For Dog Lovers, a Bigger Kennel

As Contrarians Have Lost Big,
Some Investors Learn New Tricks
In Harnessing Distressed Stocks

By E.S. BROWNING
December 26, 2006; Page C1

In this joyous holiday season, with so many stocks looking like winners, we examine this year's rarity: the lumps of coal.

By almost any measure, true losers have been hard to find. Just four of the 30 stocks in the Dow Jones Industrial Average are down this year, compared to 16 last year.

As for the broader market, of 10 big industry groups tracked by Dow Jones Indexes, all 10 are comfortably up. Last year, three were down. The weakest industry groups this year are health care, up 5.4%, and technology, up 8.6%.

For one group of investors, this good cheer is unwelcome. Contrarian investors buy beaten-down stocks in hopes of a rebound. They use a host of systems and theories, some with folkloric names such as the Dogs of the Dow. With stocks so robust, what's a contrarian to do?

Some favor buying each year's weakest stocks, but that simple method has been disappointing -- especially if you are choosing from Dow stocks that are hardly down at all.

Even the 50 weakest stocks in the Standard & Poor's 500-stock index perform inconsistently. The 50 weakest from 2002, a year when stocks were hammered, rebounded 81% in 2003, according to research and money-management firm Birinyi Associates in Westport, Conn. But the 2003 losers trailed the index the next year, and the 2004 losers fell in 2005. The 2005 bunch are more or less matching the index.

What contrarians seek is a truly abandoned stock, one that is poised for a real rebound.

For that, they need one that investors have been fleeing for several years, in which the selling has run its course, says finance professor Werner De Bondt at Chicago's DePaul University, who has studied the phenomenon for the past 20 years. He recommends the 50 stocks that have fallen the hardest over the previous three to five years, and suggests using a broader universe than the S&P 500 in order to find real losers.

"But very few people have the emotional capability to implement such a strategy," Prof. De Bondt adds.

One reason: Some of the truly beaten-down companies will go bankrupt. And many investors have trouble holding on to their portfolios for the three to five years that Prof. De Bondt's studies call for. Some hedge funds -- sophisticated, loosely regulated investment pools -- do use a variation on his strategy, he says.

One way to avoid stocks that are headed for bankruptcy, Prof. De Bondt suggests, is to buy only after a stock shows signs of rebounding. You lose some of the initial pop, but you are less likely to buy a stock that is headed for the graveyard.

A similar approach is to buy stocks that have been removed from the S&P 500. Those that suffered that indignity this year are up 27% on average since removal, while those that were added to the index are up only 1% since joining, notes Paul Hickey of Birinyi Associates. (Of course, there is the risk that a stock removed from the S&P 500 will fall into bankruptcy, although that hasn't happened to this year's crop, Mr. Hickey says.)

Similar trends can be seen among stocks that are added to and removed from the Dow Jones Industrial Average.

The idea is that, by the time a stock is removed, it probably has been heavily sold, while those that are added generally are at the peak of popularity and overdue for a pullback. (In the short run, those that are removed normally fall farther as index funds sell them, while those that are added do the opposite. But that process ends after a few days.)

An even simpler system is to look among stocks that have fallen to very low dollar prices, says Richard Evans, of Richard L. Evans Investments in Flossmoor, Ill. He believes the system works especially well in December, because of tax-loss selling. Investors often sell losers at year's end in order to generate capital losses, to balance capital gains for tax purposes. That selling can depress prices artificially.

"These are valid turnaround opportunities," Mr. Evans says. He looks for such stocks that have been down for a while, and for which he can find a logical reason to expect a turnaround. At the moment, he likes some down-and-out computer-chip stocks and makers of optical fiber.

One of the oldest year-end techniques involves buying small stocks in December in hopes of a January rebound. Despite widespread publicity, this "January effect" still occurs, probably due to tax-loss selling, says business professor Mark Hirschey of the University of Kansas.

His research shows that, even though small stocks' January effect gained notice in 1976, it has continued to occur. His research shows that small stocks still rise 6% on average in that one month, compared with a 1% large-stock gain.

Prof. Hirschey worries that small stocks in general might not benefit as much this January, because they have risen heavily in 2006. The small stocks that benefit most from the January effect are those that were sold in December, which is a relatively limited group this year, and which is the group he suspects will do best next month.

Prof. Hirschey has examined another once-popular system, called the Dogs of the Dow, and found it no better than buying the overall average.

The system calls for buying the five or 10 highest-yielding Dow stocks each year. The idea is that the high yield (dividend divided by price) often indicates a low price. Even if the doghouse stocks don't soar, the thinking goes, they at least pay good dividends.

The problem, Prof. Hirschey says, is that Dow stocks rarely fall deeply into disfavor, leaving them less room to rebound. Investment firms including Payden & Rygel, which once used versions of the Dogs of the Dow strategy, have stopped. And the system has proved inconsistent.

After a disappointing performance over the previous five years, the Dogs this year have risen more than 20%, well ahead of the overall average, which is up less than 16%. But Dow Dog General Motors, up 50% this year, still yields enough that it will be a Dog again next year. Some investors wonder whether it can deliver such brilliant gains for a second year in a row.

Neil Hennessy, whose Hennessy Funds in Novato, Calif., offers two funds based on the Dogs of the Dow, says fading interest in the system may mean that it won't be overused and might work better in the future. Anyhow, he says, buying high-yielding Dow stocks helps investors limit risk.

"Our philosophy is that it isn't what you make on the upside, it is what you don't lose on the downside," he says.

Write to E.S. Browning at jim.browning@wsj.com¹

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