What many don't realise is that sometimes in a stock market rally the quality of the stocks you own just doesn't matter. Indeed, when the whole market rallies there are times when it pays best to own junk. These periods have become known as a 'dash to trash' and understanding the phenomenon could just save you from an awful lot of pain when the music stops.
Over the last 15 months since we've been monitoring the performance of 65 stock screens and strategies in real time the market's preference for trash stocks in strong rallies has been obvious. If you navigate to the performance history page you can explore this phenomenon better. We've annotated the chart below to illustrate how the December-January rallies in both 2012 and 2013 have been characterised by the strong rebound of stocks we normally categorise as potential short sales.
Short selling screens are filled full of story stocks, glamour stocks and trash stocks. These are stocks on nosebleed valuations or those that have little or no profits, low or no dividends, little asset backing and high share price volatility. Why do these stocks rally so hard? Because there is a lot of implied optionality in these kinds of stocks. Some of them may have blue sky potential - intrepid drillers or high tech R&D stories while others may be glamorous 'market darlings' that itch to have another leg up. When the macro environment feels a bit safer, or money is easier to come by people are more willing to go swimming with these sharks.
The danger comes when the market turns
But cyclical market downturns can be absolutely devastating to shortable stocks (glamour and trash). You can see in the chart above that between April and December 2012, when the stock market steadied itself, long strategies (quality, growth and value) outperformed short strategies (glamour/trash) by a huge margin of 30% - a margin that the shortable stocks won't ever be able to make up again though they may seem hell bent on trying.
This phenomenon of value & quality outperforming during bearish market periods has been well observed. The famous academics turned hedge fund managers Lakonishok, Vishny and Shleifer studied this phenomenon and confirmed that across typical bear markets value stocks decline less and outperform the market as a whole. For those that have read our book "How to Make Money in Value Stocks" this will come as no surprise.
The most important thing is to not get flattered in a market rally and be suckered into holding poor quality stocks. Investors can get complacent as they see their stocks rise - woozy even. But price is NOT value. Market rallies should be used as a chance to sell low quality stocks, not to fall in love!
The best time to buy trash is not now
Frankly the dash to trash this year is not very pronounced and the odds of continued outperformance are perhaps low. There really is only one type of market in which trash stocks massively outperform and that's during the rebound from the pit of bear markets.
In the 2002 and 2008 bear markets trash stocks had seen such massive price falls that they rebounded en masse with huge force. A research paper by Kent Daniel showed that over the 3 months between March and May 2009 the stocks that had held up the best during the financial crisis rose by only 6.5% but trash stocks - while those that that had collapsed the hardest rose by 156% !
So the point is - why hold trash now? Where is the upside given the significant risk of further market volatility?
How to filter low quality stocks from your portfolio
Given all this, I would suggest it's vital to take the trash out now! There are a few red flags and filters that we like to use at Stockopedia to highlight stocks that are potentially at a high risk of reversal. Any stocks showing more than a few of the following signs should be seriously considered for sale in market rallies.
- High Price to Sales, High Price to Book, High Price to Earnings (the most expensive 20% of stocks are always at risk of severe reversal)
- Altman Z-Score in distress zone (<= 1.8) (high bankruptcy risk)
- Piotroski F-Score <= 3 (poor fundamental health)
- Recent EPS Downgrades
- Low Relative Strength
An example of what I'd call a low quality and vulnerable stock is the snippet of the Stock Report on the right.
Another quick way to find stocks that might have some of the above red flags is to eyeball our short selling lists for any stocks you may own.
And for those readers who aren't yet subscribers to Stockopedia, we still offer a 2 week free trial, so please take advantage to reposition your portfolio while this window still lasts.Follow edcroft on Twitter
Filed Under: Value Investing,