CHAPEL HILL, N.C. (MarketWatch) — Apple’s sales warning Wednesday illustrated, once again, the virtues of buying out-of-favor stocks instead of crowd favorites.
Consider a spectacular bet made against Apple in August 2011, more than seven years ago, by Robert Arnott, chairman and founder of Research Affiliates. He predicted that, over the longer term, Bank of America
would outperform Apple
To set the context for Arnott’s contrarian bet, consider that, at the time he made it, Apple was riding high, on the verge of becoming the most valuable company in the world. Bank of America, in contrast, was still struggling to recover from the financial crisis. Its stock was more than 80% lower than where it had stood before that crisis, and barely higher than where it was at the bottom of the 2008-2009 bear market.
Apple’s fall from grace over the past three months, and especially its drop in the wake of its sales warning, has now brought its return since August 2011 to below that of Bank of America. According to FactSet, the annualized total return of Apple stock since Arnott made his bet has been 18.2%, versus 20.6% for Bank of America. (See chart, below.) The S&P 500 over the same period produced a 13.8% annualized return.
A similar story is another bet placed by Arnott colleague Chris Brightman in August 2015: That Chevron would outperform Facebook. Like Apple, Facebook
in August 2015 was riding high, the “poster child of our new tech bubble,” in Brightman’s words. Chevron
in contrast, was in the dumps, barely higher than where it was at the depths of the Great Recession. A barrel of crude oil was actually trading for less than it had at its lows in 2008 and 2009.
Three and a half years later, Chevron is ahead. Since August 2015 it has beaten Facebook by an annualized margin of 13.2% to 11.3%, according to FactSet. (See chart, above.) The S&P 500’s
comparable return was an annualized 7.8%.
To be sure, out-of-favor stocks don’t always outperform stocks that are riding high. But over the long term, they, on average, have done so by a large margin.
Consider the Turnaround Letter, edited by George Putnam, which is one of the most contrarian-focused advisory services whose performances I monitor. Putnam focuses on stocks that are emerging from a prolonged period of trouble. Over the past 20 years, his model portfolios have beaten the Wilshire 5000 Index
by an annualized margin of 11.2% to 6.5%.
Of course, even when out-of-favor stocks outperform the market, they can take many years in which to do so. For the 12 months following Arnott’s August 2011 bet, for example, Apple hugely outperformed Bank of America.
It’s also worth remembering that these contrarian bets focus on the relative performance of various stocks, not on which companies are the most profitable. Since Arnott’s August 2011 bet, for example, Apple has generated far more profits than Bank of America. So you could easily argue that Apple is the better company in an absolute sense than Bank of America.
But that’s not what you bet on when you purchase a company’s stock. You instead are betting on whether the stock can do better than what investors collectively are expecting for the company. And that’s a separate question entirely.
I like to use a horse-racing analogy to explain this point. Imagine a 10-horse race in which we are allowed to bet on any finisher, and that one horse is the overwhelming favorite while another is expected to come in 10th. Imagine further that the favorite horse finishes second, while the horse that was expected to come in last instead finishes seventh. It’s not inconceivable that you would make more money having bet on the horse than came in seventh than the one that came in second — even though the second-place horse was a far faster horse.
The bottom line? You pay a hefty premium when you buy stocks that are riding high. It can take guts to instead invest in companies that are down on their luck and out of favor. But, over time, those with such guts often enjoy the last laugh.
As an example of a currently out-of-favor stock worth considering, Putnam mentions General Electric
In the most recent issue of his newsletter, he writes: “Following the company’s jaw-dropping fall from the pinnacle of Corporate America, GE is a chastened company determined to work its way back from the brink. Its highly capable new CEO is rapidly taking remedial action. … While there are still many uncertainties and risks ahead, the company appears to be finally moving in the right direction. Its heavily sold stock appears to reflect all but a worst-case scenario.”