Looking for gold in the stock market is often easier said than done.
But sometimes stocks fall down a deep hole and enterprising investors can scoop them up near the bottom.
The problem is, bargain hunters sometimes run afoul of momentum's dark side and latch on to stocks while they're still on their way down. History shows that stocks that have fallen the most over the past year tend to continue to decline in the short term.
But the momentum effect changes direction over extended periods of time. Long-term laggards tend to go on to outperform. It's a phenomena called long-term reversal.
In this case, the idea is to ignore a stock's performance over the past year (at least for the moment) and instead focus on its lagged prior return over the period from five years ago to one year ago.
Dartmouth professor Kenneth French collects data on the long-term reversal effect. In one study, he sorted U.S. stocks based on their lagged prior returns and put them into 10 groups called deciles. Each group was tracked for a year and then the process was repeated.
The group of stocks with the lowest lagged prior returns subsequently went on to perform the best with average annual returns of 21.6 per cent from 1931 through 2014. The group that had the highest lagged prior returns fared the worst with average gains of only 8.7 per cent annually. In this case, picking the long-term dogs was the right way to go.
Long-term reversal is just the sort of momentum effect that value investors love. After all, if a company can resolve the troubles that sent it tumbling in the first place, its stock may bounce back to its former highs.
Practically speaking, many of the stocks that have fallen the most over the past five years tend to be tiny penny stocks with very questionable prospects. Don't get me wrong, it is possible to pick winners amongst them. But I like to stick to stocks that trade for more than $2 a share and have real businesses backing them up.
These days, you might expect oil companies to dominate the worst-performers list. But the energy sector was particularly hit hard over the past year, which makes it a relatively recent laggard. Its performance over the prior four years – the period that powers the long-term reversal effect – wasn't as bad.
Instead, if you're looking for long-term reversal stocks then you'd do well to look at gold miners. For instance, Alacer Gold Corp. (ASR-TSX) is one candidate that seems to have staying power. The gold producer calls Englewood, Colo., its home but digs for the yellow metal in central-eastern Turkey.
If you pull up a five-year graph of Alacer's stock price, the picture isn't pretty. It hit a high of $12.66 a share in the fall of 2011, declined rapidly, and has been largely stagnant for a couple of years.
Over the past 52 weeks, it hit a low of $1.77 a share and a high of $3.11 a share. These days, it trades near $2.70 a share. As you'd expect, the stock is heavily influenced by the price of gold, which also declined over the period.
Despite the hard times, Alacer posted a profit last year and trades at 10 times trailing 12-month earnings. It also has $347-million (U.S.) in cash and no long-term debt. On the downside, analysts expect its earnings to slip next year and figure it trades at 22-times forward earnings.
There are other risks, of course. If the price of gold falls significantly, the firm's operations could become uneconomic. Last quarter, management estimated the firm's "all-in sustaining cost" of gold will be between $775 (U.S.) and $825 an ounce in 2015. Gold has been trading around $1,185 (U.S.). An unfavourable move by the Turkish lira could also cause discomfort.
But if the price of gold climbs, Alacer should be able to recapture at least some of its former glory.