The past financial year has been volatile for equity investors, with significant falls in June and September, offset by gradual recoveries in the other months. 

The sharemarket volatility over the past year is unusual – it’s a result of the normalising of interest rates and, for many investors, their first experience with inflation. 

For the 12 months ending April 2023, the S&P/ASX 200 Index returned -1.7% (or a mere +2.8%, including dividends). 

However, the slight fall in the ASX 200 over the past year masks a large dispersion in returns over 2022, with a range of energy and mining companies posting solid gains that offset significant falls in the share prices of many other companies. 

[Editor’s Note: Do not read the following commentary as a recommendation to use or apply the Dogs of the Dow theory to Australian equities, or buy or sell any stock mentioned in this article. Like all investment strategies, the Dogs of the Dow theory has potential benefits and risks. The strategy involves buying a small group of underperforming stocks, which has implications for portfolio diversification and the risk profile of a portfolio. Moreover, the Dogs of the Dow strategy is well known in investment markets. A feature of markets is that gains from successful and widely used strategies tend to be ‘arbitraged’ away over time. Finally, the description of ‘dog’ is based solely on the company’s share-price performance that financial year and not a reflection of the company’s quality or its future prospects.] 
 

Dogs of the Dow theory

Most institutional investors cast an eye over the market's worst-performing stocks that financial year to find some treasure to drive portfolio returns over the coming year. 

Invariably, several bottom-performing stocks will confound market expectations and stage remarkable comebacks! 

Michael O'Higgins popularised a systematic investment strategy of investing in underperforming companies named "Dogs of the Dow" in his 1991 book Beating the Dow. This approach seeks to invest in the same manner as deep value and contrarian investors. 

O'Higgins advocated buying the 10 worst-performing stocks over the past 12 months from the Dow Jones Industrial Average (DJIA) at the beginning of the year but restricting the stocks selected to those still paying a dividend. 

Restricting the investment universe to a large capitalisation index like the Dow Jones Industrial Average or S&P/ASX 100 Index improves the unloved company's chance of recovery in the following year, according to the theory.

Larger companies are more likely to have the financial strength or understanding capital providers (such as existing shareholders and banks) that can provide additional capital to allow the company to recover from corporate missteps or unfriendly economic conditions, compared to smaller companies, according to the theory.
              

Retail investors 

One of the reasons this strategy persists is that institutional fund managers often report their portfolios' contents to asset consultants as part of their annual reviews. This process incentivises fund managers to sell the underperforming stocks in their portfolio towards the end of the year as part of "window dressing" their portfolio before being evaluated. 

This selling of underperformers by institutional fund managers is especially prevalent in December and June every year. 

For example, in early May 2022, fund managers would have seen some pretty stern questioning from asset consultants about why they owned some of the worst-performing stocks.

Retail investors can afford to take longer-term views on the investment merits of any company that may have hit a speed bump, as retail investors are not swayed by asset consultants questioning short-term underperformance. 
 

Applying the strategy on the ASX in April 2022

Over the past year (to end-April 2023), the worst performing stocks from 2022 gained by 3.2% on average, slightly outperforming the ASX 200 index's return of 2.8%, according to analysis by Atlas Funds Management.

From the table below, five out of the 10 worst performing stocks of 2022 outperformed the ASX 200, with Fisher & Paykel Healthcare Corporation (ASX: FPH), A2 Milk (ASX: A2M) and REA Group  (ASX: REA) delivering the highest returns. 

Source: Iress and Atlas FM

Among stocks, Fisher & Paykel revealed that hospitals had begun restocking consumables again after working through the inventory build-up from 2021. 

A2Milk rebounded on news it had secured US Food and Drug Administration (FDA) approval to supply infant formulae to the USA. In Atlas’s view, this gives the company an alternative growth path after Chinese import restrictions limited sales into its largest market. 

Conversely, the pain continued for Domino’s Pizza Enterprises (ASX: DMP), with the company having trouble passing on higher input costs while budget-conscious consumers baulked at paying new delivery charges and traded down to frozen pizzas bought in supermarkets. 

Applying the strategy in April 2023

Looking through the list of underperformers for the 12 months finishing April 2023, the list is populated by many well-known companies. In the table below, Atlas has provided a main reason for why it believes the company’s share price has fallen. 

Source: Iress and Atlas FM

In Atlas’s opinion, the key themes in the list of the underperforming stocks to April 2023 are:

1. COVID-19 winners coming back to earth after enjoying two years of abnormal growth
   
2. Highly valued tech companies marked down as rising interest rates reduce the present value of profits in the distant future 
   
3. Companies impacted by a slowing economy.
   

Conclusion 

Every year, three or four companies of those companies that underperformed in the last 12 months look like a poor addition to an investor's portfolio. But history shows they outperform the market over the following year. 

In selecting a share price recovery candidate for the next year, Atlas generally looks at companies whose current woes are company-specific rather than caused by factors outside the control of their management team. 

DISCLAIMER

Atlas Funds Management Pty Ltd is not providing any general advice or personal advice regarding any potential investment in any financial products within the meaning of section 766B of the Corporations Act. No consideration has been made of any specific person’s investment objectives, financial situation or needs. The provision of this presentation is not and should not be considered as a recommendation in relation to an investment in any entity or that an investment in any entity is a suitable investment for any specific person. Recipients should make their own enquiries and evaluations they consider appropriate to determine the suitability of any investment (including regarding their investment objectives, financial  situation, and particular needs) and should seek all necessary financial, legal, tax and investment advice. Atlas Funds Management Pty Ltd, it’s directors and employees do not accept any liability for results of any actions taken or not taken on the basis of information in this presentation, or for any negligent misstatements, errors or omissions. Past performance of a fund is no guarantee as to its performance.