Swedroe: Fundamentals Vs. Price

August 04, 2017

Momentum is the tendency for assets that have performed well (poorly) in the recent past to continue to perform well (poorly) in the future, at least for a short period of time.

The momentum effect is one of the most pervasive asset pricing anomalies documented in the financial literature: Stocks with the highest returns over the past six to 12 months continue to deliver above-average returns in the subsequent period.

Mark Carhart, in his 1997 study “On Persistence in Mutual Fund Performance,” was the first to use cross-sectional (or relative) momentum, together with the three Fama-French factors (market beta, size and value), to explain mutual fund returns.

Initial research on cross-sectional momentum was published by Narasimhan Jegadeesh and Sheridan Titman, authors of the 1993 study “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.”

As my co-author Andrew Berkin and I show in our book, “Your Complete Guide to Factor-Based Investing,” the evidence supporting the momentum factor (both cross-sectional and time-series, or absolute, momentum) and premium is persistent across time, pervasive around the globe and across asset classes, robust to various definitions, and implementable. We also provide the well-documented behavioral explanations for the factor’s existence.

A Look At Fundamental Momentum

Dashan Huang, Huacheng Zhang and Guofu Zhou contribute to the literature on momentum with their March 2017 study “Twin Momentum.” Based on seven major fundamental variables (return on equity, return on assets, earnings per share, cash-based operating profitability, accrual-based operating profitability, gross profitability and net payout ratio) and their moving averages, they constructed a measure of fundamental implied return (FIR) to capture the expectation of future stock returns.

Similar to price momentum, fundamental momentum is formed by buying stocks in the top FIR quintile and selling stocks in the bottom FIR quintile. And, as with price momentum, the formation period is the previous 12 months excluding the most recent month. The authors’ study covered the period April 1976 through September 2015.

Following is a summary of their findings:


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