“The trend is your friend” is a common saying in investing. That is until it isn’t. But if you can catch that tailwind and ride it, it’s exhilarating, maybe a little dangerous, and potentially even profitable. One way to invest with the trend is through momentum investing. The idea is to size up the market and capitalize on the opportunities as they’re happening. The advantage is that trends can happen in all types of markets, and in varying time-frames. So the approach can work for both short and long-term investors, no matter what the market environment.
JD Henning has made an art of momentum investing – traditionally a technical analysis approach – combined with forensic analysis – more of a fundamentals-based tactic. And to make things even more interesting, he throws some value into the mix. In this way, his investing style appeals to investors seeking short-term gains, as well as those willing to hold on for the long haul. Bridging technical and fundamental approaches isn’t easy, and requires superb intelligence, patience, open-mindedness, and intuition — all qualities JD brings to the table in his Marketplace service, Value & Momentum Breakouts. JD believes there are profits to be had in a variety of market scenarios – you just have to know where (and when) to look. If you’re curious about the kind of portfolios he tracks and their performance, you can read more about that here.
JD joins the Marketplace Roundtable to talk about his eclectic yet highly intellectual approach to investing; explain how his background as a fraud examiner helps to make him a better investor; and shares his current favorite idea, which came about in large part due to some very personal experiences.
Seeking Alpha: It seems you take a more academic approach to investing. How do you break it down, and what are the advantages of your approach over other styles of investing?
JD Henning, author of Value & Momentum Breakouts: I started actively trading 28 years ago, and in that time I’ve been influenced by many different methods and by people much smarter and more experienced than I am. I’ve learned some valuable insights from people who absolutely love market theory and dissecting the mystery of price behavior, but rarely if ever actively participate in trading. Still, others who have greatly influenced me have developed powerfully intuitive systems from years of trial and error in the daily grind of day trading. If my approach appears more academic, it may just be reflective of the value I have gained from examining other people’s experiences, studies, and intuitions as a researcher while trying to gain new ground in practical ways as an active trader.
One of the main advantages to my investing approach is that it leverages many lessons learned and a concerted effort to bridge the gap between academics and practitioners. So much of what I have learned in my own doctoral pursuits explained a great deal about my own trading habits and shed light on fascinating areas I had never previously considered. First, I think we are all students of the market who can never fully understand all the variability and randomness we encounter. Second, I think there is a vast amount of information available that can teach us many valuable lessons to improve our trading profitability and better manage the risks and uncertainty. I challenge my methods every day and stay current with the latest financial articles being published in my favorite areas of market and anomaly research.
SA: What is the value of looking at stocks through the momentum and forensic analysis lenses?
JH: I see momentum theory and forensic analysis as two credible and very different ways (among other methods) I use to identify value in an uncertain market. In the simplest terms, momentum represents a type of market consensus that appreciable value can be found in buying a stock that for a variety of reasons is attracting investors. In the case of negative momentum, investors are steadily capitulating on the belief of a firm’s ability to provide future value. Identifying and anticipating these different conditions of momentum serves as a valuable component of the research I conduct for my breakout articles using technical and behavioral characteristics. On the other hand, forensic analysis typically looks more at fundamental outliers and irregularities to understand whether any unusual financial values of a firm are beneficial or adverse to the stock’s expected future value. The more lenses I can apply to stock selections, the better my perspective of value becomes and often the better I can mitigate certain investment risks and improve my returns.
SA: Is the type of momentum investing you do a day trading strategy? How do you manage risk, or is that not as big a factor because you’re looking to capitalize on short-term movements in price?
JH: The type of momentum investing I write about in the breakout forecast articles is suitable for day trading, but certainly not intended only for day trades. Ideally, the best momentum selections will sustain positive returns over much longer periods. My personal investing relies on components of momentum and value, but I rarely use it for day trading. Managing risk in all my portfolios is important and I apply diversification, risk analysis, and as much due diligence as time allows. My practical applications of different financial anomalies from academic research are intended to capture the alpha that various researchers contend is present in their studies. Since alpha is the positive return in excess of expected risk-adjusted returns, the act of trading on well-documented market anomalies should be a risk management exercise in itself.
SA: Related to that, what sorts of time frames do you invest in normally, and why do you choose to focus on that?
JH: Normally my investment time frame is determined through a process of condition monitoring. I rarely set predetermined exit points or use fixed holding periods. I find that focusing on the same selection parameters that caused me to purchase an investment can provide me with the most effective signals I need to regularly decide to sell, hold or buy more. This recurring decision cycle gets made more frequently as any position I hold begins to increase in volatility or as any previous selection parameters get closer to breaking down.
SA: How does the “value” aspect of your approach come into play? Does it “balance” the momentum strategy?
JH: The value aspect came about as an additional offering for people who aren’t just looking for short-term breakout stock ideas. Long before I decided to publish 25 weeks of momentum selection tests here on Seeking Alpha, most of my investing experience was focused on selecting value stocks using fundamental analysis. I recognized as I first began publishing on Seeking Alpha that I should probably test the most volatile short-term segment of my momentum research study. That way people, including myself, could quickly judge the value of a segment of my research without being strung along for a year waiting for a meaningful result from a low beta value portfolio. In that respect, the additional monthly value selections serve to balance the momentum selections that I offer every week.
SA: It’s not always intuitive to bridge technical and fundamental approaches, as you mention that you do. How do you incorporate fundamentals as part of your analysis?
