Following the Father of Momentum Investing

This week, we cover the stock screening strategy influenced by the late Richard Driehaus and give you a list of stocks that currently pass our revised screen based on the approach. The Driehaus strategy involves identifying and buying stocks in a strong upward price move and staying with them as long as the upward price movement continues.

The AAII Driehaus Revised screen has seen success, returning 18.7% annually since inception in 1997 while the S&P 500 index has returned 6.3% annually over the same period.

Driehaus: A Pioneer of Momentum Investing

Envision a snowball rolling down a hill: As it rolls along, it picks up more snow, which causes it to move faster, which causes it to pick up even more snow and move even faster.

That’s the basic strategy behind momentum investing — purchasing stocks that are rapidly rising in price in the belief that the rising price will attract other investors, who will drive up the price even more.

Richard Driehaus was one of the champions of momentum investing, favoring companies that are exhibiting strong growth in earnings and stock price. He is not a household name, but the firm he founded, Driehaus Capital Management in Chicago, rates as one of the top small- to mid-cap money managers. His success landed him a spot-on Barron’s All-Century Team in 2000 — a group of 25 fund managers that includes such investment luminaries as Peter Lynch and John Templeton.

This article focuses on Driehaus’ momentum strategy, which is discussed in the book “Investment Gurus” by Peter J. Tanous (New York Institute of Finance, 1997), and serves as the basis for this article.

The Momentum Approach

Driehaus emphasized a disciplined approach that focuses on small- to mid-cap companies with strong, sustained earnings growth that have had “significant” earnings surprises. If a company’s earnings are slipping, it is eliminated. Ideally, you would like to see improving earnings growth rates.

Driehaus used positive earnings surprises as a “catalyst.” An earnings surprise takes place when a company announces earnings different from what has been estimated by analysts for that period. When the actual earnings are above the consensus estimates, this is a positive earnings surprise; a negative earnings surprise occurs when announced earnings are below consensus estimates. Another factor is the range of earnings estimates — a surprise for a company with a narrower range of estimates tends to have a greater impact than a surprise for a company whose estimates have a greater dispersion. In general, positive earnings surprises tend to have a positive impact on stock prices.

Another key to momentum investing is to recognize when the momentum is beginning to fade, when sellers begin to outnumber buyers. Thus, investors need to closely monitor the company itself, as well as the market, and it therefore is a strategy that makes sense only for those willing to keep their fingers constantly on the pulse of the stock.

Driehaus cautioned investors to be mindful of events such as earnings announcement or warnings and earnings estimate revisions — anything that could either signal the slowing of the upward trend or propel the price even higher. In addition, investors should gauge the direction of both the industry in which the company operates as well as the broader market environment, both of which could affect the individual holdings.

Earnings Growth Screens

The heart of the Driehaus method is to identify those companies with improving earnings growth rates. To find those stocks that are exhibiting sustained or increasing growth rates in earnings per share, the screen first filters for stocks whose year-to-year earnings growth rate is increasing. The screen examines the growth rates in earnings from continuing operations from year 4 to year 3, year 3 to year 2, year 2 to year 1 and from year 1 to the trailing 12 months and also requires an earnings growth rate increase each period over the rate that preceded it.

There is a balancing act when comparing year-over-year earnings growth. You want to use enough periods to try to capture a trend but don’t want to use too many where the rest of the market has realized the trend and bid up the stock price.

Another filter stipulates that, at a minimum, a company has experienced positive earnings over the trailing 12 months. Many of the companies that pass the earnings growth rate screen are not yet profitable — they do not necessarily have positive earnings.

One last point to keep in mind about earnings growth concerns the base earnings level used to calculate earnings growth. For instance, two companies with 100% growth in earnings from year 2 to year 1 would be considered on an equal footing at first glance. However, upon closer examination it turns out that Company A’s earnings have gone from $0.01 to $0.02, while Company B’s earnings have risen from $0.50 to $1.00 — telling a much different story. Therefore, when you see an extremely high growth rate for a company, you may wish to check where the company started. Growth rates are very helpful in identifying interesting stocks, but you should look at the underlying figures to gauge the true significance of these changes.

