NOT ALL DOGS GO TO HEAVEN
Sometimes simple is best. Sometimes it isn't. Knowing the difference is important for investors. Buy the dogs of the Dow, the 1 or 2 worst performing stocks among the Dow's 30 components and historically you have good odds for a comeback in the succeeding year. This strategy of "worst to first" has an impressive history based on research done by Dow Theory Forecasts Chuck Carlson www.dowtheory.com, or try another perspective at www.dogsofthedow.com
However, there have been many years that this worst to first anomaly has not worked, and I think it's usually due to difficulties specific to an entire industry. For example, if telecom, real estate, or chip makers are having challenges sector wide, it is unlikely that a Dow component company in that sector will go unscathed. Because I think several industry specific recessions are likely in 2006, our new Fallen Angels candidates do not include a Dow 30 member company at this time. Instead, I've chosen two very unpopular S&P 500 components that appear to be substantially undervalued. We'll take a closer look at these selections, but first some brief thoughts about timing.
Who Let the Dogs Out?
Why do one year's worst performers have a tendency to do so well the following year? I think it's about human nature and self preservation. If you are running one of the largest and most influential public companies in the world, and your stock has lost more money for shareholders than most of the others...you have a problem. Your board of directors and all the other owners (shareholders) will blame you for their losses.
Eventually, they will all conspire to remove you and find someone else who can make them some money. This kind of pressure can force a CEO to take action in an effort to get out of last place. CEO's will often do everything in their power to enhance shareholder value after a difficult year of sagging stock prices. It makes sense to buy the laggards when they're down and out, so long as they're profitable, have lots of cash, and demonstrate a willingness to do whatever it might take to improve their share price.
Everything Moves in Cycles
Forget about Chaos Theory, quantum mechanics, and other esoteric sciences. The markets move in fairly predictable cycles. I've seen evidence that stocks and entire index's have a tendency to go up after 4 down days, and to go down after 4 up days. If you look at most stock chart patterns, you will see a rhythm which resembles a wave. These wave cycles can be lucrative to trade, if you are both lucky and smart.
Since our goal is to buy for as low as possible, and to sell at or near the top of a cycle, it's best if you have the CEO and his or her management team working towards your mutual objectives when you buy a stock. That's what I generally like about Fallen Angel's. If we pick them carefully, and management is interested in the same thing we are, it can be very rewarding. But what about selling these stocks after they turn around?
When management feels their equity is overvalued, they usually sell shares in the open market. This activity is fairly transparent, and you can follow insider activity at www.sec.gov or even on Yahoo Finance. Because I believe that over time, a company's underlying value and it's share price will converge, I like getting stocks when they sell at big discounts to their intrinsic value. It's at these depressed levels that insiders tend to be buyers, not sellers.
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