Richard Driehaus screen: A momentum strategy focused on earnings growth

Stockopedia | Aug. 22, 2012

In brief

Richard Driehaus is the founder and chairman of Chicago-based fund management firm Driehaus Capital Management. He rose to prominence in the investment community during the 1980s and 1990s by delivering impressive returns using momentum strategies that focused on small and mid-cap stocks. He was particularly attracted to firms that displayed strong earnings growth and he used earnings ‘surprises’ as buy and sell signals.

Background

Driehaus began investing in the stock market at the tender age of 13 (with the proceeds of a paper round) and he went on to spend considerable time researching and reading investment newsletters. In an interview for Jack Schwager’s book The New Market Wizards: Conversations with America’s Top Traders, Driehaus said he had been particularly inspired by John Herold’s America’s Fastest Growing Companies. It was here that he began to focus on what he perceived as the importance of long term earnings growth as the ultimate driver of share price movement.

Driehaus set up his own broking and fund management business in the early 1980s after successful spells as a money manager for firms including A.G. Becker, Mullaney, Wells & Co. and Jesup & Lamont. By 2000 his success had earned him a place in Barron’s All-Century Team – a group of influential fund managers that counts investment gurus Peter Lynch and Bill Miller among its members.

Investment strategy

While Driehaus has never directly documented his investment techniques in a book, several analysts have scrutinised his strategies. According to the American Association of Individual Investors (AAII), the heart of the Driehaus method is to identify those companies with improving earnings growth rates and then identify which of them are most likely to continue the trend. Driehaus then screens for firms that are beating analyst expectations and producing positive earnings surprises.

In Schwager’s The New Market Wizards, Driehaus explained that while he was prepared to hold equities for very long periods of time, his strategy meant being willing to turn over the portfolio more frequently than the conventional norm to get superior returns.

He claimed to take exception to the market paradigm of ‘buy low and sell high’, believing instead that more money is made buying high and selling at even higher prices. He explained:

“That means buying stocks that have already had good moves and have high relative strength – that is, stocks in demand by other investors. I would much rather invest in a stock that’s increasing in price and take the risk that it may begin to decline than invest in a stock that’s already in a decline and try to guess when it will turn around.”

In an extensive article on Driehaus for Institutional Investor magazine in November 1993, Alyssa Lappen said Driehaus was relaxed about high P/E ratios and balance sheet debt so long as sales and earnings growth looked sure to accelerate. “Not every stock that Driehaus buys has a stratospheric P/E. He’s an opportunist who sometimes picks up growth stocks at value prices,” she said. Lappen also noted that he showed no sentimentality to his stocks:

“He unceremoniously dumps his mistakes the moment the fundamentals deteriorate, the price pattern breaks down – or he finds a stock he likes better.”

What to watch

Although momentum strategies have proved to be an effective tool for investors there can be significant drawbacks – and none more so than the critical issue of timing. Momentum investors routinely risk getting their timing wrong on trades and in extreme market conditions, as seen in 2009, these strategies can crash. In addition, as Driehaus conceded, the higher level of portfolio turnover means that a momentum strategy needs a lot of work. Overall, this type of investing can be time-intensive and rack up comparatively high trading costs.

Does it work?

Driehaus has insisted that the investor who simply applies momentum as a technician will never survive and that investors must keep the faith even if the portfolio value falls significantly. In terms of performance, Driehaus Capital Management was reported to have delivered compound annual returns of 30% during the 12 years after it was started in 1980. An interpretation of Driehaus’s methods, produced by AAII, has returned 13.5% and 18.1% over five and 10 years respectively. By comparison, the S&P 500 returned just -1.1% and 4.2% over the same periods. Stockopedia’s interpretation of Driehaus’s strategy currently boasts annualised returns of 35.1% and in the last six months delivered 6.96% versus -1.48% for the FTSE 100.

Screening Criteria

Stockopedia’s Driehaus screen is based on the book Investment Gurus: A Road Map to Wealth from the World’s Best Money Managers by Peter Tanous (available on Amazon). Here are the criteria:
EPS Growth Streak > 2 EPS Growth % (TTM) > 0 EPS Growth % (TTM) > Industry Group Median % 50 Day Moving Average > 0 EPS Surprise %, Last Year > 5 # Brokers < 6 Rank ( Market Cap £m ) < 85% Relative Strength over 1 Month > 0 How can I apply this screen?

Further reading

Check out more momentum investing articles on Stockopedia, including:
Relative Strength: How Does Momentum Investing Work? The Top 5 Momentum Indicators Every Trader Needs to Know Searching for Momentum – six stocks that are riding a wave

For more information about Richard Driehaus:
Wikipedia on Richard Driehaus The New Market Wizards: Conversations with America’s Top Traders, Jack Schwager Investment Gurus: A Road Map to Wealth from the World’s Best Money Managers, Peter Tanous AAII or Dreihaus Married to the Market, Alyssa Lappen


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Alyssa A. Lappen is a U.S.-based investigative journalist. She is currently Managing Editor at the Leeb Group. A former Senior Fellow of the American Center for Democracy (2005-2008); she is also a former Senior Editor of Institutional Investor (1993-1999), Working Woman (1991-1993) and Corporate Finance (1991). She served six of her 12 years at Forbes (1978-1990) as an Associate Editor. Ms. Lappen was also a staff reporter at The New Haven Register (1975-1977). During a decade as a freelance, her work appeared in Big Peace, Pajamas Media, Front Page Magazine, American Thinker, Right Side News, Family Security Matters, the Washington Times and many other Internet and print journals. Ms. Lappen also contributed to the Terror Finance Blog, among others. She supports the right of journalists worldwide to write without fear or restriction on politics, governments, international affairs, terrorism, terror financing and religious support for terrorism, among other subjects. Ms. Lappen is also an accomplished poet. Her first full-length collection, The Minstrel's Song, was published by Cross-Cultural Communications in April 2015. Her poems have been published in the 2nd 2007 edition of Blood to Remember: American Poets on the Holocaust and both 2007 issues of Wales' award-winning Seventh Quarry: Swansea Poetry Magazine. Dozens of her poems have appeared in print and online literary journals and books. She won the 2000 annual Ruah: A Journal of Spiritual Poetry chapbook award and has received a Harvard Summer Poetry Prize and several honorable mentions. Alyssa A. Lappen can be reached at alyssaalappen@alyssaalappen.org

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