With UK equities still cheap by conventional standards, it’s tempting to look for recovery plays. Investors should, however, be wary of succumbing to this temptation because whilst there are big potential gains there are also big dangers.
The old saying 'never try to catch a falling knife' is correct. My portfolio of loser stocks (comprising the worst-performing big stocks in the previous 12 months) has fallen by almost half since it began in September 2011, and has underperformed the FTSE 350 by over 70 percentage points in this time. This is no quirk of a single portfolio. We know from around the world and from other assets such as currencies and commodities that past losers tend to continue falling. Momentum effects are strong.
One reason for this is that investors fail to fully update their beliefs in light of new evidence. We hate admitting even only to ourselves that we are wrong and so we are loath to sell stocks at a loss; this is the well-known disposition effect. And if we don’t sell a bad stock it stays overpriced after it has had bad news and so it drifts down in the months after the news, as its holders only gradually throw in the towel. Short-sellers can do little about this, simply because short-selling is risky and requires you to hold lots of cash to meet potential margin calls.
It’s not just past losers that do badly on average, though. Harvard University’s John Campbell has shown that financially distressed companies – those on the verge of bankruptcy – “have delivered anomalously low returns”.
One reason for this is that investors are overconfident about their ability to spot recovery plays. What matters is not merely that a stock is cheap. You must also get the timing right. Which is an altogether trickier matter.
Also, investors pay too much for the small chance of the big short-term price jumps that can happen if companies do turn around. In this sense, distressed stocks do badly for the same reason that Aim shares have underperformed for years while defensives have outperformed. Some investors prefer the small chance of a big rise to the larger chance of steady gains. This preference means that distressed stocks, like smaller speculative ones, are overpriced and so deliver poor average returns.
Even in good times, however, recovery plays carry some danger. My chart shows why. It shows the distribution of price changes for the 20 highest-yielding shares (with a market capitalisation of over £500m) in the following quarter in the 10 years between 2010 and 2019. The most likely return on such stocks is a gain of under 10 per cent, as you might imagine. But there has also been a disproportionate chance of a huge loss: 1.5 per cent of the shares in this period halved in price in just three months. And there has been a greater chance of falls of 20 per cent or more than of gains of a similar size: 8.8 per cent.
And I’ve drawn these numbers deliberately from good times: had I included the 2008-09 crisis (when some high yielders such as mortgage lenders collapsed) or the first quarter of this year (when seven of the 20 highest yielders lost 50 per cent or more) the chance of big losses would have been much greater.
Even if we get a reasonable recovery, therefore, you should expect some big losses on some supposed recovery plays: one in 11 will lose you 20 per cent or more, if the previous upswing was a guide.
Which raises another problem: will we get such an upturn?
Here, there is a genuine uncertainty. Will the pattern of demand return to normal? If it does, then today’s high yielders such as travel companies, pub operators and airlines will bounce back.
But, of course, this is not at all assured. Even if the lockdown is formally lifted, people might voluntarily avoid foreign travel or pubs for fear of catching or spreading the virus, or simply because they have changed their habits.
You might interpret this uncertainty as a good thing. Investors hate uncertainty, in the sense of unquantifiable risk: the Ellsberg paradox teaches us this. You might think it plausible, therefore, that stocks which carry lots of uncertainty are cheap.
I’m not so sure. There are some types of uncertainty that investors enjoy – the sort that, they believe, offers lots of upside, which is one reason why speculative or distressed stocks have been overpriced on average. The fact that prospects are so uncertain for pub and travel companies might therefore be a reason for avoiding them.
My point here is merely to remind you of an old truth: you don’t get owt for nowt. Yes, a few recovery plays will pay off wonderfully. But if they do so, it’ll only be a reward for taking on lots of dangers.