10 shares to buy now

In October each year buy the 10 worst-performing stocks in the S&P 500 index using their price performance over the previous three years. Hold these shares for three months and sell them. That’s it. You don’t even have to pore over the finer details of fundamental analysis used by stockbrokers and equity analysts when deciding on the 10 shares to hold. So forget about dividend yields, price-to-earnings multiples and price-to-book values (the ratio of a company’s market value to its net asset value). This strategy does not rely on any of these valuation measures to work.

And work it certainly does. If you had followed our trading strategy you would have turned in an average three-month gain of 17 per cent between 1997 and 2009 (excluding 2007 when we didn’t run the portfolio). That is almost 13 percentage points more than an S&P 500 index tracker made in the same period each year. Admittedly, the ‘buy the dog stocks’ strategy failed to work in the autumn of 2008 although there was a mitigating reason why - Wall Street crashed. Not even our dog stocks could withstand a 23 per cent plunge in the S&P 500 in the final quarter of that year. However, normal service was resumed in October 2009 when the 10 Dog Stocks I recommended surged over 10 per cent in the following three months, massively outperforming the S&P 500 which declined by 2.5 per cent in the same period.

S&P 500 Dog Portfolios Share Performance, October to January (1997-2009)

So why does this trading strategy of buying the worst-performing stocks in the S&P 500 index work so well?

Shares Overreact to news

In a now-famous paper* published back in the 1980s, academics Richard Thaler and Werner de Bondt found that portfolios consisting of the 35 worst-performing stocks in the S&P 500 (using price data over the previous three years) outperformed the 35 best-performing stocks by an average of 25 per cent over the subsequent three years for each three-year period between 1933 and 1979. They noted at the time: "Most people overreact to unexpected and dramatic news events. And you can make big money by exploiting this."

For instance, some companies get a bad reputation for perennially disappointing and as a result both shareholders and potential new investors are more inclined to ignore the few merits the company and its management have. In the most extreme cases where share prices of the worst performers in the S&P 500 have fallen by over 90 per cent over a three-year period, as has been the case for the majority of the 10 stocks included in our US Dog Portfolios in the past, this savage derating can take valuations way below fair value. So the autumn of 2008 aside, why has a policy of buying these shares in early October done so well?

*Source: 'Further Evidence on Investor Overreaction and Stock Market Seasonality', Werner F M De Bondt and Richard H Thaler, The Journal of Finance, Vol. 42, No. 3, December 28-30, 1986 (July, 1987), pp. 557-581 and "One Step Plan", Simon Thompson and Chris Dillow, Investors Chronicle, 3 October 2003.

Window-dressing

The reasons the dogs of the S&P 500 start to bounce back in October is easy to explain: the US fiscal year ends on 30 September. At this time, US fund managers must send reports to their investors detailing their performance during the year. However, the last thing they want to put in these reports is that fact that they are holding some of the worst-performing shares in the S&P 500. It would hardly inspire confidence in their stock picking ability if shareholders in their funds found out that they had taken big hits on some of the rottweilers in the index.

As a result, and in an effort to present themselves in the best possible light, the asset managers sell these dog stocks before the fiscal year-end. Other fund managers, for the same motives, are reluctant to buy them. The upshot is that some loser stocks are likely to be especially undervalued at the end of September and are ripe for bouncing back. So that's when the 'buy the dog' investment strategy kicks in.

There is certainly some merit in this explanation, even though it implicitly assumes that enough investors are stupid enough to be taken in by this window-dressing ruse. Moreover, it also assumes that less savvy investors haven't learnt that stocks overreact on the downside in this way. Otherwise they would simply buy the loser stocks, which would push their prices up, and so make it impossible for other later investors to make money from them.

So even if we accept that the window dressing ruse acerbates the downward pressure on share prices in the months leading up to the end of September, it is unlikely that it can be the only reason why these dog stocks have historically performed strongly in the subsequent three months. Instead, there's an alternative explanation. And it's all to do with risk. Stocks that have fallen by 90 per cent or more in the past three years carry loads of risk. There are five types of risk.

Assessing risk

■ Volatility. Stocks that have fallen by 90 per cent or more can fall by another 90 per cent - that's basic mathematics. And the fact that they have fallen so far is evidence that they are more volatile than most stocks, and so have more chance of falling another 90 per cent - that's basic statistics. So these dog shares are likely to be more volatile than the average constituent of the S&P 500. Bear in mind that stocks can be just as volatile on the upside when bouncing back as they are when falling.

