MI Rewind: Buying Winners Through Momentum Investing w/ Wes Gray

25:46Even on value, we incorporate elements of risk management, even in a deep value strategy. So for example, in quant value, the fundamentals that process is upfront, we're going to boot anything out that has horrific momentum or horrific fundamentals, what have you. So already, let's say you own some stock that is really cheap, but all of a sudden it's got horrific momentum and horrific accounting problems. Well, we're getting rid of that. We also have large elements of quality in there. And so same thing, the energy patch was like this probably five or six years ago, where it's like, oh my God, this is really cheap.

26:25Oh my God, it's also like total junk. And like, why would you ever invest in this? So we would get rid of that fundamentally, right? So even in our value system, there's a lot of like fire alarms on there where we'll be willing either on quality, degrading quality, really crappy momentum, just be like, you know what, that's really cheap, but why would I want to mess with that? Because it's like playing with fire. So it's built in there. And then obviously, a momentum strategy, I mean, that one's obvious. If it has momentum, we own it. If it doesn't, we get rid of it. And unlike value where you can kind of take your lumps and you don't need to trade it a lot to get it to work, like in momentum, which is very opposite because it's much more psychology-based strategy, you can't rebalance a momentum fund once a year because you'll die.

27:12You need to be able to get out of things that are blowing up because that's momentum. And that when things change, it changes quick. It's just a different strategy. It has a lot more or a lot less leniency with respect to turnover and trading and needing to move. We're value investing kind of, you can sandbag it, go slow, take your time, and you're not going to get hurt too bad, generally. Robert Leonard I'm curious, what did your momentum picks look like in March 2020 once things started to turn? Did your tool figure out, yeah, something's going on with these momentum plays, they're starting to turn over.

27:48So were you able to get out prior to most of the damage was done? And were you getting back in? Tell me a little bit about that. So in general, in March 2020, if we got lucky in momentum, value got absolutely destroyed, as you can imagine. It just didn't matter. There was no bids. I think QVAL was down like 50%. And then if you were in smaller names, I know people that run funds like intramunt, they had like 75%, 80 % drawdowns, which is crazy, right? Momentum also obviously had a big drawdown, but because by nature, it was owning high momentum names going into that. And a lot of the high momentum names were like tech, the things that just, for whatever reason, got relatively lucky.

28:34They didn't get beat down as hard. And then also just by dumb luck, coming out of that March 2020, we have this fund, it's called QMOM. The thing went on the biggest bender of all time. I didn't even know about it because I was an idiot in March. I was like, I'm doubling down on QVAL and IVAL. This is too crazy. I was all proud of myself because a year later, they're up a lot. But actually, I was an idiot because if I had bought the momentum stuff, it would have been 2X that. Momentum on a relative basis did well in March 2020, but that just is what it is, right? It's all about the luck and what the market gods bring you.

29:16Momentum in the last year has annihilated where it was like value's gone the exact opposite. It's one of those things where who knows? That's why I like to own them both, but sometimes they work, sometimes they don't. Robert Leonard How do you determine which companies to utilize in a momentum strategy? I mean, so we, again, having my own bias, and this is not just me, but like Jack, who's my partner in crime, I've done this research. We're value guys. So we always think like, God, when we do momentum, we could probably improve that by doing some quality checks or avoiding these obviously total horrific companies from a value perspective.

29:56And every time we've try to impose our thoughts, which we never just do thoughts. We always go test them. They just don't work. With momentum, if you want to capture the momentum effect and you want to try to exploit greed and exploit this reflexivity and market price action, you have to focus straight up on either price action, or you could look at fundamental momentum too. If you look at earnings, keep bidding the earning expectation, it's the same idea because they're basically one and the same effectively. But the minute you try to impose quality or valuation, anything that smells like a value investor was involved, you're just going to ruin the momentum strategy, period.

30:40I've tried to make momentum feel like value. It just doesn't help the situation. I wish it did. It just doesn't. Something like Rivian, this company that went public with zero cars sold and it ran up to$100 million market cap. I have no idea what the stock's now, but for a period of time, it's doing very, very well. It's like a lot of things. That's why it's important to be able to do research and test ideas you have. You don't want to go backtesting run amok, but if you have ideas and you think there's first principles behind them, it's always good to just test them a variety of ways. And we've done that.

