It may seem intuitive that stocks that dropped the most during the bear market (worst momentum, smallest market cap at the bottom, lowest price at the bottom) have shown some of the greatest returns off the bottom. This intuition is faulty however, for several reasons. First, those who own the stocks that dropped the most – owned the stocks that dropped the most. Very few investors were able to time the purchase of these cataclysmic names, like Citigroup, Bank of America, and AIG so that they avoided the bloodbath before experiencing the ecstasy of rebirth. Even the bravest value investors like Bill Miller, whose Legg Mason Value Trust had one of the strongest 10-year track records of any mutual fund until late 2007, saw his fund value drop from $85 to $22, a drop of 74% (!!) before seeing his fund rebound by almost 100% since March 9th. His fund is still down over 50% from its peak. Another reason why it makes little sense to try to buy the stocks that have dropped the most during bear markets is that these stocks usually underperform over the duration of the subsequent bull market. The 2000 – 2003 bear market is a great example. The stocks that went down the most in the bear market – JDS Uniphase, Nortel Networks, Mindspring, Cisco, etc. were very weak performers from 2003 – 2007. The strongest performers throughout the 2000 – 2003 bear market – energy, materials, and gold companies – were enormous winners during the following bull market. This is the rule, not the exception. Myles Zyblock, Chief Institutional Strategist for RBC Capital Markets wrote the following in his September 1st note to clients:
“North American stock-specific leadership, regardless of sector membership, has been characterized by a type of constituency that most analysts refer to as “low quality”. This has been a rather unnerving shift for managers who follow a discipline that emphasizes particular attributes such as earnings quality or profitability. Many mandates have not allowed managers to enter this low-quality style box, to the detriment of relative performance. Strict adherence to a process more often than not leads to investment success, but the market can and often does move against a winning long-term strategy for brief time periods. Keep in mind that low quality cycles, even in up markets, tend to be relatively short-lived and our best guess is that there are only another 1-2 quarters of life left in this one. One way to get a sense of what the low quality rally has been all about is to view the performance of stocks since the March low sorted by a few simple metrics that isolate the impact of quality factors including size/liquidity, valuations and profitability. Based on this methodology, it’s pretty clear that the smaller, less liquid, relatively inexpensive and more fundamentally broken companies have been the big outperformers over the past five months. ” (See Table 1.)
The next chart shows the performance of North American stocks, with S&P performance on the left, and TSX performance on the right. The grey bars represent the performance of highest quality stocks in each of the four major investment styles – Momentum, Predictability, Growth, and Value – while the blue bars show the performance of the lowest quality stocks. All performance is from the March 9th bottom.