Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs?

by Bill Dunbar

part 2:
Are junk stocks really dogs?
by Bill Dunbar

T his is the second part of an article by the same title published in a previous issue of Stocks &
Commodities. In the first half, my question was related to investment in junk stocks near the peak of the
market cycle. The question was: what is the risk in a portfolio of junks under such circumstances? The
answer was: on the average, less risk than in a portfolio of respectable stocks. The part that was missing
was what the relative gains were if the stock had been purchased just prior to a healthy bull market. Since
it required a different selection of stocks, I deferred it till now.
As in the first article, the selection ground rules are the same, with one exception to be covered later.
Those ground rules are:
1. All stocks selected had to be down at least 80 percent from highs of the preceding several years.
2. All stocks had to sell for $5 per share or less on the market close at the "buy" time selected.
Here I compare their performance on a percentage basis to the performance of Standard & Poor's 500
index for the same time span.
In this case, I was able to obtain an extra time period starting nearer the bottom in 1970, when junk
stocks first began to appear in the Securities Research charts after a long period of unusual prosperity.
Even so, I was only able to find nine candidates out of the 975 issues reported. That contrasted
dramatically with the market low in 1974. At that time there were so many available that I had to reduce
my buying limit from $5 per share to $3 per share to keep the number to a manageable size. Even so, I
found 72 candidates, many more than for any other period. Several of those included were showing
substantial earnings, but were simply victims of the cloud of panic that hovered over the marketplace at
that time.

It's surprising how far down stocks can go sometimes, and it's a
much more pleasant surprise when you're on the outside looking
in.
The results of the study are shown in Figure 1. The performance of the nine junk stocks selected in 1970
was miserable, but the next bull market made up for it and, on average, for the four bull markets the
junks had led the field by an overwhelming margin, 109 percent vs. 56 percent.
In order to get a composite picture of all three phases of the market cycle, I brought forward the results
from the first article and incorporated them in Figure 2. In this table, the percentage gains are divided by
the number of years involved in each period to obtain annual percentage gains. The results don't appear
as dramatic, but I think they are more realistic because they indicate better how hard your dollars would

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Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

Figure 1
Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

Figure 2
Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

be working for you (or against you).

I think the message is clear. Though on average junk stocks do better than in the general run, your money
is still better in positions initiated at the low points of the market indices than at the top, which is
important if you can call the turns in the market.
There are always junk stocks that bounce off the bottom at times other than those of general market lows.
But what are our chances at those other times? It's not easy to tell when a stock has hit bottom. Many
corporations in trouble sink lower and lower and lower.
There have been a lot of comments among financial writers about "averaging down" and
"dollar-cost-averaging" both for and against. By that method, if you buy a stock and it goes down, your
financial fairy waves her magic wand and you are transformed from a speculator into a long-term
investor. When the stock has dropped to 50 percent of its original price you buy some more, and again
when 50 percent of that price is gone, or at some such arbitrary increments.
When 75 percent of the original price has become history, you will be getting four times as many shares
for your dollar as you did when you first bought it. That may give you a comfortable feeling that you are
sticking with your convictions and that when the stock makes a turn and starts climbing again you will be
awash in paper profits. It may also help you keep from grieving about the losses you swallowed on the
way down, though if the slide continues long enough, the gradual erosion of your confidence may cause
you to sell out near the bottom and take depressing losses.
Gerald Loeb pooh-poohs that method and though he sprays around a lot of advice, not all of which is
mutually compatible, his one consistent and overriding demand is that you cut your losses and get out if a
stock goes the wrong way. I agree with that, but there are different ways to average-down.
If you watch a stock slide and let somebody else take an 80 percent drop from the top, you are certainly
on better ground than if you took the whole toboggan ride. It's surprising how far down stocks can go
sometimes, and it's a much more pleasant surprise when you're on the outside looking in.

The junkier a stock gets, the harder it is to find the bottom.

