Dog shares barking back

That's because although the stocks I selected are all large corporations with market values ranging from as low as $3bn (United States Steel - X:NYQ) to as high as $41.6bn (Hewlett-Packard - HPQ:NYQ) and are all listed on the New York Stock Exchange, they all had one thing in common: in the past three years (to the end of September) the share prices of all these stock market rottweilers had fallen by at least 50 per cent, and in most cases far more. So, having munched their way through fund managers portfolios, most investors would have run a mile rather than taking these hounds for a walk.

Still, every dog has its day, and my investment strategy – and one that has stood the test of time – was to buy these stocks at the end of the third quarter and hold them until the end of January. I had history on my side because if you had followed our trading strategy over the past 15 years 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 more than 12 percentage points more than an S&P 500 index tracker made in the same period each year.

The good news is that the 'buy the dogs' strategy is working yet again with my portfolio of 10 stock market mongrels firmly off the leash and running way ahead of the market. In fact, the 7.6 per cent average rise in their share prices in the past four weeks is double the return on the benchmark S&P 500 index in the same four week period.

Simon Thompson's S&P 500 Dog Shares Portfolio

Furthermore, there is every reason to expect this outperformance, or 'alpha' this strategy produces above the return on the market itself, to continue for the next three months. To understand why, it's worth revisiting the reasons why these dog stocks were ripe for a bounce back in October. And it is all to do with risk as stocks that have fallen so heavily in the past three years carry loads of risk. There are five types of risk:

■ Volatility. The fact that the dogs of the S&P 500 have fallen so far is evidence that they are more volatile than the average constituent of the index. 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 and wider bid-offer spreads which can further depresses prices and force them below fair value. However, liquidity risk falls as prices rise. Please note that I have taken the bid-offer spreads into account in the performance figures stated in the above table.

■ Distress risk. Dog stocks run a far greater risk of going bust as they usually have much higher levels of gearing than the average constituent in the S&P 500. In some cases, the bank covenants will be related to the company's market value, so the further the stock falls the greater the risk of a breach of these covenants. So if investor sentiment improves, distress risk will fall which helps the stock price recover.

This particular risk embedded in a company's stock price also helps to explain why shares in retailer JC Penney (JCP:NYQ), one of only two fallers in this year's portfolio, have performed so poorly: credit default swaps – a form of credit insurance that reflects the market's view of the creditworthiness of a company – have soared after investors dumped the company's bonds on fear that it will be forced to restructure its debts. That's not to say that JC Penney will apply for bankruptcy protection from its creditors to conserve cash while it continues to execute a turnaround.

In fact, in a statement to the market earlier this month the board stated it expected to have more than $2bn (£1.25bn) of liquidity at the end of its financial year in January 2014. Chief executive Mike Ullman said at the time: "When combined with the reported improvements in our business trends, the need for 'financial restructuring' is purely speculative and not grounded in fact."

It's my view that with so much distress risk already factored into JC Penney's share price after the recent sell-off, any positive news on trading and the company's cash position could see the share price bounce back strongly. I am therefore not bailing out of this holding even though it is heavily under water.

■ Market risk. The fact that the 10 worst performing dog stocks have fallen so much means they have a high sensitivity to market moves, which helps them rise faster than the market when they bounce back. This is definitely one factor in play with my 10 dog shares over the past month.

■ Economic Risk. Dog stocks are generally in cyclical sectors which historically do well during winter months as they offer high returns to compensate investors for the fact that winter is a dangerous time for the economy. For instance, academics have estimated that half of the ordinary business cycle is the result of seasonal swings in output around Christmas time.

Window dressing and exploiting seasonal factors

A further reason why my dog stocks are likely to be especially undervalued at the end of September, and so are and ripe for bouncing back, is due to window dressing by fund managers at the US fiscal year-end. Combined with the fact that October marks the start of a seasonally good time to be holding equities – the S&P 500 has risen by 4.4 per cent on average in the final quarter since 1950 – and there are some very sound reasons why my 'buy the dog' investment strategy is likely to continue to outperform the S&P 500 in the coming months.

Therefore, if you followed my advice a month ago, I would run your profits especially as the 'alpha' this particular investment strategy has created has been well over 12 per cent on average in each of the previous portfolios. The alpha the current portfolio has created is 3 per cent in the past month, so if history is any guide there should be scope for further upside even if the general market flatlines. Not that I expect that to happen because it's only reasonable to expect further gains in the S&P 500 by the year-end given equity market investors remain in buoyant mood. The investment risk remains skewed to the upside for my 10 US Dog shares.

■ Finally, as a pre-Christmas offer exclusive to Investors Chronicle readers, all telephone orders placed with YPDBooks for my new book Stock Picking for Profit will receive complimentary postage and packaging. This offer is strictly for a limited period, is subject to stock availability and applies to only telephone orders placed until Friday, 15 November 2013.

Please note the book is only being sold through YPDBooks and no other source. Full details of the content of the book is available online at www.ypdbooks.com. If you would like to take advantage of this offer, please contact YPDBooks on 01904 431 213 and quote reference 'ICOFFER'. The book is priced at £14.99. Internet orders will continue to incur the normal postage and packaging cost of £2.75. I have also published an article outlining the content of the book: 'Secrets to successful stock picking'.

MORE FROM SIMON THOMPSON ONLINE....

I published eight other articles in the past week on the following 11 companies:

■ Trifast ('A timely bolt on purchase', 21 Oct 2013)

■ Noble Investments ('Bargain shares update', 21 Oct 2013)

■ Stanley Gibbons ('Bargain shares update', 21 Oct 2013)

■ Cairn Energy ('Bargain shares update', 21 Oct 2013)

■ Eros ('Time for some price action', 22 Oct 2013)

■ PV Crystalox Solar ('Time for some price action', 22 Oct 2013)

■ BP Marsh & Partners ('BP Marsh cashed up to invest', 23 Oct 2013)

■ Moss Bros ('New highs beckon', 23 Oct 2013)

■ Molins ('Smoking away', 24 Oct 2013)

■ Bloomsbury Publishing ('Decision Time', 24 Oct 2013)

■ First Property Group ('On rock solid foundations', 28 October 2013)