Lean in close, Fools, and prepare to be stunned by a deceptively simple strategy for market-crushing gains. Ready?
First, build a cash hoard. Next, just as a market bubble is beginning to form, screen for companies whose earnings and dividends have been up, down, and sideways for the past 10 years. But don't shy away! Instead, buy this basket of wonky performers hand over fist. Hold on tight through the bubble years, and then sell with the remorseless ferocity of a loose canon right before the market nosedives.
Congratulations! Not only will you have made a killing, but also you will have doubled the returns of the poor chaps who decided to stick with high-quality names. Not bad, eh?
Nope, not really
Doesn't sound realistic, does it? This fantastic scenario flashed through my mind when I first eyed a graph that illustrates the relative performance of low-quality and high-quality stocks during the 2003-2007 bull market. Posted on Hussman Funds' website, this compelling visual is part of an article entitled "Low Quality's Round Trip."
Using S&P's quality ranking, a methodology based on stability of company earnings and dividends over the prior 10 years, the author proceeds to show that while low quality drastically outperformed high quality during the recent bull market, it's done exactly the opposite on the way down. In order to benefit from low quality's rocket ride, investors would have to know exactly when to get in and when to get out. For mere market mortals, neither is an easy task. If investors decided to hold the portfolio of low-quality stocks for just one more year, they'd now be underperforming the high-quality competition in the more important 2003-2008 period.
Does this mean that fiscal responsibility and market-trouncing gains are mutually exclusive? If you're willing to think outside the box, and take on a little more risk than a toothpaste-and-soap-suds investment in Colgate-Palmolive
The promise of stalwart cyclicals
Avoiding historic cyclicality in earnings and dividends does not mean that you cannot pursue the large upside potential of companies that operate in cyclical sectors. Caterpillar
I know what you're thinking: The severity of the current recession far exceeds the rough patches of the past 10 years. True enough, and analysts indeed forecast Caterpillar's 2009 earnings to come in at less than half of 2008's results -- not exactly A+ performance. However, assuming that future recessions are tamer than the current one, Caterpillar may be able to return to its historically consistent financial performance. And during future bull runs, its shares, currently around $31, could provide the outsized rise typical of low-quality stocks, with less downside risk. Other industrial names that might fit this profile include Eaton
Buy small-cap innovators
A second strategy for achieving portfolio outperformance is to invest in small-cap companies that are product or industry innovators. Such companies tend to develop a loyal customer base and have the potential to enjoy long-run growth across economic cycles. I'm thinking of Columbia Sportswear
The downside at present is that the performance of Columbia Sportswear and Under Armour is directly linked to the cash-strapped consumer. Innovative products have not been enough to keep shares from succumbing to market pressure. Taking a long-term perspective, however, low debt levels at both companies bode well for each business's ability to manage through this difficult period and eventually resume its former growth.
No single secret
At the end of the day, a diversified investment plan should not rely on any one strategy or metric. Mechanical approaches in particular have the potential to obscure common-sense judgment. Abiding by S&P's quality rating, for instance, could lead investors to conclude that Caterpillar's earnings and dividends are slightly more consistent than those of Coca-Cola
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More Foolishness on market-beating returns:
Fool contributor Mike Pienciak fancies himself a strategic thinker, particularly when playing Connect Four. Under Armour and Columbia Sportswear are Motley Fool Hidden Gems selections. Coca-Cola is a Motley Fool Inside Value pick. Under Armour is a Motley Fool Rule Breakers recommendation. The Fool owns shares of Under Armour. Try any of our Foolish newsletter services free for 30 days. The Fool has a rock-steady disclosure policy.
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