In Scripline of April 2 last year, I referred to the excellent comeback by Apple Computers. At that stage, the share price had increased 180 percent in two years (to US$42), and early letters to Santa were littered with requests for the world's foremost MP3 player.
During the last quarter of 2005 alone, Apple sold 14 million iPods. If we were the company's only market, that would translate into nearly one in three South Africans owning one! The share price is up 160 percent since last January, and is currently trading at about US$80. Imagine having sold a year ago...
You may be wondering what I am leading up to, especially if you missed out on owning either the share or the gadget. At least I did have an iPod, and I keep telling myself that the hours of listening to it make up for missing out on the 300 percent return in the manufacturer's share price.
Here is my point: You have to make space in your portfolio for momentum.
In his book One up on Wall Street(Simon & Schuster, 1989), Peter Lynch, who is still one of my favourite investment gurus, says one of the silliest (and most dangerous) things people say about stock prices is: If it's gone this high already, how can it possibly go any higher?
I guess that sums up how many South African investors feel about our stock market. After all, the average investor has grown up in the market waiting for the inevitable crisis to strike ... emerging markets ... politics ... our currency. Every time our market advances, we can't help thinking that this has to be as good as it gets, and that surely it cannot go any higher? And many of us have been wrong for many months - even a year or two.
As a closet contrarian investor, I often search for ideas in the "YM%" column of the share prices, where I can see how a share has fared over the past 12 months. The big negative numbers usually catch my eye. I figure that many neglected shares could offer interesting opportunities due to the mass psychology of the market. Sellers often overdo their punishment after some bad news or a corporate wobble.
However, the mere fact that a share price has fallen substantially is not a good enough reason to buy it. Similarly, if a share has increased substantially, it does not follow that you should sell it.
In fact, researchers and chartists (or followers of technical analysis) learned long ago that stock prices appear to have momentum. For example, as a group, stocks with the best price performance over the previous six-to-12-month period tend to continue to out-perform the market over the subsequent one to 12 months, while previous losers tend to continue under-performing. This is especially true when the overall market is in a bull phase, much as ours has been over the past year or two.
How momentum works
The term "momentum" refers to the rate at which a share price is moving.
If momentum is positive, the share price is moving up, and vice versa. If momentum increases over time, the share price is either rising faster than before, or it has stopped falling quite as fast as it was in the past.
If momentum declines over time, the share price is either falling or it has started rising a little slower.
Think of your high school (or nowadays pre-school) science class and the effect of gravity on the arc formed by a ball when it is thrown up into the air - the accelerating ascent, the slower climb, the slow fall and finally the plummet to the ground - and you have the general idea.
A major problem with momentum and share prices is that a share price can fall only by 100 percent to zero, but it can rise by a lot more than a 100 percent from its starting point, and that is why many people get it wrong when they sell shares with high momentum.
Although I certainly don't want to test the "can fall only by 100 percent" limit in my portfolio, the point is that upside momentum can go a lot further than downside momentum! It is a skewed picture. And getting either wrong can be painful - either seeing the share you hold plummet or missing out on another 100 percent upside after you've sold.
Application to your portfolio
How do you apply the principles of momentum to your share portfolio? The sensible way to use momentum in the current market includes the following:
- Make sure you understand why you initially included each share in your portfolio. You may have expected a share to show higher growth (for example, Apple), perhaps you expected another share to be a steady grower with good dividends (for example, Remgro), another to diversify your portfolio by behaving very differently from the rest (such as gold shares or Liberty International), or maybe you expected value to be unlocked due to corporate action (for example, Venfin).
- Make sure you understand how each of your shares is behaving regardless of why you bought it in the first place. For instance, has a share exceeded the return you expected it to give you and has it done so sooner than you expected?
- If you are lucky enough to find a few of your shares in a positive momentum spiral and you think they have gone too far, manage this portion of your portfolio separately. You should resist the temptation to sell all these shares at once. View them as shares that may have lots of upside potential, but where the upside is fuelled by momentum and sentiment rather than value.
Determine a percentage of your portfolio that you are comfortable exposing to momentum, and be disciplined about trimming back positions as they grow. You may well miss out on the last bit of the ride, but it is a sensible way to manage an illogical situation.
Don't underestimate the power of momentum, because it can be as powerful over the medium term as the most extreme value situation can be over the long term. Go with the flow, but manage the extent to which momentum influences your overall portfolio.