Animal Spirits Podcast - Talk Your Book: Value + Momentum: The Best of Both Factors

Starting point is 00:00:00 Today's Animal Spirits Talk Your Book is brought to you by Victory Capital. Go to VcM.com to learn more about their victory shares momentum suite of products. That's VcM.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Redholz wealth management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Britholt's wealth management may maintain positions in the securities discussed in this podcast.

Starting point is 00:00:42 Welcome to Animal Spirits with Michael and Ben. Michael, Eugene Fama, Mr. Efficient Market Hypothesis man himself, creator of the three-factor model. He says, what do you think is the most, the world's best factor? How did you say it? I can't remember the exact quote. Oh, yeah. Maybe the most robust factor. I can't remember.

Starting point is 00:01:03 Anyway, he said it's momentum, which is interesting. And Cliff Asden says that great story where he said he wanted to do his thesis paper on momentum stocks, and Fama didn't really say, you know, if it's in the data, it's in the data. And it is interesting. You bring up the point on this episode that just there's not a lot of money. And I think, I'm guessing M-T-U-M is the biggest momentum fund that exists. I was just looking. It's not even that big.

Starting point is 00:01:28 relatively speaking. It's like less than $20 billion. Yeah, $19 billion. So there's way more money. So MTFUM is probably the biggest momentum fund, unless someone wants to correct me. It's about $19 billion. The Vanguard value index fund, VTV, has $150 billion. So momentum is not even close in terms of. Now some people would say, well, if you own an index fund that's kind of like momentum. No. The quant people would say absolutely not. The index fund people like me would say it's kind of momentum. No, it's not. It's like long term momentum. fine. It's not the quant version of momentum that looks at the previous six, nine, 12 months,

Starting point is 00:02:02 or whatever. So on today's show, we talked to Lance Humphrey. Lance is a head of portfolio management with victory shares and victory capital. And they have a whole suite of momentum products, but they also have a value component to them. So it's value and momentum, which is interesting. It looks at both of these. And it's kind of a composite thing, and he explains the whole thing. But I think it's an apt conversation to have to understand how the quantitative side of momentum works and not just like the chasing performance. I think some people assume that the recency chasing performance is momentum. They're actually systematic ways to do it. So we get into that today. So here's our talk with Lance Humphrey from Victor Capital.

Starting point is 00:02:44 Lance, welcome to the show. Michael Ben, great to be here. Momentum is having a moment. Ben and I spoke about an animal spirits last week. There's a chart floating around from Deutsche Bank showing stocks with the most net call volume and the most shorted stocks. And they're both like going vertical. There is a lot of momentum in the markets today, a lot of momentum chasing. But momentum is not new. It's a factor that was discovered a long, long time ago. It's a very simple idea that stocks in motion stay in motion. So how do you all at Victory Capital implement momentum into your strategies? Well, Michael, I think you bring up a good point with momentum them today and really one of the challenges. As you mentioned, there's a lot of research that shows

Starting point is 00:03:28 that momentum has been a very effective factor over time for the reasons you quoted. We see that a lot of times investors see what's working and they want to continue to follow that or continue to chase that. Guilty. But one thing that we see is that in your exact example, and today, where is the momentum in the market? It's in the AI names. Oftentimes the valuations are off the charts. So one of the challenges that we've seen with momentum by itself historically is that it can lead to catastrophic crashes, where you might have stocks that are trading at two, three hundred times PEs, but they have good momentum. What we try to do at Victory and with these products in particular is somewhat balance that out, where instead of simply looking at the stocks that have

Starting point is 00:04:13 just the sky high momentum, trying to incorporate some element of valuation with that as well. So perhaps stocks that are trending higher and doing well, but the valuations are also reasonably or perhaps even good. But you bring up a great point in today's market where we think that approach is even more important because we're seeing such a dichotomy between what is a value stock and what is a momentum stock. They're very different today for the reasons you mentioned. So there are a lot of different ways to think through this and build this.

