Combining Value And Momentum from the Bottom Up, And The Top Down

Combining Value And Momentum from the Bottom Up, And The Top Down

Combining Value and Momentum from the Bottom Up, And The Top Down by Mebane Faber


Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom Up, and the Top Down

Mebane T. Faber

Seth Klarman Describes His Approach In Rare Harvard Interview

Seth KlarmanIn a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More

Cambria Investment Management

October 4, 2015


Sorting stocks based on value and momentum factors historically has led to outperformance over the broad US stock market. However, any long-only strategy is subject to similar volatility and drawdowns as the S&P 500. Drawdowns of 50%, or even 60-90% make implementation of a stock strategy very challenging. Is there a way to add value on stock selection, but also reduce volatility and drawdowns of a long only strategy with hedging techniques? In this paper we examine the possibility of following a strategy that combines aggressive offense and smart defense to target outsized returns with manageable risk and drawdowns.

Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom Up, and the Top Down – Introduction

I had an old football coach that used to say, “Nobody ever lost a game 0-0.” He was giving a motivational speech to the defensive squad, trying to hammer home the idea that defense was just as important to winning as the offense (although offense was much more “fun” since that was where all the points were scored). This saying had its own complement of course, and when the offense was doing poorly he would proclaim, “Nobody ever lost a game 0-0. But nobody ever won one either!”

Many investors struggle with the concepts of offense and defense as applied to investing. Often our emotions work against us here, and we often want to “play offense” when times are good (borrow to buy more stocks, chase hot tech names, chat about how much money we’re making to friends). On the flip side, we often want to play defense when we start losing money (selling stocks after a big decline and feeling lots of anxiety and fear.) Thinking about the concepts of playing strong offense and smart defense together may help investors to find a coherent investment strategy that they can implement and more importantly, stick with during good times and bad.


Let’s say you set out to design a stock investing strategy. Furthermore, let’s create one that is rules based so that anyone can follow it. Likely, the strategy would contain two classic elements that help determine future stock performance – value and momentum. At its core, the model should reflect the following basic generalizations:

1. Invest in cheap stocks.

2. Invest in stocks that are going up.

There are piles of academic papers, stacks of books, and real-time fund performance that demonstrate the success of these two factors. They don’t work all the time, and even better, they often don’t work at the same time – but historically value and momentum have been great ways to select stocks. The exact specifics of which value factor (price-to-earnings or price-to-sales?) or momentum factor (12-month total returns or relative returns?) to use probably don’t matter a great deal, rather, what does matter is choosing to use them in the first place.

Now, there are many, many ways to construct such a portfolio, and countless others have built simulations before – Joel Greenblatt’s The Little Book that Beats the Market is a famous example of a basic multifactor stock screen, as is Quantitative Value by Wes Gray. If you really want to examine various stock factors, the Bible of stock screens is the classic What Works on Wall Street. We will lay out an incredibly basic screen below with the help of our good friends at Alpha Architect.

The Offensive Playbook

We include all historical stocks trading on the NYSE back to 1964, and only include the large and liquid stocks above the 40th percentile market cap (around $2 billion today). The portfolios are formed monthly with a three-month holding period similar to the methods in Jegadeesh and Titman (1993). The two value and momentum variables are below:

Invest in cheap stocks (value) – Rank stocks on P/E (price to earnings ratio), P/B (price to book ratio), and EBIT/TEV (earnings before interest and taxes / total enterprise value) . The average of the three is the value rank.

Invest in what is going up (momentum) – Rank stocks on 3-month, 6-month, and 12-month momentum. The average of the three is the momentum rank.

Could we use other variables? Sure – but we’re trying to keep this simple.

Each month the top 100 value and top 100 momentum stocks are bought and held for three months (equalweighted). We will call this combination portfolio value and momentum (VAMO). All returns are total returns and include the reinvestment of distributions (e.g., dividends). No trading or management fees are included. (You can find more information in the Alpha Architect post here.) Below are the results going back to 1964.

Value and Momentum

See full PDF below.



Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom up, and the Top Down


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