When to exit a momentum stock | Fin24

When to exit a momentum stock

Aug 28 2018 14:44
Simon Brown

Investing is all about strategy. 

At the top level there is an overarching strategy that guides all your selections. For example, my overarching strategy is very much focused on a global growing middle class. 

Driven by improving economic and political conditions, more people are moving up into the middle class and spending accordingly, hence driving the profits of companies in the consumer space.   

You will also see other sectors responding, as was the case with the commodity boom of the first decade of the 2000s, which was driven by demand (mostly from China) for infrastructure for the increasing middle class.  

But as you move down from your overarching strategy, you have to make more decisions as to how to structure your portfolio.  

Firstly, how much do you invest in exchange-traded funds (ETFs)? How much in large-cap, quality stocks, which you will hold for decades? How much in potentially small and mid-cap stocks? 

And how much into trading (if at all)? My portfolio is split 50%/30%/10%/10% into the categories as above.  

But there is another consideration you also need to keep in mind, and that is your style of investing. 

Are you going to focus on momentum or value as a key investment style? It does not have to be one or the other, but as always, you need to be clear on which style you are using when buying a particular stock – so that you are clear on when it is time to exit.  

Momentum is the theory that stocks that are soaring may be expensive on pretty much every valuation methodology, but can still go higher. Here it really is all about price.

A great example is Aspen. A quality stock, it breached R100 for the first time in early 2012, with a price-to-earnings ratio (P/E) of around 20 times – not expensive, but equally far from cheap.

Yet the stock kept on going and hit R200 in May 2013. At that stage, the P/E was almost 30 times – certainly expensive, but it was still going.

It traded at R300 in June 2014 with the P/E at an eye-watering 36 times. Still the stock continued higher, peaking at just above R400 in April 2015, with the P/E still at around 36 times.  

At many stages on the journey from R100 to R400 one may have been tempted to cash in and take the profits, based either on very high valuations or simply on the fact that the stock had flown higher and surely at some point had to return to more realistic price levels.  

This is exactly what Aspen did and it now trades (more than three years after that R400 high) at R260 and on a P/E of just over 17 times. It’s at the ‘cheapest’ level it has been in a decade.  

The trick is knowing when to exit momentum stocks, because holding on can seem insane, and valuations are certainly not the answer either. For me, exiting momentum really is about when the momentum starts to fade.

You will never get the top perfectly, but you will get out close enough to maximise profits.  

Broadly, there are two methods for exiting momentum.  

The first is simple: Exit when momentum starts to fade. Compare the stock’s move against its peers (sector or even index) and when it no longer hits the top decile of the list, start to reduce size or just exit entirely.  

A second method is a blunt trailing stop-loss using something like average true range (ATR) to indicate how much to trail the stop-loss by. 

Use a long ATR period – either weekly or, even better, monthly. The monthly ATR would have kept you in all the way from R100, exiting at around R365, and your online broker charts should have the ATR value for you to use.

This article originally appeared in the 30 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

momentum  |  stocks  |  invest