Everyone Loves a Winner, But Should They? A Look at the "Loser" Approach
Everybody loves a winner. People flock to sports figures who are winners, politicians who are winners, movie stars who are winners, you name it—everybody loves a winner, including investors.
But, should they?
Now I suppose there might be some personal gratification in gaggling over celebrities, but investors who have been so thoroughly educated to invest in “winning” stocks often come up on the short end of the stick. Investors who seek out the “winners” end up in effect buying the losers!
Winners can be classified in a variety of ways, but past performance is probably the number one method of rating a stock as to whether it is a winner or not.
And, if an investor is judging a stock based on past stock price activity, he or she in effect has entered the world of technical analysis. In technical analysis, the primary assumption in studying past stock market activity is to enable investors to draw implications and make forecasts regarding likely future stock price activity. However, as we’ll see in the analysis of winners vs. losers, the actual outcomes are often the reverse of investors’ preconceived notions.
Fortune Annual Corporate Survey
For instance, many of the stocks that end up performing the best/worst in any particular year can be found in this listing—Fortune magazine’s annual Corporate Reputation Survey.
Fortune’s 1995 survey was subtitled “The winners chart a course of constant renewal and work to sustain cultures and produce the very best products and people.” The lavish praise heaped on the “best and the brightest” among the major American corporations gets a little nauseous, but the annual survey is popular. The real trouble is, though, that the true stock market winners are often apt to be found at the of bottom of the heap, not at the top.
The survey is conducted by asking more than 10,000 senior executives, outside directors, and financial analysts to rate the 10 largest companies in their own industry using eight measurements: quality of management; quality of products or services; innovativeness; long-term investment value; financial soundness; ability to attract, develop, and keep talented people; responsibility to the community and the environment; and wise use of corporate assets.
The results of the March 6, 1995, survey appear in Table 1; the table also indicates the performance of the stock’s price during 1995. The glamours on top, priced on average at over $56, were outperformed over 2½-to-1 by the dogs at the bottom, priced on average $11.68. The real winners were the bottom 10 of Fortune’s survey, not the top 10.
The bottom-ranked stock—395 out of 395, the stock ranked dead last, the least admired—was Trans World Airlines. However, the stock gave a fairly good account of itself, up 88% for the year. The top-ranked stock, Rubbermaid, may have garnered all the accolades, but it saddled its shareholders with a loss of 11.3%!
This article is not designed to degrade the Fortune survey, as the survey does provide valuable information. For anyone interested in employment, for instance, the benefits of working for the firms toward the top of the Fortune survey are infinitely more appealing than those at the bottom. Employment-wise, it definitely pays to go with a winner.
However, in looking for big winners in terms of the stock market, the opportunities among the issues ranked low in Fortune outweigh the opportunities among the issues ranked high because of the potential for turnaround among out-of-favor relatively large corporations.
Of course, the Fortune survey does not always work out as a no-brainer for picking stocks. For instance, the bottom 10 in 1995 included Leslie Fay and during 1993 the stock in last place was Wang Laboratories, both of which subsequently faced bankruptcy. While the Fortune survey overall does seem to validate the notion of overvaluation among winners, there is no such thing as a free lunch. Investors still have to do their homework.
But the fact is that when a stock has been so thoroughly trashed by analysts, corporate executives, and the like, as to cause it to appear at the bottom of the Fortune listing, much of the selling has already been done, so these low opinions are incorporated in the price.
One of the functions of technical analysis is to spotlight stocks that are depressed by a high level of discouraging fundamentals and investors disgusted by the declining stock price, but where the selling has been so heavy that the stock is completely liquidated. In other words, while there may be no reason to buy in terms of fundamentals, all the selling has been done, and the stock often has nowhere to go but up!
The Overreaction Effect
In the academic field there is a word for the phenomenon—the “overreaction” effect. One pioneering study on this was by Werner F. M. DeBondt and Richard Thaler, “Does the Stock Market Overreact?” published in the Journal of Finance in July 1985. (A follow-up, “Further Evidence on Investor Overreaction and Stock Market Seasonality,” was published in July 1987).
The authors took monthly return data for NYSE common stocks between January 1926 and December 1982 and, based on the price returns of the prior 36 months, divided the stocks into portfolios of prior winners and portfolios of prior losers. The results were fascinating.
The portfolio of “loser” stocks outperformed the market by, on average, 19.6% 36 months after portfolio formation. Winner portfolios, on the other hand, earned about 5.0% less than the market, for a net differential, between “losers” and “winners” of 24.6%.
