Momentum and Value Investing

24^th February 2006
The Malta Independent - Friday Wisdom

If you are investing in the quoted shares of our three main banks (HSBC, Bank of Valletta and Lombard), you have to be a momentum investor.

Momentum investing is the antithesis of value investing. Whereas value investors search for the intrinsic underlying value based on fundamentals and only invest where they see that the market price discounts such fundamental value, momentum investors do not care much about fundamental intrinsic value.

Instead, momentum investors base their investment decision almost exclusively on the psychology reigning in the market. If there is a momentum building round a particular share or a particular market sector – even if this creates serious and sometimes awesome gaps between the market price and the underlying intrinsic value which would make such investment totally inconsiderable for a value investor – the momentum investor joins the pack and simply assumes that market momentum will continue to push share price(s) forward.

History shows that money has been made under both investment philosophies. The difference is that while value investors may have to wait quite some time for the market to discover the value discount and thus produce the capital gains they desire only on a long term basis, momentum investors can generally reap their returns within a relatively short time.

The problem with momentum investing is that when the momentum peters out, as it unavoidably will once the price surge runs out of steam, there would be nothing left to support the wide gap between the market price and the intrinsic value and the value argument will have to come back into the equation. And just like a rocket that runs out of fuel it cannot keep hanging in the air; if it cannot surge forward it will have to fall back to a reasonable distance of the intrinsic value pulled by the investment value gravity.

There is nothing wrong in being a momentum investor, provided one knows what one is doing. Whoever chooses such an investment strategy must however realise that if it is too good to be true, then it is generally not true, and when the whole process would have run its course, there will be winners and losers – but the sum of the parts will be the same. Such investors have to make sure that they leave the party when the champagne is still flowing – as, the moment the champagne stops, there will only be tears for the road.

Managements of our banking sector ought to know better than all analysts that the prices of the shares of their organisations have gone out of all reasonable ranges and they have a moral duty to calm down the party before it finishes in tears. The following figures need no additional persuasion as they speak for themselves:(Table 1)

Table 1

                                         P/E                                  Price//Book                          Dividend

                                        Ratio                                  Ratio                                   Yield

Global Financial Sector    13.3                                     1.8                                     3.1%

HSBC Malta                      33.0                                     6.0                                     3.5%

Bank of Valletta                30.0                                      3.7                                    2.3%

Lombard Bank                   25.2                                     2.8                                     1.6%

Note; Global Financial Sector compares to 2006 estimates whilst Malta Banks compares latest 2005 result except for Lombard Bank which takes 2004 results as 2005 results not yet published. Ratios based on local share prices as at 20^th February 2006

        

The only ratio that is comparable is HSBC Malta dividend yield and only because HSBC Malta is not only distributing all generated profits, but is even distributing past reserves.

Consider now how equity prices of the main banks have been performing on the Malta Stock Exchange: (table 2)

 

Table 2

Share Price Movements

                                              2004                  2005            YTD                   Cumulative

                                                                                             2006                2004-YTD 2006

HSBC Malta                           46%                 100%             36%                        297%

Bank of Valletta                      83%                   65%             30%                       292%

Lombard Bank                        15%                  111%               7%                      160%

Note: above excludes dividend distributions and is based on equity prices closing 20^th February 2006

I would have thought that this stellar performance in share prices could have inspired prudence in dividend distribution policy and share splits and bonus issues, which in the current context is like putting out more alcohol at a party that has gone wild.

Such policies are encouraging momentum investing at the expense of value investing. In the interest of long-term orderly development of our financial markets, prudence should have prevailed over cheer-leading.

But prudence is also unknown to our political class – who is ever so ready to clutch at every shred of positive news to take credit for its performance in office.

The Prime Minister is repeating the gratuitous assertion that the performance of the banks in reporting record operating profit is indicative of resurgent economic growth.

This does not make economic sense to me, as it could well be that economic growth is in fact being suppressed by the oligopolistic profits being returned by the banking sector. This deserves a thesis on its own some other time.