Last week, I posted about two ways to improve a momentum strategy by using value and quality to screen out dangerous momentum stocks. It so happens that lots of the momentum high-fliers from 2013 were concentrated in several key industries, like social media and biotechnology. This concentration begs the question, how much of the momentum effect comes from riding the hottest industries?

One of the more interesting elements of factor/quantitative investing is the industry effect. For any style/factor—like value or momentum—how much alpha is the result of just making industry bets? For example, any unconstrained value strategy over the past 50 years has been chronically underweight tech stocks (until very recently), and this underweight has been beneficial because tech has been one of the worst performing sectors. The ability to make industry bets—like the one against tech— can be a significant advantage even though it increases some traditional measures of risk like tracking error.

So what about momentum? Does the excess return from momentum investing come mostly from rotating between industries, or can you also benefit from buying stocks within each industry that have the best momentum relative to other companies in the same line of business.

For this analysis, I use two different definitions: industry group, and industry. There are 24 industry groups and 68 different industries (you can even get more specific to sub-industry, but in many cases there aren’t enough companies in each sub-industry for this type of analysis).

Here are the results (return and volatility), by decile since 1964, for 3-calculations of momentum: raw 6-Month return (which would allow you to rotate between industries freely), and 6-Month return relative to both industry group and industry. These second two calculations would result in a portfolio that was more spread out across industries and looked more similar to the overall market[i].

A few interesting points stand out. First, momentum works both within and across industries. This means that you can do well by using momentum to determine your industry allocations, but you can also do well by using momentum to select stocks in the industries that you like. Second, the unconstrained, raw version of momentum provides the best overall returns, but requires a bumpier ride. The annualized volatility is much higher than the industry relative calculation.

The chart below shows the rolling 3-year excess return for high momentum strategies. As you can see, momentum investing is quite cyclical, and returns can be painful for years at a time. The period following 2009, for example, was one of the worst factor inversions we’ve ever seen.

Bottom line, the flexibility to rotate more between industry groups and industries has added a significant amount of alpha over the long term. Of course, you pay for this alpha by having to endure higher volatility. Either way, the trend is your friend more often than not.

[i] Specifically, these are percentiles calculated within different groups. The percentiles which are relative to industry or industry group would result in portfolio with lower overall momentum, because you’d own some stocks that may not have great momentum compared to the market, but do have good momentum compared to other stocks in the same industry (think Telco stocks in 2013, or some other laggard).

Momentum investing worked very well in 2013, but it’s been awful in 2014. The momentum reversal has been one of the major headlines in an otherwise flat and quiet market year because the high-flying stocks from 2013, especially popular tech names like Tesla, have been crushed in recent months. Momentum investing works great over the long term but can suffer from short term reversals that are painful to live through. Luckily, there are ways to significantly improve the momentum trading strategy—which would have side-stepped the momentum carnage of 2014 completely.

Momentum Works On Its Own

Momentum investing is popular because it has worked well across market history. I’ll define momentum in simple terms: total return over the past 6 months. Since 1963, a strategy that buys the top group (best 10% of the market) of stocks by 6-month total return, has delivered a 14.4% annual return, which is roughly 4.5% better than the S&P 500. But, to earn this excess return you have to live through a roller coaster ride. The annualized volatility of this strategy is 24.4%—almost 10% more than the market’s 15% annual volatility.

The weakness of a raw momentum strategy is that it will sometimes piles you into very expensive and/or low quality stocks. At the end of 2013, companies in the top 10% of the market by trailing 6 month return (which included lots of social media stocks, biotechs, and power companies) had valuations which were, on average, more expensive than 67% of the market[i]. Some of the most talked about names like Plug Power and Twitter were literally the most expensive stocks in the market. The best way to mitigate this issue is by insisting on valuation and quality—if you never buy the expensive, junk stocks, then the momentum strategy gets much better.

Improving the Momentum Strategy with Value

You may think that value and momentum are polar opposites, but they work remarkably well together. Think of the combination as cheap stocks that the market is just beginning to notice. The combination of the two factors yields results more impressive than either of the two investing styles on their own. (Note: for value, I’ll use the simplest measure possible to make the point: price/earnings)

The cheapest 10% of stocks by P/E have historically delivered 16.3% per year, and the top momentum stocks have delivered 14.4%, but a combination of the two has yielded 18.5% per year (bottom right corner of the table below). What’s more, the volatility of this combined strategy comes way down: from 24.4% for raw momentum to 18.9% for value + momentum.

The table below breaks all stocks into a 5x5 panel by value and momentum (6m return and price/earnings). Stocks in the upper left have terrible value and terrible momentum. Stocks in the lower right have great momentum and great valuations. The combination of these concepts has been very powerful.

Quality Works Too

A second way to improve the momentum strategy is to focus on companies with higher quality earnings. The simplest way to define quality earnings is by looking at non-cash earnings. The fewer non-cash earnings (which come from accruals like accounts receivable), the better[ii]. Here is a similar 5x5 panel by quality and momentum. The effect is similar to value, but quality is a different factor and so a different take on qualifying the stocks you are willing to buy.

Don’t Fight the Tape, Unless...

Momentum investing works on its own—but there are ways to improve the strategy by following some trends and ignoring others. If you are trading momentum stocks, remember that the momentum effect has worked better amongst the cheapest and the highest quality names out there. If value was a part of your momentum strategy, you’d wouldn’t have owned any of the stocks making headlines for the wrong reasons so far in 2014.

Some people are buying the dip, but most of these stocks remain very expensive. Investing based on factors like momentum is like all other investing: diversification improves and smoothens your returns.

[i] Value based on a combined measure of p/sales, p/earnings, ebitda/ev, yield

[ii] Earnings Quality defined as percentage change in total accruals