Investors Can Beat the Market by Buying Hated Stocks

In yesterday’s Daily, I showed you a simple way to beat the market with the “Bridesmaid” strategy.

Today, I have another strategy for you.

You’ll need a strong stomach for it…

But if you’re willing to be a contrarian, it has the potential to boost your portfolio’s returns and beat the market by 3% per year – year in and year out.

Like yesterday’s Bridesmaid strategy, this one also comes courtesy of The Leuthold Group.

If you haven’t heard of The Leuthold Group, it’s one of the top financial research firms for institutions in the world. (You can learn more about Leuthold here.)

With the Bridesmaid strategy, you buy the second-best performing asset class of the previous year. That’s because, based on history, the previous year’s runner-up generally outperforms in the following year.

It’s a momentum approach that’s returned an annualized 14.3% over the last 49 years. In comparison, the S&P 500 only returned an annualized 11%.

The Bridesmaid strategy can also work by sector, but today’s strict value approach – what we’ll call the “Cheapest Sector” strategy – can work even better.

It’s just as easy – and nearly as profitable.

Go Low or Go Home

With the Cheapest Sector strategy, you buy the previous year’s S&P 500 sector with the lowest price-to-earnings (P/E) ratio. Basically, you’re bargain hunting for profits.

Now, it might be difficult for some investors to buy the cheapest sector in the market. It’s usually the most-hated one as well.

But if you’re willing to go against the crowd, the returns are usually worth it…

(Note: 2021 was an anomaly year for S&P 500 sectors. All were up double-digits, ranging from 18–55%. So it’s unlikely any one sector was truly “hated.”)

Leuthold studied 10 of the S&P 500’s sectors (excluding real estate) back to 1991. The Cheapest Sector approach returned an annualized 14.2% over those 31 years.

In contrast, the S&P 500 returned an annualized 11.2% during the same period…

As you can see in the chart above, the two sectors that have outperformed the S&P 500 by the greatest margins are the second-highest P/E sector and the lowest P/E sector.

So, if you’d followed the Cheapest Sector approach, you would’ve outperformed the market by an average of 3% per year over the last three decades.

Although it’s not foolproof – like we see above, where the second-highest P/E sector has slightly outperformed the lowest – the strategy sports a solid win rate of 61%. This Cheapest Sector strategy has bested the S&P 500’s returns in 19 of the last 31 years.

It’s that simple.

Now, as Leuthold points out:

The strategy rewards only those bold enough to buy the absolute lowest P/E ratio. Sectors with the seventh-, eighth-, or ninth-ranked P/E ratios have all been long-term underperformers. Go low or go home.

With that in mind, let’s look at which sector had the lowest P/E ratio in 2021. It should be a good bet to outperform in 2022…

From the Bottom to the Top

The table below ranks 10 of the S&P 500’s sectors from highest to lowest by their December 2021 P/E ratios. (Leuthold uses median trailing P/E ratios.) As you can see, financials ranked at the bottom…

This means, based on history, financials are likely to outperform the market this year.

Therefore, if you want exposure to financials, consider the following exchange-traded funds (ETFs)…

You can use the Financial Select Sector SPDR Fund (XLF) or the Vanguard Financials ETF (VFH) for 2022.

They’re the top two ETFs based on assets in the sector. And they have super-low expense ratios of 0.12% and 0.10%, respectively.

So consider using the Cheapest Sector strategy when you’re rebalancing your portfolio at the beginning of each year. If history is any guide, you’ll beat the market by a few percent more often than not.

Regards,

Grant Wasylik
Analyst, Palm Beach Daily

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