Beware The Winner's Curse

3/28/2011


When somebody tells me they own a good stock, they usually mean it's been a good performer through the years. But whether a stock is good or bad depends on its future prospects, and stocks with the best long-term historical returns tend to deliver inferior returns going forward.

 

-- 3-Year Total Return --
Company (Price; Ticker)
Quadrix
Overall
Score
Annual.
Return
(%)
%
Rank
Aflac ($53; AFL)
97
(3.8)
66
Bard ($96; BCR)
85
(0.5)
58
Corning ($21; GLW)
97
(3.4)
65
Exxon Mobil ($83; XOM)
97
1.4
54
Hess ($82; HES)
95
(2.7)
64
NASDAQ OMX ($25; NDAQ)
96
(14.1)
81
Research In Motion ($62; RIMM)
100
(15.9)
84
Stryker ($62; SYK)
88
(0.4)
58

Stocks with the worst three-year returns delivered the best returns over the next 12 months, while those with the best three-year returns delivered below-average returns. This pattern of long-term reversal is not unique to S&P 1500 stocks:

• For stocks in the S&P SmallCap 600 Index since 1994, three-year leaders underperformed and laggards outperformed over the next three, six, and 12 months. The same is true for stocks in the S&P Midcap 400 and S&P 500 large-cap indexes.

• For stocks in all four indexes, the same pattern held true using five-year or 10-year trailing returns. For the large stocks in the S&P 500, the effect was greatest with 10-year returns. Three-year returns worked best for small and midcap stocks, many of which lack 10-year return histories.

• The long-term reversal effect was more evident with S&P 1500 stocks than when the study was limited to S&P 500, S&P 400, or S&P 600 stocks — suggesting that rotation into large and small stocks may explain part of the effect.

• Academic researchers have documented this long-term reversal effect back to the 1930s. A widely cited 1988 study by Eugene Fama and Kenneth French found that about one-tenth of a stock's performance in one eight-year period could be explained by its returns in the preceding eight years, with a tendency for stocks that did well in one period to lag in the next.

Notably, the long-term reversal effect continued to work from 2008 through 2010, a period when shorter-term measures of share-price momentum failed miserably. Historically, stocks that outperformed over the past six to 12 months tended to outperform over the next six to 12 months. But such strategies underperformed from mid-2008 until late last year, first suffering because of a sharp reversal in commodity-oriented stocks and then lagging badly in the market's recovery from its March 2009 low.

Implications for investors

You should not buy any stock simply because it has lagged over the past three or five or 10 years. Nor should you sell a stock simply because it has outperformed. The long-term reversal effect is not robust enough to swamp other considerations like valuations or growth prospects.

But the effect serves as a reminder that trees don't grow to the sky, that you should not stick with a stock simply because it has been good to you. Consider a company that has consistently grown profits faster than consensus estimates for several years, enriching shareholders and seeing the price/earnings ratio on its stock expand. If that company stumbles, even in a small way, investors' elevated expectations will be dashed — and the stock is likely to suffer. Conversely, investors may not expect much from a company that has underperformed for years.

While you should stick with a long-term winner if its valuation and growth prospects remain attractive, don't be afraid to look for opportunities among long-term laggards with superior fundamentals. Eight such stocks, all with below-average returns over the past three years, are listed above.

In June, we added trailing three- and five-year returns to our Quadrix Performance score, rewarding stocks with poor long-term returns and penalizing those with high returns. The additions should help lessen the volatility of the Performance score's relative returns. But the Performance score, still dominated by return measures of less than 12 months, is likely to remain a streaky indicator. For that reason, it is best used as a small part of a bigger system.


Current Hotline

Stock Spotlight

Individual Stock Reports

ISRs make stock research easy!

Perhaps the most valuable two page reports available anywhere.

All the data you would normally have to plow through years of 10-K filings, earnings reports, and reams of market data to assemble — yours all in one concise report.

ISRs contain our proprietary Quadrix scores — find out how we rate all the stocks in the S&P 500.

Visit us at individualstockreports.com