The Worst Way to Pick Stocks

A little more than three years ago, I moved to Las Vegas. I knew full well that it is a city of flashing lights, the electronic whirring of slots, and the kind of easy-come-easy-go attitude toward money that only casinos can engender. What I didn't realize at the time was that it's also the home of one of the top college basketball programs in Division I history: the UNLV Runnin' Rebels.

I could probably be forgiven for not knowing that, since the Rebs had a long stretch of being pretty mediocre after coach Jerry Tarkanian was ousted in 1992. But the Rebs have a tremendous history behind them, with a 0.712 all-time winning percentage -- which ranks them fourth among Division I programs. And it was right around the time that I arrived in Las Vegas that new head coach Lon Kruger started to get the team back into top form, and it's made appearances in the NCAA tourney in three of the past four years.

This year, the Rebs are off to a heckuva start -- they're 7-0, ranked 23rd in the nation, and are just coming off a win over Virginia Tech in the finals of the 76 Classic.

As for me, I've found myself in a funny situation. I'm not much of a college basketball fan, let alone a longtime Runnin' Rebels follower, and yet I've been attending games, checking scores on ESPN, reading up on Rebel players, and even sporting UNLV apparel. And yet even though I'm generally much more of a football fan, I couldn't care less about the craptastic 2-10 Rebel football team.

Am I a fair-weather fan?

It's not unusual
Thanks to renowned psychologist Robert Cialdini, I know that my newfound love for Runnin' Rebels basketball isn't all that strange. In his classic text on influence -- conveniently titled Influence -- Cialdini writes the following:

... we want our affiliated sports teams to win to prove our own superiority. ... According to the association principle, if we can surround ourselves with success that we are connected with in even a superficial way (for example, place of residence), our public prestige will rise.

In other words, I'm doing what many other sports fans do all the time -- rooting for a winning sports team so I can associate myself with its success. Of course, I don't have any special insight into whether the Rebs will keep performing well, but I've been drawn like a magnet to the fact that they have been winning recently.

Let's talk stocks
OK, so maybe you don't watch college basketball, and you definitely couldn't care less about the UNLV Runnin' Rebels. But investors get caught up in the same sort of success-chasing behavior that led me to buy a Rebels basketball jersey.

Encouraged by big profits that a stock has already created, investors chase after the market's best-performing stocks, hoping to cash in on future returns and -- likely, at least unconsciously -- trying to associate themselves with the stock's success. You can almost hear the excited cocktail chatter, "It's a real screamer! It's up 300% since last year, and there's only more to come!"

There's even a name for this kind of investing -- momentum investing -- and there are many investors who think chasing big returns like this is the only way to go.

But while being a fair-weather fan doesn't have too many serious downsides (apart from the risk of being made fun of), fair-weather stock pickers may find themselves holding a lot of underperforming stocks. I gathered data going back to 2000 and tracked how the 20 top-performing stocks of every year performed the following year. For those chasing returns, the data don't look promising.

Year

Average Stock Return

Top 20 Stocks' Average Return

Average Over/(Under)-Performance of Top 20 in the Following Year (% Points)

2000-2001 8.5% 276.3% (41.4)
2001-2002 8.8% 288.5% (10.2)
2002-2003 (14.5%) 130.1% (0.9)
2003-2004 55% 522.2% (6.3)
2004-2005 17% 210.3% 2.9
2005-2006 7.8% 237.2% (2.5)
2006-2007 15.5% 190.3% 6.8
2007-2008 (0.1%) 165.7% (24.3)
2008-2009 (38.3%) 76.9% (74.3)

Source: Capital IQ, a Standard & Poor's company. Returns measured on Jan. 1 of years shown.

As you can see, only two years out of those nine did the top-performing stocks manage to outperform the market the year after they dominated it. I'm not sure I like those odds. In fact, it would seem that momentum investors who are chasing the hottest stocks are lying down on the train tracks right as the train is coming through.

Are you a fair-weather investor?
So, what stocks should investors be looking out for right now? Here are the 10 best-performing stocks over the past year among all companies worth $500 million or more last year.

Company

1-Year Price Change

Acme Packet (Nasdaq: APKT  ) 415%
Netflix (Nasdaq: NFLX  ) 244%
United Continental Holdings (NYSE: UAL  ) 244%
Riverbed Technology (Nasdaq: RVBD  ) 232%
Las Vegas Sands (NYSE: LVS  ) 219%
RPC 209%
Chipotle Mexican Grill (NYSE: CMG  ) 206%
US Airways Group (NYSE: LCC  ) 205%
Grupo Financiero Galicia 197%
Kronos Worldwide 192%

Source: Capital IQ, a Standard & Poor's company.

Certainly, if you've owned these stocks over the past year, you're feeling pretty darn good right now. And you should -- those are some huge one-year returns. And there are plenty of investors that are still really excited about these companies now. Netflix has soundly vanquished Blockbuster and is streaming its way to the stratosphere, Las Vegas Sands will ride the Asian gaming scene to untold profits, and Chipotle Mexican Grill will continue to charm fast-casual diners with high-quality burritos.

But will these stocks really deliver over the next year? Or will investors be drawn to the stocks' success until that success tarnishes the least little bit, causing them to jump ship and look for a bigger winner?

