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Lessons for Investors

Buying stocks just because they have gone down in the recent past may look like a winning strategy on paper, but there are significant associated risks. If you are a prudent investor, with a long time horizon and a contrarian investment philosophy, you should want to buy loser stocks with controllable transactions costs and limited exposure to risk. To achieve these goals, you could consider screening all U.S. stocks for the following:

  • Past returns: Only stocks in the bottom quartile in terms of returns over the last year will be considered for this portfolio. This is a much more relaxed screen than the one used earlier in the chapter (where the 500 stocks with the most negative returns out of 7000 were picked). However, it will then allow for stricter screens for risk and transactions costs.

  • Transactions costs: To reduce the overall transactions costs on the portfolio, only stocks that trade at prices greater than $5 are considered.

  • Risk: Stocks with standard deviations greater than 80%, betas greater than 1.25 or debt-to-capital ratios that exceed 50% are eliminated from the sample. The first two operate purely as risk screens, and the last one screens for both risk and survival.

  • Catalyst for improvement: Only stocks that report positive earnings in the most recent quarter and increased earnings over the previous period are considered for the overall portfolio. The rationale is that stocks that are making money are not only less risky but also have more freedom to make the changes that need to be made to become healthy companies.


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