10 hated stocks you'll love in 2007

By Jim Jubak

Buy 'em when they're hated. I don't mean "out of favor" or "disliked." I mean HATED.

And buy 'em at the end of the year. Not in November. Not in January. But around the middle of December.

That's the simple foundation of the Dog Stars strategy I laid out in a column in December 2004.

Now it's time to tell you how well that strategy did for its one-year holding period from Dec. 15, 2004, through Dec. 15, 2005. And it's time to pick a new group of Dog Stars for 2007.

There wouldn't be any point in revisiting this strategy if it hadn't produced good returns. The average return on the 10 stocks I picked from Dec. 15, 2004, through Dec. 15, 2005, the holding period stipulated by the strategy from the start, was 14.9%. That compares with a return of 6% for that period for the S&P 500 ($INX) and 2% for the Dow Jones Industrial Average ($INDU).

(The Dog Stars of 2005, picked on Dec. 15, 2004, were Charles Schwab (SCHW, news, msgs), Hasbro (HAS, news, msgs), Interpublic Group of Companies (IPG, news, msgs), Merck (MRK, news, msgs), MBNA, bought by Bank of America (BAC, news, msgs), Nokia (NOK, news, msgs), Reynolds & Reynolds (REY, news, msgs), Teva Pharmaceutical Industries (TEVA, news, msgs), Western Digital (WDC, news, msgs) and Westwood One (WON, news, msgs). I didn't create such a list for 2006.)

That past performance isn't a guarantee of future returns, as the fine print always says. But I think there are two good reasons to believe this strategy will outperform again in 2007.

Why to love the unloved

First, on the evidence of one year -- a very small sample, I grant you -- Dog Stars are a good bet to beat the market in years the market as a whole isn't going anywhere. (The market went nowhere with a vengeance in 2005, with the S&P 500 up 3% for calendar 2005 and the Dow industrials down 0.61%.) That only makes sense: Dog Star stocks go up because of a turnaround that is specific to an individual stock and doesn't depend on the general market. (From my sample size of one year of performance numbers, you'd be right to say that I have no idea how this strategy would behave in a down market.) With 2007 shaping up as a relatively modest year for the stock market as a whole, the Dog Star strategy has a good chance of outperforming again.

Second, the stock market is in the midst of another great mergers-and-acquisitions boom, fueled by record-breaking amounts of capital raised by private buyout funds. The beaten-up companies with lots of assets (even if the asset is just a brand name) and good turnaround potential that wind up in a Dog Stars portfolio are good buyout candidates, too. Even if the general market goes nowhere, a buyout offer for a Dog Star would result in a very respectable profit for an existing investor.

So what is this Dog Stars strategy?

The Dog Stars strategy is a straightforward attempt to build on two very successful buy-them-when-they're-hated strategies.

First, there's the Dogs of the Dow strategy, the most famous example of a buy-them-when-they're-hated approach. The strategy works like this: Every Dec. 31, you buy the highest-dividend-yielding stocks in the Dow Jones Industrial Average. Because a stock's dividend yield goes up as the price of a share falls, this is a simple way to buy shares of the 10 most battered stocks in the index. You then hold the shares for a year and rebalance the portfolio by selling these stocks and buying a new group of losers next December.

This extraordinarily simple strategy has yielded market-beating returns decade after decade. From 1928 to the end of 2003, the Dogs of the Dow strategy returned an average annual compounded rate of 13%. That was almost 2 percentage points a year better than the return on the Dow industrials and 2.5 percentage points better than the return on the S&P 500.

But -- and this is a big but -- returns from the strategy have dropped over the last decade. I don't know if this represents a long-term problem or simply normal volatility in the performance of the strategy. Dogs of the Dow doesn't do well every year. In 2005, the strategy lost 5%, a worse performance than the Dow Jones industrials as a whole.

The Dogs of the Dow strategy turns in its best monthly performance in January. That led Yale and Jeffrey Hirsch, publishers of the Stock Traders Almanac, to propose an improved approach, called the "Free Lunch" strategy. Their strategy calls for buying all the New York Stock Exchange stocks selling at their lows in mid-December and holding them to Feb. 15. The average gain on the strategy since 1974 through 2003 comes to about 13.7% in six weeks. That compares with the average 3.9% gain in the NYSE Composite Index ($NYA.X) for the period.

Broadening the list

My Dog Stars strategy is designed to take advantage of the two reasons that these successful buy-them-when-they're-hated strategies work.

• First, the Dogs of the Dow strategy works because the 30 stocks that make up the Dow Jones Industrial Average tend to be long-term survivors. These companies have enough financial strength to weather short-term troubles without going out of business. They survive bad times long enough to see the return of better times, as Boeing (BA, news, msgs) did in 2004, with its shares climbing 28%.

• Second, the two strategies work because they buy already-beaten-down stocks that decline even further in the last days of the year as investors sell their losers to lock in tax losses for the year. When the selling pressure is relieved in January and February, these stocks bounce back from deeply depressed to simply depressed levels.

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