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Using Performance To Identify The ‘Dogs Of Tech’

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Value investing has become more popular, as evidenced by the record low PE dispersions we’ve had for months now, but buying the cheapest stocks on the market may not work equally well in every sector. “Our analysis suggests that a Dogs of the Dow/S&P strategy works differently for technology – historically the least expensive stocks in tech have not yielded outperformance in the following year, but the 10 biggest underperformers in tech in a given year have collectively materially outperformed the following year,” writes Bernstein Research senior analyst A.M. Sacconaghi Jr.

Dog strategy for tech stocks

According to Sacconaghi, following a dog strategy (buying the 20 cheapest stocks at the beginning of every year) beats the market by 700 – 1000 bps over the last 20 years, but when focused on just the tech sector the strategy is in-line with the market as a whole. Changing the criterion from cheapest to worst-performing fixes the problem, beating the market by 17.4% over the last five years and 6.1% over the last 20 years.

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Hit rate for underperforming tech stocks is low

In both cases the hit rate (percentage of individual stocks that outperform) is close to half, but it’s lower for underperforming tech stocks than for cheap stocks overall. This implies that anyone following a dog strategy shouldn’t engage in stock picking, and should instead buy a basket of underperforming tech stocks. Hopefully the stocks that don’t hit will just stay flat, since expectations are already low after having had a weak year.

It’s not exactly clear why tech stocks behave so differently from the rest of the market, but it connected to the difficulty of evaluating tech companies generally. Facebook Inc (NASDAQ:FB), Twitter Inc (NYSE:TWTR), and other highly valued tech companies don’t have the kinds of assets that would normally interest a value investor, so basing a dog strategy on PE might not be the best approach. In a sector where valuation is tied so closely to investor sentiment, maybe it isn’t surprising that it isn’t the best stat to use when looking for bargains.

Following this strategy, Sacconaghi recommends EMC Corporation (NYSE:EMC) and International Business Machines Corp. (NYSE:IBM) as interesting 2013 YTD underperformers. “While we see no near-term catalyst for either stock (Q4 guidance is not a slam dunk for either company), we believe that secular fears for both names appear overblown, and both are attractive value for longer term investors,” he writes.

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