Customer Reviews

Winning with the Dow's Losers: Beat the Market with Underdog Stocks

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Charles Carlson, the author of seven previous investment books, has uncovered a simple strategy using the worst calendar-year Dow performers to beat the Dow Jones Industrial Average (DJIA) at its own game! Carlson's strategy is a twist to the Dogs of the Dow (DoD) strategy presented in Beating the Dow (1990) written by Michael O'Higgins. O'Higgins selected the ten highest paying dividend stocks in the DJIA and bought them at year-end and held them for a year, and then bought the next batch of highest yielding stocks, etc. That strategy did great in back-testing, but has not done well in the past few years.

For the uninitiated, Carlson provides the historical basis of the DJIA and devotes an entire chapter to the DJIA components, developments, and changes in the index. At least one page is devoted to each stock in the index with complete information on its historical significance and business. Another chapter is devoted to counterpoint arguments against the naysayers of his strategy.

Carlson's strategy does not use dividend yield as his selection criteria, but instead focuses on those stock(s) that have the worst yearly percentage price performance. He simply buys the DJIA stock(s) with the worst annual performance at the end of the year and holds it for one year, then he selects that year's worst performer and buys it, etc. In addition to the one stock portfolio, Carlson also shows the comparative results using the worst performing 3-stock, 5-stock and 10-stock portfolios. The 5- and 10-stock portfolios show the most consistent performance and have less risk than a one stock portfolio.

The book focuses on the performance of the worst 1-, 3-, 5- and 10-stock DJIA portfolios, and provides statistical information showing how these different stock strategies compared to the DJIA annually since 1931 (using back-testing) on a dollar-term, percentage, annual return, and percentage difference from its 200 day moving average basis. He also provided comparative results for last 30 year, 20 year, 10 year and 5 year periods. In addition, there is as 37-page appendix containing the performance of each DJIA stock since 1931 as far as annual performance change, the DJIA annual change, and the performance of each of his stock strategies in each of the years.

In a separate chapter, he even compares his strategies with the Dogs of the Dow and indicates their superiority over the DoD since 1999. The performance before that time showed mixed results depending upon which of Carlson's strategies are used.

Overall, the author presents a credible case for considering his DJIA strategies. He warns investors that they should only invest a portion of their money in any of these strategies, and to be sure to have a diversified portfolio overall to be successful. This book offers investors a mechanical stock selection process that takes the emotion out the investment equation. In that respect it has much to offer.

In this book "Winning with the Dow's Losers", Chuck Carlson describes a simple strategy to beat the Dow Jones Industrial Average (DJIA) with the Dow's biggest losers: The worst performing stocks of one year will outperform the Dow in the following year. This had me raise an eyebrow, because a well established theory says that winners will keep on rising, and losers will keep on falling. That is the idea behind all the momentum strategies and relative strength strategies, and it has been outlined in O'Shaugnessy's acknowledged book "What works on Wall Street".

The author admits honestly that he got the idea about this strategy from just the two years 2000 and 2001: In 2000, Philip Morris was the biggest winner in the Dow (+91%) after being the biggest loser in the previous year (-57%), and in 2001, Microsoft (+53%) and AT&T (+36%) were big winners after trailing the Dow the year before (-63% and -66%, respectively). Carlson gives plausible reasons why it is likely to outperform the Dow with the laggards. The DJIA is a price index, i.e. cheap stocks don't have as big an influence on the index as expensive stocks do. Thus, if a cheap stock (and most laggards have come down in price considerably) increases by 10%, the Dow will increase by less than 10%. The other reason is his theory of "reversion to the mean".

Does Carlson's method leave room for criticism? It sure does. Some of it the author addresses himself in Chapter 9. But my main criticism is that the worst-to-first effects were most pronounced over the last 5 years (that's when the author noticed the effect).
He then extended his theory back to 1930 to show that it also works long time. And indeed, he did find a slight advantage for his worst-to-first strategy vs. buy-and-hold. During this 74 year period, his method returned 11%, while the Dow Jones returned 10% p.a.
If you consider, however, that you have to buy and sell shares once a year, the brokerage fees and commissions (usually 0.5% to 1% round turn) will eat up this advantage.
Also he mentions (on p. 105) that in his historical calculations all dividends are reinvested. Not only does this cost additional fees and commissions, but he just cannot invest all dividends because they are subject to tax (currently 15%).

