Your 2025 guide to buying momentum stocks

Speaking of trends, have you studied the monthly trend of the stock market?

In other words, if the stock market has gone up the previous month, will it continue to go up in this month or will it go down? Likewise, if the market has gone down in the last month, will the downtrend continue or will there be a reversal?

You see, back in 1933, two gentlemen, Alfred Cowles III and Herbert Jones, undertook a massive study to find out the answer to these questions. They went the extra mile and analysed data going back 100 years – in an era where there were no computers. Commendable indeed.

What they found

The results were beyond their expectations.

The data revealed that if the market had gone up in a given month, there was a 63% chance it would go up the next month, or, if it had gone down, would continue to fall for another month.

So, if you are a trader and you must bet between a stock that has gone up in the previous month versus the one that has gone down, you’d be better off buying the one that has gone up. Betting on a continuation of a trend would have yielded better results than betting on short term reversals. Deeper analysis revealed that this could be a winning formula in the stock market.

Unfortunately, not many investors and fund managers capitalised on this finding. They were too busy following other types of investing such as value or growth, or they were busy applying modern portfolio theory and the efficient market hypothesis.

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In fact, it was only in the 1990s that the findings of Cowles and Jones returned to the limelight. This time, there was no looking back.

The return of this strategy can be traced to 1993, when another pair of gentlemen, Jegadeesh and Titman, published their work on what came to be known as momentum investing.

Here are their findings in a nutshell.

• Investors who buy stocks that have performed well in the past and sell stocks that have performed poorly in the past generate significant positive returns over 3-12 month holding periods.

If you want to earn market-beating returns, a portfolio of stocks comprising winners from the past 3-12 months is an option worth considering.

The Jegadeesh and Titman study on momentum opened the floodgates for more research as well as investment based on their findings.

Soon, there were detailed papers that studied momentum across asset classes, geographies and time periods. In almost all of them, the momentum effect was alive and kicking.

In short, buying past winners pays off. The strategy is effective enough to generate market-beating returns over the long term. However, momentum investing is not a comfortable strategy to follow, for the simple reason that it is not easy to buy a stock at ₹200 when it was trading at ₹100 only a few months ago. It’s like buying your favourite pair of jeans at ₹2,000 after ignoring it when it was available at ₹1,000.

Harnessing inertia

I know this sounds illogical. However, as Jegadeesh & Titman found out, if stocks have gone up for six months to a year, they keep going up for at least another few months before reversing. If you bought these high-momentum stocks and held them for a few months, there could be market-beating returns for the taking.

But why do stocks keep going higher after they have been up for a while? What explains the momentum effect?

One explanation that I found convincing is that momentum investing works because investors underreact to good news. They take time to adjust to the new reality.

Allow me to explain.

Say a pharma company launches a new drug that has the potential to boost its profits. The stock price of this company will not double or triple overnight. It will usually take a few months or even a couple of years for the investors to adjust to the new reality and cause a massive rerating of the stock.

This allows momentum investors to climb aboard and ride the upside. It is this under-reaction that gives momentum investing its long-term edge.

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Investors worldwide seem to have no problem believing in the power of momentum investing. Every hedge fund, many ETFs, and financial institutions of all kinds have some or the other momentum strategy as a core theme these days.

Its popularity has grown in India as well. So, if you find investors scanning the 52-week high list instead of the 52-week low list, you can be sure they are momentum investors trying to take advantage of one of the biggest anomalies in finance.

Comparing returns

Ok, enough about theory. Let us move on to practice now.

Every ₹100 invested in a momentum strategy back in December 2013 would have multiplied 12-fold, turning into more than ₹1,200 as of 31 October 2024. This translates to an impressive compound annual growth rate (CAGR) of almost 26%.

As you can see, the momentum strategy has outperformed both the BSE Sensex as well as the BSE Small Cap index by a significant margin over this period. In fact, it has outperformed the Sensex by more than three times.

There’s no denying that mid caps and small caps have stolen the show in the past 10 years. The momentum strategy, however, has done even better than these stocks, with the BSE Small Cap Index having multiplied investors’ money eight times over this period.

Momentum strategy

Here are the rules of the simple momentum strategy that gave 12-fold returns over the past decade.

• Of the entire universe of listed stocks, select the 30% with the strongest momentum – i.e. the 30% of stocks with the highest returns over the past year.
• Remove those stocks that do not have a revenue of at least ₹200 crore and an average liquidity of at least ₹10 lakh over the past 12 months.
• Of the stocks that remain, select the top 20 based on their balance sheet strength – i.e. debt to equity ratio. The lower the debt-to-equity ratio, the better.
• The idea is to form an equal-weighted portfolio of 20 stocks with annual rebalancing. We buy the group of 20 stocks on 31 December, hold them for a year, and then sell them on the following 31 December.
• From the proceeds, we buy another set of 20 momentum stocks and again hold them for a year.

Note that there are various permutations and combinations around the momentum period and the holding period. Some investors like to hold for only three months. Others like to keep them for six months before rebalancing. However, to extract the maximum benefit from momentum investing, the rebalancing period should not exceed one year.

The force is strong with these stocks

Now, to the important point. If I was starting momentum investing today, which 20 stocks would I have on my watchlist?

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Well, here it is.

It comprises a mix of sectors, including IT, power, infrastructure and defence. Remember, these are the stocks with strong momentum over the past year.

Note that these are just suggestions and not recommendations. You need to do your own research or talk to your advisor before buying any of these stocks.

Momentum investing is speculative

It is worth highlighting that I consider momentum investing to be a speculative form of investing as it does not involve figuring out the stock’s intrinsic value, margin of safety and so on.

There is very little fundamental analysis involved, and it’s all about buying stocks that are trending.

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Therefore, you should not make momentum investing a core part of your strategy and restrict it to 10-15% of your overall allocation to equities.

This way, even if it fares poorly over a two to three years, it won’t damage your overall corpus.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com