Momentum Investing: A Proven Investment Strategy That Earns 350% When Put to the Test
By David Fessler
Oxford Club Advisory Panelist
Wednesday, May 14, 2008: Issue #795
Momentum investing is defined as: “An investment strategy that aims to capitalize on the continuance of existing trends in the market. The momentum investor believes that large increases in the price of a security will be followed by additional gains and vice versa for declining values,” by Investopedia.
So what are signs that a stock has momentum? Heavy volume for one.
Stocks that the market really likes have a much greater chance of hitting new highs repeatedly. If a stock trades at miniscule volumes, it’s likely out of favor with the investment community, and chances are it won’t be going anywhere.
What’s more, if the stock is sought after by institutions, the buying will take place in large blocks over a period of days or weeks, in order to have as minimal effect as possible on the price. Large block trades - and the corresponding increase in volume - is a dead giveaway that the big boys are piling in. If you’re fortunate to own one of these stocks, the gains can be extraordinary…
Momentum Investing’s Biggest Proponent
One of momentum investing’s biggest proponents is William O’Neil, the founder and Chairman of Investor’s Business Daily.
O’Neil, a stockbroker in a former life, achieved guru status in the 1990s with a momentum investment strategy that became wildly popular with do-it-yourself investors.
In his 1988 book, “How to Make Money in Stocks,” O’Neil coined the term “CANSLIM” to promote his investment strategy. Each letter stands for one of the seven characteristics O’Neil says that all stocks have when they’re poised to make big gains:
- C = Current Earnings Per Share: A minimum of 25% and rising over the past few quarters.
- A = Annual Earnings: At least 25% or more, over the last three years.
- N = New Product (or service): To fuel the company’s growth.
- S = Shares Outstanding: Preferably, as few as possible. The fewer the number of shares, the faster the movement of the stock.
- L = Leader or Laggard? O’Neil suggests that a stock’s Relative Price Strength should be at least 80 (which means it has outperformed 80% of publicly traded companies).
- I = Institutional Investors: Increasingly piling into the stock.
- M = Major Markets: Should be trending higher, since 75% of all stocks tend to follow the market’s overall direction.
O’Neil has repeatedly stated that “CANSLIM” is not a momentum trading strategy, and that he’s not a momentum investor. His view is that the CANSLIM system singles out companies that, first and foremost, have strong fundamentals.
Regardless of O’Neil’s feelings, what he practices is, in fact, momentum-style investing strategy. And you can do it too.
How Well Does Momentum Investing Work?
So, how well does a momentum investing strategy work? The American Association of Individual Investors (AAII) conducted a study using O’Neil’s CANSLIM investment strategy system from 1998 through 2002 and found that it was reliable, predictable and a strong performer in both bear and bull markets.
And the best part? It produced a 350% gain over the five-year period.
AAII concluded that it was a good investment strategy for, “active investors looking for growth stocks.”
And O’Neil’s system isn’t bothered by high P/Es, either. While stocks with lofty P/Es tend to be more volatile, they’re also some of the fastest moving.
So we suggest you check out O’Neil’s CANSLIM momentum stock strategy approach, pick out a few candidates, set your trailing stops and enjoy the ride.
Good investing,
David Fessler
David Fessler, Advisory Panelist for The Oxford Club, is a successful long-term investor and a renowned specialist in the semiconductor and telecommunications business. He now runs an international import business, manages his portfolio and does exhaustive investing research. Find out more about The Oxford Club.
Today’s Investment U Crib Sheet:
Relative Price Strength is a comparison of a stock’s performance to that of a market index. Generally the S&P 500 or the Dow Jones Industrial Average is used. A rising line indicates that the stock is doing better than the market and the declining line indicates that the stock is not doing as well as the market. But there are a few other things to be aware of.
- Relative Strength is based on the S&P 500 index, which may or may not be appropriate for the company being compared to it.
- Relative strength can be calculated for many different periods of time, and it is important to note whether the performance is from the past month or past year. A company’s lifetime performance may be better than the last few months, or years.
- This measure can only tell us what a company has done in the past and not what it will continue to do.
- Companies with higher relative strength in down markets have shown to continue to be high as the markets move upwards.
Relative Strength should be used in conjunction with other indicators and not as a sole reason to buy or sell.
Volume is another tool helping investors decipher the movements of stock prices. It can confirm or disprove whether a stock’s movement is sustainable. Volume is one of the purest examples of supply and demand for a company.
As the demand increases, the supply will decrease and drive the price up. As long as the demand for a stock remains high, and the supply is small or shrinking, the price will continue to rise.
All stocks have an average trading volume that can tell you whether the volume for any particular day is above or below average. Other things volume tells us are:
- In many momentum plays you will see the volume increasing. Strong stocks will see their volume increase as the price increases, while price increases on lower volume are considered suspect.
- High volume days can signal changes in direction or continuations of trends.
- Volume is one of the few indicators that informs investors immediately whether a stock is being accumulated or not. Many other indicators use older data.
Volume and Relative Price Strength are just a few of the tools investors should use when making informed decisions on whether to purchase or sell a company. Understanding these signals will give you a leg up on many investors who do not.
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