Buy 'em when they're hated. I don't mean "out of favor." Or "disliked." I mean

hated

.

And buy 'em at the end of the year. Not in November. Not in January. But around the middle of December.

That's the simple foundation of the "Dog Stars" strategy I laid out in my

Sept. 24 column. And now that we're in the middle of December, it's time to pull the trigger and pick the 10 Dog Star stocks for 2005.

An Improvement on Two Tested Strategies

The Dog Stars strategy is a straightforward attempt to build on two very successful buy-'em-when-they're-hated strategies.

First there's the Dogs of the Dow strategy, which works like this: Every Dec. 31, you buy the highest-dividend-yielding stocks in the

Dow Jones Industrial Average

. Because a stock's dividend yield goes up as the price of a share falls, this is a simple way to buy shares of the 10 most-battered stocks in the index. You then hold the shares for a year and rebalance the portfolio by selling these stocks and buying a new group of losers next December.

This extraordinarily simple strategy has yielded market-beating returns decade after decade. From 1928 to the end of 2003, the Dogs of the Dow strategy returned an average annual compounded rate of 13%. That was almost 2 percentage points a year better than the return on the Dow Industrials and 2.5 percentage points better than the return on the

S&P 500

.

The Dogs of the Dow strategy turns in its best monthly performance in January. That has led Yale and Jeffrey Hirsch to propose an improved approach called the "Free Lunch" strategy. As laid out in the

Stock Trader's Almanac

, their strategy calls for buying all the

New York Stock Exchange

stocks selling at their lows in mid-December and holding them to Feb. 15.

The average gain on the strategy since 1974 through 2003 comes to about 13% in six weeks. That compares to the average 5% gain in the NYSE Composite for the period.

My Dog Stars strategy is designed to take advantage of the two reasons that these successful strategies work.

  • First, the Dogs of the Dow strategy works because the 30 stocks that make up the Dow Jones Industrial Average tend to be long-term survivors. These companies have enough financial strength to weather short-term troubles without going out of business. They survive bad times long enough to see the return of better times. Boeing (BA) - Get Report, up 28% in 2004, is an example of the benefits of being financially strong enough to survive the worst of times.
  • Second, the two strategies work because they buy already beaten-down stocks that decline even further in the last days of the year as investors sell their losers to lock in tax losses for the year. When the selling pressure is relieved in January and February, these stocks bounce back from deeply depressed to simply depressed levels.

Dog Stars Membership Rules

In the screen I've built to identify potential Dog Star stocks, I've replaced membership in the Dow Jones Industrial Average with a series of tests to ensure that these are stocks of companies with the financial strength to stick around long enough for a rebound.

In this screen, I required a market capitalization of $1 billion or more, a debt-to-equity ratio of 1 or less so that the company has plenty of access to the capital markets to raise new cash if necessary, and a quick ratio of 1 or more. (The quick ratio divides liquid assets by current liabilities. The higher the quick ratio, the more liquid assets the company has to meet current liabilities if all revenue dries up.)

When I first built my Dog Stars screen, I looked for beaten-down stocks by requiring that the shares made a 52-week low in the last quarter, and that the current share price was within 20% of that 52-week low.

I've run this screen several times since then and each time I do, I am more dissatisfied with the pricing criteria I used to surface hated stocks.

So this time, I've tweaked my two price rules to come up with this combination:

Relative strength of 20 or less in the last three months.

A stock with a relative strength of 20 has been outperformed by 80% of the stocks in the market. I think membership in the lowest one-fifth of all stocks is a good sign that investors hate these shares.

Previous day's closing price is within 20% of the stock's 52-week low.

One of my two original price rules that assures me I'm buying shares that are not just hated, but also cheap when judged by their own recent history.

10 Stinkers That Could Really Pay Off

That screen identified 55 stocks when I ran it on Dec. 17. I took a stock-by-stock look at such gauges as price-to-sales ratio (looking for cheap stocks with low ratios) and MSN StockScouter sub-ratings that showed solid fundamentals despite lousy technicals.

Finally, I read through recent news and company reports looking for both improving conditions and warning signs for 2005.

So, for example,

Reynolds & Reynolds

(REY)

qualifies as a potential Dog Star because:

    Investors know what the company did wrong. (Current business went into a tailspin as the company tried to cram five years' worth of new products and restructuring into three years.)

    The near-term fix is relatively easy. (It hired a CEO to restore the morale in the company's sales force.)

    Fiscal 2004, which ended in September, was such a stinker. (Even with fewer shares outstanding, earnings per share fell 12%.)

    The company's financial strength (it generated $160 million in operating cash flow in 2004) means that it will have time to right itself. And in the midst of all this mess, Reynolds & Reynolds continued to add new products to buttress its leading position in information-management systems in its core automotive market.

    I don't expect any of these stocks to soar overnight, but they're all financially solid enough to weather bad times. And with 2005 shaping up as a very volatile year, I think buying the downtrodden instead of the flavor of the moment makes sound investing sense.

    After all, how hard will it be for any of these companies to exceed investors' expectations next year?

    Changes to Jubak's Picks

    Sell Analog Devices.

    It's time to take my medicine (and get my tax loss in under the wire). My buy of

    Analog Devices

    (ADI) - Get Report

    on June 18 at $45.73 just never worked out. The late-summer rally I expected in technology shares didn't materialize, and chip stocks haven't fared especially well in the otherwise very respectable year-end rally of Nasdaq stocks. Because this was a seasonal play and the seasonal forces didn't lift the stock, I don't think there's any point in hanging on and hoping. I'm taking a 20% loss on this position. (Full disclosure: I will sell my personal shares of Analog Devices two days after this column is posted.)

    At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Analog Devices and Micron Technology. He does not own short positions in any stock mentioned in this column. Email Jubak at

    jjmail@microsoft.com.

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