Avoid Investing in Poor-Performing Stocks for Maximum Returns

Key Points

• Stock selection in the stock market is not easy and requires effort
• Shorting stocks as a strategy may not always work
• Shorting low-quality and high-volatility stocks yields negative returns
• Highly leveraged financial firms saw their stock prices soar after the global financial crisis
• Stocks with poor features have certain relationships and correlations
• Combining multiple lousy features in stock selection does not improve performance
• Shorting expensive or underperforming stocks can be profitable
• Short selling has asymmetrical risks compared to buying stocks
• Lousy stocks sometimes turn out to be great investments

Introduction

Playing the stock market should be easy: When the economy is booming, buy equities. When it’s deteriorating, short them. 

Stock selection shouldn’t take much effort either — we just need to apply metrics from factor investing literature. In bull markets, that might mean focusing on cheap, low-risk, outperforming, small, or high-quality stocks, and in bear markets it might mean the inverse.

Of course, in practice, equity investing is neither easy nor effortless.

Shorting Stocks with Lousy Features

To identify what stocks to short, we focused on five factors: value, quality, momentum, low-volatility, and growth. The first four of these are supported by academic research, and while the growth factor is not, we included it in our analysis given its popularity among investors.

We created five indices composed of the top 10% of the most expensive, low-quality, low-momentum, high-volatility, and low-growth stocks in the S&P 500 and shorted them. To determine whether the strategy generated any excess returns, we added a long position in the stock market. We rebalanced our portfolios each month and added 10 basis points (bps) to simulate transaction costs.

From 2005 to 2022, shorting low-growth and low-momentum stocks effectively delivered zero excess returns, while doing the same for low-quality and high-volatility stocks yielded negative returns. Bets against low-growth stocks worked well until about a year ago, when Amazon, Meta, and other high-growth companies started to underperform.

Breakdown by Factors

Although some of these portfolios followed similar trajectories, the underlying portfolios were quite varied.

Tech and health care dominated the expensive and high-volatility portfolios over the 17 years under review. Real estate stocks tend to be highly leveraged, so screen poorly on quality metrics. Consumer discretionary companies made up the largest contingent in our portfolio of underperforming stocks. Real estate, financials, and energy stocks all demonstrated comparatively poor sales and earnings growth.

Correlation Analysis

Stocks with poor features shared certain relationships. The excess returns of low-quality, low-momentum, high-volatility, and low-growth stocks were all highly correlated. Expensive stocks had low but positive correlations with the other four portfolios.

Shorting Stocks with Multiple Lousy Features

While high correlations among stocks with lousy features do not bode well for a portfolio composed of stocks with multiple lousy features, we applied the intersectional model to build a portfolio of expensive, low-quality, high-volatility, low-momentum, and low-growth stocks.

This portfolio had substantially different sector weights compared to the S&P 500. Health care, technology, and real estate dominated, while utilities and staples were underrepresented.

Fundamental Metrics

What about the portfolio’s fundamental and technical metrics? We compared the rankings of the top 10 stocks in our portfolio with those of the S&P 500. Snap scored the worst, followed by cruise line operators and biotech companies.

These stocks do not rank poorly on all metrics. For example, they exhibited relatively high sales growth. Naturally, the more features used in the stock-selection process, the fewer stocks fulfill all criteria.

Shorting Stocks with Multiple Lousy Features

So, what sort of excess returns did combining all these features in the stock-selection process deliver? We began with our expensive stock portfolio and added the other metrics one by one. Performance did not improve.

Shorting these stocks would not have been a good bet between 2009 and 2021, though it would have worked before the GFC and again in 2022.

Further Thoughts

Why is shorting stocks so difficult? Research indicates that factor investing primarily works on the long side, so investors can generate excess returns by buying cheap or outperforming stocks but not much from shorting expensive or underperforming stocks. Another research finds just the opposite, that shorting such stocks can be profitable.

The challenge of short selling may lie in the asymmetry between making money on the long and short sides. Losses on long positions top out at 100% since stock prices can’t go negative. Losses on short positions, on the other hand, are theoretically infinite.

Famed short seller Jim Chanos shorted Tesla for years. In 2020, the electric automaker’s stock had truly abysmal fundamental metrics and was trading at an excessive valuation. Nevertheless, shares rose by more than 2000% thereafter.

Lousy stocks are sometimes great investments.