In this series, I (Jin Choi) talk about my goal of reaching $1 million in my TFSA account by 2033. If you want to know what a TFSA is, I recommend you read my free book. In this post, I’ll also revisit my skepticism regarding momentum investing, and give a rational explanation as to why the strategy may continue to perform.
March Results: Down 0.9%
At the end of March, I had $63,695 in my TFSA account, which was down by 0.6% during the month. By comparison, the Canadian stock market went up by 1.5% while the U.S. stock market went up by 0.2% in Canadian dollar terms. Therefore, my portfolio underperformed in March.
The majority of my portfolio currently consists of oil and gas stocks, so the performance of my portfolio should largely be tied to oil. In March, oil prices declined from $54.00/barrel to $50.54/barrel, and my portfolio took a small hit as a result.
Oil prices declined as investors sold a large number of oil contracts. In the 4 weeks ending March 28th, investors sold 268 million barrels worth of such contracts. To give you a sense of that magnitude, OECD countries have a total of about 3 billion barrels of oil in storage. It’s a wonder that oil prices didn’t plunge more severely.
While there’s been heavy activity on the part of investors, little appears to have changed with regards to the fundamentals. Global production doesn’t appear to be moving very much, so I still believe that the world is currently undersupplied by roughly 0.5 to 1.0 million barrels per day.
What will change going forward, however, is that we will see the effect of this undersupply more clearly in U.S. inventory data. Inventories should start to decline by 3 or 4 million barrels per week starting this month, and this rate should accelerate into the summer. This should make oil prices go up, though I’ve given up predicting what prices will actually do.
That’s all I have to say on the oil market for now. For the rest of this article, I want to talk about a style of investing known as momentum investing.
Fundamental Basis for Momentum Investing
Simply put, momentum investing is a strategy that consists of buying stocks that have gone up in the recent past. For example, momentum investing would recommend buying NVIDIA, simply because it has gone up by roughly 200% in the past year.
I had previously expressed my skepticism on momentum investing. I couldn’t think of a fundamental reason why momentum investing should work, and most of the articles I’ve read on the subject posited that works for purely psychological reasons - i.e. rising prices gives people confidence that prices will continue to rise even further. I wanted to avoid following this strategy because I reasoned that algorithms, which are free from psychological biases, would make the momentum phenomena disappear.
However, my thinking began to change as I read a book called ‘Quantitative Momentum’. Written by the same authors of ‘Quantitative Value’ (a book I really enjoyed), Quantitative Momentum looks at the historical evidence for the momentum, and puts forward an investment strategy that takes advantage of it.
As I read the book, I was curious to see whether the authors could come up with a rational explanation as to why momentum investing works. They sort of delivered. They argued that momentum investing works because investors tend to underreact to positive news.
Let’s use an example to illustrate this point. Suppose that a pharmaceutical company announced a cure for cancer, and the stock jumped 200% in a day. But maybe the news is so great that the intrinsic value of the company jumped by 400%. Investors didn’t bid up the company to that level because few wanted to buy a stock at 3 times the price as the day before. A company in this situation might see its price go up significantly in the future as investors realize the true potential of the cure.
However, I wasn’t totally convinced by this argument. After all, investors are known to overreact to news, which is why stock prices bounce from extreme lows (such as in 2009), to extreme highs (such as in 2000). But as I thought about it more, I came up with an alternative argument that’s rooted in value investing.
Different investors have different definitions of value investing as it applies to stocks. To me, it means calculating the rate of return that I would want from a stock, and then only buying those stocks that would generate that rate of return or higher. I would calculate the expected rate of return under the scenario where I hold the stock forever.
The expected rate of return of a stock heavily depends on the stock price. All things equal, the less you pay for the stock, the higher the rate of return. Therefore, my definition of value investing is equivalent to calculating the intrinsic value of a stock, and buying it at a price that is less than or equal to this intrinsic value.
In a previous article, I explained how I calculate the value of a stock. Towards the end of the article, I presented the following equation, which I use to value stocks under the simplifying assumption that a company’s earnings will grow at a constant rate forever.
Value of a company = Liquidation value + (Residual income next year)/(Discount rate - Growth rate of residual income)
Unless you’ve read my previous article, you might not be familiar with the terms ‘Liquidation value’ and ‘Residual income’. Therefore, let me simplify this equation even further, and assume that companies we examine have 0 liquidation value. Under this additional assumption, the equation becomes the following:
Value of a company = (Earnings next year)/(Discount rate - Growth rate of earnings)
To see this equation in action, let’s use a hypothetical example. Suppose that company XYZ will earn $10 million next year, and its earnings are expected to grow by 6% per year forever. Additionally, let’s say that we only want to invest in companies that generate a return of 10% per year or more (i.e. set the discount rate at 10% per year). Then, the value of the company is ($10 million)/(0.1-0.06) = $250 million.
This value of $250 million is precisely 25 times its annual earnings. In other words, because we expect the company’s earnings to grow at 6% per year forever, we think the company’s intrinsic value is 25 times its earnings.
But what if we assume that earnings will grow at 8% per year? Then, the value of the company would be $10 million/(0.1-0.08) = $500 million, which is 50 times the company’s earnings. In contrast, if we assume that earnings will grow just 2% per year, then the value of the company would be $10 million/(0.1-0.02) = $125 million, which is just 12.5 times the company’s earnings.
The point I’m trying to make is that a company’s earnings growth rate has a huge impact on the company’s intrinsic value. As a result, a company that trades at 30 times its earnings can be a bargain if its earnings will grow by 8% per year for many years. On the other hand, a company that trades at 15 times its earnings can be overvalued if its earnings will grow by just 2% per year.
However, many investors don’t grasp this, and they judge the value of every company using the same earnings multiple yardstick. If a stock trades at over 25 times its earnings, they deem the stock expensive. If it trades below 15 times its earnings, they deem the stock cheap.
Because such investors avoid buying stocks that trade at high multiples to earnings, high growth companies can remain undervalued for long periods of time. This allows the stock to outperform in subsequent years.
Furthermore, earnings from high growth companies rise quickly, so in order for the earnings multiple to stay the same, the prices of high growth stocks must also rise quickly. For example, let’s say that a high growth company has an earnings multiple of 25, and its earnings grow by 8% the next year. Then, for the earnings multiple to stay the same, the price of the stock must also increase by 8%.
Because of these reasons, high growth stocks will often exhibit momentum (i.e. their price will rise quickly), yet remain undervalued. Until investors start to more properly value high growth companies, I can see momentum investing continuing to succeed in the future.
Before I finish, let me just make a final note. When I talk about “high growth” companies, I mean companies that exhibit high earnings growth over a long period of time. I don’t mean companies that only exhibit high revenue growth, and I don’t mean companies whose growth will peter out after a few short years. For example, since it loses money every year, Tesla doesn’t qualify as a high growth company in this strict definition.
Real high growth companies are often not sexy. A prime example of such a company is Coca-Cola. While I can’t find the company’s long term earnings history, I did find this chart that shows its dividend payments over the years (dividends normally track earnings). It’s no wonder that Warren Buffett has a big stake in Coca-Cola.
In fact, buying high growth companies is at the core of Buffett’s strategy. Regarding this point, he once said, “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” Momentum investing might work because it leads to investing in such wonderful companies.