October 31, 2024

Over the last 18 months, disciplined fundamental investors such as Harding Loevner have been challenged by an episode of price momentum concentrated in a few of the largest stocks in the market.

Price momentum refers to the well-documented phenomenon where securities whose prices have risen are more likely to keep rising in the short run, while those that have fallen are more likely to experience further declines. The precise causes of this phenomenon are debated, but the evidence is strong enough for it to be classified as a “factor”— a recurring pattern associated with positive excess returns.

We have deliberately resisted incorporating the momentum factor into our investment process for several reasons. First, despite being well documented, simple price momentum does not provide a fundamental basis for making investment decisions. Serial correlation of share price changes has, at best, a weak connection to the underlying business you’re investing in, and nothing to do with what it is worth. Second, momentum investing is literally “chasing” stocks that have already gone up or outperformed (or selling those that already went down or underperformed). This approach carries real-world costs, both the actual trading costs and in increased turnover of the portfolio.

Third, although momentum investing has shown net positive returns over very long periods, there is considerable volatility in its return path, with frequent momentum reversals leading to sharp “drawdowns” in performance. This whipsaw effect makes momentum investing much harder to stomach in practice than it appears in theory.

The biggest drawback may lie in a related but distinct area. When the biggest companies, with the largest market capitalizations, experience highly correlated share-price rallies (as Nvidia, TSMC, ASML, Broadcom did this year), momentum returns become aligned with overall market returns. In such cases, a more troubling form of momentum emerges—one increasingly driven by the fear of missing out (FOMO).

Investors who hold the winning stocks are happy to hold on, while those who don’t quickly feel the pressure of “missing out,” amplified by the constant media coverage that acts as free advertising for these market leaders. Passive investors inadvertently pour more capital into these heavyweight stocks in ever-increasing percentages, further amplifying their impact. As a result, the momentum behind these stocks grows ever stronger, and they come to dominate index returns. All (human) investors who measure themselves against a benchmark index feel drawn to jump on the bandwagon.

As investors, we have spent decades crafting tools to promote objectivity and building a culture that is aware of the behavioral pitfalls in investing. One reason for this is that we can be just as susceptible as other investors to such temptations. To stiffen our resolve, we’ve made pre-commitments in the form of absolute limits in our risk guidelines, which are primarily aimed at enforcing diversification in our portfolios, but secondarily act as brakes to curb our enthusiasm. We set maximum limits on holdings of single securities to keep us from the most basic of fundamental company infatuations. We also set maximums on aggregate investments in single industries and sectors, as well as individual countries.

These are fixed limits, preferably set in moments of low controversy and neutral enthusiasm for those classifying categories. They later compel us to look through and beyond current fashion and consensus to recall and consider the investment world as it long has been and as it may be again in less florid times. These limits are arrived at from a common-sense perspective, rather than scientifically. We have altered them from time to time as reasonable considerations of changing opportunity size and enduring alterations in market significance have become manifest.

There can be, naturally, a link between stock-price momentum and company fundamentals: When a profound and structural change is harnessed by one or more companies over a long period, sustained profit growth should find itself linked to an extended share-price appreciation. A clear example is Apple, where even casual observers can recognize the transformative impact its products have had on consumer behavior, a shift reflected in its share price over the past two decades. Less iconic examples include Schneider Electric’s role in the global trend toward electrification of industry this decade and L’Oréal’s expansion into emerging markets with branded cosmetics products over thirty years.

An aversion to momentum, perhaps formalized with a pre-committed, mechanical sale rule, risks forfeiting enormous potential gains when such an extraordinary case delivers a disproportionately large and sustained run of value creation. This possibility is worth serious consideration in today’s market, where we see such dynamics possibly at play with NVIDIA in the US, leading weight-loss drug developers Novo Nordisk of Denmark or Eli Lilly in the US, and the broader Artificial Intelligence ecosystem residing primarily within the IT sector.

Nevertheless, most of the time investors tend to overestimate the number of transformative changes that will actually materialize, often falling into a pattern of “being slow to overreact” as one of our colleagues aptly described the behavioral two-step that has fueled many instances of momentum and inevitable reversals. The FOMO response to price momentum is clearly associated with poor investment decisions, and, in our experience, is most acute when it’s most dangerous—near the peak of market trends, or worse, an investment bubble. We suspect that FOMO has been a significant element contributing to some of the most damaging drawdowns in the performance record of momentum investing, and we expect it will likely feature in some doozies to come.

Inevitably, we face pressure to bend or break our risk guideline pre-commitments when FOMO is greatest. But our long experience with these absolute limits—such as the benefits of maximum weights when there were downturns in China (2020), in Brazil (2006-7), in Emerging Market banks (2012), in the IT sector (back in 1999-2000), and minimum weights during upturns in the US (2004-5) and in Japan (1998)—serves as positive reinforcement for such discipline.

Constraints such as these help you avoid the core problem with momentum investing: It works until it doesn’t, and when it doesn’t, all the gains you made can be reversed more quickly than you can exit the market. Gains of months are squandered in days.

We thank you, as always, for the trust you place in us.

Investments involve risk and loss is possible. Holdings are subject to change. A complete list of holdings is available here.

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