Starting point is 00:04:43 So especially when you're building a composite like this, you could first screen by value stocks. You could first screen by momentum stocks. You could rank them by scores. Like, how do you think about that? Because I think a lot of investors would be surprised to know how many different variations there could be on this. Exactly right, Ben. I mean, there's different ways to combine the portfolios, to construct the portfolios. Maybe the easiest example I'll use, I'll do a throwback basketball analogy. And let's go back to middle school for a minute. And let's assume, you know, we're building a basketball team. We're on the court and we have the captain that drafting their teams. If you don't know anything about the players, a couple things you might look

Starting point is 00:05:21 for is who's the tallest kid or who's the fastest kid. Those tend to be good attributes or good factors of a good basketball player. That's why I was always drafted last in the pick. But much like factors, you know, what happens is sometimes the tallest might be kind of slow or the fastest might be kind of short. So if we simply use those attributes, we're going to to build an NBA team full of Yao Ming and Mugsy Bokes. Shout out to 90s NBA fans. Instead, what we want to do is we want to find the Michael Jordans and Kobe Bryant, the ones that are pretty tall, pretty fast, that share attributes of both.

Starting point is 00:06:02 What about the Manichinobleys? Well, hey, shout out San Antonio. Victor Womeniomuth. He's very tall, decently fast as well. So that's what we're looking for when we're trying to combine value momentum is we want to find stocks that share characteristics of both. Going back to the example you brought up at the beginning, Michael, that today the AI stocks and the stocks with the greatest momentum are very expensive and the stocks that have the best valuations really aren't going anywhere. So we think it's important

Starting point is 00:06:34 to bring both of those together simultaneously as opposed to focusing on them separately. Lance, before we dive into the strategies and what you're actually measuring, why do you think there's such a acceptance of value over momentum. Value strategies, I'm guessing the assets are 40 to 1. I don't know what the numbers are. And maybe, I don't know if irony is the right word, but like value has got entranced by momentum. And it still seems to be the preferred factor. Right. I think it's a great question. I think it's because value tends to be more intuitive, regardless of where you were educated, where you were trained. We all think about getting a good deal. If we're shopping on Amazon, we're going to look for something that is 50% off instead

Starting point is 00:07:22 a full price. So I think just naturally, we're all hardwired to try to find a bargain. We're not necessarily hardwired to try to find something that has done well in the past. Even your first day of learning how to invest, someone's going to tell you, we want to buy low, sell high. The worst advice ever. Oh, my God. They don't tell you buy high and buy a higher. And that's why, again, I think that these products can make sense because we are trying to incorporate both of those. To your point, value has had an incredibly disappointing 15 years. And we've looked at this a lot. Why has value done so poorly?

Starting point is 00:07:59 And a lot of it is because the companies that are defined as value and value alone, I've had very little growth prospects. They've had very few catalyst in terms of their ability to kind of break out of that low valuation. And so even across multiple products that we have at Victory Capital, you'll find this theme that resonates through where instead of just focusing on maybe call it the level one tribute, in this case, value it. How do we gain the, call it the positive benefits of value investing, but perhaps try to back away from some of the things that have caused it to lag in the past? You know what else? It's hard to explain. It's hard to raise money by saying to investors, we buy the stocks that have gotten out the most in the last nine months. adjusted for volatility. It's like, wait, what? It's much easier to say we're finding bargains.

Starting point is 00:08:52 That's it. That's it. I think that we've, again, we've all been trained in that mantra in multiple parts of life, not just investing. And, you know, we get questions a lot. Well, why does momentum work if we all kind of know about it? And I would argue exactly what you said, Michael, that it's not intuitive. And a lot of people are sometimes worried to buy a stock that has done well. We get the question a lot, well, should I buy the stock? Did I miss it? It's gone up 40, 50% over the past six months that I missed. And what we find historically is that oftentimes that brand that's in motion can stay in motion for some time. That's why we like to use both of those. So is your process essentially, listen, whatever your value composite screen is, because there's a lot of different ways

Starting point is 00:09:37 to figure out what valuation is, do you look for those low-valued stocks, but then say, okay, we're only going to buy the ones that are in an uptrend? Like, how does that process work? So we're wading both of those equally. So the way I would phrase that would be, we equally like a stock that perhaps is very cheap or very attractively valued in showing call it decent signs of momentum. Conversely, though, we can like a stock that has very good signs of momentum, and it's pretty good on value. Said another way, the order doesn't necessarily matter. It doesn't have to be cheap and then momentum.