Further, the authors found that the more extreme the return experiences during the formation period, the greater the subsequent price reversals. In other words, the more depressed the stocks, the greater the rebound.
Call it overreaction or whatever, stocks that are “down” show better performance than stocks that are “up,” which is why the dogs at the bottom of the Fortune survey often turn out like they do.
A more recent article (by Jennifer Conrad and Gautam Kaul, “Long-Term Market Overreaction or Biases in Computed Returns?” published in the Journal of Finance, March 1993) duplicated the 1985 study but used data from 1929 to 1988, which in effect covered the bull market that started in 1982, which was excluded from the earlier study. One might expect that a period covering more bullish stock action should favor the glamours, but it did not. Indeed, the reverse seems to be true. Conrad and Kaul found that the loser portfolio consistently earns positive returns that eventually result in a return of 26.3% over 36 months, whereas the winner portfolio underperforms the market after 36 months to the tune of –11.2%, for a net differential of 37.5%.
In addition, as part of the study, the authors broke down the loser and winner portfolios as to price (given their hypothesis that low-priced stocks have a greater upward bias than high-priced stocks) and found that the average price of the loser portfolio was $11.48 and the winner, $38.576—more evidence that low-priced stocks outperform high-priced stocks. Common sense tells us that low-priced stocks generally have more risk, so the rewards should be higher, as the returns indeed are higher!
The most recent study I have read on the topic is a University of Iowa working paper entitled “Long-Term Market Overreaction: The Effect of Low-Priced Stocks” by Tim Loughran and Jay R. Ritter, which specifically addresses the DeBondt and Thaler work and the Conrad and Kaul paper. The authors, who explore the effect of statistical methodology on difference in findings, also find that superior returns are available in depressed, low-priced stocks.
Based on a prior buy-and-hold return in portfolios formed on December 31, 1928, and each of the following 57 years—the last portfolio being formed on December 31, 1985—the “prior losers” outperformed the “prior winners” by over 2-to-1. The average price of the prior losers was $10.15. The average price of the prior winners was $43.54.
Further, in constructing portfolios just based on price, the difference in performance widened as the low-priced portfolio outperformed the high-priced portfolio nearly 3-to-1. And to support their statement that price is a viable proxy for prior return, the average price of the low-priced stock relative to prior highs was –75.3%.
Simply put, the evidence is compelling in suggesting that low-priced, depressed stocks are where the opportunities are to be found.
The probability of finding a winner among low-priced and depressed stocks is enhanced when an entire industry is out of favor—badly. When the airline stocks as a group are down—as they were in 1994, the airlines being the third worst performer among the Dow Jones industry groups with a 30.11% loss—the odds increase that the airlines will offer a number of rebound opportunities once the stocks come back into favor.
Here were the “Worst Performers” for 1994:
Home construction –32.62%
Home furnishings –21.63%
Building materials –21.42%
Electric utilities –18.00%
Gas utilities –17.94%
Precious metals –17.27%
Auto parts & equipment –16.84%
In 1995, the airlines flew back into favor, with a 51.1% gain for the Dow Jones airline industry group, and, not surprisingly, there were three airline stocks among the Fortune bottom 10 “least admired” that posted big gains: TWA, +88%; USAir, +211%; and Continental Airlines, +370%.
The degree to which a group is down will also play a part in the rebound. While 1994 showed some considerable drops, the 1995 declines are fairly mild, with the 10 Worst Performers among the Dow Jones groups only showing a decline of 0.91%. Indeed, there are only four groups among the Dow Jones industry groups that even lost ground: trucking, –14.49%; steel, –8.52%; transport equipment, –4.61%; and specialty retailers, –3.61%.
While there will be opportunities for gain in low-priced stocks, there will be fewer opportunities as there are not any groups that are really down.
Indeed, one of the results of the DeBondt and Thaler work shows that on average, following down market years, long-term winners perform worse, and long-term losers better, than they do following years in which the market has risen, once again confirming what common sense tells us.
Here are some comparisons from prior years, comparing the extent of decline in the Dow Jones groups versus the performance of the top 10 stocks the next year, stocks which are usually low-priced and depressed.
For instance, 1991 was a banner year for low-priced and depressed stocks, as these stocks skyrocketed, due, in large part, because during the prior year, 1990, there were so many depressed industry groups.