31:16But the issue with momentum is I think the first principle, now that we have a much clearer understanding of how and why it works, It's the same thing with like, if I'm a value guy, why does that work? Well, it's probably because you're buying things that are, let's be honest, probably a little bit riskier. But then also we're just buying things that no one else wants to own. And the expectations are so horrific and so bloody and nasty that you just have that opportunity. But the trade-off is you got to deal with the pain and anguish of it. And you're just trying to take advantage of fear in the marketplace.

31:47Where momentum, the first principles on that is it is a shiny rock greed trade. And to the extent you believe humans like shiny rocks and like greed and the flies fly into the light and they always die, as long as you believe in that as a first principle, why would you do stuff that takes away from that first principle? And in momentum, if I'm putting quality or valuation bound. All I'm doing is I'm no longer in the greed trade. Now I'm back in the value trade. But the whole point of doing momentum was to do something different because I already do value investing. So investing is tough. Being lucky is great.

32:26It'd be a lot better to just be lucky than overthink this stuff. I like Preston's Bitcoin move. Not saying I was lucky. Preston's listening, but hey, there's probably a lot of luck involved in a lot of things in life. Robert Leonard One thing you mentioned there is that value investing a lot of times consists of buying companies that are a little bit riskier. Could you expand on why you believe that to be the case? Robert Leonard So this is something that value investors don't like to admit because they're like, I know how the religion works. Well, buy a margin of safety or whatever. They got a lot of cash in the till, blah, blah, blah.

33:03Right. But let's be honest. Like, let's go look at like Kohl's versus Amazon. Like, okay, Kohl's, I'm just making this stuff. I don't know what Kohl's sells for right now, but it used to sell for like eight times PE and it's got high quality. They make money, blah, blah, blah. Amazon obviously sells for like 50 times that and you know, what have you. And so the minute you take that bet on the valuation spread between Amazon and Kohl's. Well, what is Amazon has a low cost of capital, i.e. a high valuation, because fundamentally to execute on their business plan, it's less risky, right? Whereas Kohl's, to be able to transition to this new world, they got to do a lot of things right.

33:48They got to figure out their online presence. They got to figure out how to protect their turf with their stores. So it's just fundamentally riskier because also they have assets in place in the ground. They got a lot more operating leverage there. Where Amazon doesn't even have stores, right? So a lot of times just the business models tied to quote unquote value stocks, i.e. cheap, high quality things that sell for less than 10 PE versus other securities that sell for whatever, 50. And I'm not saying that risk explains all that spread, but it would be kind of foolish. And the evidence would suggest that you're a fool, that the differential in the valuation between classic value stocks and gross stocks, it's not just 100 % mispricing and the market's stupid because they don't know that your shiny rocks is actually a shiny diamond.

34:37It's you're just buying more risk. And so you should get paid. If you're going to buy companies that are fundamentally riskier, their business model is more at risk or whatever, yeah, you should earn extra money because you're doing something other people don't want to do. And now that said, I also agree that people throw the baby outwip the bathwater a lot in these value stocks. And so the difference between the 10 PE and 30 PE, yeah, part of that is probably for risk, but there also is a part that people are just crazy and they just don't want to, they would rather own Tesla than GM or whatever.

35:12Who knows how to quantify the mix between the risk and mispricing, but I think it'd be foolish to not suggest that there's probably elements of both involved. Robert Leonard Yeah. That makes sense to me. Your Kohl's and Amazon example, because obviously Kohl's is completely being disrupted and displaced by Amazon. I think someone could argue, say something like Berkshire Hathaway. I think somebody could argue that it's a great business at a reasonable price. Do you see that as something that's riskier than say like tech company or owning like the S &P 500 or how do you look at that? It would depend.

35:47So I don't know the exact valuation discount on Berkshire's whole portfolio versus S &B right now. But regardless, the way I would analyze any situation is on the first principles of, okay, there's a valuation discount. I don't know what it is. It's 10%. Well, does 10 % justify like maybe there is an additional risk, right? And maybe there isn't any mispricing. That'd just be something you have to analyze on a case-by-case basis. And this is what fundamental discretionary value investors rack their brains on all day. I do all this quantitatively and in the tails. I immediately am only going to buy stuff that's in the 10 % cheapest of the entire market.

