Investing in Undervalued Stocks for Higher Returns
The stock market is a dynamic and ever-changing environment, where investors are constantly seeking ways to outperform the benchmark indexes such as the S&P 500. While many on Wall Street have tried and failed to consistently beat these indexes, Research Affiliates Chairman Rob Arnott may have discovered a strategy that could potentially lead to higher returns for investors.
In a recent report titled “Nixed: The Upside of Getting Dumped,” co-authored with Forrest Henslee, Arnott highlights the potential benefits of investing in stocks that have been removed from popular indexes like the S&P 500. According to the report, companies that are dropped from indexes tend to outperform those that are added back in.
Arnott and Henslee compared the performance of stocks that were removed from indexes like the S&P 500, Russell 1000, and Nasdaq 100 to those that were added. They found that while stocks that were added initially surged in price, their momentum quickly faded, leading to underperformance over the subsequent year. On the other hand, stocks that were removed from these indexes consistently outperformed the market by more than 5% annually for the next five years.
The reason for this outperformance, according to the report, is the massive selling pressure faced by dumped stocks as a result of funds tracking popular indexes. This selling pressure often leads to prices that are artificially low, creating an opportunity for savvy investors to capitalize on a potential rebound.
In fact, the report estimates that an investor in a portfolio of dumped stocks optimized for the five years after deletion could have multiplied their wealth by a factor of 74 between 1991 and 2023. This performance far exceeds that of investors in the S&P 500, Russell 1000, and Russell 2000 Value indexes, who would have been behind by 55%-65% during the same period.
While dumped stocks may not have beaten the big indexes in the past decade due to the dominance of growth stocks in the current bull market, Arnott and Henslee believe that this trend is likely to reverse in the future. They suggest that when growth’s dominance ends, almost anything should beat the S&P 500 and Nasdaq-100.
To test these findings in today’s market, Research Affiliates launched the Research Affiliates Deletions Index (NIXT). This index buys dumped stocks from top market-cap weighted indexes, holds them for five years, and rebalances them annually to equal weight. According to the report, stocks have rebounded well after being dumped by an index over the past 30 years, and the NIXT fund aims to capitalize on this resilience in the decades ahead.
Arnott’s previous predictions have also been accurate, such as his forecast in December 2020 that Tesla would lag the S&P 500 after being added to the index. Just six months later, the S&P 500 was up 17% while Tesla was flat, and the stock that was dumped, Apartment Investment and Management, had surged 44%.
In conclusion, investing in undervalued stocks that have been removed from popular indexes like the S&P 500 could potentially lead to higher returns for investors. By capitalizing on the rebound potential of dumped stocks, investors may be able to outperform the market and achieve significant wealth growth over time. As the market continues to evolve, strategies like the NIXT fund offer a unique opportunity for investors to diversify their portfolios and potentially achieve higher returns in the long run.