I talked yesterday about one of the biggest mistakes most investors make.
That is, thinking that a stock’s recent “price discount” must certainly make it a “better value.” (A.k.a., a “buy” at a “good price.”)
But the sad truth is, buying recently “discounted” stocks is usually a losing strategy. That’s because weak stocks usually get weaker, not stronger.
And I have some eye-popping numbers to back up that claim.
Imagine for a minute that you’re limited to buying S&P 500 stocks. And that you can choose one of the following two investment strategies.
After sorting all 500 stocks in the S&P 500 index, based on their performance over the last quarter or so… you can either:
Buy the 50 Best Performing stocks… and hold them for a quarter or so.
Buy the 50 Worst Performing stocks… and hold them for a quarter or so.
We’ll call Option A, “buying the winners,” and Option B, “buying the losers.”
Although most investors don’t think they’re buying “losers,” they mistakenly think they’re buying “a nicely discounted stock.” That’s what Bill, our fictitious investor from yesterday’s story, thought when he decided to buy three stocks in late 2007, at “discounts” of 13%… 17%… and 40%.
Sure enough, the three stocks that Bill bought at a “discount” – Bed Bath & Beyond, American Airlines and E-Trade – were trading at even deeper discounts a few months later, as the stocks dropped a further 17%… 54%… and 65%, respectively, by March of 2008.
Simply put: “cheap” got cheaper (and Bill lost his shirt).
And this concept isn’t limited to a few cherry-picked examples. Take a look at three of the research studies I ran, all of which show the same trend: weak stocks get weaker.
Buying the losers (Bottom 50 S&P stocks) in late 2007 would have handed you an average loss of 17% by March 2008. Meanwhile, Top 50 stocks held up much better. Take a look:
The same thing happened a few months later.
Buying the losers (Bottom 50 S&P stocks) in early 2008 (while thinking, “the worst must be over”) would have handed you an average loss of 16% by August 2008. Meanwhile, Top 50 stocks held their ground.
Clearly, buying “recently discounted” stocks in late 2007 and early 2008 was an awful strategy.
Now, fast forward to more recent times. The S&P 500 was trading at an all-time high in late July of last year. Naturally, investors were hesitant to “overpay” and instead looked for “good discounts.”
But again, buying recently discounted stocks (Bottom 50 S&P stocks) in late July turned out to be a terrible idea. Those stocks have fallen a further 20% since then… while Top 50 stocks have lost a milder 10%. Take a look:
I hope my message is becoming clear now:
Weak stocks tend to get weaker, not stronger!
That’s certainly true when you’re making your investment decisions on price alone. Remember, as Warren Buffett says: “Price is what you pay. Value is what you get.”
To truly understand what a stock is worth, you need to dig deeper into the company’s books.
That’s exactly what forensic account John Del Vecchio does – he unravels the “tricks” that companies use to try to fool investors.
And on January 28, he’ll show you some of these trade secrets in a special online exclusive that he’s prepared just for Dent Research. It’s called Earnings Exposed and airs at 4 p.m. (with a rebroadcast at 8 p.m. for those who can’t make the earlier showing).
Registration is required to participate though, so make sure to get your name on the VIP list.
You won’t want to miss this.
To good profits,
Adam O’Dell, CMT
Chief Investment Strategist, Dent Research
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