Father of ‘momentum investing’ shares tips for stock picking
“This is what I call ‘right brain’ investing. Where my intuition, or gut feeling, leads me to an investment decision different from that reached through traditional, analytical research or ‘left brain’ investing,” he said in a speech at DePaul University.
Although Driehaus was not as popular as the likes of Warren Buffett and George Soros, his performance as a fund manager was truly phenomenal and he was well respected in the investing circle.
His extraordinary success can be attributed to his expertise in “aggressive growth” style of investing, for which he is also known as the ‘father of momentum investing’. Driehaus identified and bought stocks when they are in a strong upward price movement and stayed with them as long as the upward move continued.
(Masters of the Markets: Read up other investing strategies and trading tips from market greats)
The basic concept of momentum investing is that short-term performance is repeated with winners continuing to be winners and losers continuing to be losers in the short run.
In his early days, he often distributed newspapers to earn money and bought his first shares with that money when he was only 13. Later Driehaus went on to earn a bachelor’s degree and an MBA from DePaul University, and in 2002, the university gave him an honorary doctorate.
Driehaus began his career in 1968 with AG Becker, where he worked in the Institutional Trading Department as a Research Analyst. He also worked at various other brokerage firms such as Mullaney, Wells & Co. and Jesup & Lamont before forming his company in 1982.
Driehaus founded Driehaus Capital Management in 1982, which now manages over $13.2 billion through its mutual funds and other accounts. It produced a compounded annual return in excess of 30% over 12 years. In 2000, Barron’s named Driehaus to its “all-century” team of 25 individuals it identified as most influential in the mutual fund industry.
Investment philosophy
Driehaus was of the view that investors’ expectations of a firm’s earnings growth was the main driver of its stock price. “Companies that have a record of strong and consistent earnings growth have been the most successful ones,” he said.
Driehaus said the key to extraordinary performance in the stock market is picking companies with the greatest earnings growth potential. He focused on picking smallcap stocks, instead of largecaps.
His approach for picking stocks was in sharp contrast to the more conservative approach that most investors used called ‘value investing’ whereby an investor tried to find undervalued stocks having relatively low valuations evident by their low P/E ratios.
“Such an approach of buying stocks only with average to below-average P/Es automatically eliminates many of the best performers,” he said.
Driehaus invested mainly based on fundamentals. But to improve his entries and exit timings and to confirm his stock selection, he considered technical analysis as a helpful tool.
Driehaus once shared his wisdom in a speech at DePaul University where he talked about what he had learnt over the years from the stock market and how he thinks investors can avoid the common pitfalls that lead them to mediocre performance.
- Stock prices heavily influenced by market dynamics: Driehaus says a stock’s price was rarely the same as the company’s value as he felt that the valuation process was flawed. He believes stock prices were heavily affected by market dynamics and by investors’ emotions which widely swung from pessimism to optimism.
Also, he felt many investors bought stocks with the intention of holding them for a long period of over 1 to 5 years based upon information that only was applicable to a short-term time horizon.
“While the information they are using to invest may be valuable, it is often the wrong information for their investment time-frame. If people invest in a company based on current information, they have to be prepared to make any changes in that information in a much shorter time frame than most investors are prepared to do,” he said.
- Don’t hold stocks for the sake of diversification: Driehaus says some sectors and industries were much greater beneficiaries of secular changes than others. He felt investors were best suited to concentrate on their investments.
He believed there was no point in holding stocks of companies in sectors and industries with poor current outlooks. He says if investors were only holding stocks of companies with poor current outlooks for diversification purposes only then they shouldn’t do so.
“Look for companies in favored sectors with strong market positions and improving outlooks. In doing so, you may be able to identify trends or secular changes earlier than the herd and “deal with what will become big while it is yet small.” Additionally, by selling stocks of companies with poor outlooks, one may be able to “take care of what is difficult while it is still easy”. he said.
- Adjust to new ideas: Driehaus says investment managers should constantly adjust to new concepts and ideas.
“Many investors find comfort with money managers who say they have rigid disciplines that they have adhered to consistently. Unfortunately, those managers may be making decisions without the full benefit of the rapidly changing technology that is available today,” he said.
Driehaus says investors needed to be willing to do things differently from most other investors. He felt many investment managers followed a set of investment paradigms, which lead them to mediocre results.
The legendary investor says there were some conventional wisdoms or investment paradigms worth avoiding as they were now almost outdated and were really no longer true. He says investors make the mistake of holding on to these beliefs and often search for clues to support them and reject information that conflict with the paradigm.
