Perusing the list of stocks hitting their 52-week lows inspires a little ditty called Down, Down, To Goblin Town to play in my head. It's the victory song of a horde of goblins in the 1977 animated version of The Hobbit, and they sing it while dragging the heroes down into the bowels of their dark lair. It neatly captures the dangers investors face when buying falling stocks.
Value investors are often attracted to such stocks. After all, the market was once willing to pay a far higher price for them and it might do so again should their current difficulties prove to be temporary.
Problem is, stocks have a tendency to exhibit momentum both on the upside and on the downside. That is, trends often persist in the markets.
To put some numbers on this phenomenon, I turn to Richard Tortoriello's book Quantitative Strategies for Achieving Alpha. He tracked portfolios of U.S. stocks nearest to, and furthest from, their 52-week highs over the period from 1988 to 2007.
The portfolio that followed the 20 per cent of stocks closest to their highs went on to outperform the S&P 500 by an average of 2.7 percentage points annually, which is pretty good.
On the other hand, the 20 per cent of stocks nearest their 52-week lows went on to underperform the S&P 500 by a whopping 5.5 percentage points annually, which is atrocious.
The trend might be your friend on the upside, but it's your mortal enemy on the downside.
Mr. Tortoriello's study, and similar investigations, should make value investors sit up and take notice. Scouring the list of stocks at their 52-week lows for bargains can be a dangerous endeavour. The odds are stacked against them.
Don't get me wrong. I'm not saying that it's always a mistake to buy stocks near their lows. Other factors have to be considered. But it's clear that investors have to be very selective when it comes to such stocks.
These days, I put stocks that are near their 52-week lows but pique my interest on a watch list. Then I track them for a few quarters to see how they progress. Sure, I miss out on quick snap backs. But waiting provides some protection against value traps.
Alternatively, it's worth melding a little positive momentum with a value approach – that is, to look at stocks trading near their highs provided they're still reasonably cheap. The idea here is to buy cheap stocks on the mend.
To get a taste of both ends of the momentum spectrum, I recently sorted the stocks in the S&P/TSX 60 index, which tracks large Canadian firms, by their recent performance.
The bottom of the list is peppered with gold miners that have taken it on the chin in recent months. The three stocks that have fallen the most from their 52-week highs, according to S&P Capital IQ, are: Iamgold Corp. (IMG), Barrick Gold Corp. (ABX), and Eldorado Gold Corp. (ELD). While I'm not a big fan of resource stocks, I'll put them on my watch list for further review in a few months.
On the other hand, financials are well represented at the top of the performance parade. But I also want a measure of value and stick with those that trade for less than 1.5 times book value.
The top three candidates that fit both criteria are: Manulife Financial Corp. (MFC), Power Corp. of Canada (POW), and Sun Life Financial Inc. (SLF). Dividend investors will appreciate the yields these stocks provide, which range from a low of 3.3 per cent on Manulife to a high of 4.9 per cent on Sun Life. (I own a few shares of Manulife myself.)
Even if you don't buy into the positive momentum story, I urge extra caution and patience when it comes to dealing with stocks on the decline. It is possible to delve too deep and too greedily when digging for treasure on the 52-week low list.