Starting point is 00:10:14 It could be high momentum and pretty good valuation. So what we're doing is we're simply averaging those two scores independently of a value score and then a momentum score. So there's a few different ways that you could get into a portfolio, but most importantly is you must be sharing some sort of decent characteristics on both attributes. What happens if there is a real bare market that lasts longer than a cup of coffee? I guess maybe where were you guys and what were you guys invested in towards the latter half of 2022? In these types of products, we score all of the stocks, sector neutral.

Starting point is 00:10:52 And so what that means is it avoids moving into one area. of the market, which we do see sometimes in momentum strategies where going back to 2022, if we look at, let's say September, that was, of course, after the market had come back a strong degree. Many stocks were down 40, 50, 60 percent. Well, momentum ended to be focusing on consumer staples and utilities and stocks that were safe because they were down less. So we saw a lot of momentum-based strategies move into that area, kind of call it sector-wide. And then, of course, we saw a strong rebound in 23, and you saw a little bit of a whipsaw effect. To answer your question, in this product, do we tend to not group in one given sector or one

Starting point is 00:11:37 given style because we're evaluating the different securities within their own sector? So we don't find that it kind of all of a sudden moves all the way to AI or all the way to staples or all the way to financials. So we're rebalancing on a quarterly basis. And each time we're simply looking for the stocks that have that stronger momentum, that stronger value within their own sector. And you have this whole suite of momentum, so it's the Victory Shares Value Momentum suite.

Starting point is 00:12:05 There's four funds, I think. Is it just large-cap, small-cap, mid-cap, equal weight? Is that the-it's four different, we'll call them regional variance. So we have U.S. large-cap, U.S. small and mid-together, international developed, and then emerging markets. Okay. And one of the things Michael and I have talked a lot about annual spirits, is that some of the factors that people think are dead in the U.S. like value are still working

Starting point is 00:12:31 really well overseas. So how do you see the differences between momentum and value interacting with, you know, it seems like large-cap U.S. stocks are kind of in their own galaxy at this point. But do you see different characteristics based on the geography? Generally speaking, we find that the factors are somewhat correlated among regions, meaning in most cases, if values working internationally, it's usually working in the U.S., usually working in small cap, that's not always the case. And you highlight exactly what we're seeing this year as well, which in international markets, both value and momentum are working well, which we'll probably talk about in the conversation,

Starting point is 00:13:09 those tend to be somewhat negatively correlated. But international is a rare example where value and momentum are working well, which then when you pair the two together, you do get somewhat of a leverage effect where it even works better than either of the ones separately. But I do agree the U.S., particularly a large cap, is in a world of its own, really, and I think it's because of, and you guys have talked about this a lot, the MAG 7 is really distorting the U.S. market. And I don't necessarily mean that that those stocks are good or bad, but when those stocks comprise of over 30%, they're pretty good. They're very high quality. There's a lot of good attributes of those stocks. Well, when they make up

Starting point is 00:13:46 over 30% of the market. Well, it's really kind of those seven stocks versus everything else. So it creates some distortions when we make those cross, call it region comparisons. But bottom mind, we generally see that they work in similar ways across regions, but there are times where they don't. And again, this year is a perfect example where value is continuing to struggle in the U.S. market, but doing very well in overseas markets. The way that investors think about value has changed a lot over the years. How much does the inputs matter to the performance, whether you're measuring on EBITDA, book value, cash flow? How do you all think about that and how do you measure value? So in this particular product, it's really about trying to find companies that are generally

