Monday 26 August 2019

Keep winner-loser effect in mind when investing in the New Year

Mining giant BHP Billiton is one name worth considering in 2018. Stock image
Mining giant BHP Billiton is one name worth considering in 2018. Stock image

David Flynn

Markets are discounting mechanisms: they price-in what is known, discount those things and look forward - not backward. People tend to invest based on what is already known and therefore already built into the price, which exposes them to risk based on the factors that are unknown. In my opinion, this is why the price anomaly explained below, exists.

Werner DeBondt and Nobel prize winner Richard Thaler are best known for their work in the field of behavioural finance. In an mid-1980s article, they concluded that the majority of market participants tend to overreact to long periods of positive and negative momentum in the stock market which eventually led to stock prices moving in the opposite direction.

They tested the hypothesis that "if stock prices systematically overshoot, their reversal should be predictable from past return data alone, with no use of any accounting data such as earnings". Specifically, two hypotheses were tested: First, that extreme movements in stock prices will be followed by subsequent price movements in the opposite direction; Second, that the more extreme the initial price movement, the greater will be the subsequent adjustment.

They tested their hypothesis focusing on stocks which had either an extreme capital gain or losses over a long period of time. They used data for the period of 1926 to1982, building loser and winner portfolios for a five-year period after they had constructed their portfolios. Over a five-year look-back period, the loser portfolio outperformed the winner portfolio by 31.9pc over the following five years. This phenomenon is known as the winner-loser effect.

DeBondt and Thaler found that the effect was much less pronounced for the winner portfolio than it was for the loser portfolio and that a large majority of the returns were made in January.

At this time of year, momentum tends to beget momentum. Stocks that have done well on the year tend to rise further into year end, while stocks that are down on the year tend to continue to fall into year end. The main reason is tax related: we tend to crystallize our losses in the current calendar year and book gains after the new calendar year has begun. This is probably the main reason returns on the loser portfolio mentioned above tend to be best in January.

Considering the winner-loser effect, and the staggering gains in tech darlings of the last five years, it seems highly unlikely that they will be the market darlings of the future. By contrast, it is mainly food and staples retailing, commodity, energy, mining and materials sectors which look much more likely to be the leading stocks of the future. I've screened major European countries (including Britain) for the stocks with market caps in excess of €2bn, with sufficient daily trading volumes, which had the worst performance over the last five years and I then filtered for stocks that have a financial health index score of six or higher. (The higher the score the better, with a score of six or more indicating a reasonable level of financial stability.)

Here are the names: Hugo Boss, BHP Billiton, Antofagasta, Eramet, Fresnillo, Eni, Mail.Ru, Eutelsat Communications, Anglo American, Marks & Spencer, Polymetal International, Wm Morrison Supermarkets, Distribuidora International de Alimentacion, Vedanta Resources, J Sainsbury, Koninklijke Vopak, Tesco, and Amec Foster Wheeler. Perhaps January will be a good time to consider some of these names.

David Flynn works with Baggot Investment Partners (baggot.ie)

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