How to Love a Loser

How do you love a loser? I dunno. Ask my wife. (Rimshot)

No, seriously, there is an answer to that question. How do you love a loser?

Very slowly.

Back up a bit
Many value-investing strategies -- the kind we try and practice at Motley Fool Inside Value -- depend on being a contrarian. What do I mean by that? Well, I don't mean buying Google these days. Despite the well-meaning email I got from a fan of Big Goo, which said "I'm a contrarian because I disagree with you," being a contrarian means betting against the market.

And that's a scary thing to do.

Finding your loser
You want to be contrarian? Try buying one of these:

Those are just seven of the most notable names on my latest loser screen. All told, there have been 81 companies with enterprise values of more than $500 million that have dropped 25% or more year to date.

Why love a loser?
That's actually a very good question. As much as I try to be a value guy, and buy what's gotten cheap, I'd be remiss in my duties if I didn't share a little stock-market secret with you: What goes down tends to go down some more.

This has been shown in several studies that are sliced, diced, and summarized by noted NYU finance professor Aswath Damodaran in Chapter 8 of his book Investment Fables.

In these studies, when you measure time in terms of months, stocks that have gone up tend to keep going up. In other words, winners keep winning. And vice-versa. So when people advise you not to try to "catch a falling knife," they're not being silly -- they're playing the smart odds.

However, when time is measured in terms of years, the contrarian strategy begins to pay off. Oft-referenced work by Fama and French found that the contrarian strategy is far more successful for five-year returns than for one-year returns. Moreover, it works better for smaller companies than large ones.

One "Losers" vs. "Winners" portfolio study showed a risk-adjusted five-year outperformance of 40 percentage points for the Losers against the Winners: The Loser portfolio put up a 30% increase while the Winners turned in a 10% loss.

Over the long run, losers do better than winners. That's why you should learn to love them.

Ready to love the losers?
Hang on just a moment. As Damodaran points out, many of these stocks are losers for very good reasons. Perhaps growth has fallen off. Perhaps we're at the top of a business cycle and the company is expected to have the rug pulled out from under it completely. Perhaps (as is common these days) management is getting love letters from the SEC saying, "Show me how you've been dating your options."

In other words, you probably don't want to just start piling losers into your portfolio and hope for the best. In fact, that's part of the secret of my loser screen. I'm always most interested in losers who look fundamentally sound over the long term. How do I measure that? Well, I start by looking at their near-term record of earnings growth. As you can see, these losers have all been increasing earnings at a reasonable clip over the past half decade -- some of them at lightning speed.

Those are the losers I'm most likely to invite to my portfolio love-in, especially when I can find them with stellar balance sheets, as many of these have. That way, should we be in for an extended bout of stormy weather -- and history suggests that's likely right now -- these companies will be able to survive until they turn around whatever troubles are plaguing them.

Foolish bottom line
Betting on the market's darlings often gets you immediate gratification, but only if you have a perfectly functioning crystal ball that tells you when the party is over. Folks who bought Qualcomm or Hansen Natural recently can tell you just how quickly up can turn to down.

By picking your stocks carefully from the losers of the litter, you can expect near-term bumpiness, but rest easier knowing that you're investing with a method that promises a greater likelihood of long-term outperformance.

This time-proven method explains why we devote an entire newsletter team to sifting through the market's latest losers. Once a month, Inside Value analyst Philip Durell gives you his picks for downtrodden companies that are ready to make their way back, as well as a few worth watching. And a free look is just a click away.

Seth Jayson spends a lot of time looking at the latest losers. That's where he makes his best money. At the time of publication, he had no positions in any company mentioned here. View his stock holdings and Fool profile here . eBay is a Stock Advisor recommendation. Fool rules arehere.