Easy as pie

And work it certainly does. If you had followed our trading strategy you would have turned in an average three-month gain of 17.5 per cent between 1997 and 2012 (excluding 2007 when we didn't run the portfolio). That's over 12 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.

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. Moreover, the 18.8 per cent three-month gain on the 10 US stocks I advised buying 12 months later in October 2010 was even more impressive: that portfolio beat the benchmark US index by 7.9 percentage points by the time we banked profits in early January 2011.

But that was nothing compared with the rocket-fuelled performance in October 2011, when my 10 S&P 500 dog stocks surged by 22 per cent in only four weeks, an eye-catching performance that prompted me to recommend banking these massive gains early. True to form, the share price performance of the 10 S&P 500 dog stocks I advised buying at the end of September last year was equally impressive: on average they rose by 17.8 per cent in the following 16 weeks, an eye-catching 13 percentage points more than the S&P 500 index in the same period. So why does this strategy work so well?

S&P Dog Portfolios share performance, October to January (1997-2012)

Shares overreact to news

In a now-famous paper* published 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 example, 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 50 per cent over a three-year period, as has been the case for virtually all 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, Volume. 42, No.3, December 28-30, 1986 (July 1987), pp.557-581 and 'One Step Plan', Simon Thompson and Chris Dillow, 3 October 2003.

S&P 500 Dog Shares Portfolio October 2012

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 the fact that they are holding some of the worst-performing shares in the S&P 500. It would hardly inspire confidence in their stockpicking ability if shareholders in their funds found out that they had taken big hits on some of the rottweilers in the leading US stock index.

As a result, 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. 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 such window-dressing exacerbates 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 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 at least 50 per cent in the past three years, and in most cases by far more, carry loads of risk. There are five types of risk to consider.

S&P 500 Dog Shares Portfolio October 2011*

United States Steel, Alpha Natural Resources and First Solar all performed well for last year’s portfolio.

Assessing risk

■ Volatility. Stocks that have fallen by 50 per cent or more can fall by another 50 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 50 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, too, 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 wider than normal 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 on 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 in value by 50 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 that 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 that 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.

The bottom line is that 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 an average of 4.4 per cent in the final three months of the year since 1950 - all help these risky stocks to outperform in the final quarter.

S&P 500 Dog Shares Portfolio October 2010

This year's dog stocks include Cliffs Natural Resources, Hewlett Packard, and First Solar.

Trading strategy one

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 period between October and January. Therefore, it pays to bank profits from this short-term trading strategy in the new year, and if you are heavily in profit, as was the case in 2011, there is no harm in banking gains early. It is also worth noting that these shares can be volatile, so view your investment as a portfolio and monitor the performance on that basis rather than trying to pick one or two companies that will do well. It's for this very reason that I don't place a stop-loss on the shares. I have good reason, too, because in the past the initial poor performers from my portfolios have a habit of recouping most, if not all, of their paper losses by the time I come to close the positions in January.

So, if you can stomach the risk from this trading strategy, the 10 S&P 500 dog stocks to buy now are:

■ First Solar (FSLR: NSQ)

■ Cliffs Natural Resources (CLF: NYQ)

■ Peabody Energy (BTU: NYQ)

■ Newfield Exploration (NFX: NYQ)

■ Newmont Mining (NEM: NYQ)

■ United States Steel (X: NYQ)

■ JC Penney (JCP: NYQ)

■ Hewlett-Packard (HPQ: NYQ)

■ Frontier Communications (FTR: NSQ)

■ Avon Products (AVP: NYQ)

These are large companies with market values ranging from as low as $3bn (United States Steel) to as high as $41.6bn (Hewlett-Packard) and are all listed on the New York Stock Exchange. However, they all have one thing in common: in the past three years the share prices of all bar one of the companies have fallen by at least 50 per cent, and in most cases far more.

To put their dire share price performance into some perspective, the S&P 500 index has risen by over 47 per cent in the same three-year period and 78 of the indices constituents have more than doubled in value. But every dog has its day and, although this strategy carries above-average risk, now is the time to buy these 10 US stock market rottweilers.

S&P 500 Dog Shares Portfolio October 2009

Trading strategy two

For risk-averse investors there is also an opportunity to create 'alpha' by buying our 10 US 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 downside protection (through an S&P 500 short ETF such as Proshares Short S&P 500) to mitigate against a general market fall. This worked a treat in 2009 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, for example, if you invest $3,000 in each of the 10 dog shares, you would also need to buy $30,000 of Proshares Short S&P 500 ETF (SH:PCQ) to create the long-short pair trade. That said, given my upbeat view of the market, I would recommend buying the 10 Dog shares without creating a short side to the trade this year.