I'm not going to make any guarantees that any individual stock in this group is going to underperform over the next year, but if you own one of these or find one of them blinking on your buy radar, be sure to think long and hard about why that particular stock is going to be the exception of this group and not lag the market over the next year.

I don't think it's the time to be buying any of the stocks above. But my fellow Fools have put together a free report detailing five stocks that The Motley Fool owns, and they think you should own, too.

Acme Packet and Chipotle Mexican Grill are Motley Fool Rule Breakers picks. Netflix is a Motley Fool Stock Advisor choice. The Fool owns shares of Chipotle Mexican Grill, which is a Motley Fool Hidden Gems selection. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy assures you no Wookiees were harmed in the making of this article.


Read/Post Comments (9) | Recommend This Article (20)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 02, 2010, at 3:22 PM, mtracy9 wrote:

    "What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value -- in the hope that it can soon be sold for a still-higher price -- should be labeled speculation." --Warren Buffett

  • Report this Comment On December 02, 2010, at 4:15 PM, TMFKopp wrote:

    @mtracy9

    Absolutely!

    Matt

  • Report this Comment On December 02, 2010, at 7:26 PM, motleyguitarist wrote:

    When you say this:

    "As you can see, only two years out of those nine did the top-performing stocks manage to outperform the market the year after they dominated it."

    I only see the 2002-2003 year as being the one year that the Top 20 avg. beat the avg. stock. (0.9) compared to (14.5)

  • Report this Comment On December 02, 2010, at 8:50 PM, Diagoras wrote:

    @motleyguitarist: That column shows the outperformance of the index by the 20 best performers of the previous year, not the next-year performance of those 20. Thus, the only two years in which those stocks beat the index are 2004-2005 and 2006-2007.

  • Report this Comment On December 02, 2010, at 10:32 PM, TMFKopp wrote:

    @Diagoras

    Precisely, thanks!

    @motleyguitarist

    The total average performance presented is to compare to the top 20's average performance -- as can clearly be seen, the top 20 absolutely slaughtered the averages every year. The year ahead, as Diagoras pointed out, is simply the over/under-performance of that top 20 group versus the average.

    Matt

  • Report this Comment On December 03, 2010, at 3:42 AM, Libertarian71 wrote:

    Matt,

    Your article and your data are absurd depictions of a momentum investing strategy. Investor's who follow William O'Neil's CAN SLIM approach do not merely look at the 20 best performing stocks, and then hold them for the following year. They also look at many fundamental factors, such as earnings growth, and, from a technical perspective, they also make sure the stock is in a solid base. CAN SLIM investors also cut losses after the stock is 8% below the buy point.

    Another thing momentum investors and Trend Followers look at is the general market direction. In December 2007, O'Neil advised to GET OUT of the market. A simple review of the 200 day EMA at the time would have disclosed the same exit signal. So the 74.3% underperfomance in 2009 is highly misleading, and not at all representative of CAN SLIM, momentum investors, and Trend Followers. CAN SLIM investors were out of the market, while the buy-and-hold die hards were getting crushed. And many Trend Followers were crushing the market at the time.

    I am not trying to get into a value vs. growth investing debate here. There is more than one way to skin a cat. Value investing is certainly fashionable at the moment. But if you are going to assess or critique a momentum or Trend Following strategy, you should present data or backtest a reasonable representation of such a strategy.

  • Report this Comment On December 03, 2010, at 12:05 PM, ChrisFs wrote:

    Keynes,

    "I am not trying to get into a value vs. growth investing debate here."

    Then you are failing spectacularly at that goal.

    Please try harder.

  • Report this Comment On December 03, 2010, at 5:19 PM, Libertarian71 wrote:

    ChrisF,

    Matt is the one who raised the issue. If he is going to critique growth investing, fine. But in doing so, he should present a real growth investing/momentum/Trend Following strategy, not a parody of one.

  • Report this Comment On December 10, 2010, at 10:46 PM, Alijac wrote:

    Something's only worth what the buyer/seller is willing to transact at that particular point in time. If the buyer holds onto it, but does it 'hold' value? And has the seller 'sold' value? Time and the course of events will tell its ...... tale_nt.

    If you now consider and conclude that you paid too much for something [anything], it's quite possible that someone will offer you more than that which you paid for it. And its 'value' could then take off like a rocket. Or a lead balloon. It's happened before, and history does so enjoy curtain-call. "All the whirled's a stage....and we are butt[sic]" [to put a spin on it].

    Re mtracy9's [comment #1] Warren Buffett quote: What if instead, a stock's purchased unconscionably? And why Warren's rush to offload it [stock] with his 'ipse dixtism' "soon"? How long's a piece of string-theory? If one does intend to soon-sell the stock in hope of profit, one could soon find themself strung_out in their st-drug-gle.

    I've no contention at all with the inherent import of any 'speculation'. Why, even Warren's [Berkshire Hathaway's] purchase of Burlington Northern Santa Fe may, by him inter alios, be railed at, later[maybe 'soon'er], down the track, as being a train-wreckulation. I am of course.....only speculating! Its purchase could be, after all, a......goodbuy f'now! I must rush!

Add your comment.

DocumentId: 1387058, ~/Articles/ArticleHandler.aspx, 4/16/2014 10:08:08 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement