Here’s a puzzle: Should you invest in last year’s beaten-down stocks, or should you stick with the winners and put even more money there?
The answer appears to be yes, do both.
That conclusion is based on an analysis conducted by S&P Capital IQ conducted exclusively for U.S. News & World Report. It looked at 25 years of data going back to 1990 and found that investing in last year’s 10 worst and 10 best-performing subsectors of the Standard & Poor’s 500 index is historically a winning strategy.
“It’s a barbell approach,” says Sam Stovall, equity strategist at S&P Capital IQ. It gets its name from the idea that barbells have all the weight at opposite ends of the lifting bar.
In terms of strategy, you play both extremes by sticking with the winners and by grabbing those sectors that have been squashed.
For instance, if you had invested in the prior year’s 10 best subsectors every year since 1991, you would have averaged 14.8 percent returns per year excluding dividends. Your performance would have beaten the S&P 500 68 percent of the time; that index rose an average of 9.2 percent per year over the period.
The results of a similar strategy for the worst 10 stock subsectors would have yielded average annual returns of 16.3 percent excluding dividends, which also beat the S&P 500 68 percent of the time
Better still, there were only two years in the sample period when both strategies did not beat the index of major stocks — 1997 and 2008. Those years coincided with the Asian contagion and the subprime meltdown.
On average, the barbell strategy beats the broad market, and it is rare for both halves of the equation to do worse than the index in any given year.
The theory behind buying more of the winners is based on behavioral finance: People brag about their winnings and others buy into the momentum. “How many people whose stock hit a 52-week high are upset?” Stovall says.
Buying the beaten-up sectors relies on something called mean reversion, whereby eventually the performance of stocks tends to normalize over time around an average. Even when a sector is down a lot, it tends to catch up eventually. “It also assumes that those bottom-performing sectors aren’t headed into oblivion,” says Vinny Catalano, global investment strategist at Blue Marble Research in Maspeth, New York.
But investors beware: Human nature being what it is, things can get overdone with too much enthusiasm at the top and too much fear at the bottom.
If you decide to follow the strategy for 2016, the first thing to do is identify the best and worst subsectors. The S&P analysis finds that best subsectors so far were automotive retail, building products, construction materials, footwear, home entertainment software, home improvement retail, Internet retail, Internet software, tires/rubber and oil/gas refining and marketing.
The worst were agricultural products, aluminum, casinos/gaming, coal/fuels, department stores, diversified metals/mining, independent power producers, motorcycle makers, oil/gas drilling and oil/gas storage and transport.
For some subsectors you may be able to find an exchange-traded fund that is tailored for the subsector. For instance, the PowerShares Dynamic Building and Construction ETF (ticker: PKB) tracks a basket of stocks in the construction business, and the SPDR S&P Metals and Mining ETF (XME) tracks metals and mining stocks.
For other areas, such as motorcycles and tire manufacturers, you may need to work a little harder and construct baskets of stocks yourself.
Any investment strategy carries some risk. Take beaten-down stocks, for instance. “A stock that is down 80 percent can be cut in half again,” says Michael Batnick, director of research at Ritholtz Wealth Management.
There can also be problems with the actual companies themselves, says Steven Weiting, global chief investment strategist Citi Private Bank in New York. The energy sector has been rocked by falling oil prices, so Weiting says investors should see what has changed in the credit profile of individual stocks before opening new positions. Will beleaguered oil companies still be able to borrow as cheaply as they used to?
As anyone who witnessed the tech bubble at the turn of the millennium can attest, what goes up can quite easily come down again. It still holds that stocks that have done well and continue rising eventually can get too pricey.
For these reasons, it may make sense to limit your exposure to this strategy to a fixed percentage of your portfolio. A good starting figure might be 10 percent of your overall investments. That way, even if the strategy loses 25 percent in a year, it’s still only 2.5 percent of the whole.
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Lift Your Returns With a Barbell Strategy originally appeared on usnews.com
