Hated stocks trump market darlings

Assembling a portfolio of unpopular stocks might seem like an unconventional investing approach, but research indicates it may well be a winning one. Forgotten and unloved stocks have trounced market darlings over the last four decades, according to the authors of Dimensions of Popularity, a new study which appears in the latest Journal of Portfolio Management. The authors examined the performance of thousands of stocks over a 42-year period, from 1972 to 2013, as well as noting their "popularity" – that is, how often they were traded – with investors.

The results were unequivocal: the least popular quartile of stocks generated average annual returns of 15.51 per cent, almost twice as high as the most popular stocks’ annualised returns (8.27 per cent).

Typically, the most traded stocks will be companies that are in the news. Their stock price may have soared in previous months, or they may be generating a lot of excitement due to some apparently hot new product or service. The least traded stocks, on the other hand, “tend to be smaller, less liquid, and perceived as lacking growth potential”. The former will be perceived as having exciting growth prospects, while the least popular are viewed as yesterday’s news, market dullards that ignite little excitement among analysts and even less among investors. For these very reasons, however, stocks in the news are more likely to be overpriced. Little-traded stocks, “with their low relative prices, may offer investors better future performance as they move along the spectrum toward popularity”.

Focusing on trading volumes is obviously not the only way of assessing a stock’s popularity. Other studies have examined different criteria but have generally come to the same conclusion: a portfolio made up of unpopular stocks is more likely to be a profitable one.

Least admired

For example, a 2010 paper co-authored by behavioural finance expert Prof

Meir Statman

assessed the stock performance of America’s “admired and spurned” companies, as exemplified by

Fortune

magazine’s annual list of the most admired companies in the

United States

. Annual increases in admiration were generally followed by poorer returns; on average, the most admired companies underperformed the least admired firms by almost two percentage points per year.

Often, the most admired companies were simply firms that had enjoyed strong stock market performances over the previous year, only for this outperformance to prove all too fleeting.

It would be comforting if market analysts could alert investors to these biases, and warn that it's rarely advisable to buy into the latest flavour of the month. Unfortunately, a recent paper, Stock Duration, Analysts Recommendations and Misvaluation, suggests that, far from mitigating the optimism of investors, analysts tend to aggravate the problem. The paper found that when popular stocks – that is, heavily traded stocks – receive enthusiastic analyst recommendations, strong price reversals tend to occur. Instead of dampening excessive bullishness, the analysts fall prey to it, and the resulting overvaluation is predictably followed by a sell-off.

Similarly, a 2011 study found that analysts can be too optimistic for their own good, with stocks attracting “strong buy” recommendations going on to underperform.

Investors' willingness to eschew the unpopular has long offered opportunity to contrarian investors unafraid to bet against the crowd. The famous Dogs of the Dow strategy, for example, involves the buying of the 10 highest-yielding stocks in the Dow Jones index at the start of each year. Typically, these will be unpopular stocks that have underperformed in recent times. The strategy has historically proven to be a big winner in the US, and international variants have enjoyed similar success, most obviously in Japan – between 1981 and 2010, the strategy returned 13.6 per cent annually, compared with a meagre 3.97 per cent for the overall Japanese market.

Unpopular funds

Most investors don’t bother with stock- picking, preferring to entrust their money to professional fund managers. Here, too, the curse of popularity is all too evident, according to US research firm

Morningstar

.

Over the last 20 years, funds that suffered heavy redemptions – typically, funds that underperformed in the recent past – went on to enjoy average annual returns of 10.4 per cent over the following three years. In contrast, the most loved funds that saw the greatest inflows of money went on to record annualised returns of just 6.4 per cent.

The same phenomenon can be found in the varying international stock markets, says US author and money manager Mebane Faber. Last year, Faber launched the Cambria Global Value ETF, a basket of stocks from what are deemed to be the 11 cheapest stock markets in the world. Generally these will be hated markets that have been beaten up in prior years, markets where the fundamentals look awful and where the headlines are ugly – think Ireland in 2008-2009, Greece in mid-2012 or Russia in in recent months.

Such markets are not for the faint-hearted: usually they are hated for very good reasons. However, when things look ugly, even the slightest uplift in sentiment can cause stocks to surge. Faber’s data indicates that, since 1980, markets with the very lowest valuations averaged annual returns of 20.4 per cent over the following five years.

In contrast, returns in the most expensive indices – typically, when sentiment is euphoric and investors are falling over themselves to invest – were actually negative over the following five years.

The performance differential is less significant when one looks beyond the extreme cases, although it remains a wide one, with the cheapest 25 per cent of countries returning 16.9 per cent annually compared with 10.6 per cent for the most expensive.

Not easy

Good investing may be simple, as

Warren Buffett

likes to say, but it’s not easy. An investor might buy a basket of unpopular stocks, but how will s/he feel if they continue to underperform? What if the high-flying stocks recommended by one’s exuberant next-door neighbour continue to soar?

This was the case in the late 1990s, when the most popular technology stocks continued to trounce unfashionable but solid old- economy names, costing many a value manager his job.

Similarly, the Cambria Global Value ETF has lost a fifth of its value since it was launch last March, falling month after month even as popular but seemingly expensive markets such as the US and India continued to hit all-time highs. Unloved markets can become more unloved, as was the case in 2014 for stocks in Russia and Greece, hurting Cambria investors.

The truth is that no strategy works all the time. Popular stocks and popular markets may well temporarily justify the hype that surrounds them, just as hated stocks might perform in a manner suggesting they’re not hated enough.

Over time, however, the same pattern seems to eventually play out; the most loved investments tend to disappoint investors, while unloved stocks often confound their critics. The more unpopular an asset, it seems, the better.