Earnings Surprises

After identifying companies with accelerating annual and quarterly earnings growth, the next step in the AAII Driehaus Revised momentum strategy is to look for companies most likely to continue that trend in earnings growth. One event Driehaus suggested seeking is a “significant” positive earnings surprise, where the company’s reported earnings exceed the consensus estimate.

Earnings estimates are based on expectations of the future performance of a company; surprises signal that the market may have underestimated the company’s future prospects in its forecast.

Driehaus did not quantify what he considered to be a “significant” earnings surprise. However, studies show that analysts tend to be pessimistic when it comes to their quarterly earnings estimates. Therefore, it is more likely that a company will report a positive earnings surprise than fall short of consensus estimates.

The AAII Driehaus Revised strategy requires that the latest reported earnings for a company must have exceeded the consensus estimate by at least 5%.

Price Momentum

Like most investors, Driehaus remains invested in a stock until he sees a change in the overall market, in the sector, or in the individual company. If he believes that trend will continue, he has no qualms with buying a stock that has already seen a rapid rise in price.

Aside from strong, sustained earnings growth and positive earnings surprises, there are several other characteristics that Driehaus looks for to identify stocks that will continue their upward trend. These characteristics primarily concern momentum.

The first momentum screen looks for those companies whose stock price has experienced a positive increase over the last four weeks; the larger the required price increase, the stricter the momentum screen.

The second momentum screen focuses on relative strength. Relative strength communicates how well a stock has performed compared to some benchmark — usually a market or industry index — over a given period. A positive relative strength means that the stock or industry outperformed the S&P 500 for the period, while a negative relative strength means it underperformed the S&P 500 for the period.

The relative strength screens here provide two measures — the firm relative to the S&P 500 and the company’s industry relative to the S&P 500.

The first relative strength screen seeks companies that over the past 26 weeks have had stock performance better than that of the S&P 500. The 26-week time period allows for patterns to develop for both the industry and the company. Shorter time periods tend to produce false signals, while longer time periods may signal a trend that has already ended. The 26-week period provides a solid middle ground.

Small- and Mid-Cap Universe

One difficulty that can arise when attempting to invest in small-cap stocks is that they may lack liquidity, meaning that they have relatively low daily trading volume. This may not be an overriding concern for a buy-and-hold investor, but fast-paced momentum investors need sufficient volume and float (number of shares freely tradeable) to buy and, more importantly, to sell shares with ease.

Once again, the rules are subjective. A key factor is how many shares will be bought and sold during each trade; the more shares you will be buying and selling, the higher the daily volume that should be required. Buying 1,000 shares of a company that typically trades on volume of 10,000 shares a day will most likely be more difficult than buying 100 shares of that same company.

Our screen uses the percent rank function in AAII’s Stock Investor Pro, which breaks down the entire database in percentiles for a given data field. We required companies to have a daily trading volume that falls in the top 50% of the database.

The results of any type of momentum screen will mirror the current sentiment of the market — companies in the “hot” industries will be favored over less popular industries.

Summing It Up

The momentum approach to stock selection used by Richard Driehaus identifies companies that have strong sustained earnings growth, accompanied by earnings announcements that exceed analysts’ estimates and upward-moving prices. The approach seeks the “home run” that will provide above-normal returns. The key is to have a system in place that gets you out of a trade with only a minimal loss, while allowing the winners to run until the momentum dies.

By implementing a strategy built on discipline and careful examination of a company, its industry and the market, momentum may be on your side. However, remember that screening is just a first step. There are qualitative elements to examine that cannot be captured by a computer-generated list. Further fundamental analysis is necessary for successful investing.

Stocks Passing the Driehaus Revised Screen (Ranked by 4-Week Price Change)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

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