The Portfolio: Highly leveraged stocks can rally in the short run

I used Saxo Bank’s stock screener to screen for financially distressed stocks which resulted in a portfolio of 15 volatile stocks with high leverage (8 US and 7 European). Creating a portfolio of highly leveraged stocks is of course a high risk, high reward play! A portfolio of highly leveraged stocks is usually a very volatile portfolio, which can show significant outperformance in good times and terrible performance when sentiment turns.

Since I made the initial screening late last year, the market has had its ups and downs, and therefore it is interesting to see how this portfolio has performed vs. benchmarks. First, take a look at the constituents in the table below:

Year-to-date performance
The first quarter of 2012 was the best first quarter for the S&P500 since 1998. With little more than half of the portfolio in US stocks, the distressed portfolio managed to outperform benchmarks by 6.5 percent during the first quarter, but took a drastic hit when things turned for the worse at the end of March. At that point markets were hit by global growth worries, with China's growth slowdown factored in to stock prices and weak macro data pushed stock markets even further down. YTD the portfolio has returned a negative 5.5 percent while its main benchmarks, S&P500 and MSCI World Index have returned 3.7 and 1.7 percent respectively.

Individually the stocks in this portfolio differ greatly performance-wise, ranging from a negative 62 percent to positive 42 percent. Further highlighting how volatile these stocks are is the average annualised standard deviation of the portfolio which is currently at a little over 50 percent.

What this portfolio basically demonstrates is that financially distressed companies are strongly correlated to sentiment and fear in the market. When fear abates, these stocks easily outperform the indices, but the opposite is also true.
To play this portfolio one should be equally aggressive taking both long and short positions. Once market outlooks are promising this portfolio tends to return more than its benchmarks in the short term and vice versa. That is of course a pretty risky play, but if you can time the market correctly you could make decent returns. For a longer-term perspective, highly leveraged stocks tend to perform well below benchmarks which could make them long-term short candidates.

For more details on the screening procedure, please refer to my previous post: Underperforming highly leveraged stocks.

We create a new and unusual portfolio every week on TradingFloor.com. If you'd like to be notified with an email whenever a new story is posted, become a member of TradingFloor.com - it's free, and you can sign in with Facebook, Twitter, LinkedIn or Google - and follow the tag "the portfolio."  You can also bookmark our The Portfolio page.