Academic Evidence The existence of a price momentum factor in stock markets is well-researched with the seminal study by Jegadeesh and Titman2 (1993) showing that performance persists over medium-term horizons: a strategy that buys stocks that have performed well in the past and sells stocks that have performed poorly generates significant positive returns over holding periods of 3 to 12 months. Subsequent studies including one by Geczy and Samonov3 (2015), have shown that the phenomenon exists across equity markets as well as other asset classes and has done for hundreds of years. Therefore, the question is not whether a price momentum factor exists, but why does it exist? For a current overview of equity market momentum literature see Subrahmanyam4 (2018). There are several possible explanations for momentum. One is that momentum’s higher returns are a compensation for some unique risk associated with investments that have recently outperformed. However, like others, Jegadeesh and Titman failed to identify any risk factor that could explain the momentum effect, therefore in many ways challenging the EMH that past prices do not provide information about future prices. What Jegadeesh and Titman did find was evidence for delayed price reactions to firm specific information when looking around earnings announcements dates, driven by potential investor over-reaction and under-reaction. However, the decomposition of those observations was outside the scope of their study. Further work along these lines has continued over the years with the use of behavioural finance theories to try and explain the momentum effect. Here, it is posited that share prices can deviate from their true fundamental intrinsic value and these deviations are due to investors not acting rationally. Behavioural finance combines psychology and finance to understand and explain irrational stock market and investor behaviour. This has led to the search for new models and ideas that may be able to predict and explain various market anomalies and behaviour from various psychological biases.

Despite the prolific rise of highly quantitatively driven investment strategies, algorithmic trading and passive buy and hold strategies, financial markets remain a field with heuristic investor behaviour that is not always rational. Sir Isaac Newton famously exclaimed in despair “I can calculate the motions of the heavenly bodies, but not the madness of the people“, as he lost a fortune during the South Sea Bubble of the 18th Century. Given that human participation in financial markets is so embedded it is no surprise that they are subject to anomalies and behaviour that is driven by its participants. As a result, traditional theories of security pricing and markets have been rightly questioned as to their validity, particularly so has the “efficient markets hypothesis (EMH)” developed by the economist Eugene Fama in the 1960s1. The EMH holds that a stock’s price at any moment reflects all of the relevant information about a company and other input factors and that the capital market as a whole acts completely rational. These characteristics would make it impossible to beat the market on a risk adjusted basis because share prices are always exactly what they “should” be, given what investors collectively know. Although research on the various anomalies that counter the EMH is varied and insightful, our goal with this brief paper is to touch on one, namely, the momentum factor which is probably one of the most documented phenomena (and thereby counter-EMH anomalies) in financial markets.

1 E. F. Fama (1965): The Behavior of Stock Market Prices, in: Journal of Business, 38 2 Jegadeesh and Titman (1993): Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency, in: THE JOURNAL OF FINANCE VOL. XLVIII, NO. 1 3 Geczy and Samonov (2015): 215 Years of Global Multi-Asset Momentum: 1800-2014 in SSRN 4 Subrahmanyam (2018): Equity market momentum: A synthesis of the literature and suggestions for future work in: Pacific-Basin Finance Journal 51 (2018)

Investing in “Fundamental Business” Momentum Using Behavioural Finance to Ride the Momentum Wave

Common biases identified include anchoring, recency, disposition and herding and we subscribe to the view that such biases play a part in market dynamics and security pricing. Anchoring Investors can be slow to react to new information. EMH theory assumes that once new information is released, it is instantly available to all investors and that prices immediately adjust to reflect these news. The phenomenon of “anchoring” implies that a fundamental change in a company’s business is often only reflected in its stock price with a time lag. As investors are still “anchored” in their old opinion regarding the company, they only react with a delay to fundamental changes. The anchoring effect can be observed in every stage of a stock cycle (i.e. where share price tends to be below or above its long-term fair value). Anchoring could also be due to the nature of the financial market participants, i.e. a trader versus a casual investor. Each would receive news from different sources, reacting over different time horizons and in different ways. Below we provide an example of anchoring pertaining to GE, where negative news over years has the ability to anchor investors per ception despite a potentially transformational turnaround (via i.a. debt cuts, divesting of non-core assets and the streamlining of core business). GE Share Price Over Time

The last impression counts! Change

Change

Fair long-term share price

“Anchoring““Recency effect“: overreaction and extrapolation

“Anchoring“: delayed reaction

Stock rises on good news, but as investors might be anchored in their old opinion, they may underestimate the true potential of the turnaround ⇒ Buying opportunity?

