Just like it would be any investor's dream to have perfect foresight, it would be any short-seller's dream to know which stocks were going to fall by the highest percentages every year. In an earlier post, we saw that identifying a “perfect portfolio” ahead of time using valuation and other measures was basically impossible. But today we will see that finding the worst stocks, “the putrid portfolio,” may be much easier.
The putrid portfolio is formed by using perfect foresight to select the 25 stocks from a large cap universe that will perform the worst over the next 12 months. Think of this portfolio as Jim Chanos’s dream. Its historical return (since 1963): negative 50% per year!
Wouldn’t it be great if these stocks could be identified ahead of time, so that you could avoid them or short the hell out of them? Turns out valuation is a good starting point for finding these putrid stocks ahead of time.
As a reminder, valuation was not a great guide for finding the best performers. Here is the historical distribution by STARTING valuation for the stocks in the perfect portfolio over the past 50 years. Pretty random. Some started expensive, others cheap.
But here it is for the “putrid portfolio.” There is a clear and strong relationship between valuation and putridity. Nearly a third of the worst performers each year started their terrible run trading at very expensive multiples.
Here are the two charts together.
Why does this happen? Remember that valuations are a proxy for expectations. Higher price multiples (of earnings, cash flow, sales, etc) mean that the market is expecting big things from these expensive stocks. Often they have great prospects and great stories which seduce investors. Turns out, investors are often overly optimistic about these companies.
This phenomenon lines up neatly with the historical excess returns by valuation decile among larger stocks, shown below. Cheap stocks outperform by a nice margin (nearly 5%). But more interesting is the fact that the most expensive stocks underperform by an even wider margin (7%).
I’ve reached this conclusion in many different posts, but it bears repeating here. Some stocks priced at huge multiples (think $TWTR) will deliver outstanding returns. But as a group, expensive stocks have always delivered terrible returns relative to the market, and you would be smart to avoid them entirely rather than trying to pick the few diamonds in the market rough. You’ll miss out on the most fun stories, but your portfolio will be healthier for it.