36:28So I'm never going to get into these pissing battles between Berkshire and XYZ because Berkshire is not the 10 % cheapest stock. Clearly, it's probably more market efficiency to price than in the tails. I just focus in the tails and then like fundamental discretionary managers, they can go quibble and quabble over the differences in the valuations on things like that. But the principles would still apply. And I would say, without having a forensic deep diver being up to speed on Buffett at the current time, just knowing how he invests, like fundamentally, whatever the heck he's investing in, almost certainly has more risk fundamentally tied to the economy, valuations aside, because he's going to be buying hard assets, things of free cash flow, energy, stack, like all that kind of stuff.

37:18Whereas obviously the S &P is 25 % in like tech, right? Which is putting valuations aside, just on a fundamental first principles of business risk. You know, I see less risk in Apple than it will actually Berkshire owns Apple, but that's not a great example, but whatever, Google, than I do in the railroad station. I don't know if Buffett still owns that, but they're just different businesses. Now, risk also is tied to the price you pay. Railroad at five times earnings might be way less risky than buying Google at 5 ,000 times earnings. But that's something that people have to figure out. If there is additional risk, is it compensated or are you getting a good deal?

38:00And so that'd be something a fundamental investor would have to determine.

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41:29All right, back to the show. Have you seen momentum investing to be a really successful strategy over the past decade with us being in this really long bull market? Not really, actually. I was just actually looking up all the factors over the past 10 years for the US and international. Basically, if you're not familiar with factors, all that's trying to do is say like, hey, if I were to try to synthesize different characteristics of stocks, and we usually look at like value, the momentum, the quality, and the size. And I said, hey, like how have those factors done? Like if I tried to best I could isolate just how are those components returned.

42:09The interesting thing about the market over the past 10 years is in the US especially, is the only thing that's made money is lowish quality, super big beta stocks. Values our last 10 years have been a dog. Momentum's kind of like blah. Quality's kind of like blah. Like I said, like mega cat, like the size factor is kind of blah. It's really all about just been owning the S &P 500, honestly. And all factors across the board haven't been great. And so to the extent, if you ran momentum and it was mega caps, you probably did okay. But if you did momentum and you had elements of small or mid caps in there, because we know small as a strategy up until very recently has been a total dog, maybe the extra momentum juice you got was overcome by the size anti-juice you got.

43:07So in general, all factors outside of just owning mega cap US stocks in the S &P at the highest mega cap levels, it hasn't done that well. In the international markets, it's a little bit different. You've had a little bit more mojo from momentum, but in general, it's the same problem. Value sucks, size sucks, quality was okay in international markets. But if you just want to keep quality out of it, because it can co-found things, but if you just look at size, momentum, and value, over the last 10 years globally, I would say none of them have been great and size has been terrible. It's all about buying really big stocks that don't really have great momentum, aren't really especially cheap.

43:52It's just own passive markets, basically. And there's a lot of theories on why that might be. I'm getting more and more open to the idea. Well, I've always been open to the idea that flows matter, right? There's a thing called supply and demand in the market. Initially, I was a skeptic on the idea like, well, yeah, everyone just goes passive and they own S &P 500 stocks, like no big deal. But at this point, it's such like an escalating pace. And Vanguard every day is buying billions of dollars a day, where they're literally, their clients or someone is liquidating value, psi, whatever, and they're turning around and going, say, and buy S &P 500 stocks.

44:34So if you start doing that at scale, and everyone's doing the same thing, of course, you're going to have influence on asset prices. And I think we have a realization been of the past 10 years, and I don't know when this will end, but stocks that are in the S &P 500 that get the most capital contributions have obviously kicked butt. And if you did anything that's not that, you underperform, basically, no matter what it was, pretty much everything that wasn't that underperformed the S &P because S &P is up like, I don't even know, it's like 80 % annual returns for the past 10 years. It's crazy.

45:10So honestly, nothing's worked that well. I should have just owned the S &P 500 the past 10 years. I've been a lot better off. Making a pretty good case for passive investing. I think that's a case for if I knew what I knew now 10 years ago, and I knew the moths would all go to the flame at the same time at scale and just assume that you never have impact on prices and passives of free lunch. But we invest ex ante on a go-for-it basis. And to me, anytime you have a situation where people perceive something that's free, has infinite supply, and always works better than something else, that never leads to outcomes that are favorable because those equilibriums are unstable.

45:54It's impossible to have a good that is free, unlimited, and always works. markets are good about mean reversion. And I think the whole passive craze is about the like, I don't know when, because it'd be foolhardy to try to predict human psychology. But fundamentally, it's not in 50 years from now, it'll look like the nifty 50. It'll look like many other episodes in the marketplace. It's just crazy. So how can the typical retail investor use momentum investing in their own strategy? Probably the best thing I would say is most people, frankly, are never going to wrap their head around momentum investing, especially value investors.

