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Why You Shouldn’t Ignore Losing Stocks

Rather than ignoring or hiding from losing positions, investors should turn those losers into valuable portfolio assets or look to capitalize on underperforming stocks where the selling has been overdone.

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The S&P 500 is, at the time of writing, up 18% year to date. Despite that apparent strength, more than half of the index has posted negative returns thus far in 2023.

In fact, roughly one in ten has lost a quarter of its value or more this year.

And that weakness is not limited to large-cap stocks, as the Russell 2000 index, a common barometer of small-cap performance, remains flat for the year, having just turned positive in the last few days.

While investors strive to identify and invest in winning stocks, losing stocks are an unavoidable part of investing, regardless of investing style or time horizon.

But when faced with losing stocks, rather than throwing in the towel and waiting for a fresh start next year, investors can look to convert this year’s losers into valuable portfolio assets and, potentially, winners in the year ahead.

2 Ways to Find Value in Losing Stocks

One way that is available to taxable investors is to use their losing stocks to reduce their tax bills. Short-term capital gains are taxed as ordinary income, with rates as high as 37% at the federal level alone. Adding state taxes can raise the combined short-term capital gains tax rate to 47% or higher. Long-term capital gains tax rates are lower, but investors of course want to avoid paying taxes as much as possible.

So, investors can sell their loser stocks to generate realized capital losses, which can potentially shield some or all of these profits from taxes. Short-term losses, for positions held less than a year, can be netted against short-term gains, helping to reduce tax bills. Short-term losses can also be used to offset long-term gains in some circumstances. And, if combined losses exceed gains, they can be used to offset up to $3,000 of ordinary income, making losses a valuable asset. This asset can extend into future years, as realized losses that aren’t used in one year can be carried forward to future years.

Investors wanting to maintain a position in a particular stock or ETF will want to avoid getting tripped up by the 30-day wash sale rule which can invalidate the tax benefits of a capital loss. Surprisingly, cryptocurrency losses aren’t yet subject to the 30-day wash sale rule. Before making any tax-related trades, investors should consult with their qualified tax advisor to help ensure proper tax treatment.

Another way to capitalize on losers is by buying down-and-out shares that others have sold due to artificial year-end selling pressure.

Tax-motivated selling, as discussed earlier, is a major source of artificial selling pressure. Individual investors as well as professional advisors that manage taxable accounts are primary sources of tax-motivated selling. Surprisingly, mutual funds also make tax-related trades, as these funds distribute their capital gains to their shareholders around year’s end. Managers would rather avoid hitting investors with these taxable events, so they offset gains by selling losers.

Year’s end brings three other sources of artificial selling pressure. The first is window-dressing by professional investors. These managers want to avoid showing their clients and consultants that they held losers, so they sell these stocks to keep them out of year-end reports. This is particularly true in a year when many managers held previously touted stocks that went on to produce embarrassing and large losses. These managers have a strong career-driven motivation to sell these losers at any price.

Also, managers tend to chase performance as the year’s end approaches in order to maximize their performance-based annual bonuses. This means selling losers before they go down any further.

A third source is behavioral. Investors of all types tend to want to start the new year with a fresh perspective – so losing stocks are offloaded without regard to price.

Once the selling pressure fades around year’s end, many of the worst-performing stocks bounce upward, sometimes sharply. Nimble investors can capture some of the bounce before longer-term fundamentals return as primary drivers in late January or so.

Each year, the Cabot Turnaround Letter sorts through the market’s year-to-date losers to find the ones most likely to bounce sharply. Although our investing approach focuses on underlying business fundamentals and share valuation, we, too, can be tempted by the attractive risk/return trade-off that can come with year-end selling driven by artificial pressures.

Last year, all seven bounce stocks we recommended rose more than the S&P 500 through the end of January 2023. Four of these names, Match Group (MTCH), Meta Platforms (META), Walt Disney Company (DIS) and Paramount Global (PARA) increased by 25% or more in the first month of the year. While not every stock in every year of our articles does this well, our record has proven its worth over time.

We will be publishing this year’s bounce candidates in the December edition of the Cabot Turnaround Letter on November 29th. Consider adding our newsletter to your roster of investing sources.

Bruce Kaser has more than 25 years of value investing experience in managing institutional portfolios, mutual funds and private client accounts. He has led two successful investment platform turnarounds, co-founded an investment management firm, and was principal of a $3 billion (AUM) employee-owned investment management company.