Combining value and momentum strategies with fundamentals : Empirical evidence from the returns of the combined investment strategies in US equities

Abstract

Traditional value, momentum and fundamentals-based equity investment strategies have been studied extensively in the previous literature. In contrast, studies on combined investment strategies are still at an early stage. The previous literature has, however, shown that fundamentals can be used to enhance value and momentum portfolios’ performance. This provides an interesting framework to study combined investment strategies as there seems to be a premium towards fundamentally stronger stocks particularly among smaller and less followed stocks. Hence, the main purpose of this thesis is to examine whether ex ante fundamental information can be used to enhance value and momentum strategies in order to earn abnormal returns.

The sample used in the empirical part is from Thomson Reuters Datastream and Kenneth R. French Data Library. The sample period is from 1997 to 2015 and includes all stocks listed in the S&P Composite 1500 index, which combines three different indices: The S&P 500, S&P MidCap 400 and S&P SmallCap 600. Each year we form value and momentum portfolios using the book-to-market ratio and the past 12-month cumulative total raw return (skipping the most recent month). We use the FS_SCORE to measure stocks’ fundamental strength, which is very close to the original FSCORE by Piotroski (2000), but makes some key improvements. To test whether fundamentally stronger value and momentum stocks outperform weaker ones and all value and momentum stocks, we use several risk and return measures including market-adjusted returns, the Sharpe ratio, the CAPM, the Fama-French three-factor and Carhart four-factor model.

Our results indicate that fundamental analysis does not help to discriminate winners from losers among value and momentum stocks. Firstly, stocks with high FS_SCORE did not outperform stocks with low FS_SCORE. These results were also strengthened using time-series tests that showed that monthly regression intercepts were primarily close to zero and less than two standard errors from zero. Secondly, the size partition analysis showed that fundamental analysis was not economically or statistically more beneficial among small-sized stocks. Thirdly, the results were also relatively robust across the sample period as the high FS_SCORE portfolio outperformed the low FS_SCORE portfolio only 7 out of 18 years in the value context, compared to 11 out of 18 years among momentum stocks. Based on our results it is also difficult to argue that the financial markets are inefficient or that the information dissemination is weak among value and momentum stocks.