The Risks of Beaten-Down Stocks

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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?

That would not be easy. To duplicate the survey’s results, assuming the future is the same as the past, one would have to buy dozens of high-priced stocks every month, hold them for 12 months and sell them. Brokerage commissions would surely devour any extra gains from this “buy high, sell higher” strategy.

If you bought just a few stocks, there would be a good chance your sample would not accurately reflect the whole group of high-priced stocks.

The investor, therefore, would have to add other criteria to the selection process, trying to distinguish stocks that have been pushed too high by investors' exuberance from those that have a solid reason to keep going up.

Of course, if you’re going to get that deep into analyzing individual stocks, you might as well also try to distinguish those that have been driven down for good reason from those that don’t deserve to be hovering at 52-week lows.

It would be a huge amount of work. But if there were a simple, fool-proof system of selecting stocks with criteria that are easily obtained, everyone would use it. Investors would rush to buy the “bargain” stocks, and the heavy demand would drive their prices up until they were no longer bargains.

Investing in individual stocks inevitably takes a lot of judgment and insight, which is why so many investors opt for mutual funds, leaving the hard work to the pros.

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