46:36I got a whole book dedicated to value investors trying to convince themselves to do momentum. But it's like the old saying, you bring a horse to water, you're not going to drink it. And that's fine. That's cool. I always tell people like, hey, only do things that you're convinced of. And things that Wes does, they could be the worst idea you ever had for you to do it. And same thing for you may have great ideas and they work amazing for you, but they would be the worst idea ever for me. So in general, I would say most value investors should probably not end up doing momentum. They truly believe in the thing in their bones, but they could still use it as a tool.

47:16So for example, let's say you're kind of anchored value as a philosophy. Well, then let's say you're going to go sell some securities. Let's say you have a stock, you own your portfolio, and you're like, man, it's getting a little pricey. It's like right at my target, but the momentum is like epic. Well, maybe you don't sell that. Maybe you hold onto it, and then it hits a point where momentum flatlines or breaks down. Okay, now I'll blow out of it. So maybe you use it as kind of like a tactical trading tool. Or on the opposite thing, let's say you're questionable on selling something. You're like, well, you know, God, it's like pretty cheap.

47:53But I got this other name I kind of like, maybe it's a little bit more expensive. But like the name that's marginally cheaper has like horrific momentum. And the other one that's marginally more expensive has like decent momentum. And they're both candidates for a sell. Hey, maybe you blow out the one that's got horrific momentum because we know on average, owning baskets of low momentum securities, especially in the extreme 10%, is like the worst strategy on the planet earth. Even as a value investor, you could probably use these momentum things for technical indicators when to buy and sell at the margin, but you don't have to go full selling to the religion if you don't want to.

48:32That might be a way for people in the audience to use momentum as a tool if you're not going to go all in or go buy ETFs and do these sort of things. It reminds me of what people would call a value trap. Sometimes value investors will get into a stock because it has fallen so far because it's something that is not appreciated by the market and looks very cheap. Some of these companies that are falling in price are value traps because they end up falling another 25 or 50%. And these value investors that thought they were getting a good deal are stuck holding the bag. One of these stocks that fell for years is GameStop.

49:09And it's one that Preston and Stig talked about often well before the short squeeze that eventually happened. That's actually a great example of price action affecting fundamentals. I'm a big GameStop fan as a user of the product. I got three kids now, so I don't get to use it as much as I used to, but I used to be a big gamer and still am. And so I liked it, but back in the day, I used to own it. It's a total value dog because it's just so cheap on cashflow basis and expectations were so terrible. But those guys couldn't get out of their own way trying to raise capital to help them out. All of a sudden, they go on the short squeeze.

49:48Price action goes bonkers. And now because they can raise capital for negative cost of capital, it seems, I don't know if that's a concept, now they're fundamentally in a better position as a business than they've ever been in the history of their lives because of price action. Obviously, the fundamentals of GameStop have not changed basically one iota in their core business. But now that their price action was so crazy, they actually did fundamentally change because they raised capital at nothing. And now they can go do experiments on the cheap with other people's money. And who knows, they may break out and become like a SaaS.

50:27God only knows what they could do now. Yeah. They'll probably start getting into the NFT space or something. Yeah. Because now they got free money to go burn on experiments, right? Because their cost of capital is zero. So price action matters a lot. And if value investors don't incorporate how price action affects their businesses fundamentally, then they're missing out on a key component of value investing, which is cost of capital. It's like a big variable in your DCF, as you know. So a momentum strategy, as you mentioned, requires frequent rebalancing with trading in and out of positions. How much of an effect do capital gains taxes have on a momentum fund?

51:11Trying to do momentum as a retail investor, unless you got your ax squared away on your execution frictional costs and or you got a tax dodge, or not dodge, we'll call it avoidance. It's silly to do it, right? We never did momentum until we got the ETF wrap, because at least the ETF wrap, I can get rid of the problem. I live in Puerto Rico now, so I can make a case to just do it organically because I don't pay taxes and cap gains. But outside of living in Puerto Rico or investing in it through an ETF, unless you're going to use your qualified account, it makes no sense to do a momentum strategy on taxable money because you got to pay 50 % back to Uncle Sam.