Starting point is 00:14:39 attractively valued. And to your point, Michael, there's, you know, if you go year by year, decade by decade. There's always going to be one factor that was the best, one that was the worst, and oftentimes those kind of moved back and forth. It's very noisy. Very noisy. Our idea here is we simply want to bring together a, call it, composite of value metrics to try to help us get closer to, is this company cheap or is it not? The way we do it in these products is by focusing on three different metrics. I don't necessarily think these three are the magic metrics by any means. But what we do is we do take one metric from each primary financial statement. So we have a balance sheet metric, a cash flow metric, and an income statement metric in the way we use

Starting point is 00:15:22 price to book. We use an enterprise to cash flow. And then we also use a price to earnings. So again, I'm not suggesting those are the best three. But we think that when you average those to me together, we're going to get a general understanding of is this company deeper than average, or is it more expensive than average? So I'm curious if you have any other rules in place. And I think one of the things that people don't appreciate about creating a portfolio is it's not just about like the security selection. There's other portfolio management things you have to do. You have to position sizing and you have to figure out if there's sector controls and maybe volatility waiting. So what other what other rules do you implement on the

Starting point is 00:15:57 portfolio? Like what other guidelines do you have? There's a couple of things that I like to think about. And this is how I evaluate products when I'm considering them for our portfolios. A couple things I look at, number one is concentration, and number two is construction. We'll call that weighting. I'll start with concentration where, you know, even in kind of, we'll call it in our nerdy quant factor world, there's this idea of factor purity and how much factor exposure do you have. And one opinion that I have, particularly in the case of value and momentum, is there's somewhat an element of what's called a credit score, right, where there's a really big difference between a credit score of 600 and 700. There's not as big of a difference between 700 and 800.

Starting point is 00:16:39 If you're 750, if you're 800, you're probably going to be getting the prime rate. If you're at 600, lenders are going to kind of back off, meaning there becomes a level where you're good. And if you're exceptional or just above average, it's pretty similar. I bring that up because we want to weigh the factor purity or our factor exposure with diversification. So in an extreme example, if I wanted to have the, call it cheapest portfolio, or the portfolio with the most exposure to value, well, we'd just buy the single cheapest stock. And I would definitionally have the most value. But of course, at that extreme, we would never do that.

Starting point is 00:17:18 So in our case, we want to make sure that we're providing exposure to the value momentum factor, but doing so in a diversified way. So in our case, we take the top 25% of the starting universe, which we feel gives us potent exposure to what we're looking to achieve, but we also achieve diversification within the portfolio. The second piece, and I think this is probably the most overlooked element of most what's called non-cap-weighted ETS, which would be the weighting. I see all sorts of weighting schemes and different products.

Starting point is 00:17:51 And so we thought a lot about that in this particular product. Much like my last example, once we've selected the stocks we want to invest in, and again, in our case, here it's the top 25%. I don't necessarily want to preference the first stock over the 50th stock, going back to the credit score example. They're all attractive in terms of their value momentum characteristics. So we simply want each name to have an equal contribution to the portfolio. Now, the initial thought would be, well, if you want to have an equal contribution in the portfolio,

Starting point is 00:18:24 equal weight them. The issue with equal weighting would be that it does not account for the volatility of a stock. So let's say the three of us were going to build a portfolio together. I don't know if the viewers would want to do that, but let's say we did. I want to say that Michael picked a high-flying crypto-based stock. And then Ben, you wanted to be a little bit more conservative, and you picked a consumer staple that makes soap, let's say. And then let's say I pick one of the Mac's seven, right?

Starting point is 00:18:52 Well, one thing that we would never do is say in our hypothetical portfolio, I'll take 90% of the portfolio you guys can split up the other 10, simply because my stock is 10 times bigger than yours. That would be market cap weighting. We wouldn't naturally do that. What we might naturally do is equaluate the three names that we selected. The issue would be, well, Ben, you picked the safe consumer staple as very little volatility. And then, Michael, you picked the volatile crypto stock. What's going to happen is that crypto stock is going to drive the portfolio day to day. It's going to be the risk driver of the portfolio. How would we correct for that? Well, maybe we take a little bit of weight away from Mike.

