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US dog shares to bark back

It is one of the simplest trading strategies devised, and undoubtedly one of the most profitable. Simon Thompson reveals the 10 stocks in the S&P 500 you should buy now.
September 25, 2014

This is possibly one of the simplest investment strategies ever devised. It is also one of the most profitable. All you need to do is the following: at the end of September 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 until January and sell them. That's it. You don't 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 16.3 per cent between 1997 and 2013 (excluding 2007 when we didn't run the portfolio). That is over 11 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.

S&P 500 Dog Portfolios Share Performance, October to January (1997-2013)
YearDog shares (%)S&P 500 (%)Outperformance (%)
19972.32.6-0.3
199841.820.821.0
199910.414.6-4.2
20004.7-8.112.8
200137.210.326.9
200255.47.947.5
200327.111.715.4
200434.18.725.4
200515.51.514.0
20065.56.2-0.7
2007
2008-40.0-23.0-17.0
200910.3-2.512.8
201018.810.97.9
2011**22.012.89.2
201217.84.413.4
2013-2.05.1-7.1
AVERAGE16.35.211.1
Source: Trading Secrets: 20 Hard and fast rules to help you beat the stock market, FT Prentice Hall, author Simon Thompson (first published December 2008) ** Simon Thompson advised taking profits early (Source: Investors Chronicle, Trading strategies that work, 28 October 2011)

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.

S&P 500 Dog Shares Portfolio October 2009
CompanySymbol: exchangePrice on 19 Oct 2009 ($)Price on 29 Jan 2010 ($)Percentage change
Eastman Kodak EIC: NYQ4.276.0541.7%
GannettGCI: NYQ13.0016.1524.2%
SLMSLM: NYQ9.1810.5314.7%
Huntington Banc CorpHBAN: NYQ4.274.7912.2%
KeycorpKEY: NYQ6.457.1811.3%
PrologisPLD: NYQ11.4312.6010.2%
Zions BancorporationZION: NYQ18.1720.0010.1%
Regions Financial CorpRF: NYQ5.836.358.9%
Marshall & IsleyMI: NYQ7.366.91-6.1%
Office DepotODP: NYQ7.485.68-24.1%
Average return   10.3%
S&P 500 1,1001,073-2.5%
Outperformance   12.8%
Source: Investors Chronicle, 'Dog shares bark back', 22 March 2010

S&P 500 Dog Shares Portfolio October 2010
NameSymbol: ExchangePrice on 20 Sep 2010 ($)Price on 6 Jan 2011 ($)Percentage change
American International  AIG: NYQ39.1060.7155.3%
Eastman KodakEK: NYQ4.205.6233.8%
Office DepotODP: NYQ4.606.0030.4%
CitigroupC: NYQ3.914.9827.4%
ProLogisPLD: NYQ11.7814.5023.1%
E*Trade FinancialETFC: NSQ14.5716.2811.7%
KeyCorpKEY: NYQ7.968.8911.7%
Regions Financial CorpRF: NYQ7.277.270.0%
Marshall & Ilsley CorpMI: NYQ7.047.02-0.3%
MEMC Electronic MaterialsWFR: NYQ11.9211.29-5.3%
Average   18.8%
S&P 500 1,1461,27110.9%
Outperformance   7.9%
Source: Investors Chronicle, 'New Year Stock Take', 11 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 2012 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.

S&P 500 Dog Shares Portfolio October 2011*
CompanySymbol: exchangePrice on 30 Sep 2011 ($)Price on 27 Oct 2011 ($)Percentage change
PultegroupPHM: NYQ3.965.4637.9%
CitigroupC: NYQ24.9034.0036.3%
SupervaluSVU: NYQ6.668.7030.6%
E*Trade Financial Corp ETFC: NSQ9.1111.4625.8%
AK SteelAKS: NYQ6.547.8720.3%
Janus CapitalJNS: NYQ6.007.1619.3%
MEMC Electronic Materials WFR: NYQ5.246.2118.5%
Bank of America BAC: NYQ6.127.1116.2%
Hudson City Bancorp HCBK: NSQ5.666.148.5%
US SteelX: NYQ22.0123.416.4%
Average   22.0%
S&P 500 1,1311,27612.8%
Outperformance   9.2%
*Simon Thompson advised taking profits early (Source: Investors Chronicle, ‘Trading strategies that work’, 28 October 2011).

S&P 500 Dog Shares Portfolio October 2012
Company Symbol: exchange Price on 28 Sep 2012 ($)Price on 25 Jan 2013 ($)Percentage change
Genworth (GNW: NYQ)5.239.4580.7%
Alpha Natural Resources (ANR: NYQ)6.579.2140.2%
First Solar (FSLR: NSQ)22.1530.2136.4%
United States Steel (X: NYQ)19.0724.5328.6%
E*Trade (ETFC: NSQ)8.8010.3317.4%
Devry (DV: NYQ)22.7624.517.7%
Avon Products (AVP: NYQ)15.9516.684.6%
Hewlett-Packard (HPQ: NYQ)17.0616.99-0.4%
Best Buy (BBY: NYQ)17.2015.78-8.3%
Apollo Group (APOL: NSQ)29.0520.70-28.7%
Average   17.8%
S&P 500 1,4401,5034.4%
Note: All share prices in US dollars, all TIDMs are NYSE/Nasdaq, not London Stock Exchange prices. Source: Investors Chronicle, ‘Taking profits after a winning streak’, 28 January 2013.

