smallcases in focus: Momentum smallcases, Part 1

Momentum investing via smallcases

Between Jan ‘21 – Oct ‘21 Nifty surged by 26% due to the abatement of covid scare and a pick up in economic activity. There were feverish predictions of how quickly Nifty would reach the 20k or 25k mark. However, the Russia – Ukraine war and global supply chain issues caused inflation across the world to surge, forcing Central banks around the world to hike interest rates. Add to this fear of recession in the US. All this combined to pull the Nifty down by ~14% by mid-June ‘22. However, since then, a marginal drop in oil prices, as well as inflation, has contributed to market “momentum” and the Nifty has gained ~16%.

What is momentum and what is its connection with investing? 

In layman’s terms, momentum is the force gained by a moving object. Momentum investing uses this aspect of physics. It is the technique of buying/selling stocks based on the strength of recent stock market trends. It is based on the assumption that, if the price of a stock has enough momentum, it will continue to rise. Proponents of this type of investing argue that when the price of a stock starts moving up both traders and investors will take notice and buy into the stock further pushing up the price. While the usual refrain in the market is to “buy low and sell high”, momentum investing aims to “buy high and sell higher”. 

Windmill Capital’s multi-factor smallcases (where momentum is the major screening criteria) have also displayed improved performance in line with market trend.

Most momentum strategies have momentum characteristic as the only screening criteria. However a single factor, like momentum, tends to be cyclical in nature and will drag down the performance of the overall portfolio when the factor is out of favor. Hence it is important to combine different factors to achieve a smoother performance. Research suggests that different factors like growth, quality, value, momentum etc. have low correlation between each other and assists in reducing portfolio volatility as well. 

Keeping these aspects in mind, Windmill Capital created multi factor smallcases, Quality Smallcap – Smart Beta, Value & Momentum and Canslim-esque. The common feature of these smallcases is that they have momentum factor as the primary screening criteria. In addition, they also include other screening criteria that provide exposure to factors like quality, value and growth. Hence, these smallcases are “multi factor”, as they provide exposure to multiple factors.  

The below table indicates the additional factors that are used to screen companies in our multi factor smallcases:

Let’s take a look at the performance of these smallcase during bull and bear phases**:

During times of market crisis, stocks of good quality companies do not drop too much and help steady the portfolio. During bullish phases, momentum kicks in and helps the smallcase beat the broader market. These additional factors help weed out companies which might witness short term momentum but have major defects such as corporate governance, overleveraged balance sheet, dodgy accounting practices etc.