Starting point is 00:19:30 stock, we add a little bit of weight to your stock bin. Now we have an equal risk contribution to the portfolio. That's what we do in this particular speed of products is once we've selected the stocks that we deem to be attractive or the index has selected the stocks that are attractive, we then weight them based off of their risk in order to create an equal risk contribution across the securities. We spent some time on value and how you define it. What about momentum? I know similarly there's no magical number. You know, you basically get to the same place, but you got to have something. So how do you guys do it? What the research would show is you don't want to be too short in terms of, let's say, one month. We find that oftentimes stocks have been

Starting point is 00:20:13 really well recently tend to give some back. You also don't want to go too long, let's say four or five years. You kind of want to focus in that intermediate term range. Where that lands for us as we focus on six and 12-month momentum. Those are probably the two most, call it researched and standard factors in terms of defining momentum. Something that we think is important, just like we mentioned on value,

Starting point is 00:20:34 is we tend to not want to rely on one specific metric. So in our case, we average the six-and-12-month together, which helps just smooth out that number and give us a general sense of how the momentum is trending. One thing that we do and other products do in the market as well as we make a volatility adjustment for that number as well. The easiest way to describe that would be give two stocks that are up 40% over the last year. One was flat until last week and then rose 40% in one week compared to one that gently

Starting point is 00:21:05 trended higher. You generally would prefer the one that had a more gentle trend as opposed to kind of all at once. So we make a slight volatility adjustment to those six-and-month momentum metrics when selecting those securities. Based on the way you've described it, obviously, I assume this is a rules-based portfolio. you're not going and tinkering and making any changes on the fly? Absolutely.

Starting point is 00:21:26 So this product is a systematic rules-based product that does follow an underlying index. We worked with our index provider in identifying and building the rules that the product follows. But you're exactly right. Then my personal opinion of a security is not going to make it into the portfolio. So we are following a systematic index-based approach. But the one thing that I will mention is that does not mean that the index has to stay static forever. let's say that myself, my team, the index partners that we work with, identify what we feel to be perhaps a better way or perhaps a way to augment our value factor. We have the ability to make

Starting point is 00:22:05 those changes in the index, but those would be communicated and identified in advance within the methodology document. So bottom line, it's a systematic process that we follow, but we do have the ability to continuously research and innovate on the index itself. So how do you, how do you balance the need for wanting to have some level of concentration to really get the best out of these factors, but also have enough diversification. How do you pick the sweet spot for a number of securities? You know, a lot of what we've talked about today has been numbers and research oriented. I would say this is definitely more art compared to science. I don't know that there is a right number on should you be taking 20 stocks, 50 stocks, or 500. I don't know that there is a

Starting point is 00:22:47 specific right answer. So what we try to do is find what we feel as a sweet spot. which is that, call it 25% range, which is what we invest in here. Again, the results when we look historically would be pretty similar if we did 20 or if we did 30. It's really trying to find, how do we reduce the single stock risk that you would get as you get more concentrated relative to the dilution you would get as you take on more and more names? So like I said, I don't know that there is an exact correct.

Starting point is 00:23:22 answer, but for us, we feel that that 25% is that sweet spot between diversification and the factor exposure that you're seeking. I think there's one more thing to mention about momentum that maybe is counterintuitive to some people. And I think a lot of people assume in the last 10 years that momentum is the same thing as growth, right? And momentum stocks are just all growth stocks. And I think one of the cool things about momentum as a factor is that it's a chameleon. It can change its stripes. And if there's a downturn of low volatility stocks, are doing well, momentum will pick those up, right? If it's consumer staples or whatever dividend stocks, whatever it may be values, it could be, you know, you could be doubling up on value here

Starting point is 00:24:00 and it's all the value stocks that are working. So I just thought you could maybe talk about that because I think some people who aren't familiar with it, and Michael mentioned not as many people invest in momentum as value might not understand how this strategy can kind of change its stripes of different sectors and types of stocks. That's a great question, Ben. And I think it really hits at the heart of this product. You're exactly right that sometimes, and today being one of them, momentum and growth happened to be one and the same. But that's not always the case. And it's really important to understand that fact. Again, if we think about, let's just take the Russell 1000 value and the Russell 1,000 growth, those almost definitionally

