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Each of the past two years, at about this time of the year, I've used a stock screen to find stocks that had stumbled during the year but appeared ripe for a comeback. These stocks created my Comeback Kids portfolio, which I tracked for the following 12 months.
The portfolio I put together in November 2004 averaged a 15% return over the next 12 months, more than double the S&P 500 Index's ($INX) 7% return. Seven of my 10 picks scored gains. Two of the remaining stocks dropped less than 3%. Only one selection, down 15%, suffered a significant loss.
Last year's results were less impressive. Again, I picked 10 stocks in November, and as before, after 12 months, seven had recorded gains. This time, though, I picked a big loser, Boston Scientific (BSX, news, msgs), which fell 40%. Even so, the portfolio averaged a 10% return, respectable but below the S&P 500's 12% run-up. Without Boston Scientific, the portfolio would have gained 15%.
But something interesting stood out when I reviewed the performances. In each of the two years, three stocks dropped. What I noticed was that I could have eliminated all six losers with some simple tweaks to my screen. I'll give you the details in a minute, but first some background.
More dogs to choose from
My Comeback Kids strategy was inspired by a simple concept popularized by Michael O'Higgins in his 1991 book, "Beating the Dow." O'Higgins' Dow strategy involved buying the most out-of-favor members of the Dow Jones Industrial Average ($INDU), holding them for a year, then repeating the process.Over the years, O'Higgins' dogs have produced returns more or less in line with the major averages, but with less volatility.
For my Comeback Kids portfolio, I followed O'Higgins' concept, but made two major changes to his selection strategy.
First, I broadened my candidate universe to include all the stocks in the S&P 500 instead of limiting the field to the 30 stocks making up the Dow industrials.
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O'Higgins limited his picks to Dow stocks because the Dow comprises the biggest and strongest U.S. companies, those likely to overcome just about any adversity. But Standard & Poor's limits the stocks in its S&P 500 Index to the largest companies in all major U.S. industries. So, while S&P stocks may not be as solid as the Dow stocks, they still register low on the risk scale.
My second change from O'Higgins' strategy involves the definition of "out of favor." O'Higgins used dividend yield, which is the next 12 months' expected dividends divided by the current share price. O'Higgins reasoned that high-yield stocks got that way because their share prices dropped. That's not necessarily the case.
Dividend yield is more about a firm's dividend policy than it is about its stock-price action. For instance, the last time I looked, AT&T (T, news, msgs), which has been one of the Dow industrials' top performers this year, pays a dividend equating to a 3.9% yield. By contrast, the yield for Wal-Mart Stores (WMT, news, msgs), one of the year's worst performers, is only 1.5%. So, relying on dividend yield for those two stocks would mark AT&T as the dog instead of Wal-Mart.
Instead of using dividend yield as a surrogate for market sentiment, I cut to the chase and looked at the past 12 months' returns. I figured that the stocks that have dropped the most, on a percentage basis, are the most out of favor.
I limited the field to large-capitalization S&P 500 stocks because they are usually considered lower risk than smaller stocks. I defined large cap as stocks with market capitalization of at least $10 billion. (Market capitalization is the recent share price multiplied by number of shares outstanding and is how much you'd have to pay to buy the whole company).
I also ruled out stocks trading below $5 per share, because such stocks are probably cheap because investors see serious problems.
When I listed the screen results, I sorted the lists using the past 12 months' returns. The first 10 stocks on the list, the biggest losers, made up my Comeback Kids portfolio.
When I reviewed the portfolio returns last week, I noticed that, for each year, the three stocks that had lost money for me were congregated near the bottom of the list. In other words, they were among the stocks that had barely qualified for the portfolio. Aha!
My strategy worked. The biggest losers were the best prospects, but I was allowing stocks on the list that weren't big enough losers.
So for 2007, I'm making some changes.
Bigger losers
This year, I'm still looking through the stocks that make up the S&P 500 Index, but I'm limiting my candidate universe to stocks that have dropped at least 25%.Screening parameter: S&P Index Membership = S&P 500
Screening parameter: % Price Change Last Year <= 25
With that change, maintaining last year's $10 billion market-cap requirement cut my list down to only five passing stocks. I don't think that gives enough diversification to keep one bad apple from ruining the portfolio returns, so I lowered the minimum market cap to $2 billion, which allowed midcap stocks as well as large caps.
However, to reduce risk, I upped the minimum required recent trading price to $15, from last year's $5 threshold.
Screening parameter: Market Capitalization: >= $2 billion (entered as 2,000,000,000)
Screening parameter: Last Price >= 15
After making those changes, my screen listed 11 stocks. However, two of them, First Data (FDC, news, msgs) and Wendy's International (WEN, news, msgs), were dropped because they had spun off parts of their operations to shareholders in the form of dividends. The share price of a third, CBS Corp. (CBS, news, msgs), went up, not down, last year (I think the error came from a recent corporate reorganization).
Deleting those errors, my screen yielded eight stocks. If your screen lists more than 10 stocks, use the 10 biggest losers. Here's the list of passing stocks:
| Company | Recent price | Industry | % Price change past year |
|---|---|---|---|
39.05 | Education, training services | -43 | |
49.30 | Medical instruments, supplies | -40 | |
16.65 | Medical instruments, supplies | -35 | |
19.60 | Processing systems, products | -29 | |
31.98 | Internet software, services | -28 | |
17.46 | Electronics stores | -27 | |
49.04 | Grocery stores | -36 | |
26.48 | Internet information provider | -34 |
Interestingly, Boston Scientific was the only repeat from last year.
The list is well-diversified. MSN Money lists both Boston Scientific and Bausch & Lomb in the medical instruments industry. But, in reality, they are in different businesses. Boston Scientific makes stents (used to prop open clogged arteries) and heart defibrillators (used to restart hearts that have stopped beating), while Bausch makes eye-care products.
O'Higgins advised buying equal dollar amounts of all 10 Dow dog stocks and holding them for one year. Apply the same strategy to the comeback stocks. Avoid the temptation to cherry-pick the list. There's no way to predict which stocks will do best.
At the time of publication, Harry Domash did not own or control any of the stocks mentioned in this article.
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