US dog shares to bark back

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 2011 (excluding 2007 when we didn't run the portfolio). That is 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 in October 2010 proved even more impressive, beating 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 last year, when the 10 S&P 500 stocks I selected surged by 22 per cent in the space of four weeks, an eye-catching performance that prompted me to recommend banking these massive gains early. So why does this strategy work so well?

S&P 500 Dog Portfolios Share: Performance, Oct to Jan (1997-2010)

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

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 by 50 per cent or more in the past three years carry loads of risk. There are five types of risk (see 'Assessing risk' below).

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 at the very latest, and if you are heavily in profit, as was the case last year, there is no harm in banking gains early.

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), Alpha Natural Resources (ANR: NYQ), Hewlett-Packard (HPQ: NYQ), Apollo Group (APOL: NSQ), Devry (DV: NYQ), Avon Products (AVP: NYQ), United States Steel (X: NYQ), Best Buy (BBY: NYQ), Genworth (GNW; NYQ) and E*Trade (ETFC: NSQ).

These are large companies with market values ranging from as low as $1.5bn (Devry) to as high as $36bn (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 their share prices have fallen by at least 48 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 40 per cent in the same period. 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 a clear 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 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.

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.

S&P 500 Dog Shares Portfolio Oct 2011

S&P 500 Dog Portolios Shares Portfolio Oct 2010

S&P 500 Dog Portfolios Shares Portfolio Oct 2009