Starting point is 00:24:39 are opposites of one another. If you bought 50% value and 50% growth, you just own the Russell 1000. Your core, you've completely cancelled out the exposures. But you bring up a really important point that momentum is not necessarily growth. And there's times where the momentum is in value stocks. That's what's happening in international, which we talked about before, where we're seeing this value momentum combination do really well in international because it is value that has the momentum. There's somewhat of a leverage effect where when you own them both, when they're working well, you're going to be able to invest more into that. So value momentum tend to be negatively correlated, which is why they're such an effective pair. But there are these times historically where

Starting point is 00:25:22 momentum can move. And again, it can become value. It can become low of all. It can become smaller size. It really is that swing factor that allows the portfolio to move to different areas of the market. And that's why I personally think that it can be a more effective approach than simply pairing value and growth, which is probably the most common way we see, most advisors and allocators investing their assets. Can you talk about what happens when companies come out of the portfolio? Is it because the, I'm assuming because momentum wanes, but does that mean that you're always selling low? Like, how does that work? So it can come out of one of two reasons, really, it could come out that the momentum is waning. It could also come out because the valuation has

Starting point is 00:26:05 become more expensive. So again, we're putting an average score on those two things. But to your point, Michael, the momentum tends to be what's called the faster moving signal of the two. Companies that are cheap usually aren't becoming cheap, expensive, and vice versa, quarter by quarter. It usually is the momentum that is changing. So we find that a lot of the turnover occurs because, let's say, we had invested in a stock that had attractive value and good momentum and the trends start to weaken. That's one that could be removed from the portfolio. But it definitely can happen that we own a stock that performed really well and its valuation became more expensive and it was removed from the portfolio. One thing I'll mention on the turnover, which we do get asked

Starting point is 00:26:51 a lot because momentum tends to be a little bit more of a higher turnover factor than value. We also have buffers on the indexes that these strategies follow. And what I mean by that, I've mentioned before, we target the top 25% of stocks in a given universe. But let's say we buy a stock that was in the 24th percentile, so it barely made it in. And then at the next quarter, the index evaluates that it's the 26th percentile. Well, we don't necessarily need to sell that stock to replace it. It's very close to being right within our cutoff. So what we do is the index will continue to hold a stock that was in the portfolio all the way down to the 50th percentile, meaning that allows us to slow down that turnover somewhat, and we will preference

Starting point is 00:27:36 to stock that we hold. Again, it allows us to just lower the turnover of the overall strategy. Lance, where does a strategy like this fit in a portfolio? Is this simply core satellite where, all right, I've got 20% of my portfolio in US large cap and let me peel off a couple percent for this? We see it used in both use cases. My personal opinion is that it is more of a core holding within a portfolio. Again, going back to the reasons that we mentioned. When I think about the various factors that we have at our disposal in a portfolio, I preference value and momentum. Those are two factors that I don't want to avoid. I want to have them in the portfolio all the time. So I think about value and momentum more as a core holding

Starting point is 00:28:17 within a portfolio. That being said, we find a lot of advisors who like to have a heavy portion of their portfolio and passive market capulated type products. And they'll utilize this as a satellite to that. We see both use cases. I personally see it as a core holding, given the fact that it's holding two factors that we think work well over time that provide correlation benefits to one another. Okay. If people want to learn more, where do we send them? So they can go look at vcm.com where they can view our fact sheets, our prospectuses on the products that we talked about. Our phone number will also be listed there if they'd like to call to learn more from any of our product specialists. Perfect. Thank you very much, Lance.

Starting point is 00:28:57 Thank you. Okay, thank you to Lance. Remember, check out Vcm.com to learn more about their whole suite of value and momentum products. Email us, Animal Spirits, at the compound news.com.

Animal Spirits Podcast - Talk Your Book: Value + Momentum: The Best of Both Factors

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