5 Stocks That Could Slaughter the Market

"Bulls make money, bears make money, but pigs get slaughtered" is an oft-quoted Wall Street saying. That may be, but in 2003 my Pigs truly crushed the market, returning 51% and doubling the return of the Dow Jones Industrial Average. In 2004, the strategy did not fare quite so well, but it still outperformed the Dow and easily beat the Dogs of the Dow strategy. In 2005, the Pigs were heavily influenced by General Motors' (NYSE:GM) 51.5% annual decline and were slaughtered, underperforming the Dow by more than 11%.

But you can't keep my Pigs down for long.

In 2006, my pigs returned 31.5% versus 16.3% for the Dow. Over the past four years, the Pigs have murdered the Dogs and crushed the Dow.

Of course, there's a catch
First, let me say that tracking the Pigs is a bit of Foolish fun for me, and although early evidence suggests that following the Pigs has some merit, it's not a method I'm advocating. I much prefer hunting for undervalued individual companies, which I do every month in Motley Fool Inside Value. The Pigs originated when I decided to track the five worst-performing Dow companies of 2002. My selection criterion was percentage of stock price decline. The idea was to hold these Pigs of the Dow for a year, sell them, and reinvest the proceeds in the five worst-performing Dow companies of 2003.

The Pigs of the Dow differ from the Dogs of the Dow strategy, which selects companies based on those with the highest dividend yield at the end of the previous year. It's my premise that there aren't enough Dow companies paying a significant dividend and that a strategy based on the previous year's stock price decline will yield better returns.

For example, in 2002, Intel's (NASDAQ:INTC) stock price was cut in half, the second-worst decline of all Dow companies. In 2003, it more than doubled, making it 2003's best-performing Dow company. Even today, Intel pays such a low dividend yield (1.9%) that it could not qualify for the Dogs of the Dow. The lowest of the top five dividend yields in the Dow is currently 3.6%. There's a wide disparity, with the highest yield of the bottom five at just 1.2%, and none of these companies is ever likely to qualify for the Dogs of the Dow.

The 2005 Pigs (tracked in 2006) were GM, Verizon (NYSE:VZ), IBM, Disney (NYSE:DIS), and DuPont.

Here are the results since I started tracking them in 2003:

While four years is way too small a sample to draw meaningful conclusions, that won't stop me from saying that these results do make sense. As Charles B. Carlson espoused in his 2003 book Winning With the Dow's Losers, you can beat the market by buying the Dow's biggest losers because these stocks have likely been oversold. Carlson calculated that such a strategy would have outperformed the Dow by 1.2 percentage points annually since 1931.

So who are this year's Pigs of the Dow? Four out of the five have the distinction of being Inside Value recommendations. They are:

• Intel, down 18.9% in 2006
• Wal-Mart, down 1.3%
• Home Depot (NYSE:HD), down 0.8%
• 3M (NYSE:MMM), up 0.6%
• Alcoa (NYSE:AA), up 1.5%

The Foolish bottom line
Although the Pigs strategy has a lot going for it, I still prefer my own research. Why? Because the Pigs misses the best-performing Dow stocks and completely ignores potentially great, undervalued stocks outside the Dow 30.

Furthermore, strategies such as the Dogs and Pigs do not account for the frictional costs of brokerage fees and the tax costs of changing the portfolio each year. I track the Pigs of the Dow because it's a plausible strategy. However, the major flaw in the strategy is that companies do not simply become undervalued at year's end. Great companies can be undervalued by the market at any time of the year, and losers can stay on their losing trajectory for much longer than one year. The arbitrary nature of the sell decision may also be getting you out of a great company just in time to miss out on the next upswing in price appreciation. One last thought: Just because it was a Pig or a Dog last year doesn't mean that it can't be one next year!

To me, what's really important is the idea of searching for value in the market's castoffs, whether they're Pigs or not. This is precisely the strategy I use in my Inside Value investing service, where we're beating the market by more than eight percentage points on average since October 2004.

If this strategy makes sense and the returns appeal to you, why don't you try out Inside Value, with the first 30 days on me? No charge. You can join the Value Team and immediately see our most recent recommendations and other favorite picks for new money now.

Philip Durell is the advisor/analyst for Motley Fool Inside Value and owns none of the companies mentioned in this article. Intel, Home Depot, 3M and Wal-Mart are Inside Value recommendations. Disney is a Stock Advisor recommendation. The Fool has a full disclosure policy.