Stock looses 78 percent in almost two years ⇒ Anchoring (“GE is bad”)

35

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25

20

15

10

5

030.12.2016 30.03.2017 30.06.2017 30.09.2017 31.12.2017 31.03.2018 30.06.2018 30.09.2018 31.12.2018

Source: Thomson Reuters, Bloomberg, Union Investment; as of: 27/02/2019

GE misses Q4 sales targets GE CFO: „Earnings

trending to low end of forecast“

Bloomberg: „New CEO slashes profit outloook“ Rumours of urge for

capital increase and dividend cut Debt cut, sale of

stake in Baker Hughes

Stock rise as „year of transformation” starts

Recency The recency effect can be described as the phenomenon wherein we tend to give greater importance to events or developments that have occurred more recently than to those that have taken place in the distant past. For example, if a company’s improved fundamentals are already reflected in stock prices and extrapolated too far into the future, stock prices may overshoot long-term fair values. In this stage, market participants tend to be over-influenced by the recent upward trend and the positive per-ception of the stock in the market, which ultimately leads to an overreaction to the observed trend. As a result, investors fall into the trap of overbuying the current outperforming stock and under owning the underperforming one. This holds true not only for stock prices but also for the perception of business models. Market participants tend to overestimate the probability of the future success of a business model, if its past success lasted long enough. This additional layer of anchoring and recency effects could intensify the described stock price movements (i.e. deviation from long-term fair value). Another commonly cited behavioural bias includes the disposition effect where investors tend to sell winners too early and hold onto losers for too long, which can lead to price momentum. See Shumway & Wu5 (2006). The internet/tech bubble of the late 1990s is a relatively recent example of another behavioural bias amongst investors to “herd” and where markets seemed to dislocate completely from fundamental values, having momentum of their own and perhaps subject to “irrational exuberance”. Although there might be several explanations for the momentum factor, we strongly believe in its persistence as it stems from human behaviour and is therefore unlikely to disappear. If this is a sound premise, we would argue that seeking to exploit the source of the momentum factor as part of an investment strategy should prove a profitable endeavour.

CSX Corporation (rail transportation) Share Price Over Time

5 Shumway and Wu (2006): Does Disposition Drive Momentum? SSRN Electronic Journal

30.12.2016 30.03.2017 30.06.2017 30.09.2017 31.12.2017 31.03.2018 30.06.2018 30.09.2018 31.12.2018

Source: Thomson Reuters, Bloomberg, Union Investment; as of: 07/03/2019

80

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55

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35

30

Stock gains 73 percent in two years

Stock still rises on good news, but head-winds increase (economy slowdown, reduced pricing power). Do investors over-extrapolate the recent upward trend (recency effect)? ⇒ Sell signal?

CSX posts record efficiency level for a US railroad corp.

Railroad veteran Hunter Harrison will take over as CEO

Restructuring story unfolds: Hunter Harrison and

team streamline the company and also profit from external

factors:

– strong growing US economy boosts volumes

– truck driver shortage provides pricing power for railway

transportation

Price Momentum in Active Global Equity Investing Given that we accept that momentum exists and that it is most likely driven by innate human behavioural biases: what type of investment strategy might be able to exploit this phenomenon consistently all the while not suffering from the same biases itself? We believe that the answer lies in having a structured investment process that is multi-faceted. We believe potential features of such a strategy might include: Fundamentally driven approach – investing in global equity markets implies that you are making a decision to own a stake in a company. Before making such an important decision, we believe to be a successful investor and fiduciary, one should fully understand the company, its business model, competitive market position, the strength of its management, its financials amongst other aspects to make an informed decision. Although we believe quantitative screening and methods can be useful, we strongly believe that owning a company demands more and detailed fundamental analysis and due diligence is essential. In some ways the recent recognition that ESG factors can have an impact on company value has strengthened the case and our conviction that fundamental analysis will lead to better investment decisions. Robust selection criteria – although the existence and persistence of momentum in company stock prices is a valuable phenomenon from which to generate alpha, we believe that the efficacy of any investment strategy that seeks to exploit it, will be more robust if it is based on detailed fundamental analysis that identifies high-quality companies with an attractive valuation and that have exhibited a positive fundamental change catalyst that is borne out by evidence in the form of key performance indicators. The last criterion is the most important and is the key driver for any potential momentum trends. Catalysts could be a new product launch, a positive change in the management team etc. and are kept track of by real time monitoring of pertinent variables. Stock selection – given the heterogeneity of companies we believe company specific factors tend to dominate stock returns when assessing momentum and is consistent with the findings of Jegadeesh and Titman regarding price reactions being firm specific. Robust portfolio construction – we believe in constructing portfolios based on an equal active weight rather than personal confidence or preference because confidence is heavily influenced by behavioural biases (preference for that which we have known or worked on recently). You are either favourable on the position/theme/company or you are not! Equally weighting the active bets not only helps from behavioural perspective but also helps to manage risk by not relying on single themes or companies. Disciplined Trading – we believe it is vitally important to strictly follow the signals provided by the fundamental change catalyst for buy/sell decisions to mitigate and potentially profit from the behavioural biases such as anchoring or recency effect. Conclusion The price momentum effect has been shown to exist for more than 25 years. We believe that behavioural finance (e.g. anchoring and recency effects) provides useful insights and potential explanations as to its existence. We are convinced that being aware of those anomalies and their nature can serve as a useful source of generating alpha. Although it has been more common to exploit momentum in the form of systematic and quantitatively driven investment strategies, we believe that investment strategies that are driven by rigorous fundamental analysis, that seek to mitigate and exploit behavioural biases through portfolio construction and strict trading discipline can provide strong risk adjusted performance from a pool of high quality companies that are attractively valued.

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