Stocks At 52-Week Lows Or 52-Week Highs? Where To Find Your Next Big Winner

In the 1990s Cliff Asness, who would later go on to become a billionaire investor, was at Chicago University. Asness was analysing a ton of stock market data along with economist Eugen Fama, who was one of his advisors.

This is the same Eugene Fama who developed Efficient Market Theory which argued that the current price of a stock reflects all available information and that markets are efficient. In other words, Fama said outperforming the market over the long term is very difficult.

Coming back to Asness...

He had spent a lot of time with the data and then one fine day, discovered something very interesting.

He observed that stock returns show strong momentum. Stocks that went up the most in the previous six months to one year, had higher average returns going forward than stocks with poor momentum.

Do you see something fishy in this?

Typically, stocks that go up a lot, tend to revert back to the mean. However, Asness observed that they did not mean revert immediately. The average stock continued to go higher for some more time before it stagnated or started its downward journey.

When Cliff probed further, he found this effect to be as strong as value investing. In other words, stocks having strong momentum regularly outperformed stocks with weak momentum.

Quite understandably, this made Cliff both excited and nervous at the same time. Excited because he had stumbled upon a new, promising market beating strategy of which there was little evidence in academic circles at that time.

He was also nervous because his advisor, Fama, was a staunch believer in Efficient Market Theory. He would therefore dismiss Cliff's discovery as just a random occurrence.

To Cliff's delight though, Fama allowed him to pursue his momentum idea as it had data backing it.

And pursue he did, eventually writing his Ph.D. thesis around the idea of momentum investing.

Well, around the same time, two gentlemen, Jegadeesh and Titman released what later became one of the most influential papers on momentum investing.

In fact, it won't be wrong to say that Jegadeesh and Titman gave momentum investing a new lease of life and started the process of its widespread adoption across the investment world.

Summarised in one sentence, they found investing strategies that bought past winners and sold past losers yield positive returns.

Buying winners and selling losers? I know the idea sounds counterintuitive.

Value investors believe in buying stocks at their 52-week lows because fundamentally sound stocks tend to mean revert.

Therefore, what is trading at a yearly low today will turn around and start going up in price. The idea that buying a stock trading at 52-week highs just doesn't seem as logical.

However, as Cliff Asness as well as Jegadeesh & Titman found out, if stocks have gone up for six months to one year, they keep going up for at least another few months, before starting a reversal.

Therefore if one bought these high momentum stocks and held them for a few months, there are market beating returns for the taking.

But why do stocks keep going higher after they have been up for a while? What explains the momentum effect?

Well, one explanation is the mirror opposite of why value investing works. Value investing works because people over react to bad news.

You see, when a fundamentally good company misses its earnings estimates for a couple of quarters, investors get nervous and begin selling the stock.

They overreact when the price of a stock has fallen a lot but its intrinsic value hasn't fallen much. Sensing this gap, value investors swoop in and buy the stock. Then they hold the stock until Mr Market comes to its senses and closes the gap between price and value.

Likewise, when a company posts record earnings, investors tend to under react to this good news and do not take the stock price higher all at once. They do so gradually.

This allows momentum investors to climb aboard the rising stock and ride the upside.

So if you believe investors over react to bad news, you should not have a problem believing they also under react to good news.

Well, investors the world over, seem to have no problem in believing in the power of momentum investing. Every hedge fund, many ETFs, and financial institutions of all kinds have some or the other momentum strategy as a core theme these days.

In fact, it has grown in popularity in India as well. A lot of momentum offerings having come up in the last few years.

Therefore, if you find investors scanning the 52-week high list instead of the 52-week low list, you can be quite sure they are momentum investors trying to take advantage of one of the biggest anomalies in finance.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.

This article is syndicated from Equitymaster.com

(Except for the headline, this story has not been edited by NDTV staff and is published from a syndicated feed.)