Any frequent reader of our blog knows we are fans of momentum investing. At this point, investment professionals should know that momentum historically works, that momentum is painful, and we have our own opinions on how to implement momentum investing via our Quantitative Momentum Index.

Sometimes we feel there is nothing new when it comes to momentum. However, a new momentum investing paper, “Overpriced Winners,” by Profs Kent Daniel, Alexander Klos, and Simon Rottke, is really cool and worth consideration.

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One key chart from the paper sums up everything:

Avoiding Overpriced Winners

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The chart shows that 12-2 momentum winners do well upon formation, 12-2 momentum losers do poorly (initially), and the market grinds along (we already know that).(1)But the chart also shows that “overpriced winners” are absolutely terrible.

Overpriced winners? Let’s dig in further!

What Are Overpriced Winners?

Within the high momentum portfolio (the “winners”), the authors examine a difference between what they classify as “constrained” and “unconstrained” firms. Specifically, the paper defines a “constrained” momentum firm using an independent triple sort. The authors split the universe into quintiles using the past 12_2 months returns (the stock’s momentum over the past year, ignoring the previous month). The additional two sorts are quintile ranks on (1) institutional ownership and (2) changes in short interest over the preceding year.

A “constrained” winner is a firm that is in the top quintile on 3 measures:

  1. Momentum
  2. Institutional Ownership (Low is more constrained)
  3. Change in Short Interest (High is more constrained)

Behavioral finance generally theorizes that the momentum anomaly is caused by investors suffering from an underreaction to firm news / fundamentals. (see here) ((2) However, for this subset of high momentum firms, the authors suggest a different behavioral bias at work — unwarranted optimism.

The logic is the following, in the author’s words:

… for the constrained winners, we argue that a possible source of the price rise was that only a subset of investors revised upward their valuation of the firm in response to what we will label a “sentiment” or “disagreement” shock. For an unconstrained firm, the price would not move appreciably in response to such a shock; the subset of now-optimistic investors affected by the sentiment shock would demand more shares, but in response the arbitrageurs (whose valuation of the firm was unaffected by this shock) would short the shares demanded by the optimists. However, for a constrained stock, where it is difficult for the arbitrageurs to borrow and short the stock, competition between the optimistic investors will lead to a strong, unwarranted price rise for the stock.

The authors highlight the performance of the three portfolios (winners, losers, and constrained winners) in Figure 2 below. The returns shown are associated with portfolios hedged against the market, size and value factors.(3)

Avoiding Overpriced Winners

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Figure 2 highlights that shorting, or ignoring the subset of “constrained” winners, is a good idea!

In the paper the authors create a model to predict the investor behavior for this subset of stocks — here it is in the author’s words:

In our simplified setting, for unconstrained firms where the cost of locating shares to borrow is zero, a shock to disagreement or optimism has no effect on the price. Here, such shocks result in trading volume – the agents who become more optimistic buy shares from those who are more pessimistic – but the market clearing price remains constant. However, for firms where short selling is constrained (i.e., where it is costly to find shares to borrow) the more pessimistic agents choose not to short because of the high cost of finding shares to borrow. Thus, the market-clearing price no longer reflects the valuations of these newly “sidelined” pessimists, and moves upward. Hence, if we see that a constrained firm has experienced a large price rise over the last year, it is likely that disagreement for this firm has increased, which further implies that this firm is likely to earn low returns as the disagreement is resolved.

Figure 3 (below) graphs the deciles of earnings forecast dispersion over a 6-year period. Note that most of the dispersion deciles stay similar across time. Within Decile 10, one notices that there are firms with a large dispersion of earnings forecasts around portfolio formation. The authors use this in their model to highlight the following fact — for constrained firms, where the optimists are setting the price, they may need to bring their earnings estimates downward in the future– in a sense predicting lower returns while also lowering their forecasts.

Avoiding Overpriced Winners

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

So far, we know that (1) we should short / avoid the constrained winners and (2) lower returns in the future may be predictable. The authors also test how these firms react around earnings announcements in Figure 10 of the paper (shown below). Similar to earnings announcement returns for other anomalies, there is a large reaction to the constrained firms around earnings announcement dates.

Avoiding Overpriced Winners

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Natural question: Do CFOs and CEOs take advantage of their overpriced stock?

Yes!

The authors use the composite equity issuance variable from Daniel and Titman (2006) to measure the amount of the firm’s market capitalization that cannot be accounted for through the firm’s stock return. In Table 6 (below), the authors find that 12.85% of the constrained winner’s market capitalization cannot be explained by the stock return! Thus, these constrained winners are issuing overpriced stock!

Avoiding Overpriced Winners

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect

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