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Copyright 1999, Association for Investment Management and Research. Reproduced and republished from "The Profitability of Momentum Strategies," from the November/December 1999 issue of the Financial Analysts Journal, with permission from the Association for Investment Management and Research. All Rights Reserved.

Copyright 1999, Association for Investment Management and Research. Reproduced and republished from "The Profitability of Momentum Strategies," from the November/December 1999 issue of the Financial Analysts Journal, with permission from the Association for Investment Management and Research. All Rights Reserved.

holds stocks that have accelerating earnings and sells (or short sells) stocks with disappointing earnings. The notion behind this strategy is that, ultimately, a company's share price will follow the direction of its earnings, which is one "bottom line" measure of the firm's economic success. In judging the degree of momentum in a firm's earnings, it is often the case in practice that investors will compare the company's actual EPS to some level of what was expected. Two types of expected earnings are used most frequently: (1) those generated by a statistical model and (2) the consensus forecast of professional stock analysts. Panel B of Exhibit 17.9 shows that, over the 1994-1998 period, earnings momentum strategies were generally successful as well, although surprisingly not to the same degree as price momentum strategies.

In our examination of market efficiency in Chapter 6, we saw several anomalies that suggested a role for active equity management. Two of these—the weekend effect and the January effect—involved investing during particular times of the year. While conceptually viable, the limitations inherent in these anomalies do not produce particularly effective portfolio strategies. That is, managers investing in stocks only in January are not likely to be able to justify their annual fees, while the number of transactions implied by the weekend effect (i.e., buy every Monday, sell every Friday) generally makes for a cost-ineffective portfolio. Remember, however, that whether or not these calendar-related anomalies produce successful active portfolios, they still are useful rules for trades that an investor plans to make anyway.

A more promising approach to active anomaly investing involves forming portfolios based on various characteristics of the companies themselves. Two such characteristics we have seen to matter in the stock market are the total capitalization of the firm's outstanding equity (i.e., firm size) and the financial position of the firm, as indicated by its various financial ratios (e.g., PIE, P/BV). The studies we saw in Chapter 6 came to two general conclusions about these firm characteristics. First, over time, firms with smaller market capitalizations produce bigger risk-adjusted returns than those with large market capitalizations. Second, over time, firms with lower PIE and P/BV ratios produce bigger risk-adjusted returns than those with higher levels of those

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