Should I resist the temptation to buy falling stars?

Exploring Stockopedia’s rankings recently, I felt a guilty temptation. A quick screen revealed that there were only 40 UK shares classified as Falling Stars. On that list were quite a few shares I’ve often thought I’d like to own.

For example, at the time of writing, the two largest companies on the Falling Stars list are drinks group Diageo (LON:DGE) and tool hire giant Ashtead (LON:AHT).

Other big names that caught my eye included Spirax (LON:SPX), Croda International (LON:CRDA) and Howden Joinery (LON:HWDN). And there were more. You can see the current list here.

Many of these companies have seen big share price falls in recent times:

Browsing through the list, I felt sure that some of them ought to offer value at current levels…

Did I hit buy and add any of these Falling Stars to my portfolio? More on that shortly. But first, I want to consider the type of company we’re likely to find labelled as a Falling Star and take a closer look at their historic performance.

Is there any data to support a more positive stance on these out-of-favour stocks?

Once again, my thanks go to Alex for crunching the numbers and producing these excellent charts.

What’s a Falling Star?

Falling Stars are a losing StockRank Style in the Stockopedia system:

Falling Stars are often glamour shares that have fallen out of fashion – often because their growth has stalled.

You can read a more detailed review here, but in short they tend to have low StockRanks and be characterised by a high quality rank, but low value and momentum scores.

For contrast, here’s an overview of the average StockRank and factor scores for the current crop of Super Stocks:

I think there probably are some long-term opportunities among the Falling Stars. But I also think there’s a Buffett quote that covers this situation:

I don’t look to jump over seven-foot bars; I look around for one-foot bars that I can step over - Warren Buffett

A lack of multiple positive factors means that finding winning opportunities among Falling Stars is likely to be more difficult than when hunting among winning styles.

Falling Stars can perform (sometimes)

The only infallible rule I know in investing is that it’s important to develop an approach that you both understand and are comfortable with.

Are there investors out there who successfully specialise in finding profitable opportunities among Falling Stars? Probably.

But as the chart below shows, beating the market with Super Stocks has been much easier over the last decade (Buffett's one-foot bars). 

Falling Stars have underperformed the wider UK market on a 10-year view. Anyone beating the market by investing in these stocks has probably been very selective and had good timing:

Note: This chart compares an annually rebalanced portfolio of Super Stocks and Falling Stars. It does not include transaction costs and does not take into account stocks that may have fitted these styles at other points during each year.

However, it’s clear that there have been periods over the last decade when Falling Stars have outperformed. This chart highlights these more explicitly:

The most notable period of outperformance was during the pandemic, since when a dramatic correction has occurred.

The data suggest the Covid boom for Falling Stars may have been driven by the opportunity to buy quality stocks whose profitability was above average…

… at valuations that were below average:

This apparent buying opportunity was followed by a period of outperformance, as the era of cheap money delivered a final, indiscriminate burst of glory.

My reading of the subsequent slump in Falling Stars is that it reflects the post-pandemic reality of higher interest rates, inflation and sluggish economic growth. This has persuaded investors to become more discerning and seek stocks with stronger growth or value characteristics.

This cycle is perhaps well illustrated by drinks giant Diageo. This FTSE 100 stalwart was a Falling Star in April 2020 and remains so today.

However, having peaked at over £40, Diageo shares have since fallen by almost 50% and are now below the level seen in the March 2020 crash:

This de-rating has taken place even though profits are largely unchanged, as earnings estimates have drifted lower:

Is the worst over for Diageo? It’s an open question, as I discussed in my recent review of fund manager Terry Smith’s 2024 letter. Personally, I would be (much) more interested in Diageo if its balance sheet was not so heavily leveraged.

Are there any Falling Stars worth a closer look?

I think that any sensible factor-driven strategy should probably include the general assumption that Falling Stars are best avoided.

However, for investors who are keen to take a stock-picking approach and really dig deeper, I’ve taken another look at the current list. How would I find any potential opportunities?

Leveraging the StockRanks

If I was considering investing in a Falling Star, my aim would be to buy shares in a quality business as it’s emerging from a difficult period. In other words, a turnaround.

In such a scenario, I’d hope the business would have the potential to deliver operating leverage and a share price re-rating as it returned to growth.

Although making selections like this is definitely a stock-picking strategy rather than a systematic approach, I’d still aim to benefit from the StockRanks where possible.

Even mid-ranked stocks have outperformed the lowest-ranked shares over longer periods. This suggests to me that focusing on higher-ranked Falling Stars could still be worthwhile, especially if time available for research is limited:

I’d be inclined to focus my initial efforts on the top quartile of Falling Stars, in terms of StockRank.

At the time of writing that’s 10 companies, which is more manageable than trying to consider the whole list:

Using this short list, I’d then begin a more in-depth research process. Some of the factors I’d consider would be:

• Does the underlying business show genuine quality? Does it have a durable competitive advantage and can it generate above-average returns?

• Has something changed in the business in the last year or two?

• Is there a strong balance sheet? Net cash or minimal debt can provide useful downside protection during difficult periods.

• Valuation? I’d consider recent earnings, but perhaps also the 10-year average (CAPE 10y) valuation. Could the business be cheap if normalised trading conditions resume?

• What about other valuation metrics - relative to assets, free cash flow or sales?

• Model scenarios: for example, what impact would a 1% change in operating profit (+/-) have on profits? What about a 5% change in revenue? This could tell me something about both risk and opportunity.

• Review recent trading and use this as context to critically consider broker forecasts. Read broker notes for extra insight if possible, especially with small caps.

Finally, look for any early signs that momentum might be about to turn positive.

A recent ahead of expectations trading update is sadly unlikely, as such a stock would probably no longer be a Falling Star.

However, other more subtle signals may exist. Stockopedia’s new Smart Money Playbook explains how investors can benefit from signals such as director dealing (preferably by C-suite execs) or fund manager moves.

This new report contains some excellent insights and is a valuable read, in my view.

Next steps

If my top 10 proved fruitless, then I might move further down the list (or shift my attention to a more favourable style!).

If I believed that I’d found an opportunity, I’d ask myself why I should invest in this business, rather than a company with a more favourable multi-factor outlook:

• Even if there’s an opportunity here – is it the best opportunity for my capital?

• Is the risk-reward balance favourable when compared to higher-ranked alternatives?

Some of my biggest investing losses have resulted from not evaluating the downside risks, both in terms of performance and valuation. A cheap share can always get cheaper.

Have I added any Falling Stars to my portfolio?

Quality doesn’t always last forever, but recognising when a company has lost its competitive advantage isn’t always easy. Unfortunately, there’s an opportunity cost to holding a losing position while waiting for a turnaround. We could be employing our capital more profitably elsewhere.

A further challenge is that managing such investments is made more difficult by our hard-wired psychological bias to loss aversion. This can make it harder to objectively recognise the correct time to let go.

From my perspective, the UK market offers plenty of buying opportunities at the moment. Although one of my long-term holdings has dropped to Fallen Star status, I have not bought any stocks with this style.

I don’t feel I need to take the extra risks of a solo factor rank stock, when there are other stocks on my watch list that score highly across a broader range of factors.

As always, I’d love to hear what you think. Are you tempted by the turnaround potential of Falling Stars?

Or do you prefer to avoid these often-complex situations, even at the potential cost of buying in at a higher price further down the line?