Momentum and Growth

I make no pretense to being anything more than a value manager.  It’s what I’ve done for the past fifteen years, with pretty good results.  Granted, my new methods over the past seven years attempt to incorporate industry rotation in two ways:

  • Industries where pricing power is near there nadir, such that the only direction is up, given enough time.  Strong companies in weak industries survive weak pricing cycles, and do well when the cycle turns.
  • Industries where pricing power is underdiscounted, and it will pay just to wait for future earnings to validate a higher P/E.

But no, I don’t explicitly focus on earnings growth, though I do look at forecast earnings for next year, which embeds a future ROE forecast.  I ignore growth forecasts for several reasons:

  • Growth forecasts tend to mean-revert.  Low growth companies tend to surprise on the upside, and high growth on the downside.  With a little help from pricing power, I tend to get more good surprises.
  • ROEs also tend to mean-revert.  Competition enters spaces with high ROEs and exits spaces with low ROEs.
  • It’s rare for a high growth, high P/E company to grow into its multiple.
  • Low growth, low P/E companies can be treated like high-yield bonds.  A P/E of 10 implies an earnings yield of 10%; I may not capture all of that 10% in dividends and buybacks, but a modestly good management team will find ways to deploy excess cash into other organic growth opportunities which will grow earnings in the future.  With a little good management, I can see my company with a P/E of 10 grow its intrinsic value by more than 10% in a year.

As for momentum, my rule of thumb is that momentum persists in the short run, and mean-reverts in the intermediate term.  I have to size my trading to the rest of my strategies.  Value emerges over the intermediate term, not rapidly.  The same tends to be true of industry rotation; it works with a lag, but it works.  I have to become like Marty Whitman at that point and say that often the fundamentals and price action are lousy when I buy, and for me that’s fine, because:

  • I focus on balance sheet quality,
  • Accounting integrity, and
  • Cheapness.
  • I have my rebalancing discipline standing behind me, which often has me buy more before the turn occurs.
  • I also stay reasonably well-diversified.

The turns usually do occur.  I never make a ton of money on any trade, but typically 80% of my trades make money. And, my losses are typically small, so this method works well for me.

Anyway, that’s why I embrace negative momentum and don’t explicitly embrace growth.  It can place me in the “caricature” camp for value managers, because my valuation metrics are usually lower than most.  Given my longer holding period, I’m fine with that, because low valuations tend to produce their own catalysts for change, if one has done reasonable research on the shareholder-friendliness of the corporation, and the strength of its financials.  Besides, as intrinsic value grows with companies having low valuations, there is a strong tendency for the stock to rally.  Think of PartnerRe, which has never had a high valuation; as it puts up good earnings year after year, the price of the stock keeps running.  Just another example of an underdiscounted trend in the markets.

Full disclosure: long PRE