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Momentum Investing

03/14/07 12:25:05 PM PST
by John Devcic

What is momentum investing and who is it for?

Buying low and selling high is the oldest advice on Wall Street. That said, it is also common sense that even a novice investor can easily grasp. What if someone told you that the price you pay doesn't really matter? What if that same person told you that there is no such thing as too high a stock price? These are both concepts that even the seasoned investor will find hard to swallow. One stock-picking strategy believes in "Buying high and selling even higher." Welcome to the world of momentum investing. You may have heard the term before, but have you ever thought about what momentum investing is all about? This article will introduce you to momentum investing and show you everything you need to know to decide if momentum investing is for you.

Momentum investing refers to a strategy that looks for stocks that are poised to have huge gains. In its simplest form, momentum investing is simply buying stocks that have already had a nice rise in stock price. When it comes to momentum investing, instead of the old saying "Buy low and sell high," you must substitute the momentum investor saying, "Buy high, sell higher." Momentum investors do not concern themselves about overpaying for a stock. Instead, their only concern is to buy stocks that have already gained and in some cases gained big in hope that the stock will continue in that direction. One of the most important things a momentum investor has to do is find the right stock to buy. Not all stocks are appropriate candidates for momentum investors. How, then, do momentum investors go about picking the right stock?

Choosing the right candidate for a momentum investor to buy depends on a number of factors. This is akin to finding a needle in a haystack. Momentum investors use fundamental analysis to narrow the search down for the right stock. Momentum investors look for a few key ingredients in order to help make the right decision. Momentum investors look at relative strength, earnings momentum, revenue growth, return on equity, and volume.

Relative strength is simply a measure of how a stock is performing relative to the market. Momentum investors are looking for stocks that have outperformed the market over the past 12 months. The reason for the 12-month time frame is easy to understand; stocks that have gone up the past 12 months are more likely to continue to do so.

Earnings momentum is the increase in the earnings per share growth rate from one reporting period to the next. Momentum investors will first look for a positive earnings surprise in the last quarter before they dig into earnings a little deeper. Momentum investors dig deeper by looking for fast growth when it comes to a companies earnings. Momentum investors will usually look for a 12% to 15% increase in year-over-year earnings per share.

Revenue growth is the increase in revenue for a company from quarter to quarter. Revenue is a term used to describe the amount of money that a company earns from its business activities in a specific time period from sales of products or from services it provides to customers. Momentum investors are looking for a constant growth in revenue from a company. You want to look for consistent growth, from quarter to quarter and even year to year.

Return on equity is a measure of a corporation's profitability that reveals how much profit a company generated with the money that shareholders have invested. Momentum investors want to see a good return on equity from a company, the higher here the better.

Volume is the number of shares traded in a security during a certain time period. Momentum investors want to see good volume going up. This will signal that there is interest in that stock. You do not want to get into a stock with very low volume, as that can usually complicate things when you want to sell at a later date.

Momentum investors have another key to their strategy just as important as what to buy: when to sell. Momentum investors are looking for fast growth, so they do not have time to buy a stock that does not have consistent share price increases. Successful momentum investors have mastered when to sell as well as if not better than what to buy. If you are going to become a momentum investor, you need to make quick decisions when it comes time to sell.

There are certain factors that momentum investors use to signal that one of their stocks needs to be sold. First and foremost, any bad news is usually a good signal to cut your ties with that stock immediately. Guidance to the downside for earnings or downside revisions of revenue is a signal to sell. Momentum stocks have growth. Anything opposite of that is a reason to sell your position. Keep an eye on the relative strength; if it is declining, you need to sell. These are all factors that help pinpoint the time when a momentum investor must get out.

A delay in opening your position once you have uncovered the right stock or delay of any kind in selling cannot be tolerated when it comes to being a momentum investor. Momentum investing is not for everyone, mainly because of how labor-intensive it requires you to be. You work hard to identify the right stocks. That alone is a time-consuming process that can be more time than the average investor is willing to put into stock-picking.

You are going to pay a premium for those stocks that are momentum plays. This premium can make it difficult for smaller investors to take a larger position in that stock. Selling quickly is often the biggest issue with most investors. Investors find it difficult to simply cut and run when they are wrong, especially after working to identify the proper stocks. You must not use the hope of future growth or the fact that you paid a premium for the stock to keep you in a momentum investment.

We cannot forget about the "buy high and sell higher" mantra that is in the back of every momentum investor's mind. You buy a stock in the hopes that someone else down the line is looking to buy that stock from you at a higher price. Obviously, there is potential there to be the fool left holding the bag at the top of a stock's price range.

Momentum investing is not easy work. Identifying a stock that could have big gains in a short period isn't easy either. The theory behind momentum investing is simple, but the practice of identifying the right candidates may be more work than most investors are willing to do. We cannot ignore the fact that momentum investing works mostly in bull markets. Momentum investing has been rewarding for those willing to do the work.

You will not always be right, and this is where cutting your losses is very important. You cannot be around for the next momentum play if you are sitting in a stock that was a momentum play but has declined since you bought it. Is momentum investing for everyone? The obvious answer is no. For the few, however, momentum investing can be very profitable.

John Devcic

John Devcic is a market historian and freelance writer. He may be reached at

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