This was a simple question posed to me by one of our blog readers–what impact does excluding stocks trading at 10x P/S have on a Momentum portfolio?
A good question–especially for those who are “value” investors that are interested in momentum. For most systematic value investors, the prospect of adding stocks trading at over 10x P/S sounds ludicrous–see this article on the performance of stocks trading over 10x P/S.
Since I didn’t know the exact impact, I went and ran the tests described below.
The universe is the largest 1,500 common stocks in the U.S. Data is from FactSet. The data runs from 1/1/1992 through 12/31/2021. Momentum portfolios are constructed every quarter (12/31, 3/31, 6/30, 9/30) by selecting the top quintile (300 firms) using a 12_2 Momentum calculation (the prior 12-months’ total return ignoring the last month). Returns are shown to equal-weight (EW) portfolios.
Within this top quintile of momentum stocks, I then bifurcate the sample into the following:
Above 10x P/S
Below 10x P/S
The image below shows the number of firms in each bucket.
As we can see, there are two time periods when the momentum portfolio has a decent amount of firms trading above 10x P/S (100 firms or more):
Post internet bubble–1/1/2000-12/31/2000
However, the majority of the time the momentum portfolio is under 50 stocks (out of 300) that trade above 10x P/S. The average number of firms within the momentum sample trading above 10x P/S is 44 firms (44 out of 300 = 14.67%).
So what happens if we include/exclude these firms from the momentum portfolios?
To test the impact, we examine the returns of 3 momentum portfolios, and compare them to the market:
US MOM– ALL FIRMS EW: Top quintile of momentum firms (300). Portfolio is equal-weighted.
US MOM–EX-FIRMS > 10X P/S EW: Firms within the top quintile on momentum that are trading below 10x P/S. Portfolio is equal-weighted.
US MOM–FIRMS > 10X P/S EW: Firms within the top quintile on momentum that are trading above 10x P/S. Portfolio is equal-weighted.
SP500 INDEX: S&P 500 Index
All returns shown below are gross of any transaction fees and management fees.
The results above highlight a few things:
Comparing columns 1 and 2, we get the answer to the main question I was posed. Excluding momentum firms trading at 10x P/S has a marginal impact over the long-run (1/1/1992-12/31/2021). There is only a 6 bps a year difference over the entire time period.
Comparing columns 1 and 3, we see that building a momentum portfolio solely on stocks trading above 10x P/S is a bad idea (not surprising). One would lose ~ 3.5% annually compared to the simple momentum portfolio.
So is excluding stocks trading above 10x P/S a horrible idea?
There are time periods when there is a pretty large divergence in returns between the naïve momentum portfolio and the momentum portfolio excluding stocks above 10x P/S.
Below are the annual returns, with a few years highlighted:
The annual returns above show that in the internet bubble and the post-COVID there were some pretty large divergences between the 3 momentum portfolios.
Overall, we see that excluding firms trading above 10x P/S has a minimal impact over the entire time sample (6 bps difference from 1992 to 2021). However, if one wanted to build a momentum portfolio and exclude these firms, it didn’t historically hurt performance. However, as many know, momentum requires a lot of turnover (see here), which can cause tax issues if not done within an IRA or another tax-efficient wrapper (such as within an ETF).
Jack Vogel, Ph.D., conducts research in empirical asset pricing and behavioral finance, and is a co-author of DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His dissertation investigates how behavioral biases affect the value anomaly. His academic background includes experience as an instructor and research assistant at Drexel University in both the Finance and Mathematics departments, as well as a Finance instructor at Villanova University. Dr. Vogel is currently a Managing Member of Alpha Architect, LLC, an SEC-Registered Investment Advisor, where he heads the research department and serves as the Chief Financial Officer. He has a PhD in Finance and a MS in Mathematics from Drexel University, and graduated summa cum laude with a BS in Mathematics and Education from The University of Scranton.
Performance figures contained herein are hypothetical, unaudited and prepared by Alpha Architect, LLC; hypothetical results are intended for illustrative purposes only. Past performance is not indicative of future results, which may vary. There is a risk of substantial loss associated with trading stocks, commodities, futures, options and other financial instruments. Full disclosures here.