While some people spend the majority of their time looking for that homerun stock which might double over the next year, more time should be allocated to weeding out stocks that have a high risk for a dropping price. But how do you know which stocks are a high risk for capital loss?
While there are a plethora of valuation tools, from F-Score to ‘old school’ Buffett valuations, another simple filtering process also works well. We pick stocks where the average analyst recommendation one week ago fell from what it was 2 months ago. We also require that the current year's earnings estimate drop by at least 10% between last month until today.
How poorly have these S&P 500 stocks performed historically? If we re-balance our portfolio weekly, the damage looks like this over 10 years (red line is our screen and blue is S&P 500):
62% of our portfolio has been eroded. Before you run out and panic, this does not mean that holding these stocks long-term resulted in a 62% loss. We are re-balancing our portfolio every week to show the short-term effects of holding these types of stocks. Still, in down markets, these stocks have lost 3.51% per week on average over the past 10 years. The S&P 500 has historically lost less than 2% per week during down markets.
These downgraded stocks have had a particularly difficult time since the beginning of 2011.
Downgraded and Downward Revised Stocks:
*(Data and Figures complied by Portfolio123 and FINVIZ)
AK Steel Holding Corporation
Hudson City Bancorp, Inc.
Sprint Nextel Corporation
Sears Holdings Corporation
What fundamental clues do we have that these stocks are lackluster right now?
The earnings growth numbers look rosy for next year, but right now a different picture is being painted. Earnings are expected to be in the negatives this year for AK Steel (NYSE:AKS), Sprint (NYSE:S), and Sears Holdings Corporation (NASDAQ:SHLD). Over the past 5 years the earnings have been in the red for all but CenturyLink (CTL), Hudson City Bancorp (NASDAQ:HCBK), and Tellabs (NASDAQ:TLAB). Only CTL and TLAB have return on equity ratios that are positive. Despite this, dividends are being offered on the majority of stocks. If you pay out more cash than you have earned, this is sure to erode share value.
On another note, Sunoco (NYSE:SUN) has made a healthy bounce back from the $30 mark on very high volume. Is it because SUN is a fantastic company to buy? Hardly. It has more to do with investors pushing down prices so low that as the different company operations are separated, the sum of the parts are worth more than the total current share price. The owners are fighting back at the investors as fear and loathing may have driven prices too low, although it is still not a great stock to own long-term.
What This Means For You
1. Does this mean that you should instantly sell any of the above stocks? Not necessarily... and here is why. After holding the stocks for various time frames – from one week to one year – the empirical evidence shows that you might fetch a better price by waiting it out. At no time do the stocks bounce back extremely well, but if you hold for a couple of months, or even a year, the losses are significantly reduced.
2. A second reason that you might want to hold is if you feel confident that the market is about to bounce back imminently. While these stocks may fall up to twice as hard in down markets, they also jump back twice as fast in good markets. As you might know, leveraged investments are not meant to be held long-term as they are statistically slanted toward losing overall value. But if an upturn is around the corner, you could quickly recover at least a portion of those losses.
3. A third reason to hold is if you are a contrarian investor and you feel that investors, as a whole, have this all wrong and will soon re-price the stock. I’m not a huge fan on contrarian investing simply because a change of sentiment can take a very long time – and in this game, time is money as it relates to annual returns.
If you think the market is about to spring back to life, you may want to leave these stocks in your portfolio a little while longer to reduce some of your current losses. Otherwise, if you are like the majority of investors who are unsure of what the future holds, you may want to cut your risk down and leave these picks to the contrarian-types.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.