamental investors, we may find the whole concept a little irksome, but that doesn’t make the evidence any less valid. Compounding this, our own analysis shows that the Australian equity market is as susceptible as any other to this phenomenon, and in many cases more so. So, what is a fundamental investor to do when faced with this evidence?
Before we get too carried away, there is an important caveat. If you hold a portfolio of stocks with strongly rising prices during a bull market, you will end up owning a portfolio of “high-beta” stocks – stocks that tend to move in the same direction as the market, but to a larger degree than the market. If the bull market turns into a bear market, you can suddenly find yourself holding exactly the wrong portfolio. In times of market distress, having a portfolio that falls faster than the overall market can have a devastating impact on portfolio value as well as limit the ability to take advantage of any bargains that may emerge.
With that in mind, our approach in managing the Montgomery Fund is this: Our investment decisions are driven by fundamentals, but in prioritising which companies to focus our fundamental analytic efforts on, we take some account of price momentum (as well as a host of more conventional metrics related to value and business quality, of course). We do this because, every now and then, price momentum can alert you to situations where the market is gradually coming to appreciate the hidden long-term growth potential of a high-quality business. Being alerted to those situations early is obviously of interest to us.
At the end of the day, if we can’t see that fundamental investment case, we will move on to something else, and we certainly won’t invest in something simply because of a trend. However, it seems logical to first enquire why the trend might be there, and then move on, instead of dismissing it without further thought.