Still, every dog has its day, and my investment strategy - and one that has certainly stood the test of time - was to buy these stocks at the end of September and hold them into January. Not that I am averse to taking profits early as I banked gains last year when my portfolio racked up an eye-watering 22 per cent gain in only four weeks. However, I am going to resist banking profits right now even though my portfolio is up an impressive 15.6 per cent excluding dividends in only three months. This compares very favourably with the benchmark S&P 500 index which has risen by 1.8 per cent in the same period, although the return on my portfolio of US stocks is still less than the 17.5 per cent average quarterly gain made by adopting this specific investment strategy each year between 1997 and 2011. Moreover, you don’t have to look far for a catalyst for markets to rally even more as investors are clearly in bullish mood after the US economy avoided the fiscal cliff as I had predicted (Reasons to be bullish, 21 December 2012).
How Simon Thompson's US Dog Share Portfolio has fared
| Company | Closing price, 28 Sep 2012 ($)* | Latest price, 4 Jan 2013 ($)* | Percentage change (%) |
| Genworth (GNW: NYQ) | 5.23 | 8.28 | 58.3 |
| Alpha Natural Resources (ANR: NYQ) | 6.57 | 10.38 | 58.0 |
| First Solar (FSLR: NSQ) | 22.15 | 33.59 | 51.6 |
| United States Steel (X: NYQ) | 19.07 | 25.70 | 34.8 |
| Devry (DV: NYQ) | 22.76 | 25.25 | 10.9 |
| E*Trade (ETFC: NSQ) | 8.80 | 9.39 | 6.7 |
| Avon Products (AVP: NYQ) | 15.95 | 16.09 | 0.9 |
| Hewlett-Packard (HPQ: NYQ) | 17.06 | 15.14 | -11.3 |
| Apollo Group (APOL: NSQ) | 29.05 | 22.03 | -24.2 |
| Best Buy (BBY: NYQ) | 17.20 | 12.11 | -29.6 |
| Average | 15.6 | ||
| S&P 500 | 1,440 | 1,466 | 1.8 |
| Source: New York Stock Exchange closing prices on 28 September 2012 and on 4 January 2013 | |||
To understand why this particular phenomenon regularly occurs in this three- to four-month period, it is worth revisiting the reasons why these dog stocks were ripe for a bounce back in October. And it is all to do with risk. 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 they have fallen so far is evidence that they are more volatile than the average constituent of the S&P 500. 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 depress prices and force them below fair value. However, liquidity risk falls as prices rise.
■ 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. 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.
■ 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.
■ 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.
S&P 500 Dog Portfolios share performance, October to January (1997-2011)
| Year | Dog shares (%) | S&P 500 (%) | Outperformance (%) |
|---|---|---|---|
| 1997 | 2.3 | 2.6 | -0.3 |
| 1998 | 41.8 | 20.8 | 21.0 |
| 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 | 14.0 |
| 2006 | 5.5 | 6.2 | -0.7 |
| 2007 | No portfolio recommended | ||
| 2008 | -40.0 | -23.0 | -17.0 |
| 2009 | 10.3 | -2.5 | 12.8 |
| 2010 | 18.8 | 10.9 | 7.9 |
| 2011** | 22.0 | 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, October 2011) | |||
A further reason why dog stocks are likely to be especially undervalued at the end of September, and so are 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 works at this time of the year. So if you followed my advice, as I realise hundreds of you have from your correspondence, I would recommend running your profits for the next three weeks at least to take advantage of the portfolio’s tendency to outperform a rising market.
■ Finally, if you followed my advice to exploit the spike in equity market volatility in the autumn through a short term ‘buy-call spread traded options strategy’ on the FTSE 100 ('A smarter option', 25 October 2012) you will have now banked a 38 per cent gain in only eight weeks. That’s even more impressive when you consider the market only moved up 1.3 per cent by the time the options expired on Friday 21 December. So, given I am still in bullish mood, I have devised another short term trade using the same 'buy-call spread trading strategy' which potentially could make similar impressive sized returns in the next five weeks even if the market barely moves. This article is available online (Highly profitable options, 3 January 2012).
