Be Conservative . . . By Chasing Performance

1/28/2013


It's easy to buy stocks when they're going up.

Based on conversations with numerous subscribers, I can attest that many investors purchase stocks simply because they've delivered strong returns in the past. Our research suggests many of those investors end up disappointed.

As the table below shows, S&P 1500 Index stocks that outperformed the index by 5% or more during 12-month periods averaged returns at least 1% below the index average during the following 12 months. The data is based on rolling periods since 1994. In contrast, stocks that underperformed the index by 5% or more averaged at least 1% outperformance over the next 12 months.

WHAT DOES LAST YEAR TELL YOU ABOUT NEXT YEAR?

In rolling periods since 1994, S&P 1500 Index stocks that outperformed the broader index by at least 5% over the last 12 months averaged returns at least 1% below the index average in the next 12 months. Stocks that had lagged the index averaged returns above the index average. However, stocks that lagged over the previous year were less likely to outperform in the following year.

Standard deviation is a measure of volatility. Winning percentage reflects the proportion of periods in which a given strategy outperformed the index average.

Stocks That Outperformed Over
The Previous Year By At Least
Stocks That Underperformed Over
The Previous Year By At Least
20%
15%
10%
5%
5%
10%
15%
20%
All Periods Since 1994
Average 12-Mo.
Outperformance  (%)
(1.2)
(1.1)
(1.1)
(1.3)
1.0
1.3
1.6
2.2
Standard Deviation (%)
12.8
12.1
11.2
10.4
8.7
10.4
12.6
15.4
Winning (%)
55
58
61
60
40
41
41
40
Periods When Index Returned At Least 10%
Average 12-Mo.
Outperformance (%)
(2.5)
(2.7)
(2.9)
(3.1)
3.2
4.1
5.1
6.5
Standard Deviation (%)
14.1
13.4
12.5
11.6
9.9
12.0
14.6
17.9
Winning (%)
53
54
55
53
50
53
54
55
Periods When Index Had Positive Returns
Average 12-Mo.
Outperformance (%)
(1.5)
(1.6)
(1.8)
(2.1)
2.1
2.7
3.3
4.3
Standard Deviation (%)
14.0
13.2
12.2
11.2
9.3
11.1
13.5
16.5
Winning (%)
55
58
59
58
44
47
48
48
Periods When Index Had Negative Returns
Average 12-Mo.
Outperformance (%)
(0.1)
0.6
1.2
1.5
(2.4)
(3.2)
(4.2)
(5.0)
Standard Deviation (%)
7.3
6.8
6.3
6.0
4.9
5.5
6.1
6.7
Winning (%)
53
57
66
66
28
21
17
15

The conclusion is obvious: Buy stocks that have underperformed the index.

But for most investors, that conclusion is also dangerous, for at least three reasons:

More losses than wins. Stocks that underperformed over one year were more likely to underperform over the next year than to outperform, superior average returns aside.

Market-dependent performance. During periods when the S&P 1500 Index returned at least 10%, stocks that underperformed during the previous year averaged market-beating returns. Unfortunately, underperformers tended to lag again if the index declined.

Too much uncertainty. When you buy stocks that have lagged the market, you're swinging for the fences. Our research suggests such stocks are less likely to outperform and will generate more volatile returns. In rolling 12-month periods since 1994, a strategy of buying underperformers would have outperformed during up markets and lagged during down markets.

It may seem counterintuitive, but buying winners could reduce portfolio volatility. In our study, stocks coming off years when they beat the index by at least 5% tended to lag in up markets and outperform in down markets. And in all but the strongest markets, they were more likely to outperform than stocks coming off poor years.

In our view, a stock's performance over the last year isn't enough on its own to justify a buy or sell decision. Even the Quadrix Performance score, which considers a variety of return periods up to one year and even looks at longer-term returns, isn't very reliable on its own. But we view it as a crucial counterweight to other metrics. Our research suggests that since 1994, excluding Performance would have lowered the returns of top Overall scorers.

Screen of the month

All else equal, we'd rather a stock have share-price momentum than not have it. But as I've said before in this space, all else is rarely equal. With that in mind, below are eight recommended stocks that have outperformed both the average S&P 1500 stock and the average stock in their industry over the last year — and also boast Value and Overall scores above 75.

• Apple ($505; AAPL)
• CF Industries ($224; CF)
• Fifth Third Bancorp ($17; FITB)
• Foot Locker ($34; FL)
• J.P. Morgan Chase ($47; JPM)
• Magna International ($53; MGA)
• U.S. Bancorp ($33; USB)
• Wells Fargo ($35; WFC)


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