Low prices, high scores
Avoiding trouble comes naturally to most of us. Touch something hot, and your reflexes pull away from the danger before your conscious mind feels the pain.
The same instinct often drives stock investors. When a stock drops, a part of our mind starts yelling “Sell!” But while pulling away from a hot stove is a good move, the same is not always true for selling losers.
As is the case with many portfolios in today’s rough market, the Forecasts’ recommended lists contain plenty of stocks down sharply from their highs. Subscribers often ask why we stick with such stocks, so the following paragraphs present the three chief reasons:
• High Quadrix® scores. All else equal, share-price declines are likely to have a positive effect on Quadrix Overall scores. The Performance score hinges on total-return metrics and tends to fall when a stock underperforms the average stock. But the Value score — which tends to rise when prices fall — is more heavily weighted in the Quadrix system.
Much of the Value score is determined by valuation ratios, which become lower — and thus more attractive — when stock prices decline. If the stock’s price falls because of a fundamental change, such as problems with profits or debt, other scores will decline when the changes are reflected in quarterly income statements or balance sheets.
• Subpar returns. For the Oct. 20 issue of the Forecasts, we tested selling strategies and determined that selling S&P 1500 Index stocks after a 10% or 20% decline resulted in a portfolio return slightly below that of buying and holding the average stock — and well below a strategy of holding stocks with high Quadrix scores. Many stocks recover from dips to post excellent gains.
Sure enough, we’ve held onto some losers for too long. In hindsight, we should have sold several names when Performance and Earnings Estimates scores began to drop. While selling all losers automatically generates below-average returns, selling stocks after Quadrix scores decline is usually a good move. In fact, declining Quadrix scores can help you determine whether your stock is a victim of weakening fundamentals, rather than just short-term market turbulence.
• Looking to the future. Investors who buy a stock for $50 and watch it fall to $40 in a day can be forgiven for wanting to sell immediately. However, the reaction is short-sighted. You can’t go back in time and sell before the dip, and agonizing about the loss will not spark wise investment decisions. The only value relevant to today’s investment decision is today’s value. Once a stock has fallen, we must reassess it at current prices to maximize total return. If XYZ shares trading at $40 seem likely to deliver market-beating returns in the year ahead, investors should hold them regardless of whether XYZ traded at $50 or $30 a month ago.
Share-price declines by themselves do not always reflect a reduction in the quality of the stock. Suppose a stock has solid growth potential and a reasonable valuation at $50, then quickly falls to $40. Many declines stem from bad news about a company, and in such cases it might be better to cut bait. But often the lower price represents a buying opportunity in a quality stock.
The table below lists stocks that remain Forecasts recommendations despite price declines in recent months. All 13 of the stocks in the table seem capable of outperforming the broader market over the next 12 months (Buys and Focus Buys) or the next 24 to 48 months (Long-Term Buys).