The book was written in the second half of 2003, and most trading systems suffer from the fact that they were adapted to the past. Now, with three more years gone by, we can check, if the worst-to-first method stood the immediate future after publication. The following data were taken from Carlson's website (www.dowunderdogs.com). If you use his preferred worst-to-first version (a portfolio of the 5 worst performing stocks), in 2004 (+5.7%) he barely outperformed the Dow (+5.3%).
In 2005, his portfolio (-9.5%) underperformed the Dow (+1.7%).
And in 2006, he outperformed (+31.5%) the Dow (+16.3%).
So from 2004 to 2006, the worst-to-first outperformed the Dow by just 0.3% annually. And that is before fees and taxes! Do these results create confidence in his method?

Be it as it may, the book is well written (I finished it in just over a day) and easy to understand, and it is worthwhile reading because it outlines a coherent concept.

The main idea of the book is explained in a few first pages. The big goal is to buy low, sell high. The way to achieve that is to buy the worst performing stocks of the Dow and sell them in a year and one day. A purely mechanical, emotionless, low overhead approach. The rest of the book gives you some information on how Dow index is calculated, what companies are included, how to buy stocks and use options etc.

How good is this strategy? The author's own goal is to be able to outperform the Dow index. Well, it does beat Dow in most cases. So should you use it? Before you decide, consider this:

1. Dow has been pretty much flat for the last 6 years, so the bar is not that high. Even not investing money at all would outperform Dow in some of the recent years.
2. Dow stocks are typically US large cap companies. If US runs into a new recession, they'll probably all go down. How about more diversification?
3. If you buy the worst performer year after year, do you think it's likely one of them will eventually file bankruptsy and your investment will become worthless?

So if you were thinking about investing in Dow index, this strategy is a reasonable alternative. But keep in mind that typically "mechanical" "automated" "emotionless" systems tend to work for some time and then their performance degrades. The market is changing and locking yourself into some automated process can be very risky.

Here is an example. A few years ago everyone was talking about investing in indecies. Dow was beating most of the funds and buying index was so much cheaper, so over time you were supposed to enjoy top performance with no research effort. Sounds familiar? Guess what happened. Dow Jones is still lower then it was 6 years ago. Did you have other options? Or yes! International stocks, real estate, natural resources, gold, energy etc. But diversification accross right sectors in right time is not what mechanical systems do well.

So my advice is don't be too excited about "no brain" systems. If something looks to good to be true ...

Charles Carlson's recent book is a variation of the "Dogs of the Dow" and like the Dogs books, this one also is flawed in the overall strategy. I suggest one take the data as presented in Carlson's book and calculate what percentage advantage the worst-to-first stocks have in order to double the DOW 30 from 1931 through half of 2003. When I checked out the ten worst price performers, Carlson's top performing portfolio, I found that the advantage only amounted to 1.22%. That means Carlson's strategy of selecting the ten worst performers by price as the stocks to purchase the follow year, outperformed the DOW 30 by 1.22% per year. This small advantage results in a portfolio that is doubles the DOW 30 over a 72 year period.

What Carlson fails to tell investors, or at least does not emphasize, is that commissions, taxes, bid/ask spread, and market impact will more than use up that 1.22% advantage. Therefore one is significantly better off to purchase an index of the DOW 30, sit back and do nothing. This is an investment book where you can save your money and invest in an index. You will be further ahead seventy years from now.

Charles B. Carlson's Winning With The Dow's Losers is an excellent resource for today's investor. The wealth of information provided between the covers is both unbiased and rich in content.

Carlson provides extensive charts and graphs displaying key statistical information where anyone can easily evaluate for their own purposes. The section where Carlson evaluates each of the 30 DOW stocks is quite exemplary. Even though the information is pretty current, Carlson keeps into account the trends of the market. He is conscience that such DOW Stocks as Eastman Kodak and AT&T might not be in touch with the current market conditions. Therefore, it may not be profitable to investment money in thoses stocks even after a battered down prior year. He also provides insight on future changes in the DOW and possible new candidates in the 30. Further analysis into the DOW Transport and Utility stocks are given as well.

The main focus of the book is to guide the reader on the simple stragegies of investing in reliable DOW Stocks and to turn over your portfolio systematically from year to year. However, the supplemental points as illustrated above certainly make this book fully loaded with valuable information. Therefore, I say keep this one handy on your shelf.