If you've ever forgotten to put on your parking brake on a steep hill, you know that objects in motion tend to stay in motion. The same is true with stocks — not just individual stocks, but broad sectors and investment styles, as well.
In recent months, of course, momentum has done the same thing to your portfolio as your car did to Mrs. Finster's chicken coop. Nevertheless, following a hot trend is not an entirely bad strategy, provided you're willing to take big hits in years such as 2008.
Market observers have long noted that hot stocks tend to stay hot for a reasonably long time. For example, consider McDonald's mcd, one of 17 stocks in the Standard & Poor's 500-stock index that have actually gained in the past 12 months. It's up 7.3%, including reinvested dividends.
True, it's been a choppy ride for McDonald's, but the stock has found favor on Wall Street. One reason could be that the company has actually increased its earnings. Mickey D's earned $1.07 a share in the third quarter of 2008, vs. 90 cents a share the same period a year earlier. And analysts expect the fast-food chain to earn $3.82 per share this year, vs. $3.62 in 2008.
Other reasons? It may be that more people on Wall Street are eating at McDonald's these days than the $400 tasting menu at Le Grande Bonus. It may be that McDonald's is improving its menu. Or it may be that those few buyers left in the stock market perceive McDonald's as a reasonably safe bet in rotten economic times.
Whatever the reason, McDonald's has some positive momentum, as do a few other stocks, such as Family Dollar Stores fdo (+72% the past 12 months), Wal-Mart wmt (+10%) and General Mills gis (+7%). What's more, these stocks have been plugging along for some time. Had you recognized the trend a few weeks or even a month late, you may have been able to catch some of the ride.
Similarly, good performance in mutual funds tends to persist. The No-Load Fund Investor, a newsletter, has been tracking its Persistence of Performance strategy since 1991. The premise is simple: Each year, invest in the no-load fund that has had the best performance in the previous year. ("No-load" means that the fund charges no commission, or load.)
The system has gained an average 18.8% a year since 1975, vs. 12.2% for the average no-load stock fund. This is remarkable, considering the system's obvious drawback: the possibility of investing in a hot fund just as it goes dead cold. And that's what happened last year, when the system's pick was CGM Focus. The fund, run by star manager G. Kenneth Heebner, soared 80% in 2007, but plunged 48% last year, vs. 38% for the average diversified no-load.
Nevertheless, the system has beaten the average no-load fund for 21 of the past 32 years. Its record since 1991 has been a bit spottier. The Persistence of Performance strategy has beaten the average no-load fund nine years out of 17, and gained an average 10.8% a year, vs. 8.7% for the average no-load.
This year's pick is Heartland Value Plus, says Mark Salzinger, editor of The No-Load Fund Investor. The fund looks for stocks whose prices are low, relative to earnings, as well as low debt and rising earnings. Should this snakebit market revive this year, it seems like a reasonable bet.
Salzinger's system rules out funds that keep big portions of the portfolio in cash when the manager gets worried. That would rule out Forester Value, the top-performing diversified stock fund last year. Manager Thomas Forester says the fund is now fully invested in stocks.
The core of the system is not so much a fund's manager as it is the investment style he or she follows. Investment styles often remain in favor on Wall Street for several years in a row. Growth investing, for example, was in favor throughout the 1990s. A growth manager looks for stocks of companies with rapid earnings growth. Since 2000, however, value investing has been the favorite.
Salzinger rules out sector funds for the system, because their hot streaks usually don't last as long as diversified funds'. And so far, at least, most of the funds that use a sector rotation system have produced disappointing returns.
Does it make any sense to invest in funds that are out of favor, rather than in favor? In most cases, no — for the same reasons. An investment style can remain in the doghouse for a long time. If you try following a fund in motion, however, do it with the money you use for speculation. Sometimes, momentum can take you straight downhill.
John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays. new book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. Click here for an index of Investing columns. His e-mail is firstname.lastname@example.org.