Warren Buffett and plenty of other money managers say you should buy stocks now. If you agree, which funds should you take? Investors with a taste for risk might consider momentum funds. These can skyrocket when markets climb. Momentum funds typically buy stocks with rising share prices or improving earnings. The funds soared in the 1990s bull market and collapsed when stocks tumbled earlier this decade. That tarnished the reputation of momentum investing. But many of the funds are sound choices. The problem is that shareholders tend to buy them at the wrong times, piling in at market peaks and selling at troughs. Consider Turner Midcap Growth ( TMGFX), which typically buys stocks with increasing prices and annual earnings growth of more than 20%. Long-term shareholders have good reason to be satisfied with their fund. During the 10 years ending in September, Turner returned 8.4% annually, more than 5 percentage points ahead of the S&P 500. Unfortunately, few investors stayed with Turner for the whole decade. The fund had only $35 million in assets in 1998. The next year, it returned 125.5%, and investors poured in. By 2000, assets had grown to $937 million. New investors arrived just as the market began to fall. Faced with losses, many shareholders bailed out, and assets slipped to $509 million in 2002. Those who departed missed the recovery, which occurred in 2003, when Turner returned 49.6% and outpaced the S&P 500 by more than 20 percentage points. Based on that history, the time to buy Turner and other momentum funds is when the outlook is bleak. By jumping in during a downturn and holding patiently, investors stand a good chance of outdoing the market in future years.
While momentum funds can be volatile, academic studies show they can succeed, provided managers work carefully. Once a stock surges, it tends to stay ahead of the market for periods of three to 12 months, according to research by Narasim Jegadeesh of the University of Illinois and Sheridan Titman of the University of Texas. But after 12 months, the winning stocks begin to cool, eventually delivering middling results. Academics say the performance of hot stocks tends to revert to the mean. Why do winning stocks only enjoy a brief time in the sun? Research suggests a stock may jump after it produces an unexpected earnings gain or other good news. Investors overreact to the new information, pushing the shares to unrealistic heights. Gradually, the market comes to its senses and pushes the stock back down. To profit from a momentum strategy, a fund manager must act quickly, buying as a stock is spurting and selling before the highflyer crashes. Moving at the right time takes a deft touch. For a classic momentum fund, consider Monetta ( MONTX), which returned 4% annually during the past decade, outdoing the S&P 500 by about 1 percentage point. Portfolio manager Robert Bacarella looks for stocks whose prices and trading volumes are rising. After spotting a candidate, Bacarella checks to see if earnings are improving, an indication the shares may continue climbing. "Stocks go up for one reason: because there is buying interest," he says. "My job is to determine whether buying interest will continue going forward."
In normal times, Bacarella grabs skyrocketing shares. These days, not many stocks are climbing, so he has had to modify his approach. To spot the best choices, Bacarella looks for stocks that rise the most on days when the market climbs. A favorite holding is Potash Corp. of Saskatchewan ( POT), which makes fertilizer. The company's earnings are growing as farmers around the world increase production. "The earnings are exceeding expectations, and the growth should continue," says Bacarella. Another veteran momentum player is American Century Vista ( TWCVX), which returned 10.3% annually during the past decade, outdoing the S&P 500 by 7 percentage points. Portfolio manager Glenn Fogle seeks out companies whose earnings and share prices are improving. The fund will buy stocks losing money as long as prospects are getting better. "We are often attracted to stocks where the earnings are declining, but they are falling less than they were," Fogle says. Recently, Fogle has been buying airline stocks, including Delta Air Lines ( DAL) and Continental Airlines ( CAL). Those were pounded last summer as rising fuel prices hurt earnings. In response, the airlines eliminated flights and instituted fees for luggage handling. When fuel prices dropped, airline margins improved. Though the airlines were still losing money, the shares began to rise. "The airlines are not good businesses, but their prospects are improving," says Fogle. While some of his holdings are troubled companies, Fogle mainly holds stocks of companies with growing earnings. Lately he has been buying discount retailers, such as Family Dollar Stores ( FDO). With consumers seeking ways to save, the discounters have been reporting growing earnings. That has sent the shares climbing in a way that can attract the attention of momentum investors.