The ‘Momentum’ Investors Begin to Lose Their Steam

Playing the stock market was a fairly simple game last year. If a stock was moving up, you bought it. The market’s leaders just kept getting stronger.

That strategy, known as “momentum” investing, caused stocks in such industries as biotechnology, specialty retailing and medical instruments to double or triple in price during 1991. It looked like the sky was the limit.

But so far this year, many momentum investors are stumbling. They concede that it’s getting much more difficult to figure which stocks are the true market leaders and which are mere flashes in the pan.

Perhaps even more dangerous for the momentum players is that many appear uncertain about when to sell the 1991 leaders that have soared to thin-air heights. And when you miss an exit cue on one of these stocks, you risk seeing the price collapse overnight.

Jim Collins--whose Insight Capital Management in Moraga, Calif., manages $65 million for clients--is one of last year’s star momentum players who admits that he’s having a tougher time identifying stock winners and losers today.

Collins specializes in small-growth stocks traded in the NASDAQ over-the-counter market. In his monthly OTC Insight newsletter, Collins lists his 100 favorite OTC stocks. Last year, the average gain on the model portfolios built from that 100-stock list was a stellar 149%.

But in January, Collins’ 100-stock list managed an average gain of 4.6%. That lagged the 5.8% rise in the NASDAQ composite index of 4,000 OTC stocks.

Collins’ performance in January was hardly a disaster, but for someone used to beating the market averages, it was a troubling signal. “It really upset me,” he says.

What’s the problem? Collins believes that he and other momentum investors are being tripped by a yardstick known as “relative strength.” A stock’s relative strength is its price movement over a recent period compared to the market as a whole. It’s often expressed as a number between 1 and 99, with 99 being the strongest stocks.

In searching for future market leaders, some professional investors look for the stocks with the greatest relative strength over the most recent three months. Some use relative strength over the last 12 months. Investor’s Business Daily newspaper, read by many avid investors, publishes a 12-month relative-strength figure for each stock in its daily market listings.

Relative strength was a great guidepost in 1991, as rising stocks continually attracted new money and rose further. But this year, Collins and other managers say relative-strength rankings are much more suspect.

Here’s why: If a stock has been rising steadily for a long period--as many small-growth stocks did last year--relative strength ratings give an accurate account of the market’s leaders. But when stocks begin to spike way up or way down in a matter of days, it’s much more difficult to separate true long-term leaders from short-term phenoms.

Collins, noting that many small stocks have experienced huge daily price moves over the past two months, argues that the OTC market is becoming a victim of its own success. “An awful lot of money is coming into the small-stock market now, and that is having an impact on the momentum game,” he says.

Because small-stock mutual funds, in particular, have been inundated with cash from individuals, fund managers are in some cases tossing money at small stocks with what would have been termed reckless abandon a year ago. “Some of these stocks are just accelerating too fast,” Collins says.

But doesn’t the momentum game dictate that the strong only get stronger? Not necessarily, Collins says. Though momentum players may appear to do little more than chase lines on charts, the good managers among them want a stock to go up because it deserves to go up. That is, they want to see hefty earnings growth at the company to justify a continuing rise in the stock price.

A stock that spikes up 30% in a matter of days, as some small issues have recently, can’t accurately be judged to be a market leader with staying power, Collins says. “Somebody may just be throwing money at the market,” he says. Once those investors move on to the next hot stock, the spike up in the old “leader” can quickly become a spike down.

The momentum players also have another big problem now. Many investors have become much more excited about stocks of industrial companies whose earnings should rebound if there’s an economic recovery this year. These stocks have turned hot recently, after lagging the growth stocks in health care and other consumer businesses since 1989.

In theory, if the industrial stocks begin to lead the relative-strength rankings, they should be the issues toward which momentum players gravitate. But shifting from consumer to industrial stocks is a tough mental transition for many momentum players, who psychologically still feel bound to their favorite growth stocks.

Peter Schliemann, who manages the $175-million Babson Enterprise stock fund in Boston, argues that his kind of stock--small industrial companies that have lagged the market for years--are overdue for a rebound. A recovering economy should be the catalyst for such a move, he says.

