Should you be afraid of successful stocks?
A ‘winner’s curse’ can hit good stocks while laggards start to pull ahead, says a U.S. advisory that also reviews two high-tech stocks, one Canadian.
Here’s how you define a good stock.
Never mind how it did yesterday, how will it do tomorrow?
In other words, success starts now. And in many cases, stocks that have done well tend to reverse roles with stocks that have lagged behind.
That’s the conclusion of a leading Wall Street advisory that has added up the results over the past decade and a half.
Mr. Richard Moroney, CFA, the editor and director of research of Dow Theory Forecasts calls this the “winner’s curse.” Here’s why.
“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.”
As usual, this advisory has the numbers to back up its case. The gist of the argument, however, isn’t to precipitously abandon long-term winners, but to keep an eye out for promising laggards.
Before we get to that argument, we turn to an update on high-tech stocks, including a Canadian firm that has been under a lot of fire lately.
Surrogate suppliers
In the wake of the catastrophic earthquake and tsunami in Japan, a number of Western companies faced new worries.
For Apple (NASDQ-AAPL), the problem is a shortage of key components made in Japan. It can likely line up surrogate suppliers for some of the components for its iPad, says the advisory. But it may have trouble finding alternatives for the device’s electronic compass, display glass and a battery that is thinner than most.
Apple buys big future contracts on parts and makes large buys in advance, so it can probably skirt around the problem more easily than its rivals can. And iPad 2 hit the market just over a week ago.
The advisory keeps this stock as a Focus List Buy (best buy for the next 12 months) and Long-Term Buy (best buy for 24 months). It trades at $341.92 with no dividend.
Research in Motion (TSX-RIM; NASDQ-RIMM) is getting ready to launch its Playbook on April 19. Best Buy started taking orders for the tablet last month.
At the same time, the company confronts wireless carriers who wish to keep customer data and other information used in mobile payments on a removable network-access card. RIM wants to keep it on the device.
The company can’t seem to appease Bay Street or Wall Street these days. Fourth-quarter results showed gains in revenue, sales and shipments, but not enough to meet expectations.
The stock fell 11 per cent after those results were released a little less than two weeks ago and hasn’t really recovered. They sit at $53.82, also with no dividend. The advisory has kept RIM as a Buy and Long-Term Buy. We will see what the launch of the Playbook brings.
From worst to best
Good stocks may start to lose momentum for many different reasons, but the fact is that most good stocks start to lose steam over time.
Mr. Moroney shows a chart that covers average 12-month returns for the S&P 1500 (that’s large, mid- and small-cap stocks) since 1994. Based on trailing three-year returns, these were sorted into 33 baskets.
“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 results.”
This was true of stocks in every size and shape — in the S&P 600 Small Cap Index, the S&P Midcap 400 and the oft-quoted S&P 500.
With its usual thoroughness, the advisory tested five-year and 10-year returns. Same pattern. In fact, the change in fortunes was even greater for large cap stocks in the S&P 500 over 10 years.
Another study in 1988 that traced stocks back to the 1930s came to the same conclusion. This study covered eight-year periods and discovered that stocks that did well in one period tended to slip in the next one.
This long-term reversal effect also held up from 2008 and 2010, when short-term measures of share price momentum “failed miserably,” writes Mr. Moroney. So what should investors do?
Not growing to the sky
Do not leap to the wrong conclusions, says the editor.
“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 does not trump important 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,” adds Mr. Moroney.
If a company that has consistently added to its profits, beaten consensus estimates and rewarded its shareholders stumbles just a little, things can go awry in a hurry. Investors’ elevated expectations can be dashed and the stock can get hammered.
On the other hand, investors will expect less from a stock that has been dragging its feet. Any progress will be appreciated.
“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.”
The advisory publishes a list of eight such stocks. One of them, interestingly enough, is Research in Motion.
The editor’s message is simple. Don’t be misled by momentum. When you accept that winners are bound to slow down and that losers can blossom into winners, you’re on the road to a stronger portfolio.
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