Risk is inherent to stock market investing. Broadly speaking, risk and reward appear to go hand in hand. That is not to say that all high risk gambles lead to a big reward or that modest rewards are always associated with low risk.
For instance, you might bet 100% of your funds in out-of-the-money options with stocks facing binary decisions that could make prices double or plummet. If you continue to trade with the high-stakes poker mentality of all-in, you will eventually lose it all on one trade. Or you might find many strategies that have an average annual gain equivalent to the market (as tracked by the S&P 500 index), but you should look to max draw-down to get an idea of risk. One strategy that gains 5% relentlessly year after year (much like bonds) has lower risk than one with wild annual profitability swings that average out to 5% gain.
Another substantial risk comes from sector momentum. What is the risk of momentum and how can you reduce its effect? (If you are a contrarian investor that doesn't flinch while looking risk in the face, then check out these Cheap Stocks near 52-week lows)
Momentum-Based Risk and Neutralization
Stocks tend to trade in packs. If a large number of stocks are jumping in one sector, this will often pull up other laggard stocks as well. When an entire sector is dropping, prices will often compress on all stocks within a sector, despite the strong financials of certain individual stocks.
What this means is that although you might be able to pick great stocks, sector momentum could be unknowingly working against you for reduced gains. By spreading out your stock picks among many sectors, you can largely neutralize this momentum effect.
Buying ETFs or index funds that contain many sectors is one method to reduce momentum-based volatility. But you also have a pre-selected group of stocks that you may or may not want. You could also utilize a strategy to buy individual stocks within many sectors. Here is one technique to pick up rising stocks in various sectors.
Stocks upgraded by analysts, as well as stocks with raised forecasts, have a tendency to drift upwards. This is reported on in a paper by Boni and Womack entitled "Analysts, Industries, and Price Momentum(2004)." As reported by the American Association of Individual Investors, buying stocks with raised earnings estimates has yielded an average 30.5% annual return since 1998. I will outline some broad sectors along with some upgrades below to put this strategy into practice.
Industrial Goods Sector
- United States Steel Corp. (X) – This stock is included based on its EPS revisions. Earnings have been revised upwards by 4% for the year, and by 2.7% for next year. The stock is currently struggling, but this could make a timely purchase albeit somewhat contrarian.
- Oracle Corp (ORCL) – The amount of upwards revisions over the past 30 days has been overwhelming. 40 upward revisions were made for the current years earnings estimates, which equates a 4.3% earnings upgrade. This upcoming quarter was revised upwards by 7.5%.
- Intel Corporation (INTC) – This makes the list due to a ratings upgrade by Standpoint Research from Hold to Buy. This is a welcome trend since February with an initiated Buy rating from Longbow, and an upgrade from Neutral to Outperform from Robert W. Baird.
Basic Materials Sector
- Walter Energy, Inc. (WLT) – This coal producer was sharply revised upwards over the past seven days for an earnings boost of almost 16% for this year alone. Next year was also revised by more than 10%. The long-term growth trend for the next five years is guessed at 18%, which creates a very low PEG ratio of 0.53.
- Exxon Mobil Corporation (XOM) – This oil and gas producing giant has seen earnings forecasts jump by almost 10% for the year, and by 6.7% next year when comparing to forecasts from one month ago.
- Chevron Corp. (CVX) – The earnings estimate jump over the past 30 days is 8.7% for this year, and almost 7% for next year. Chevron has been an extremely good price performer over the past year.
- Dollar Thrifty Automotive Group Inc. (DTG) – The next quarter was sharply revised upwards over the past month by 33%. Next year’s earnings are expected to be 36% higher than what was thought last month. Renting vehicles just got a whole lot more attractive.
- Zumiez, Inc. (ZUMZ) – This specialty clothing retailer has received some very mild earnings upgrades recently, but is included due to the analyst ratings upgrade from Underperform to Neutral by Wedbush. The stock is trending upwards when looking over many years of data, but it has retreated from $33 highs in late 2010.
- DepoMed Inc. (DEPO) – This specialty pharmaceutical company with its proprietary oral drugs for diabetes and urinary tract infections is looking at a much more profitable year than it figured one month ago. From 38 cents to 50 cents annual EPS, the earnings estimate jumped by almost 32%. That being said, next year was sharply revised downward, so this may weigh on the stock.
- Liberty Property Trust (LRY) REIT – Stifel Nicolaus has trouble sticking to a rating; since July 2010, the recommendation has went from Hold to Buy, back to Hold, and most recently a Buy once again. If the analysts stop waffling, this could make a decent holding, until they change their minds one more. It’s nice to see an upgrade financial stock.
So you attempt to reduce sector-specific momentum by diversifying, while simultaneously buying upgraded stocks – both in ratings and earnings forecasts – to take advantage of what might be a small market inefficiency. Of course, caution is always warranted and due diligence is a must. This technique might provide a good starting point but investigation into each and every stock is desirable when attempting to lower risk of hidden dangers.