In Praise of Oversold Stocks

Over the last year or so, the stock market has produced stunning disparities between the most and least popular stocks on a couple of occasions.

The result is usually bad when you’re holding the most popular stocks at their peak, which is what technology and Internet investors experienced during the last year.

But if you’re buying the most hated stocks anywhere near their trough, the result can be some breathtaking bounces.

Here’s a look at a complicated system that has produced some stunning returns over the last year and four months: more than 40% last year, and 20% so far this year. Compared to declines of 14.5% in the S&P 500 over that period, 5.5% in the Dow, and 47% in the Nasdaq, a return north of 60% is pretty impressive.

First, the usual caveats. Past performance is no guarantee of future results, as they say, although this approach does have 30 years of research and 14 years of actual practice behind it. More on that in a moment.

The second caveat is that value stocks reached their greatest disparity early last year in relation to growth stocks since 1972. For those of you not familiar with that period, that was the peak of the original “Nifty Fifty” stocks and the start of a two-year 45% bear market in the S&P 500. So the opportunity in value stocks last year was a historical one.

The approach on which this method is based was pioneered by a broker named Kenneth Lee, who wanted to find a way to protect his clients after many of them were hit hard by the crash of 1987. The approach he came up with, outlined in his book “Trouncing The Dow,” is a complicated formula for determining when stocks are oversold on a 10-year historical basis, using Value Line data and Return on Equity (ROE), among other measures. Lee back-tested the theory to include the 1973-1974 bear market and found it would have produced an average annual return of about 30% since then, double the broader market. Lee limited his study to Dow stocks, but expanding it to include the S&P 500 produced the results above. In short, buying the four most oversold stocks in the S&P 500 whose growth rates are 10% year over year or greater produced those returns.

Last year, the four stocks returning more than 40% were Philip Morris , Washington Mutual , Toys R Us and Dana Corp. . The ones up 20% so far this year are Textron , Dell Computer , Newell Rubbermaid and Staples . Microsoft just missed the cut this year, or the returns would have been even better with Mr. Softie’s 70% year-to-date return.

Unfortunately, the current profits recession has greatly reduced the number of oversold stocks whose growth rates are still holding up, and three of this year’s four buys would no longer make the cut for that reason. But here’s a few stocks whose earnings are holding up that are within 10% or so of their buy price: Boeing , United Technologies , Paychex , H&R Block , Tyco and Staples . They haven’t reached the hugely oversold levels seen in this year’s or last year’s picks, but it’s not a bad list to choose from on pullbacks. Most tech stocks have disqualified themselves with declining earnings, but the two cheapest at the moment are probably Tellabs and Oracle .

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