The worst market “correction” that has taken place in the last eight years was 1990, when the Dow Jones industrial average was down over 21% at one point in time.
And industry groups like the autos and banks were among the worst performers, but in being so in 1990, they were setting up great performances by Chrysler and Citicorp the following periods. Common sense dictates that the best opportunities for investing in low-priced and depressed stocks are after years when there have been major declines.
Still, the key is to be able to separate the wheat from the chaff. How can an investor differentiate between a Brooke Group, for instance, which was ranked dead last in the 1994 Fortune survey only to advance from 17/8 to 33/4 in 1994, for a 100% gain, and then to advance to 9 by the end of 1995, a gain of 140%, versus a Leslie Fay, for instance, which moved into bankruptcy?
Brooke Group, formerly known as Liggett Group, unquestionably has been bullish, technically. Looking at the chart, you can see the massive ascending triangle—the horizontal top tangent reflects resistance at 6, but an uptrending lower tangent reflects more aggressive support. What happens when resistance is overcome? The stock explodes.
Leslie Fay, on the other hand, looks like a waterfall. Who could buy into a chart that looks like what Leslie Fay represented—a steep down trend? Whereas Brooke shows accumulation via a massive ascending triangle, Leslie Fay shows distribution via a massive descending triangle. During 1993 and most of 1994 support kept bolstering the stock at 3, hence a horizontal bottom tangent. Weaker and weaker rallies, though, formed a downtrending top tangent. What would a reader expect from a picture like Leslie Fay? Exactly what happened—the stock collapsed.
Other Sources: CalPERS
The Fortune survey, as with any list that provides a listing of low-priced and depressed stocks, is just a starting point. Investors have to do their homework in order to make sure they are riding up with a Brooke, rather than down with a Leslie Fay.
CalPERS, the California Public Employees’ Retirement System, the nation’s largest public-employee pension fund, has increasingly caught my attention as a stock picker of sorts among low-priced and depressed stocks.
The fund has taken on an activist role as a shareholder in that it annually issues a list of “underachievers” in its portfolio in an attempt to motivate management to improve performance for the benefit of CalPERS’ beneficiaries and all shareholders.
The February 6, 1996, list, dominated by retailers at the top, is:
Not surprisingly, the stocks that are targeted are low-priced and depressed to some degree. The CalPERS Top 10 Target Companies features six stocks priced under $10, and the underperformance of the overall list is –24.2%.
The studies mentioned earlier, as well as the Fortune survey results, indicate that the better gains come from low-priced stocks that have underperformed the market. What about CalPERS?
CalPERS’ record from 1988-1995 covers 55 companies, so the track record has been long enough.
A Wilshire Associates study of the CalPERS effect of corporate governance examined the performance of 53 companies targeted over a five-year period. Results showed that while these stocks trailed the S&P 500 index by 75.2%, in the five-year period before CalPERS acted, the same stock prices outperformed the S&P 500 index by 54.4% in the following five years.
CalPERS unquestionably deserves credit for spurring on individual managements to improve. But, it will be interesting to watch how these stocks continue to perform. At a minimum, it suggests that the CalPERS list of underachievers offers a fertile area for potential stock market winners.
The Wall Street Journal Shareholder Scoreboard, most recently published in February 28, 1996, is another handy resource to finding stocks for their potential rebound, as the Journal ranks the Worst Performers for one, three, five, and 10 years.
Here is the three-year worst performers listing: Charming Shoppes; Morrison Knudsen; Rollins Environmental; U.S. Surgical; Kmart; Stride Rite; Nord Resources; Int’l Game Technology; Shoney’s; Woolworth; Navistar; Fruit of the Loom; Novell; Yellow Corp.; Nasuha Corp.; Alza Corp.; Toys R’ Us; Unisys; Apple Computer; Centerior Energy; Dillard Dept. Stores; GTech Holdings; Policy Management Sys.; Brown Group; Zurn Industries. Their average price was $15.55; the average prior return was –23.5%.
Investors have seen some of these names before. It will be interesting to see how this group fares.
This article is probably not going to convince many readers to look down at the bottom of the pile, into the abyss, and not at the top, the pinnacle, if investors truly want to find the future winners.
However, the evidence suggesting that investors turn those preconceived notions “upside down” is overwhelming. There are just too many studies, and examples, and plain common sense advice from a few Wall Street veterans, not to pay some attention to the “worst performers” if indeed investors truly want to come up winners.