Of course, the closer you can get to the bottom, the better, but therein lies the problem. Nobody seems to
know where the bottom is until after it has happened.
Loeb says, "This ever-liquid method also rarely calls for attempts to buy at the bottom, as bottoms and
tops are actually impossible to judge ordinarily, while trends after they are established and under way can
be profitably recognized."
Well, maybe so, maybe not. I haven't done any research on that question but I'm sure that Loeb overstated
his case. On many occasions I have "profitably recognized" when stocks appeared low and when they
appeared high without trying to catch the trend in full swing. And if I can do it anybody can. It is simply a
matter of judgment, based on the past history of the stock and the phase of the general market.
However, the junkier a stock gets, the tougher it is to find the bottom. If a stock has dropped over 95
percent from recent highs, is selling for less than a dollar, and has not sought reorganization under court
protection, I would not expect too much further deterioration in price. Sure, maybe it will drop another 50
percent or maybe it is headed for liquidation out of court, but of the 179 stocks covered by this study only

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Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

Figure 3
Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

Figure 4
Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

6 percent were either known to be liquidate; or disappeared from the listings. I think, based on that, that
the fear of complete loss in a junk stock is largely a bugaboo inhabiting investors' minds, rarely venturing
out into the real world of corporate securities.
Robert Edwards goes on and on about reversal patterns, both top and bottom, but I have not had very
good results looking for double bottoms, triple bottoms, inverted head-and-shoulders or rounding turns
among the junk stocks.
When it comes to bearish trends, Edwards says, "From the technical analyst's point of view, it is to be
regretted that few bear markets have produced major trendlines of any practical significance on the charts
of individual stocks."
So how can the bottoming problem be handled other than just shooting in the dark? Well, I think at least
part of the answer can be seen in Figure 1. Buy at the market lows if you have the patience to wait for the
major market cycles to unfold. I don't seem to have it, but if I advise anybody else to, maybe I can shame
myself into waiting for the market bottom before jumping in.
In the meantime, are there other occasions when the action is worth the risk? To answer that question I
made another brief study to assess the junk stock lows and gauge the frequency by month. The results are
shown in Figure 3 and Figure 4. The lows selected do not necessarily meet the same criteria as in the
above study—just any stock that bottomed at $5 or less including substantial secondary lows.
Note that not much can be said about the first 12 years because the junk stocks were so scarce. The
source was the same as above and all the "twos" may appear strange. The reason for them is that I
normalized all the numbers to 1,000 issues and at that time the Blue Book was reporting only 566.
Therefore, all the "ones" became "twos." More recent issues have been reporting 1,105 issues, so the
count was reduced slightly to make it comparable.
There were seven general market lows (marked by rectangles) during the period and in two out of the
seven no junk stock bottom appeared. In four of the seven there were more lows in the following
December than during the month of the low point in the S&P 500. The most striking of those occasions
was in 1974 when December saw a count of 124 available.
It's hard to miss the bias toward the last part of the year. This repeats the pattern plotted in my earlier
article for the general run of stocks, except the December dominance is more marked in the case of junks.
When I plotted the results (Figure 4) I arbitrarily deleted 100 issues from the December 1974 results so
that the unusual conditions that existed at that time would not completely overwhelm the other months.
Even so, December dominates the pattern.
However, none of the patterns that can be picked out of Figure 3 occur consistently and it would be a real
drag if any of them did. That would take all the fun out of it.
As of the market close on the last day of June 1985, from reference 3 I counted 28 issues per 1,000 that
were selling for $5 per share or less. How close those 28 were to their bottoms only time will tell. Of
those junks counted, 41 percent were in petroleum-related industries and 23 percent were in electronics
and computer oriented industries. Does that mean those industry groups are the ones to get into or stay
out of? I can't tell you now. Perhaps later, after I've made a bundle or lost my shirt.

References Copyright (c) Technical Analysis Inc. 3

Stocks & Commodities V. 4:8 (316-318): part 2: Are junk stocks really dogs? by Bill Dunbar

References:
The Battle for Investment Survival. G.M. Loeb. Simon & Schuster, NY, 1957.
Technical Analysis of Stock Trends . Robert D. Edwards and John Magee. John Magee Inc. Boston, MA,
1966.
The SRC Blue Book of 5-Trend Cycli-Graphs . Securities Research Company, Boston, MA.
"Stock Market Business Cycle." Bill Dunbar. Technical Analysis of Stocks & Commodities magazine,
December, 1984.

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