The Risks of Beaten-Down Stocks

Every investor knows the basic goal is to buy low and sell high. But a recent study by discount-broker Charles Schwab (Stock Quote: SCHW) underscores how “bargain” stocks can disappoint.

Screening tools like one offered by Schwab allow investors to prospect among stocks trading at or near their 52-week lows. While some of the beaten-down stocks are true bargains, how does the group do as a whole?

Schwab sorted the 1,500 largest stocks into three groups for every month from December 1989 through September 2009, then gauged performance during the next 12 months.

Stocks trading within 10% of their 52-week low continued to do poorly, trailing the overall market by 3.2 percentage points during the next 12 months. That was somewhat surprising, as many investors assume many beaten-down stocks are poised for a rebound.

The apparently high-priced stocks, trading within 10% of their 52-week peaks, beat the market by an average of 1.5 percentage points during the next 12 months. Again, that defies common wisdom.

The study also found that that the high-priced group did better than the low-priced one regardless of whether the broad market was doing well or poorly.

The study indicates that stocks trade near their recent lows or highs for good reason — because a company is doing poorly or doing well. A low-priced stock isn’t necessarily bound for a turnaround, as many investors assume. It could keep going down. And a big winner may keep rising rather than “settling back.”

All of this suggests that a strategy of “buy high, sell higher” could beat the market. But it’s somewhat academic. How could an ordinary investor put the findings to use?