Adding A Defense To A Value And Momentum Offense
By DailyAlts Staff The concept of combining value and momentum investing to create more durable equity portfolios has really caught on as of late, with recent coverage from Barron’s and a white paper from Research Affiliates extolling the virtues of the combined strategy. Meb Faber of Cambria Investment Management has also chimed in with a paper of his own : “Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom up, and the Top Down.” Mr. Faber’s view is that value and momentum can be combined for offense, but even more care needs to be taken on the defensive end of investing. The Importance of Defense Mr. Faber relays a story from his high-school football days to express the importance of defensive investing. To rally the defensive unit, Mr. Faber’s old football coach would tell the players that nobody ever lost a game by a score of 0 to 0 – thus, if the defense did it’s very best, the odds of the team losing were practically nil. The same can be said of investing, where protection against drawdowns of 50% or more is probably more than “half the game.” Offensive Playbook That said, no one ever won a game with a score of 0 to 0 either, so in order to have investment success, your portfolio is going to need to “score some points.” Mr. Faber favors a combined value/momentum approach, since the two styles have been proven to add value over time, and they have the added benefit of being inversely correlated. Put simply, the value/momentum offensive playbook consists of two rules: Invest in cheap stocks (value) Invest in stocks that are going up (momentum) Offensive Methodology How should one measure a stock’s “cheapness” or select an appropriate time frame for determining bullish price momentum? The details aren’t all that important, in Mr. Faber’s view, since cheap stocks are likely to be cheap by most or all sensible measures, and the same can be said of the bullish price momentum of good candidates for the momentum half of the playbook. Nevertheless, Mr. Faber’s own methodology for determining cheapness involves price-to-earnings and price-to-book ratios, as well as EBIT (earnings before interest and taxes) divided by total enterprise value (market cap plus debt.) His momentum methodology looks at price movements over the past three, six, and twelve months. From there, the top 100 qualifying value and momentum stocks are added to a portfolio and rebalanced every three months. This combined “VAMO” (value + momentum) portfolio has outperformed the S&P 500 by a significant margin since 1964. Defensive Strategy Despite VAMO’s dramatic besting of the S&P 500 over the past half-century, the strategy did suffer a larger maximum drawdown of 56.05%, compared to the S&P 500’s worst of 50.95%. If you have the capital and temperament of Warren Buffett or his partner Charlie Munger, these drawdowns are just good opportunities to add to positions, but for most of the rest of us, big selloffs like we saw in 2008 can be stress-inducing and cause us to sell at the worst possible times. That’s why Mr. Faber prefers combining VAMO with a defensive strategy designed to mitigate those maximum drawdowns. Its two-rule playbook is simple: Don’t invest in stocks when the broad market is expensive Don’t invest in stocks when the broad market is going down Conditions for rule #1 are satisfied when the broad market’s P/E ratio is in the top 20% of its historic valuation range. Rule #2 is in effect whenever the S&P 500 is trading beneath its long-term moving average. When either set of conditions are apparent, the “VAMO Hedge” strategy initiates a short position in the S&P 500 equal to half of the VAMO portfolio’s size. When both conditions are met, then the VAMO Hedge strategy becomes “market neutral,” with shorts on the S&P 500 equal in size to the VAMO portfolio’s long holdings. The results? A surprisingly lower annualized return, but a much smaller maximum drawdown combined with lower volatility, and therefore a superior Sharpe ratio. If you have the stomach of Warren Buffett and Charlie Munger, perhaps you can do without this hedge. Otherwise, combining value and momentum with Mr. Faber’s hedging strategy appears to be a prudent means of maintaining market exposure while protecting against downside risk.