51:55It's not that good. And that's just the tax, not to mention the frictional costs. Momentum strategies, if you're going to do them right, on average, you're going to be looking at 200 % turnover. And so if you're not really good at execution, you don't spend a lot of time thinking about impact costs, like how to execute the trades, and you're just like winging it, you're going to get destroyed in frictional costs. So unfortunately, and I hate to say this because I'm a big DIY fan, but momentum is just not for retail investors, period. It's a system. Unfortunately, you should probably go, if you like it, go buy a product, go invest in someone else who's kind of doing this professionally.

52:35They're just in a better advantage position than you are. Robert Leonard So do you think of your momentum strategy to try and enhance returns or diversify your equity exposure? Robert Leonard I think it's highly contingent on the circumstance of the investor, right? So for example, if I go to Kathy Wood and I say, hey, Kathy, do you want a momentum strategy? She might say, well, I don't know if that's a diversifier or a return enhancer, right? She's already got banked up risk as far as the eye can see. So it's not going to do anything. Whereas let's say you're a value investor that's hardcore, I'd say, okay, you probably got higher expected returns in the market.

53:19And momentum is probably also an expectation, got higher expected returns in the market. But from a diversification standpoint, it's a slam dunk, right? Because when your stuff's yinning, this thing's yanging. And if you have two positive expected bets, but they're uncorrelated, there's going to be a benefit from a portfolio standpoint. So in that case, diversification would be great. And then a third example might be like, okay, let's say you've got, you just hate stocks. They're too risky. You're like 20 % stocks, 80 % bonds, or you put your money under your mattress. You're basically under invested in equities, but you need kind of like high octane.

53:55I might say, well, instead of sandbagging it on like S &P for 20%, because you already got 80 % of your money under your pillow, something like that, a momentum strategy is going to be able to amp your exposure with the same dollars. So there might be an expected return booster and probably maybe a little bit of a diversifier. So again, it can go either way. It just really depends on the situation and how you use it as a tool. Now, you've mentioned trend following a few times during this episode, which sounds a lot like momentum, and I'm not really familiar with trend following. So how does a trend following strategy differ from a momentum strategy?

54:35Great question. I wish you flagged me down earlier because it's all about semantics, unfortunately. So when I talk about momentum, I am speaking specifically to relative strength momentum in the context of stock selection. The best example is I see two stocks, stock A and B, stock A is down 10%, stock B is down 20%. When I say momentum, it would suggest that I would prefer A to B, right? Because on a relative basis, A is doing better than B. That's what they call momentum is it's used for stock selection. Trend following is not about comparing things at the same point in time across each other.

55:20It's about comparing the same thing over time. So for example, we had those same two stocks, A and B. A was down 10%, B was down 20%. With momentum, I would say, great, A is awesome, B sucks. I'm going to buy A and not buy B. With trend following, I would say, I'm not buying any of these things because A's trend sucks and B's trend sucks. So trend following is in reference to basically the absolute momentum on an individual security relative to itself. Whereas momentum, at least how I use it, is in reference to a stock picking strategy. It's all about picking the relative best, but it still could have terrible trend.

56:07And so when I talk about trend falling, it's usually in reference to like broad asset classes, right? So if the S &P is over its whatever, 12-month moving average, own it. Otherwise, consider risk managing it, right? But it doesn't have anything to do about what stocks to own in the S &P. Do I own GameStop or do I own GM? That'd be more like in the realm of what I call momentum. It's a great question. And the problem is you need people to define it because some people call momentum. So it's really just dependent on the definition and making sure you get down to brass tacks of what people are referring to.

56:44Wes, thank you so much for coming on to the Millennial Investing Podcast. you have your own momentum funds that if the listeners are interested in learning more about momentum, I highly recommend you check out his website. Before we close out the episode, Wes, tell us a little bit about your company, Alpha Architect, and where the audience can go to connect with you. So we kind of have two companies now. So Alpha Architect has a firm mission in power investor through education. It's alphaarchitect.com. That's where you can learn about all the strategies and all kinds of things related to factors.

57:20And then we have another business called ETFarchitect.com, where the mission there is to help ETF sponsors win. And that business is focused on bringing other people to market who want to participate in the ETF game. So if any of your listeners want to convert into an ETF, launch an ETF, that's where they go. And then you can always follow me on Twitter, just at Alpha Architect. And those are three good places to find us, depending on what you're looking for. Awesome. Thanks again for coming on, Wes. I really appreciate it. Yeah. Appreciate it, Clay. Good chatting. All right, everybody. I hope you enjoyed today's episode.

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