Swedroe: Momentum Rooted In Earnings

Momentum in prices is the tendency of assets that have performed well recently (such as over the prior year) to outperform assets in the same asset class that have performed poorly recently. This phenomenon has been found not only in stocks all around the globe, but in bonds, commodities and currencies. Furthermore, it has generated large—though highly volatile—returns, and it’s also subject to crashes.

The persistence and pervasiveness of the momentum anomaly in stocks led Nobel Prize-winning professor Gene Fama to call momentum the greatest challenge to the efficient markets theory—it’s hard to construct a risk-based explanation for it (other than it is subject to crashes).

That said, as my co-author Andrew Berkin and I explain in our book, “Your Complete Guide to Factor-Based Investing,” the academic research has provided evidence of some possible risk-based explanations: Momentum is stronger among stocks with large growth opportunities, and risky cash flows and liquidity risk can explain at least part of the phenomenon.

Momentum & Earnings

In his February 2015 NBER working paper, “Fundamentally, Momentum Is Fundamental Momentum,” Robert Novy-Marx presented the evidence demonstrating that momentum in stock prices isn’t an independent anomaly. Instead, it’s driven by fundamental momentum.

Specifically, he writes, it’s “a weak expression of earnings momentum, reflecting the tendency of stocks that have recently announced strong earnings to outperform, going forward, stocks that have recently announced weak earnings.”

Following is a summary of Novy-Marx’s findings:

• Momentum in firm fundamentals, e.g., earnings momentum, explains the performance of strategies based on price momentum. It holds for both large and small stocks.
• Measures of earnings-surprise subsume past performance in cross-sectional regressions of returns on firm characteristics, and the time-series performance of price momentum strategies is fully explained by their covariances (a measure of how much two random variables change together) with earnings momentum strategies. The data was statistically significant at the 5% level
• Controlling for earnings surprises when constructing price momentum strategies significantly reduces their performance, without reducing their high volatilities.
• Controlling for past performance when constructing earnings momentum strategies reduces their volatilities and eliminates the crashes strongly associated with momentum of all types, without reducing the strategies’ high average returns.
• Earnings momentum subsumes even volatility-managed momentum strategies. Price momentum strategies that invest more aggressively when volatility is low have Sharpe ratios twice as large as the already-high Sharpe ratios observed in their conventional counterparts.

Issue Of Acceleration
Novy-Marx’s findings are consistent with those of Shuoyuan He and Ganapathi Narayanamoorthy, authors of the October 2017 study “Earnings Acceleration and Stock Returns.” They examined the implications of earnings acceleration for future stock returns.

Their data sample included almost 380,000 observations, spanning more than 8,800 different firms and 176 fiscal quarters over the period 1972 through 2015. They defined earnings acceleration as the change in earnings growth from one quarter to the next, and earnings growth as the scaled change in earnings over the corresponding quarter the previous year. Following is a summary of their findings:

• Earnings acceleration has implications for earnings growth, especially two and three quarters ahead. Moving from the bottom decile to the top decile of scaled earnings acceleration leads to a nearly 25% incremental change in the decile of earnings growth three quarters forward.
• Earnings acceleration is a significant predictor of future stock returns.
• A trading strategy that involves going long in the top decile of quarterly earnings acceleration and short in the bottom decile of earnings acceleration produces large market-adjusted returns, both in one-month and quarter-long trading windows that start two days following an earnings announcement. Market-adjusted returns are 1.8% (3.4%) over the month-long (quarter-long) window, which translates to annualized returns in excess of 23% (14%).
• Going long high earnings acceleration, represented by consecutive positive earnings growth quarters, and going short low earnings acceleration, represented by positive earnings growth followed by negative earnings growth, can improve the anomalous returns by nearly 45% (from 1.8% to 2.6%) over a month.
• The significant excess returns persist even when low-priced stocks (less than $5) and/or low-capitalization stocks (up to $0.5 billion) are excluded from the trading strategy.
• Moving from the bottom decile to the top decile, stock returns monotonically increase, which shows the anomaly gradually increases in earnings acceleration deciles and isn’t concentrated in a particular decile.
• While the primary trading strategy involves buying/selling stocks two days after the earnings announcement, there are still significant excess returns when a conservative trading strategy involving calendar month rebalancing is adopted.

He and Narayanamoorthy found their results were not only statistically significant at the 1% confidence level, but robust to a wide range of previously documented anomalies (including time-series momentum and post-earnings announcement drift) as well as the Fama-French three-factor (beta, size and value) and five-factor (adding profitability and investment) models.

They also noted that the trading strategy spanning 176 quarters rarely produced losses (the hedge return is positive in 140 out of the 176 fiscal quarters, or 80% of them), which suggests the relation between earnings acceleration and subsequent stock returns is quite stable over time. And, importantly, the trading strategy is even more persistently successful in recent years compared to earlier periods—from 2004 to 2015, the strategy yielded positive excess returns in 41 out of 48 fiscal quarters (85%).

If there was a risk-based explanation for the returns, the frequency of losses would be significantly higher. Thus, the authors concluded that future return predictability appears to arise because of investors missing predictable implications of earnings acceleration for earnings growth two and three quarters forward. In other words, investors appear to underestimate the magnitude of the effect of earnings acceleration on two- and three-quarters-ahead earnings growth.

Conclusions

At least one investment firm, AQR Capital Management, has incorporated the findings on fundamental momentum, as well as price momentum (both cross-sectional and time-series), into their fund construction strategies. As measures of fundamental momentum, AQR employs three metrics: earnings momentum, analysts’ revisions and margin growth. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

As the authors state, evidence of the extremely high persistence of a positive return to the strategy indicates there is not a likely risk-based explanation for the high returns. Thus, returns are likely a result of a behavioral anomaly. This begs the questions: Why are investors so myopic and fail to price the implications of earnings acceleration two and three quarters hence? What are the behavioral underpinnings of such a bias?

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.