The greatest returns on the stock market rarely come from buying the well-loved stocks whose share prices have recently performed strongly, but rather from unloved companies that outperform low expectations. As a fund manager, I like to look through the underperformers over the past year to try and sift through the market’s “trash” to find some investment “treasure”.
Dogs of the Dow
A systematic investment strategy investing in underperforming companies named “Dogs of the Dow” was popularised by Michael O’Higgins in his 1991 book “Beating the Dow." This approach seeks to invest in the same manner as deep value, and contrarian investors do. O’Higgins advocates buying the ten worst-performing stocks over the past 12 months from the Dow Jones Industrial Average (DJIA) at the beginning of the year, but restricting the stocks selected to those that are still paying a dividend. Restricting the investment universe to a large capitalisation index like the DJIA or ASX 100 improves the chance that the unloved company may have the financial strength or understanding capital providers (such as existing shareholders and banks) that can provide additional capital to allow the company to recover over time. Smaller companies tend to face a harder road to recovery with a greater chance of insolvency when they make it onto the “Dogs” list. The strategy then holds these ten stocks over the calendar year and sells them at the end of December. The process then restarts, buying the ten worst performers from the year that has just finished.
While buying the bottom performing companies each year involves owning some companies with issues that may worsen, this strategy has outperformed the DJIA in six of the past ten years, and the ASX in six of the past ten years with a tie in 2018. In 2019 the Dogs of the Dow strategy in the USA delivered a good absolute result, though this trailed a stellar return of 22% for the Dow. Strong gains in the unloved JP Morgan (+46%) and Procter & Gamble (+39%) were insufficient to offset falls in Pfizer (-8%) and a number of other companies such as Exxon (+8%) and Cisco (+13%) that trailed an index pumped up by exceptional returns from Apple (85%), Microsoft (+55%) and United Technologies (+44%).
Advantage Retail Investors
One of the reasons why this strategy persists is that institutional investors often report the contents of their portfolios to asset consultants as part of their annual reviews. This process incentivises fund managers to sell the "dogs" in their portfolio towards the end of the year, as part of "window dressing" their portfolio before being evaluated. For example, in early 2019 fund managers with IOOF in their portfolios would have been facing some pretty stern questioning from asset consultants about why they owned the troubled financial services company in their portfolio, as owning it might suggest that the fund manager's investment process was faulty. IOOF’s share price recovered by 59% throughout 2019 to be one of the top-performing stocks on the ASX.
Here retail investors can have an advantage over institutional investors, picking up companies whose share prices have been under pressure late in the year that could see a rebound when the selling pressure stops in January and February. Furthermore, retail investors can afford to take a longer-term view on the investment merits of a particular company that may have hit a speed bump.
Last Year's Dogs in 2019
Over the past year, the Dogs from 2018 returned 27%, significantly outperforming the ASX 200 index’s return of 23%. Underperformance from AMP, Challenger and Boral was outweighed by recoveries in the share prices James Hardie, Lend Lease, IOOF and BlueScope Steel. The common theme in the reversal of performance in 2018’s “Dogs of the ASX” is an improvement in the company-specific issue that has been weighing on the share price. James Hardie benefited from both a recovery in the US housing market and falling raw material costs; Financial Services company IOOF rebounded as the company merely stabilised the ship after falling -47% in 2018, and Lend Lease had a solid 2019 after progressing its troubled engineering business towards a sale and demonstrating the underlying strength of its global residential developments.
When we went through this exercise in January 2019 looking at which of the Dogs of 2018 would shine in 2019, Atlas saw that the pain would likely continue for both AMP and IOOF, a view that was only partially correct. Similarly, our assessment for the building products companies was also mixed with James Hardie defying the dark clouds overhanging the housing construction sector in Australia and the USA. Boral (-4%) and Adelaide Brighton (-16%) performed in line with our gloomy expectations.
Last January Atlas considered that the share prices of Janus Henderson, Lend Lease and Virgin UK née CYBG were the most likely to rebound over 2019, as these companies either solved issues impacting their businesses or recovered on the prospect of a solution to Brexit, with investments made in Lend Lease and Janus Henderson.
Dogs of 2019?
Looking at the list of the underperformers for 2019 in the ASX 100, the key themes impacting their share prices are falling coal prices, interest rates, and a slowing domestic housing market. In seeking to identify which among these Dogs of 2019 will shine in 2020, history suggests that it will be those companies whose falling share price was due to company-specific problems, rather than industry-wide issues such as a falling coal price. Therefore in 2020, we see that construction company CIMIC and financial services Link Admin are the most likely to stage a recovery, either due to a takeover bid in the case of CIMIC or a Brexit-led recovery in Link’s financial administration business.
Where is Costa Group ?
And where is Speedcast?
In trying to mimic O’Higgins' Dogs of the Dow strategy, I have limited the analysis to ASX100 stocks - CGC is in the tail end of the ASX200 and SDA is outside the ASX 200. The rationale for that larger companies are more consistently able to stage recoveries as they both have greater access to the capital markets (debt and equity) that can provide breathing room when adversity strikes and generally a more established business model. Though this does always hold, Arrium was a Dog of the ASX Top 100 in 2015 and subsequently went into administration.
Interesting strategy Hugh, though of course, you still need to have a deep understanding of company-specific issues affecting share price. Perhaps like James Sloman (other comment) I'm in investor in Speedcast and rode the highs and am now plumbing the depths with this business whose balance sheet took a big hit from a recent (unwise?) acquisition. I'm expecting a better result this coming financial year.