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How to use the StockRank Styles

Using the various combinations of the three factors which drive stock market returns (quality, value and momentum) leaves us with eight different investment archetypes which we call the StockRank Styles.

Falling Stars: How to handle glamour shares that fall from grace

Ben Hobson

In the ten years to 2014, shares in online fashion retailer Asos soared from around 7p to £70 each. The stock became the stuff of folklore among those that had either made a fortune or missed the chance of making millions by selling out too early. Its relentless growth seduced investors and created blistering momentum that pushed it to a nosebleed valuation.

Despite concerns that Asos was priced far too highly, investors continued to buy into expectations that it could keep keep up the pace. So when it finally did start showing the signs of slowing down, the impact on the shares was dramatic. When the hopes of more spectacular growth were dashed, Asos found itself out of fashion.

In the taxonomy of stock market winners Asos had become a Falling Star. Its financial and business quality continued to hold much appeal, but in the absence of hope, the extremely stretched valuation didn’t reflect underlying fundamentals. When momentum declined, the stock lacked two of the main drivers of investment returns. As a result, it looked expensive and deteriorating. For some, it still looks expensive.

The profile of a Falling Star

Earlier in this series, Ed wrote about how focusing on high Quality, high Momentum shares regardless of price can open the door to finding the stock market’s High Flyers - a class of high priced, compounding, market beating shares. Falling Stars are what you get when the Momentum leg of High Flyers gets kicked away. When brokers begin cutting their forecasts and the companies miss earnings expectations then expensive, quality companies can look very vulnerable.  

Falling Stars might be good quality businesses suffering temporary declines - and they may bounce back. But is the opportunity cost of holding them in the hope of higher share prices too much to bear? And is the sudden decline in momentum, as seen in Asos's case, something that will become far more severe?

One of the highest profile cases of this kind of re-rating occurred with the so-called nifty fifty companies of the late 1960s. Back then, this group of 50 large, good quality blue chips like General Electric and Polaroid were rated at anything up to 100 times earnings. Researchers Vitali Kalesnik and Engin Kose[1] describe these stocks as spurring “a shift from value investing to a 'growth at any price' paradigm.” But it didn’t end well. When the S&P 500 fell by 39% between 1973-74, the nifty fifty fell by 47%. It took investors in these stocks a decade to recoup their losses and they never caught up with the broad market.

In their paper, The Moneyball of Quality Investing, the researchers note: “Just as hiring great ballplayers at rocket-high salaries may be bad business decisions, buying quality stocks at high prices are likely to be bad investment decisions.”

Where do Falling Stars go next?

Evidence suggests that some Falling Stars don’t easily recover. But these stocks don’t all languish forever.

So perhaps the best way to interpret Falling Star status is to use it as a reason to re-examine the investment case for a stock and wait for either the valuation to fall, or the momentum to rebuild. This sort of strategy echoes an approach used by American investor Richard Driehaus. He famously waited for earnings surprises in companies with a history of earnings growth before buying them. This might offer one way of isolating Falling Stars that might recover quicker than others - although Driehaus was averse to stocks that had already declined.

Alternatively, it might be possible to reassess Falling Stars based on their potential for offering Growth at a Reasonable Price - if the falling share price offers a more reasonable valuation. A GARP screen would take into account valuation measures like price-to-earnings, against growth indicators like earnings growth and return on capital employed. Time of course may also allow earnings growth to rise and bring the P/E ratios of these shares back to more acceptable levels without any fall in price.

Is it worth the wait?

The stock market is littered with examples of market darlings who had prices that were stretched, snapped and never recovered. Having shattered the confidence of investors, they can spend long periods in the doldrums. For investors that own them, the opportunity cost of holding on may well be too great to bear. And for any investor looking for opportunities, the risk of catching a falling knife may well make these shares untouchable. Without the benefit of an appealing valuation or improving momentum, Falling Stars are generally worth avoiding.

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