■ Liquidity risk. The 10 worst dog stocks in the S&P 500 have low absolute prices. That often means they have wide bid-offer spreads, so it not only costs more to trade them, but if things go wrong and investors are forced to sell this could be very expensive indeed. But liquidity risk works both ways. On the downside, it depresses share prices and can force them below fair value. But to the upside, liquidity risk falls as prices rise so offering scope for above average price rises when these stocks start to bounce back.

■ Distress risk. Dog stocks that plunge by 90 per cent or more run a far greater risk of going bust. In particular, they usually have much higher levels of balance sheet gearing than the average constituent in the S&P 500. In some cases the bank covenants on the debt will be related to the market capitalisation of the company, so the further the stock falls the greater the risk of a breach of these covenants. Moreover, investors clearly sense this as distress risk will be an increasing factor in the downward share price momentum seen in poorly performing stocks.

However, if investor sentiment improves and the perception of a company going bust or breaching its bank covenants diminishes - which is likely to be the case if the stocks start to rise strongly - then distress risk falls, which helps the recovery in the stock price.

■ Market risk. The fact that the 10 worst-performing dog stocks have fallen so much at the same time - in most cases, the falls have been far greater than falls on the S&P 500 - means that they have a high sensitivity to market moves. This is another source of risk and one which helps our dog stocks rise faster than the market when they bounce back. It also explains their underperformance in the autumn of 2008 when the market collapsed.

■ Economic risk. Dog stocks are generally in cyclical sectors which have in the past done well during winter months. This is because winter is a dangerous time for the economy. In fact, academics have estimated that half of the ordinary business cycle is the result of seasonal swings in output around Christmas time. So to compensate investors for this risk, cyclical stocks, including Dogs of the S&P 500, normally offer high returns in winter. However, with investors fearing an economic Armageddon in the final quarter of 2008, this was bad news for cyclical stocks and our Dog Stocks. But with markets returning to some form of normality last year, it paid to take on the economic risk factored into share prices.

Common sense tells us that risky stocks should outperform other stocks eventually, simply to compensate for their greater risk. And the combination of the US fiscal year-end, window dressing by fund managers and the start of a seasonally good time to be holding equities - the S&P 500 index has risen by 4.4 per cent on average in the final three months of the year since 1950 - all help these risky stocks to outperform in the final quarter.

Trading strategy

Over the years, our Dog stocks have performed remarkably well in the final quarter of the year, but don't expect the recovery to be long lasting. Interestingly, an analysis of all the Dog Portfolios since 1997 has one thing in common: there is a clear bias for the best of the gains to come in the four-month period between 1 October and 31 January. Therefore, it pays to bank profits from this short-term trading strategy especially as the market has shown a tendency to correct in January in recent years.

Moreover, there is an obvious opportunity to create ‘alpha’ by buying our 10 Dog shares and simultaneously short selling the S&P 500 to the same value. This way we benefit from our Dog portfolio’s historic short-term outperformance of the S&P 500 while maintaining a degree of downside protection (through the S&P 500 short index trade) to mitigate against a market fall. This worked a treat last year when we profited on both sides of this ‘pair’ trade as our 10 Dog Stocks rose in value by over 10 per cent in the three-month period while the market fell 2.5 per cent.

So if you can stomach the risk from this trading strategy, the 10 S&P 500 Dog stocks to buy now are: American International Group (AIG:$37.13), Citigroup (C:NYQ: $3.87), E*Trade Financial (ETFC:$15.32), Eastman Kodak (EK:$4.13), Prologis (PLD:$11.36), MEMC Electronic Materials (WFR:$11.81), Marshall & Ilsley (MI:$6.95), Office Depot (ODP:$4.54), Regions Financial Corporation (RF:$6.97) and Keycorp (KEY:$7.84).

These are all large companies with market values ranging from as low as $1.1bn to as high as $112bn and are all listed on the New York Stock Exchange. However, they all have one thing in common: in the past three years their share prices have fallen by at least 75 per cent.

How to place your trade

Since my recommended pair trade of buying the 10 dog stocks and selling the S&P 500 is a relatively short-term one, the easiest way of buying S&P 500 stocks is through the large spread-betting companies in the UK: IG Index, City Index, Cantor Index and CMC Markets. All firms allow investors to bet on the underlying share price movements of major S&P 500 corporations.

There are several advantages of investing in this way. First, there is no foreign-exchange risk as you can place a bet in sterling for every one-cent movement in the dollar share price of a US stock. Second, profits are tax-free as spread betting is not subject to UK capital gains tax. Third, at the same time as opening long trading positions on the 10 Dog shares you can also short sell the S&P 500, making it easy to monitor your overall net position on one trading platform.

Alternatively, the shares can be bought in a normal way through a UK stockbroker offering trading on the US stock market.