And even last year’s portfolio delivered the goods: in the three month period between the end of September and the end of December, the portfolio surged 10.1 per cent. True, the S&P 500 also rose by 9 per cent, so the market back drop was clearly favourable. Please note though that by the time I updated the trade at the end of January this year, those gains had evaporated for the very specific reasons given below and ones worth noting.

S&P 500 Dog Shares Portfolio October 2013
Company TIDMOpening price, 27 Sep 2013 ($)Closing price, 31 Jan 2014 ($)Percentage change (%)
Hewlett-Packard CoHPQ:NYQ21.2228.0932.4%
United States Steel CorpX:NYQ20.5326.1127.2%
First Solar IncFSLR:NSQ40.3650.5825.3%
Frontier Communications CorpFTR:NSQ4.284.689.3%
Peabody Energy CorpBTU:NYQ17.7517.06-3.9%
Newfield Exploration CoNFX:NYQ27.4424.77-9.7%
Cliffs Natural Resources IncCLF:NYQ21.5719.32-10.4%
Newmont Mining CorpNEM:NYQ28.3921.60-23.9%
Avon Products IncAVP:NYQ20.7214.89-28.1%
J C Penney Company IncJCP:NYQ9.535.92-37.9%
AVERAGE   -2.0%
S&P 500 169617825.1%

Source: New York Stock Exchange opening price on 27 September 2013 and closing price on Friday 31 January

2014

How our S&P 500 dog shares portfolio performed in the final quarter of 2013
     
Company TIDMOpening price, 27 Sep 2013 ($)*Closing price, 31 Dec 2013 ($)*Percentage change (%)
United States SteelX:NYQ20.5329.543.7%
First SolarFSLR:NSQ40.3654.6435.4%
Hewlett-PackardHPQ:NYQ21.2227.9831.9%
Cliffs Natural Resources IncCLF:NYQ21.5726.2121.5%
Peabody EnergyBTU:NYQ17.7519.5310.0%
Frontier CommunicationsFTR:NSQ4.284.658.6%
J C PenneyJCP:NYQ9.539.15-4.0%
Newfield ExplorationNFX:NYQ27.4424.63-10.2%
Avon ProductsAVP:NYQ20.7217.22-16.9%
Newmont MiningNEM:NYQ28.3923.03-18.9%
AVERAGE   10.1%
S&P 500 169618489.0%
Source: New York Stock Exchange opening price on Friday, 27 September 2013 and closing price on Tuesday, 31 December 2013

So why does this strategy work so well?

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 many 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

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 stock-picking 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 heavily in the past three years carry loads of risk. There are five types of risk to consider.

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.

This risk certainly helps to explain why all of the 10 per cent paper gains made on our dog stocks in the final quarter last year were lost in the first month of 2014. That’s because with the S&P 500 falling over 4 per cent in January this year, and Wall Street’s gauge of fear, the Vix index, rising by more than half during the course of the month, our dog stocks were hit by a double whammy of markedly increased equity market volatility and market risk.

■ 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 have already plunged in value 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. Furthermore, 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 and why they sold off so sharply in January this year.

■ 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.

So 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.

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 as was the case last year. 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. So if you are heavily in profit, as was the case in 2011 and last year too, 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 not 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 at the year-end or early January.

So, if you can stomach the risk from this trading strategy, the 10 S&P 500 dog stocks to buy this year and run to the end of December are:

Newmont Mining (NEM:NYQ)

Peabody Energy (BTU:NYQ)

Avon Products (AVP: NYQ)

Diamond Offshore Drilling (DO: NYQ)

Coach (COH: NYQ)

Transocean (RIG: NYQ)

Firstenergy (FE: NYQ)

Exelon (EXC: NYQ)

Teradata (TDC: NYQ) and

Joy Global (JOY: NYQ).

These are large companies with market values ranging from as low as $3.85bn (£2.4bn) for coal mining group Peabody Energy to as high as $29bn for Exelon, a utility group operating in Illinois and Pennsylvania. All are listed on the New York Stock Exchange and have one thing in common: in the past three years their share prices have fallen, and some cases very sharply, even though the back drop for equity markets has been favourable. In fact, the S&P 500 index has risen by 69 per cent in the same three-year period and no fewer 151 of the constituents of the index 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.

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 positive view of the markets for the rest of this year, I would recommend buying the 10 Dog shares without creating a short side to the trade this year.

Placing your trade by spread betting

S&P 500 shares and ETFs can be bought in a normal way through a UK stockbroker offering trading on the US stock market including Charles Schwab, TD Waterhouse, Barclays Stockbrokers, Hargreaves Lansdown and Selftrade.

An alternative way of playing this trade is to buy the 10 S&P 500 stocks through the large spread-betting companies in the UK: IG Index, City Index, Cantor Index and CMC Markets. All these companies 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 1¢ 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, if you are pair trading the 10 dog shares against the S&P 500, then your short index trade would be on the same dealing platform, making it easy to monitor the net profit/loss on the position.

Fourthly, several UK stockbrokers levy a currency conversion charge of around 1.5 per cent on each side of the trade which you have to take into consideration. The advantage of spread betting these S&P 500 holdings is that trading this way not only avoids the currency risk, but it also avoids this levy too.

DOG STOCKS FOR 2014:

Newmont Mining (NEM:NYQ)

Peabody Energy (BTU:NYQ)

Avon Products (AVP: NYQ)

Diamond Offshore Drilling (DO: NYQ)

Coach (COH: NYQ)

Transocean (RIG: NYQ)

Firstenergy (FE: NYQ)

Exelon (EXC: NYQ)

Teradata (TDC: NYQ)

Joy Global (JOY: NYQ)