Let’s look at some of these paradigm he felt should be avoided by investors-
- Paradigm #1: Buy low and sell high
Investors can make much more money by buying high and selling at even higher prices than buying low and selling high. “I buy stocks that have already had good moves. That are making recent or long term new highs. Have positive relative strength and are in groups that demonstrate similar characteristics. These are stocks in demand by other investors,” he said.
He said there was obviously a risk of buying near the top in this strategy, but he believes investors should much rather be invested in a stock that is increasing in price and take the risk of it declining later, than to invest in a stock already in a decline and trying to guess when it will turn around.
- Paradigm #2: Buy stocks of only good companies… and hold on to them
Driehaus believed that just buying stocks of good companies and holding them may make investors lazy and they may not pay close daily attention to the stocks. Instead they should only hold onto stocks until there are unfavorable changes.
“Buy good stocks of good companies and hold onto them until there are unfavorable changes. Closely monitor daily events because this will provide the first clues to long term change,” he said.
- Paradigm #3: Don’t try to hit home runs. You make the most money by hitting a lot of singles.
Driehaus says investors can make the most money by hitting “home runs” and not by hitting a lot of singles, but they should also remain careful and disciplined of not striking out. “I cut my losses, and let my winners run. Perhaps that’s a paradigm, too, but it is one that works,” he said.
- Paradigm #4: A high turnover strategy is risky
Driehaus says most investors believe a high turnover strategy is risky. “I think just the opposite. High turnover reduces risk when it is the result of taking a series of small losses in order to avoid larger losses. I don’t hold on to stocks with deteriorating fundamentals or price patterns. For me, this kind of turnover makes sense. It reduces risk,” he said.
- Paradigm #5: An investment process needs to be very systematic
Driehaus felt many investors believe an investment process needs to be rigidly systematic but that shouldn’t be the case. “I believe a good process involves discipline, but must be flexible enough to respond to changing market conditions. Over the last several decades, I could think of many reasons why not to be in the market. But, instead, I stayed invested. Don’t invest because of what you think should be happening. Invest because of what is happening,” he said.
- Paradigm #6: You must have a value-based process
Many market experts often say that investors must follow a very systematic, value-based process and each stock should be submitted to some type of uniform evaluation. But the fact is the real world is not that precise and there is no universal valuation method that can guarantee good returns in such plans.
“In the short run, valuation is not the key factor. Each company’s stock price is unique to that company’s place in the market environment and to its own phase in its corporate development,” Driehaus said.
- Paradigm #7: You need to buy good Street research and have contact with the best analysts
Many market experts give sermons to investors on the need to buy good Street research and have contact with the best analysts. But Driehaus says news reports, company contacts and technical information were really the best sources of research. “This research combines many factors that directly affect the fortunes of companies. They deal with things like product development, patent awards and secular changes which can materially impact a company’s sales and earnings,” he said.
- Paradigm #8: The best measure of investment risk is the standard deviation of return
Driehaus says for many investors the best measure of investment risk is the standard deviation of return which is the volatility.
But he feels volatility is only a risk for short-term liquid assets and investors should rather focus on long-term objectives. “For many, if not most investors, their greatest long-term risk is the lack of sufficient exposure to high returning, more volatile assets. In my opinion, investment vehicles that provide the least short-term volatility often embody the greatest long-term risk,” he said.
- Paradigm #9: It’s Risky to place your money with a ‘Star System’ manager
Driehaus felt often experts tend highlight the fact that it’s risky to place money with a star system manager. “I disagree. In any industry, top performance is achieved by the star. Working with a diversified group of investment management stars is probably the safest way to invest,” he said.
These paradigms from Driehaus provide a different insight into market behaviour, which reveal that sometimes going against the conventional wisdom can lead to bring in investment opportunities.
Driehaus always felt it was important for investors to use both “right brain” and “left brain” in the decision-making process. “Always remember to keep that sense of awe with respect to the stock market. Remember the stock market is illogical and the only constant is change. Finally, remember that the “mind is like a parachute; it is only good when it is open,” he said.
- Develop your own trading philosophy
Driehaus believes successful investing requires a lot of hard work and dedication and for individual investors to succeed in the market they needed to develop their own trading philosophy which matched their personality. He believed this would more often require thorough research and commitment of time.
“A carefully crafted investing strategy will provide the confidence necessary to persevere with methodology during hard times. There are times when even the most successful strategies don’t seem to work well and traders who don’t have faith in what they are doing tend to get frustrated,” he said.
(Disclaimer: This article is based on speech of Richard Driehaus at DePaul University)
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