Getting burned playing with hot stocks. Raise your hand if you still believe in momentum investing.
I see at least a few hundred thousand hands going up. But I imagine that a year ago there would have been a lot more.
As for me, I'm a skeptic. Last year I wrote a column called A Gentleman's Bet Against This Year's Best Stocks. In it, I said that investing on raw momentum -- buying stocks that are going up, just because they are going up -- "used to be considered as unsophisticated as picking your nose in public.
"Now, many people consider it a legitimate school of investing." In an attempt to debunk momentum investing, I bet that a portfolio of ten stocks I picked at random by closing my eyes and stabbing at the stock listings with a felt pen -- the Smudge Portfolio -- would beat the ten stocks that had the best gains year to date through July 7, 2000.
The period specified for the bet was July 7, 2000 through July 6, 2001.
The momentum stocks (which were required to have a market value of US$1 billion or more) had a full head of steam at the time I proposed the bet. Tollgrade Communications Inc was up 654 percent in 2000 through July 7. Rambus Inc was up 499 percent.
Newport Corp was up 473 percent. And so on, through the tenth-hottest stock, Cor Therapeutics Inc, which was up 245 percent.
As I predicted, the hot stocks have cooled. Tollgrade fell 81 percent from July 7, 2000 through July 6, 2001. Rambus was down 90 percent and Newport 73 percent. As a group, the ten momentum stocks declined 65 percent.
For the record, that figure includes reinvested dividends (although most of these stocks didn't pay any).
The Smudge Portfolio declined 16 percent, beating the Momentum Portfolio by 49 percentage points. It did slightly better than the Standard & Poor's 500 Index, which declined 19 percent.
The best gainer in the Smudge Portfolio was Republic Security Financial Corp, up 82 percent. The worst loser was Next Level Communications Inc, which fell 94 percent.
In the Momentum Portfolio, no stocks rose. The "best" performer was Elantec Semiconductor Inc, down 28 percent.
What's the moral of this story? You can get burned playing with hot stocks.
Of course it's not true that all red-hot stocks are overdue for a correction. Last year's market climate was particularly manic. And computer-related stocks were just concluding a magnificent four-year run.
But if a parabolic rise in a stock isn't necessarily a sell signal, it certainly is a strong reason for caution. When a stock rises 200 percent to 600 percent in a few months, it usually means that investors are letting their greed glands work overtime, and losing sight of fundamentals.
This year I will renew the bet with some modifications.
Instead of the Smudge Portfolio, we'll pit this year's momentum stocks against a "Trudge Portfolio" of unglamorous stocks.
To make the Trudge Portfolio, a stock must sell below book value (corporate net worth per share), have a market value of US$1 billion or more, and pay a dividend of at least a dime a share.
Twenty companies met those statistical requirements. To pick the Trudge Portfolio, I simply selected the largest ten by market value. They are AT&T Corp, Raytheon Co, R.J. Reynolds Tobacco Holdings Inc, Safeco Corp, Rockwell International Corp, Avnet Inc, Visteon Corp, American National Insurance Co, MONY Group Inc and Western Resources Inc.
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