Earnings Momentum Strategy Stumbles in Market Drop

"Earnings momentum" strategy is back in a big way, but right now, it's not such a momentous time for investors, as market forces seem to be pushing their portfolios down, according to The Wall Street Journal.

The idea calls for investing in companies with earnings on the upward tick. And while it can make investors a lot of money during a run up, in times like these, drops are deep and swift.

"May was a poor month for earnings momentum," said Daniel Taylor, a portfolio manager with Numeric Investors.  The Cambridge, Mass.-based firm uses computer-based quantitative strategies to manage its $10.8 billion portfolio, and accounts for different variables to determine whether stocks are expensive.

In recent years, earnings momentum  funds have paced past the competition.

The N/I Numeric Investors Emerging Growth Fund has risen an average of 23.3% per year over the past three years, for example, beating the Russell 2000 Growth Index by 5.3%. In that timeframe, the Numeric Investors Fund has beaten the Standard & Poor's 500 by 11.6%, on average, per year. American Century's New Opportunities II Fund, meanwhile, delivered a 22.5% return in the three-year period that ended May 31.

"There is a purity to the strategy in that you are getting stocks whose prospectus for growth are pretty decent compared to the rest of the market," said Russel Kinnel, director of mutual fund research at Morningstar in Chicago. Still, he warned, "you definitely have to be careful with it."

Investors learned that the hard way in the late 1990s when many tech-heavy earnings-momentum funds sank, taking with them investors' savings.

Part of the problem back then was a conflict of interest, whereby certain analysts promoted certain companies. Regulations have since squashed many of those practices.

"Earnings always matter," said William D'Alonzo, chief investment officer at Friess Associates, the management company of Brandywine Funds of Greenville, Del.

Another problem for investors can be above-average trading costs and fees, since the strategy requires managers to sell funds that break a trend of earnings. Furthermore, the strategy can result in high concentration in certain sectors. 

In 2005, for example, the Brandywine Blue Fund, a large-cap fund, had 17% of its holdings in energy stocks, while other growth-oriented large-caps had an average allocation closer to 5%, according to Morningstar. The Brandywine Blue Fund beat 85% its other large-cap growth peers.

 Turner Investment Partners concentrates on investing widely across sectors. Nine of Turner's 10 funds beat more than 75% of their peers over three years. In the May mêlée, several of those funds, however, were among the bottom fifth of their class. 

"It's not something I would like to trade with on a stand-alone basis," Taylor said.

American Century, on the other hand, which claims to have pioneered the strategy, remains steadfast, adding three new earnings momentum funds to its fold. Harold Bradley, their new manager, promises to "go all out."

The staff of Money Management Executive ("MME") has prepared these capsule summaries based on reports published by the news sources to which they are attributed. Those news sources are not associated with MME, and have not prepared, sponsored, endorsed, or approved these summaries.