That's because stocks near their highs tend to climb still higher over the next six to 12 months. (The reverse is also true: Stocks near their 52-week lows tend to slide lower.)
The main reason for this phenomenon: The market usually underreacts to good news when a stock is near its 52-week high. That's because investors who are taught to "buy low and sell high" get skittish as stocks near their recent peaks and - in the short run - they hesitate to bid up prices furthers. But the reluctance doesn't last forever.
"Eventually the impact of the news wins out and the stock's price trends up," says Thomas George, a finance professor at the University of Houston's Bauer College of Business. Dr. George and colleague Chuan-Yang Hwang pioneered research about the 52-week high as a predictor of future performance.
Greg Forsythe, senior vice president of equity ratings at Charles Schwab, says his clients are just as reluctant as many professional traders to buy stocks near their recent peaks. His response, in some cases: The stock price may be higher than it was a few months ago, "but it's low relative to where it should be."
Mr. Forsythe urged clients to consider selected stocks near their highs in a November 2005 newsletter. He picked eight stocks that had Schwab's highest rating for potential outperformance - based on factors including earnings quality and valuation - and that were close to their recent peaks. Over the following twelve months, the group of stocks gained 22%, compared with the Dow Jones Industrial Average's 13% advance for the same period.
The accompanying table lists five stocks that last week held Schwab's top rating and were near their 52-week highs.
Cigna (CI) $130The case for buying stocks near their highs may seem counterintuitive, especially since investors are usually counseled not to chase performance when it comes to individual mutual funds and fund categories - high-yield bonds, for example, or technology stocks. But the research shows individual stocks that are near their highs can sustain that momentum through the next 12 months.
Hasbro (HAS) $28
Hewlett-Packard (HPQ) $42
International Business Machines IBM) $97
Prudential Financial (PRU) $88
There are some "momentum" investors - on the lookout for companies with recent outsidezed stock returns - who do use 52-week highs to spot possible targets. And, to be sure, some stocks near their 52-week highs may be unattractive and overpriced relative to the companies' earnings and prospects. For instance, stocks near their 52-week highs that have Schwab's lowest ratings include Las-Vegas-based station Casinos (STN) and auto-parts company Amerigon (ARGN).
Proximity to the high is perhaps best used as a tiebreaker that helps investors choose among a handful of stocks with good potential. If you have three equally attractive stocks, the one closest to its high is likely to be a "better performer and to perform more quickly" than the others, says Schwab's Mr. Forsythe.
[8/30/06] What goes down tends to go down some more.
This has been shown in several studies that are sliced, diced, and summarized by noted NYU finance professor Aswath Damodaran in Chapter 8 of his book Investment Fables.
In these studies, when you measure time in terms of months, stocks that have gone up tend to keep going up. In other words, winners keep winning. And vice-versa. So when people advise you not to try to "catch a falling knife," they're not being silly -- they're playing the smart odds.
However, when time is measured in terms of years, the contrarian strategy begins to pay off. Oft-referenced work by Fama and French found that the contrarian strategy is far more successful for five-year returns than for one-year returns. Moreover, it works better for smaller companies than large ones.
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[8/25/06] Barry Ritholtz at The Big Picture had a recent comment about never buying a 52 week low. As you might expect, such absolutes simply don’t exist in trading.
Here’s fellow RealMoney.com columnist James “quant-jock” Altucher’s take:
I took all Nasdaq 100 stocks since 1996, including stocks that have been deleted from the index (to avoid survivorship bias). What happens if you buy stocks hitting 52-week lows that are trading for greater than $5 (avoiding penny stocks) and sell them one quarter later?
The results actually demonstrate that, over this period, the odds were on your side to outperform the market if you bought stocks at 52-week lows. The average return per trade was 7.34% (over 662 trades), including wins and losses. This far outperforms the average return per quarter of the Nasdaq during this period of 2.6%.
Some 60% of the trades turned out favorably and 40% were failures.
This would seem to run counter to O'Shaughnessy's What Works On Wall Street which found that buying stocks with the worst 1-year price performance turned out to be the worst strategy in the whole book.
The difference could be the universe of stocks looked at. Altucher looked at the Nasdaq 100 while O'Shaughnessy used the CompuState database which had about 3500 stocks on average. It could well be that the smaller companies chosen had a higher percentage of companies headed for bankruptcy. The "Large Stocks" did decidedly better that the All Stocks universe, but still underperformed the Large Stock universe.
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What Works on Wall Street (Chapter 15) looked at stocks with the best and worst 1-year price changes.
The stocks with the best 1-year price appreciation outperformed the All Stock universe by 2-to-1.
The stocks with the worst 1-year price appreciation widely underperformed the All Stock universe beating it only 11 of the 43 years reviewed and only once on 39 5-year periods.
Conclusion: buy the stocks with the best 1-year relative strength.
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However another study found that the momentum strategy is a relatively short effect, the biggest gains were over the next year. Momentum doesn't seem to affect the stock after a year.
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Tweedy Browne's study What Has Worked In Investing (page 43) cites a study which the 35 worse and 35 best performing stocks over the last five years. The worst performing stocks over the preceding five-year period produced average cumulative returns of 18% in excess of the market index 17 months after portfolio formation, a compound annual return in excess of the market index of 12.2%. The best performing stocks over the preceding five years produced average cumulative returns of about 6% less than the market index after 17 months, a compounded annual negative return of 4.3% versus the market index.
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In summary, the above studies indicate that buy high works in the short term (about a 1 year period), while buy low works in the longer term.
-- written up after the Tweedy Browne study was uploaded at magicformulainvesting
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[5/28/06] In the June 2006 SmartMoney, Jaack Hough cites a study by George and Hwang which looked at stocks within 5 percent of their 52-week highs and lows (rather than the top six month gainers and losers that the Jagadeesh and Titman study looked at). This would for example exclude stocks that was up 60% for six months though it has backed off 15% from the high. Again, these stock beat the overall market but "strong returns kept rolling in for at least five years".
I'd say this strategy would have worked quite well in 1998 and 1999, but pretty poorly in 2000. So value would have to figure in somewhere.
Hough looked at stocks with PEG <= 1 and trading within 5% of their 52-week highs. The screen came out with the following stocks. ABK (79.70), ACO (28.28), PLCE (56.22), DFG (51.00), EBF (19.38), GS (158.12), KAI (22.37), LEH (144.82), NE (81.44).
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