“I think the market is confused now, and it’s looking for its next leaders,” Schliemann says. “But it can be several months of turmoil before the new leaders start on a sustainable advance.

“Markets tend to go in cycles,” Schliemann notes. “Momentum investing works for a long time, and then those stocks become the worst place to be.”

Collins, however, believes that momentum investing will still produce good returns this year. But the giant price gains already experienced by many growth stocks tell you that investing solely on price momentum won’t work anymore, he concedes. Many stocks simply are too high.

“You’ve got to couple momentum investing with good stock selection now,” Collins says. In other words, be sure you’re paying a reasonable stock price relative to a firm’s earnings power.

That’s just common-sense investing, of course. But last year, when the growth-stock boom was in its infancy, you didn’t need common sense; you just needed to be in the stocks that everyone else wanted to own. Now, says Collins, “those investors who are just traveling on momentum--their days are numbered.”

KBH Turns Cold: Sometimes, stocks that lose momentum quickly become bargains. California home builder Kaufman & Broad Home Corp. may be a case in point.

The stock soared from $13.50 in December to $25 on Feb. 13, as investors turned bullish on the housing industry. But since then, KBH has slid to $21.50 as of Friday.

The company continues to benefit from the rebound in housing demand in California. In the five weeks ended Feb. 16, KBH said it sold 478 homes, versus 392 in the same period a year earlier.

But some investors apparently are worried about KBH’s French arm. That division provided about half of KBH’s profits last year. Now, housing demand has eased with France’s slowing economy.

That has forced KBH to turn to promotions. One Wall Street rumor had KBH giving away a car with every home sold in France. Not so, says Chad Dreier, KBH’s finance chief. The giveaways apply only to the firm’s highest-priced homes (about 40% of total sales in France), he says.

Moreover, he adds, the cost of the promotion is about $10,000 per $300,000 home--which he says is less than what KBH spent to spur California sales in 1991.

Another concern: KBH recently announced plans to issue 7.5 million new shares of stock to retire warrants. The firms lists 33.6 million common shares now, so some investors appear worried about the new stock significantly diluting per-share earnings.

But Dreier says two-thirds of the 7.5 million new shares are already counted in KBH’s 33.6-million share total, because of the warrants. So the net effect of the stock sale is to add just 2.5 million shares.

The bottom line: KBH, which earned just 80 cents a share in the year ended last Nov. 30, says it is confident that it will earn more this year. How much more? The company won’t give a number, but Wall Street expects about $1.50 a share. At $21.50 a share, that puts the stock at 14 times 1992 estimated earnings--hardly an outrageous price by today’s standards.

New Market Leaders? Maybe, but . . .

Here are some of the stocks that have recently zoomed to the top of the “relative strength” list compiled by Investor’s Business Daily newspaper. The relative strength rating, on a scale of 1 to 100, measures a stock’s price performance versus the broad market over the past year. But the ratings don’t guarantee further gains.

52-week Fri. Pct. change Relative Stock high/low close year to date strength American Pacific 37 3/4-10 34 3/4 +93% 97 Tandy Brands 27 1/4-6 1/8 26 1/2 +77% 95 Grand Casinos 24 1/4-6 3/4 20 1/2 +148% 95 Designs Inc. 20 1/2-7 20 1/4 +59% 91 Black & Decker 26 5/8-11 3/4 26 1/8 +54% 89 Bank of Boston 19 7/8-6 3/8 19 3/8 +68% 89 Checkers Drive-Ins 26 5/8-13 7/8 26 +41% 88 Egghead Inc. 26 1/4-10 1/2 25 3/4 +54% 87 Presley Cos. 17 3/8-7 16 3/8 +56% 86 Rexon Inc. 12 1/4-5 3/8 11 1/2 +92% 83

All NASDAQ issues except Black & Decker, Bank of Boston and Presley (NYSE).

Source: Investor’s Business Daily

. . . This Hot Stock Has Stalled Out

Shares of Southland-based home builder Kaufman & Broad have surged in recent months on the New York Stock Exchange, but the stock’s momentum has weakened substantially over the past few trading sessions--leaving many shareholders confused.

December 17, 1991: $13.63

February 21, 1992: $21.50