Low Quality Losers: Not a Formula for Long-term Success

It won't work for much longer

By Murray Leith
Globe Investor Magazine Online, June 9, 2009

Murray Leith is director of research for Vancouver-based Odlum Brown Ltd. This is taken from a report to the firm's clients.

The winning strategy for 2009 can be summed up in one sentence: Bet on last year’s low quality losers.

That's right. The best performing asset classes thus far in 2009 are the low quality assets that performed worst in 2008. Emerging market stocks were down 44 per cent in 2008 (measured in Canadian dollars), but are up 21 per cent in 2009, as measured by the MSCI emerging markets index. The Canadian stock market, which has been a developed market leader, is up half as much, or 11 per cent.

High yield bonds, which are commonly referred to as “junk bonds,” have trounced the returns generated by investment grade corporate bonds. Similarly, long-term Canadian corporate bonds have returned almost 10 per cent, while long-term Canadian government bonds have produced losses for investors (down three per cent year-to-date). Within the equity market universe, lower quality has been the winning mantra in 2009. Stocks of highly leveraged companies (as a group) have handily beaten those with no or little debt. Likewise, shares of cyclical businesses have performed much better than those with more stable income streams. If a company was on the “endangered” list in 2008 and survived, chances are it has been a top performer in 2009. Teck Resources (TSX:TCK.B) is a prime example. The stock is up almost fivefold from its $3.35 low in November 2008 and more than 160 per cent year-to-date.

When markets bounce off the bottom, the losers that survive always lead the way. The reason is basic mathematics. Stocks that take the biggest beating on the way down need the least amount of absolute gains to produce the most spectacular percentage advances. A stock that goes from $10 to $2 and back to $4 is up 100 per cent from its bottom, whereas a stock that goes from $10 to $6 and back to $8 is up one-third as much, or only 33 per cent. The better than 160 per cent year-to-date advance in Teck Resources is less impressive considering that the stock is still down almost 70 per cent compared to where it was a year ago. Many investors now claim that the bargains on the 2008 loser low list were obvious and that they have ridden last year’s dogs to riches in 2009. Don’t be fooled by most of these claims.

By definition, the 2008 loser low list was created because the masses were selling, not buying. The very small minority of investors that did catch the bounce can be congratulated for having nerves of steel, cash to deploy at the bottom and, most of all, impeccable timing. While the timing of the latest market bounce looks obvious in hindsight, do not forget that market gurus called numerous market bottoms on the way down.

We were part of the crowd that did not recommend and buy 2008’s low quality losers. Although we always suffer from a bit of “could have, should have” hindsight regret whenever we do not participate in big market moves, we are not harbouring misgivings this time. To ride 2009’s biggest winners, we would have had to sell attractively priced high quality assets in favour of low quality assets. That is something we do not regard as prudent. Not only do we believe that this is the best way to preserve and grow wealth over time, it also lets our clients sleep better at night. Our track record demonstrates that this strategy works. Having the temperament to resist selling low when investors are panicking and markets are crashing is essential to long-term success. This is considerably easier to do if an investor owns high quality assets.

While it is true that client portfolios have not recovered as briskly as the assets on the 2008 loser low list, it is equally true that our portfolios were not battered as much during the downturn. To use an amusement park analogy, we have been on a much less volatile “kiddie” roller coaster compared to the terrifying low quality ride.

Special to the Globe and Mail