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: in October 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 companys 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 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)
| Year | Dog shares (%) | S&P 500 (%) | Outperformance (%) |
|---|---|---|---|
| 1997 | 2.3 | 2.6 | -0.3 |
| 1998 | 41.8 | 20.8 | 21 |
| 1999 | 10.4 | 14.6 | -4.2 |
| 2000 | 4.7 | -8.1 | 12.8 |
| 2001 | 37.2 | 10.3 | 26.9 |
| 2002 | 55.4 | 7.9 | 47.5 |
| 2003 | 27.1 | 11.7 | 15.4 |
| 2004 | 34.1 | 8.7 | 25.4 |
| 2005 | 15.5 | 1.5 | 14 |
| 2006 | 5.5 | 6.2 | -0.7 |
| 2007 | No portfolio recommended | ||
| 2008 | -40 | -23 | -17 |
| 2009 | 10.3 | -2.5 | 12.8 |
| 2010 | 18.8 | 10.9 | 7.9 |
| 2011** | 22 | 12.2 | 9.8 |
| Average | 17.5 | 5.3 | 12.2 |
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) | |||
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' in the main article).
