Why blending value and momentum is a WISE investment strategy

Last year I noted that blending a strategy designed to include cheap stocks with rising stocks could be the 'ultimate market strategy'. The evidence that Value & Momentum are excellent bedfellows is utterly compelling. The two strategies are complementary as value tends to prosper when momentum lags and vice versa. Given that the returns to value and momentum are fairly uncorrelated investors in both can reap additional returns for less volatility.

If you are a hardcore value investor it's worth seriously considering if you could really stomach the inevitable 3 or 4 year periods where you massively underperform the market. As mentioned in the article linked above the career of Tony Dye (a dedicated value investing fund manager) famously didn't survive the dotcom bubble, while others threw in the towel right at the wrong time.

While momentum investing is anaethma to most serious investors, there's a growing body of research that shows it should be taken just as seriously as growth investing and clearly a dose of it might just save a few careers. So if you wanted to build a systematic investment process around value and momentum how might you go about it?

Getting WISE

Societe Generale's quant team have been running a so-called 'WISE' investment strategy across various markets for over 8 years. At it's core the strategy blends a few value and momentum ratios through a very simple scoring system. The results historically have been quite impressive - especially given the large cap bias - with the original backtest showing a 12.6% annual performance on the long/short portfolio.

The team backtested all the traditional value ratios (P/E, P/B, Yield, P/S, P/CF) including the enterprise value ratios (EV/EBIT, EV/EBITDA, EV/Sales) and added in the 'growth relative ratios' for good measure (PEG and its enterprise ratio cousin the VEG).

They studied each company's ratio on an absolute basis against the entire universe (e.g. large caps in Europe), against their local market index (e.g. FTSE 100) and against their sector. They also tested each ratio relative to each stock and sector's historical average in what looks like a very comprehensive backtest.

On the momentum side they tested the classic pure price momentum ratios (like 6 month relative strength) but also heavily tested earnings surprise ratios - like earnings revisions, upgrades and downgrades.

To figure out which ratios to include in the end portfolio, they picked the ratios that generated portfolios of stocks with the highest Sharpe Ratios - essentially these are the portfolios offering the highest returns for the least volatility.

Value Ratios Winners: While "in most cases we were able to observe an average outperformance of value stocks" they surprisingly found that the growth relative ratios (PEG and lesser known VEG) carried less volatility. The four winning value ratios (with annualised added value of between 7% and 10.5%) proved to be the Price to Cashflow relative to the sector, Price to Sales relative to sector, PEG (12 months forward PE vs Expected Growth), VEG ( EV/EBIT vs Expected Growth).

Momentum Ratio Winners: The winning ratios from a momentum perspective proved to be weighted towards earnings surprises - the balance of upward vs downward earnings revisions, standardised unexpected earnings, unexpected returns around earnings announcements, six month absolute price strength.

What's fascinating about momentum strategies versus value strategies is that they work on completely different timeframes. The winning value ratios all work best on 12-24 month time horizons, whereas the momentum ratios work best on 3-6 month time horizons. As a result, the optimal blended portfolios have holding periods of 12 months - a boon for individual investors who want to put this kind of strategy to work, but don't want to trade like amphetamine fueled schizophrenic rabbits.

Show me the money?

Admirably for a City Quant team, Societe Generale used a simple scoring method to pick the combined portfolio. Each company is ranked from 1 to 10 according to the decile of each ratio, which are then summed to generate an average value and average momentum score - the combined average provides a 'WISE' score for every company in the market and the top ranked stocks are picked for purchase.

How to build your own WISE portfolio

Societe General run indices based on these WISE scores around the world - all can be investigated at the excellent sgindex.com portal and there may well be ETFs based upon them (DYOR!). New stocks in the latest WISE basket for UK investors include 3i (LON:III), Berkeley Group (LON:BKG), and Mondi (LON:MNDI).

But how would our readership at Stockopedia go about building their own value/momentum portfolios in a similar way? Well we've news for you on that front.

Last week we discussed O'Shaugnessy's 'composite value' ratios that, while composed differently, are scored in a very similar way to the ones in the SocGen paper. We have been generating our own sets of value, growth, momentum and quality factors which are in beta testing. For those that want to road test our 'highly beta' ValueRank, MomentumRank, QualityRank and GrowthRank you can search for the ratios in the Stockopedia Screener. They all score from zero (worst) to 100 (best) for each category. If you haven't got a subscription to Stockopedia please do take a 2 week free trial and check it out.

We plan on releasing these more officially in the next couple of weeks after we've had some time to finesse them and may start tracking their performance. I anticipate we will iterate on the composition of each rank based on subscriber feedback in coming weeks but you can search for them in the knowledge base - for the time being please consider them black box constructs. We also plan on launching blended composite scores (Value+Momentum, Quality+Value, Growth+Momentum etc) so that you'll be able to build your own WISE-style investment strategy quite easily. And the boon for individual investors is that this will work across the entire UK stock market - hopefully helping you pick better small caps too!

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