Two Portfolios. Pick One by David Merkel, CFA of AlephBlog
I’m going to show you two portfolios — I’m not initially going to tell you much about either one, but then you can consider which one you might like better. Here’s portfolio A:
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And here is portfolio B:
There is one obvious difference in the two portfolios: portfolio B has gone up more than portfolio A in the past year. But the hidden story is that portfolio A’s stocks have had price returns of -85% or worse over the past four years, whereas portfolio B’s stocks have has price returns of 1000% or better. They are the only stocks with current market caps of over $100 million that meet those criteria.
Now, which one would you choose, if you had to hold one portfolio for the next year? The next four years?
Oddly, the right answer might be portfolio A. Currently, I am reading through a book called Deep Value, which I will review in a week or two, and they cite in Chapter 5 some research by Thaler and De Bondt which indicates that portfolios that have gone through extreme failure tend to outperform portfolios that have gone through extreme success.
Though the momentum anomaly (weak as it has been recently) usually favors portfolios with stronger price momentum, the relationship breaks down over longer periods of time, and more severe moves, where mean-reversion tends to take over. One thing that I can tell looking at the two portfolios — the expectations are a lot, lot higher for portfolio B than portfolio A. Things only have to stop getting worse for there to some positive price action there.
Sometimes I like to run a screen for stocks have done badly over the last four years, but have begun to outperform over the last year. This can point out areas that are still ignored by most of the market, but where trend may have shifted. I’ll post that screen after my software has its weekly update on Saturday. Until then.
PS — as an aside, it will be fun to review the relative performance of these portfolios.