JH: I hold the view that different streams of financial theory can help explain market anomalies and should be applied with an open view toward whatever insights emerge. In my doctoral research, I bridged 24 technical, fundamental, and behavioral variables using multiple discriminant analysis to see which characteristics might best explain different conditions of stock price momentum. Without getting into more detail here, I found that in the short term, the fundamental characteristics were not as strong as the technical variables. So generally, the way I incorporate fundamental analysis is on a time-weighted method with less value in the short term and increasingly more value after a series of confirming quarterly reports. Several studies show there is also a significant decay in the impact that financial data has on the price of a security a year after an initial report.
SA: You talk about “anomalies” in stocks. How do you suss those out, and why, in your view, is it important to do so?
JH: There are thousands of market anomalies documented in the peer-reviewed financial literature. Some of these anomalies regularly yield alphas of 10% per year and researchers are constantly testing new asset pricing models and new variables to explain why these abnormal trading returns persist. Some of these anomalies have been explained by researchers and arbitraged away over the years by informed traders.
However, one anomaly, in particular, continues to defy a rational finance based explanation and has been the focus of many academic studies. Nobel Laureate Eugene Fama and Professor Kenneth French, in their 2008 seminal paper “Dissecting Anomalies,” concluded after testing many different market irregularities that “The premier anomaly is momentum.”
Naturally, this unleashed many more studies including my own dissertation to try to identify some of the key drivers behind price momentum and reversal event signals. One segment of this research I apply in selecting accelerating momentum stocks to see if I can outperform expected market returns and at the same time, validate key variables that may help explain this anomaly. All this is important to me because I’m fascinated by irregularities and especially interested in any market phenomena that regularly generate abnormal returns.
SA: What do you see happening in the broader markets in the next quarter and into next year?
JH: The macro picture of the market is an assortment of probabilities of different changes in tax policy, interest rate hikes, foreign policy risks, natural disasters, and more variables than I can possibly make sense of. I agree with many assessments that stock valuations are quite high and risks are increasing. However, since I’ve not found a way to predict the future I am just content to find opportunities for the short and long-term that satisfy my risk tolerance for returns in our uncertain market.
SA: You actively follow the LED sector. How has it changed over the past year, if at all? Do you see LED stocks as more of a long-term play? What about it appeals to you, and what opportunities are you seeing there?
JH: My interest in the LED sector originally stemmed from the conversion of my house to LED lighting for all the great long-term advantages it offers. I see adoption rates of LED bulbs accelerating as prices have become significantly more affordable in the last couple of years. However, the price wars have really begun to squeeze the margins for firms in that sector. Because of investments in that sector and my own curiosity, I took up an informal study using the fundamental analysis of ROE decomposition to see how operational efficiencies were affecting the share prices of firms. There has been a strong correlation between efficient management and price appreciation, but I’m not quite satisfied that ROE analysis is as valuable to investors as it is to the firms who can use it to fix their operational weaknesses.
SA: You have a background as a fraud examiner. Does that ever come into play in your investing, and if so, can you tell us a story about how it maybe influenced you to steer clear of a stock or created an opportunity most others would have missed?
JH: What I’ve learned as a fraud examiner always comes into play with my investing in one way or another. Even the basic principle of “whatever seems too good to be true, probably is” has saved me more times than I can count. I have found that when it comes to stocks there is always another “once in a lifetime opportunity” right around the corner. I avoid pressure calls for urgent decision-making, more often than not they are a strong warning signal, not a good invitation.
Related to that, I have found that when a stock can’t be sold using credible financials and figures, there’s always someone who will peddle you a story of why you should invest anyway. Always be skeptical and do your own due diligence. I don’t want to single out any particular firm, but you can hear it sometimes in the overly optimistic narratives that management will give in conference calls that are just not substantiated by key financial indicators.
Excluding any crazy outliers, I tend to trust verifiable numbers a lot more than what people decide to tell me. All of these factors have aided me many times in finding some excellent opportunities and avoiding a few more bad choices than I already make without the additional help.
SA: What’s one idea you’re excited about now, and what’s the story?
JH: If I have to select just one stock based on a good story, I would go with Clean Harbors, Inc (CLH). CLH is a $3.25 billion company with $2.86 billion in revenue that has more than 12,000 employees. They are making a significant impact with their cleanup efforts of the tragic trifecta of hurricanes Harvey, Irma, and Maria.
Clean Harbors is extremely well positioned with highly trained labor and a very diverse portfolio of disaster recovery services already active in the hardest hit areas around the Gulf of Mexico and Puerto Rico. As a former Coast Guard officer who has been impacted by at least five hurricanes over the years and most recently by over 50 inches of rain from hurricane Harvey, I can appreciate how long and difficult the recovery process can be. The struggle for so many hurricane victims goes on long after the emergency crews, rescue operations, and the media coverage have moved on. Recovering from these tragedies depends on the long-term service solutions for properly managing hazardous waste, chemical spills, dangerous debris removal, and other key services that companies like Clean Harbors capably deliver.
I see a lot of value in the dirty jobs that few people want to do, especially after one of the worst hurricane seasons we have ever experienced. So I have a small position in CLH and I plan to hold it for at least a year based on an excellent growth projection from the unprecedented workload that lies ahead. I would encourage others to do their own due diligence before taking a position.
Thanks to JD for talking with us on the Roundtable. You can more of his work on momentum and forensic investing on his author page, and if you’re interested in more detailed, actionable weekly value and momentum ideas, consider a subscription to Value & Momentum Breakouts. There’s still time to take advantage of the introductory offer of 20% off the annual price for the first year, available only to the first 30 subscribers during September. There are still a few spots left, so check it out.
Be sure to follow the SA Marketplace account above or below this article to keep up with all things Marketplace. We continue to build momentum in the last few months of the year, and you won’t want to miss out on the excitement.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: JD Henning is long CLH.