Stocks: Should You Ride 2007's Winners?

S&P says sectors and subindustries that scored top gains last year may be just the ticket for investors in 2008

It's that time of year when we look to the past 12 months for an idea of the likely outperformers for the coming 12 months. My "Let Your Winners Ride" portfolios are lists of the three Standard & Poor's 500-stock index sectors and 10 S&P 500 subindustries that posted the strongest price performances in the past 12 months. While past performance is no guarantee of future results, it has been a market-beating guide for subindustries since 1970 and sectors since 1990. Of course what worked in the past may not continue to work in the future.

Last year (BusinessWeek.com, 1/12/07), you may recall, I posed the question: If you were given the choice of investing in one of two portfolios, which would you choose? Portfolio No. 1 consists of an equal dollar amount in the 10 S&P 500 subindustry indexes that posted the worst performances during the prior year. Portfolio No. 2 comprises the 10 best performers from last year.

A rationale for choosing the worst performers could be, in our opinion, the expectation that this group may stage a recovery, whereas those who selected best performers may believe momentum is on their side. Which does history say was the better choice?

Best/Worst S&P 500 Subindustries & Sectors: 1970–2007
  CAGR (%) Std. Dev. Risk/Return Freq. of Outperf.
SINCE 1970:        
S&P 500 7.6 16.1 0.47 NA
Worst 10 Subindustries 7.8 25.4 0.31 50%
Best 10 Subindustries 13.7 23.3 0.59 71%
SINCE 1990:        
S&P 500 9.2 16.5 0.63 NA
Worst Three Sectors 8.7 17.5 0.58 41%
Best Three Sectors 10.8 20.6 0.62 71%

Source: Standard & Poor's Equity Research. Past performance is no guarantee of future results.

Since 1970, the S&P 500 posted a 7.6% CAGR, or compound annual growth rate (price appreciation only, no dividends reinvested), and experienced a standard deviation, which is a measure of volatility, of 16.1. Its risk-adjusted return (return divided by risk) during this period was 0.47 (more on this later, but the higher the number the better).

An investor who chose the "worst" portfolio saw a 7.8% CAGR, but experienced an increase in volatility as seen in the higher standard deviation. This portfolio beat the market only 50% of the time as shown in the frequency of outperformance column, and its risk-adjusted return at 0.31 was dramatically lower than that of the S&P 500. Hence the return was not worth the risk, in our opinion.

Return Worth the Risk

The investor who selected the "best" portfolio, however, received a 13.7% compound return, for an annual outperformance of more than 600 basis points. And despite an increase in volatility, we believe the return was worth the risk since the risk-adjusted return was higher than the S&P 500's.

Finally, this portfolio beat the market more than 7 times in every 10. This technique also worked on a sector level, gaining 10.8% since 1990 vs. the market's 9.2%, and outperforming 71% of the time.

We think there could be a good reason for the old Wall Street adage "Let your winners ride, but cut your losers short"—how many investors who own a stock that has recently hit a 52-week low are disappointed? Probably a lot. As a result, should this stock's share price begin to show improvement, we think those investors who finally get whole again are likely to unload these "dogs" and redirect their funds to more potentially rewarding investments. Technical analysts refer to an abundance of investors in this position as "overhead resistance."

Worst Portfolios Outperform Best

Conversely, how many investors are unhappy that their stock prices have outpaced the overall market? And wouldn't they be likely to tell others of their success, thus possibly extending the winning streak?

What about the portfolios established for 2007? The "best" portfolio of 10 subindustries advanced 8.9% through Dec. 31, outperforming the S&P 500's 3.5% rise. The "best" portfolio of three sectors also beat the S&P 500, gaining 8.8%. Uncharacteristically, the "worst" 10 portfolio outperformed the best portfolio, rising 10.2%, while the bottom three sectors advanced 10.3%.

So which S&P 500 sectors and subindustries were the winners in 2007? Our "2008 Let Your Winners Ride" list below shows the best-performing sectors, accompanied by the related S&P sector ETF, and the top subindustries, along with a proxy component stock with the highest S&P STARS rank (tie goes to the issue with the highest market value). Will this approach outperform the S&P 500 in 2008? No technique works all the time, so we'll just have to wait and see.

S&P 500 Sector ETF Price
Energy XLE $79
Materials XLB $42
Utilities XLU $42
     
S&P 500 SPY $146
Subindustry Company (Ticker) S&P STARS Rank Price (12/31/07)
Agricultural Products Archer-Daniels-Midland (ADM) 4 $47
Coal & Consumable Fuels Peabody Energy (BTU) 4 $61
Construction & Engineering Fluor Corp. (FLR) 4 $146
Diversified Metals & Mining Freeport-McMoRan Copper (FCX) 3 $105
Education Services Apollo Group (APOL) 4 $70
Fertilizers & Agricultural Chemicals Monsanto (MON) 3 $111
Health Care Services Laboratory Corp. (LH) 5 $76
Industrial Gases Air Products (APD) 3 $101
Internet Retail IAC/InterActiveCorp (IACI) 4 $27
Oil & Gas Equipment & Services Baker Hughes (BHI) 5 $83

Source: Standard & Poor's Equity Research. Past performance is no guarantee of future results.

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