How to Bottom-Fish

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How to Bottom-Fish
by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
March 6, 2008

Reprinted from the February 2008 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

As we're all painfully aware, it's been a rough year so far for the stock market—many stocks have fallen 30%, 40%, even 50% or more below their 52-week highs. But are there buying opportunities among these underperformers? No doubt the temptation to bottom-fish is strong, as the potential payoff can be high. After all, buying a stock that's down 50% provides a 100% return if it can just recover to its prior level. Sounds simple, doesn't it?

Before you get too excited, I must warn you not to fall into the trap of concluding that a stock whose price has dropped has automatically become a better value. Global stock markets are highly efficient in processing information—meaning your default assumption should be that a stock's current price simply represents fair value.

Most finance academics believe in the "efficient market hypothesis," which teaches that past stock price changes provide absolutely no information for forecasting future price changes. But just how true is this theory in practice? Is bottom-fishing really a viable strategy?

Price reversal or price momentum?
Fortunately, stock price data is readily available for analysis. Schwab's equity research team has extensively studied the relationship of historical stock price changes to future stock price changes in markets around the world.

For the purposes of this article, we took the 3,000 largest U.S. stocks by market capitalization each month from 1990 to 2007 and divided them into five uniform portfolios, according to their price changes over the prior 12 months. We then measured portfolio returns over subsequent six-, 12- and 24-month holding periods relative to the 3,000-stock-universe average.

Are stocks that have performed poorly over the past year potential bargains? The graph below reveals that the answer depends on your time horizon. Let's focus on Portfolio 5: the 20% of stocks with the weakest past performance, underperforming the average stock by 30% or more over the prior year. Note: On average, Portfolio 5 stocks continued to underperform for the first six months after portfolio formation, but then eventually reversed and outperformed over a longer 24-month holding period.

This pattern suggests that investors tend to initially under-react to whatever caused the poor performance over the previous year, but then eventually overreact—leading to potential market-beating opportunities for bottom-fishing investors with a longer-term focus.

As a quick aside, these results certainly throw some cold water on the efficient market hypothesis. Past price performance trends tend to persist for holding periods up to six months, which suggests that price momentum can be a useful indicator for active traders.

A risky strategy
Although poor-performing stocks may have long-term bounce potential, let's pause and consider risk before developing a stock-picking strategy. The stocks in Portfolio 5 tend to be extremely risky: about 50% more volatile than the average stock! Obviously, investors have been dumping these stocks, and people tend to get emotional when experiencing losses—which increases price volatility.

Disagreement among investors and analysts often runs high when a company is having problems and its stock is sinking, triggering further volatility (especially around company announcements). And don't forget: Bankruptcies are typically preceded by big price drops.

The point is that a bottom-fishing strategy could yield some big winners for your portfolio, but you'll likely take some big losses as well—making this strategy both financially risky and psychologically difficult to implement with discipline.

Classifying the losers
If you haven't been scared away, you'll want to try to understand why a given stock has recently performed poorly. Often, several interrelated reasons are at work, and judgment is required to ascertain the true story. Here are four factors to look out for:

Deteriorating fundamentals. Of most concern to investors are companies with business problems of a serious, long-term nature. Bottom-fishers would do best to avoid such stocks and leave them to private equity, hedge fund or vulture investors to salvage. Research tools available to individual investors (such as stock screeners) are inappropriate for determining whether a company has a viable business model, is threatened by new technology, or has the management team to restructure failing operations.

Examples of companies falling into the deteriorating fundamentals category would be the many firms tangled up in today's real estate and mortgage crisis.
Declining growth expectations. Another common cause for poor recent returns is a decline in investor perceptions of a stock's future earnings growth. Successful firms usually go through a corporate life cycle: After achieving business viability, they often enter a phase of above-average growth. The faster the growth rate and longer this phase persists, the more likely that investors take note and bid up the stock's valuation multiple. But when perceived future growth slows, these stocks often get hammered as growth- and momentum-oriented investors sell.

Pharmaceutical stocks have gone through this process in recent years. Bottom-fishing in this category is possible, though difficult, since stocks such as these typically don't fully rebound to past valuation levels.
Industry group weakness. A third basis for weak price performance could simply be stocks caught in an industry downturn. Analysis typically shows that market and industry group movements can explain much of an individual stock's short-term volatility. For example, if oil prices decline, the oil exploration business usually suffers, as do most individual stocks in that industry.

Bottom-fishing within a weak industry can be fruitful for patient investors, because weak industries tend to rebound, and because each company's success is the most important driver of long-term individual stock returns.
Valuation contraction. A fourth group of poor performers consists of stocks experiencing valuation contraction, meaning their stock prices have recently dropped much further than their sales, earnings, cash flow or book value. Besides reasons 1 through 3 above, valuation contraction may also stem from short-term issues such as weak earnings, product problems or management turnover.

Aggressive investors with a "sell first, ask questions later" style often dump a stock at the first hint of trouble, causing downward price pressure that can feed on itself as momentum and loss-averse investors also bail out. Bottom-fishing can be profitable among such stocks if you can determine that the business problem is temporary and that investors may have overreacted.

Sifting through the wreckage: Good hooks and bad
Once you understand why a given stock hasn't done well lately, your next objective is to try to identify stocks where recent price weakness has created buying opportunities for selective, long-term investors. Mirroring the investment concepts behind Schwab Equity Ratings, we tested many fundamental, valuation, momentum and risk indicators for their ability to find stocks with turnaround potential. Our results might surprise you—especially what didn't work.

Neither brokerage analyst recommendations nor earnings forecasts (or changes in same) were useful bottom-fishing hooks. Also of little value: mimicking trades of "smart money" investors such as short sellers or corporate insiders. Potential short-term turnaround measures (such as whether a company's last earnings-per-share report was positive, outperformed the same quarter one year prior, or exceeded consensus forecasts) did not flag the best turnaround candidates. Finally, we found there was no benefit in focusing on less risky stocks with large market caps or low debt levels.

So what might actually work? Deep value and cash-flow generation indicators were the best bottom-fishing criteria we tested. Among stocks with poor past-year price performance (e.g., Portfolio 5), those that tended to rebound strongly over the subsequent 24 months often had higher (relative to their market capitalizations):

Sales
Operating income (earnings before interest and taxes)
Free cash flow (cash flow from operations plus depreciation, and minus capital expenditures)
Cash and equivalents
Excess cash earnings (cash flow from operations less net income)

For example, screening for the 20% of stocks with the lowest price/sales ratios from among Portfolio 5 underperformers yielded stock lists that historically beat the 3,000-stock universe by an average of more than 20 percentage points over subsequent 24-month holding periods (though still with high volatility). Since price/sales is the only deep value ratio available for screening on Schwab.com, the simplest and most comprehensive way to identify turnaround candidates may be to screen for underperformers with high Schwab Equity Ratings. Historically, such stocks have tended to also perform very well relative to their Portfolio 5 peers and the overall market.

You can find them by logging in to Schwab's new Stock Screener (found at the top of the page at Schwab.com/stocks):

Under Price Performance, check Price Change box "Last 52 Weeks", click "Enter Range", then select "Compare to the Market" and "Lowest 20%" in the drop-down menus.
Under Analyst Ratings, check "Schwab Equity Rating" and click "A" and "B".
Click "Total Matches" to see all stocks passing this screen.

Bottom-fishing can be rewarding, but knowing where to cast your line can help you catch something worth keeping—and not a piece of junk that you wish you could throw back.

Important Disclosures

Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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