Return Persistence: Good News for Commodity Firms

Thu, Jan 13, 2011 - 10:59am

Return persistence or price momentum - the tendency for stock prices to trend in the same direction – was the topic of an article in a recent edition of the Economist magazine. They noted that in 2010 European investors would have prospered by purchasing the best-performing stocks of the previous year (2009), regardless of the valuation or fundamental outlook for these companies. Those best-performing stocks enjoyed returns more than 12 percentage points higher in 2010 than someone who bought 2009’s worst performers.

When a stock is performing well the old Wall Street saying is to ‘let your winners run’. When a stock is performing poorly the old saying is to ‘cut your losses short’. The historical market data on price momentum and studies of the issue appear to support these decision rules.

Academic Studies

- Since the 1980s numerous academic studies have repeatedly shown that, on average, shares that have performed well in the recent past continue to do so. Longer-term studies of market data have confirmed that this “momentum” effect has existed across long periods of time and even across asset classes. Not only does this pricing effect impact stocks, market prices of commodities like crude oil or grains tend to exhibit this characteristic also.

The momentum effect raises questions with regard to the efficient-market theory. This theory claims that since all information with regard to a company is public, past stock price movements should give no useful information about future stock prices.

This momentum effect has been utilized by technical analysts for some time. Technical analysts have been called ‘trend followers’ by some – but if the momentum effect is as strong as studies indicate trend following strategies should generate excess returns.

For longer term applicability of the price momentum strategy, a study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) looked at the price performance of the largest 100 stocks in the British market since 1900. The professors calculated the return from buying the 20 best performing stocks over the previous 12 months, rebalancing the portfolio every month.

The Economist article noted the subsequent performance of the well performing stocks was massively better than the market and poorly performing stocks:

“This produced an annual average of 10.3 percentage points more than a strategy of buying the previous 12 months’ worst performers. An investment of £1 in 1900 would have grown into £2,300,000 by the end of 2009; the same sum invested in the losers would have turned into just £49. Messrs Dimson, Marsh and Staunton applied a similar approach to 19 markets across the world and found a significant momentum effect in 18 of them, dating back to 1926 in America and 1975 in larger European markets.”

Chart courtesy The Economist.

And the article noted a study by AQR Capital Management, a hedge fund, found that the American stocks with the best momentum outperformed those with the worst by more than ten percentage points a year between 1927 and 2010. AQR has set up a series of funds that attempt to exploit the momentum anomaly.

Earlier studies have indicated that the excess returns attributed to persistence was much larger for small cap stocks than for large cap stocks. While the best performing U.K. portfolios weighted by company size had an annual return of 18.3% for the 1956-2007 period, using an equally weighted portfolio in which smaller companies had the same impact as larger ones resulted in an annual returns of 25.6%. The smaller companies during this period added significantly to the excess returns.

The professors conclude the momentum effect, both in the UK and globally, has been pervasive and persistent. Even if investors do not set out to exploit it, “momentum is likely to be an important determinant of their investment performance” according to their reports.

James O’Shaughnessy in his book “What Works on Wall Street” examined decades of stock market data. He also found the ‘momentum effect’ was a relatively powerful attribute in predicting future stock returns.

Investment Implications

– If these studies are correct and buying stocks that have performed best over the last year is a strategy that may enhance returns, the energy and commodities sector are ripe with stocks that have performed very well. Significantly many of these commodity firms are small or mid-cap companies, not the larger cap giants.

Last year the large cap S&P 500 Index increased in value by 15.1%. The small cap Russell 2000 index increased by a sizzling 26.9%. Smaller companies significantly outperformed lager ones, and if the Economist is correct they should continue to ‘run’. Investors therefore should ‘let their winners run’ as the old Wall Street saying advises – and enjoy the market in 2011.

About the Author

SMU School of Law Professor
jdancy [at] smu [dot] edu ()