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Lacking bouncebackability

Created:
9 May 2008
Updated:
20 May 2008
Written by:
Chris Dillow

Bombed out stocks, on average, don't bounce back. That's the lesson of the lamentable performance of our loser portfolio, which comprises the 20 worst performers in the FTSE 350 in the previous three years, reformed every quarter.

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Since we started it in June 2004, this portfolio has lost 13.5 per cent whilst the FTSE 350 has risen 43.7 per cent. Although losers have been badly hit by the credit crunch, their poor performance predates it; in the two years to August 1 2007, our portfolio under-performed the index by 5.3 percentage points.

This is not what behavioural finance predicts. In a famous paper written in 1986, Werner de Bondt and Richard Thaler, two US-based academics, showed that the worst performing stocks of the previous three years subsequently beat the market massively. This, they said, was because investors over-reacted to long runs of bad news, causing shares to become under-priced.

The poor returns on our losers suggests this is no longer true.

You might think this just shows that investors have - at last - learnt from the behavioural finance literature not to make silly mistakes.

But things are more puzzling than this. Economic theory tells us that loser stocks should out-perform, at least in good times, even if investors are perfectly rational.

One reason for this is that they have a high beta, because such stocks are more sensitive to changes in investors' appetite for risk. They should therefore out-perform in a rising market.

Also, loser stocks are more vulnerable than the average to an economic downturn. Losers often have high debt-equity ratios, which makes earnings sensitive to small changes in turnover. They might be making losses, or be in need of refinancing, or in danger of cutting dividends. On all counts, they would suffer badly if the economy slows. And their travails during the credit crunch shows that this is just what happens.

However, the counterpart of this extra risk is that losers should do especially well in good times, to compensate us for their greater exposure to the threat of recession. But they don't.

And this puzzle isn't confined to the UK recently. Harvard University's John Campbell has shown that the US stocks which are most financially distressed have under-performed the market ever since the early 80s.

All this does more than just show that the stock market can be a puzzling place - which is why it's so interesting. It's also a warning for anyone who might be tempted to buy bombed out retailing and financial stocks. The fact that a stock has fallen a long way is no assurance at all that it'll bounce back - even if both behavioural finance and risk-pricing theory predicts that it should.

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