Similar Companies Doesn’t Mean Similar Stocks

Ok class, today’s lesson is on the pitfalls of similar stock performance. It’s tempting to think that all companies in a certain industry group behave the same way. The reason why is that in the short term, they often do.
Once you start following a sector closely, you’ll see that, say, all the major banks will go up or down together on a particular day. In fact, if bad news hits one company, then all of its competitors will behave similarly that day albeit not as much. Oddly, one would think that bad news hitting a competitor would be a positive, but such is often not the case.
I want to bring up the case of the major drug stocks. Here’s a chart of six major drug stocks over the past month. The stocks are Merck (gold), Pfizer (red), GlaxoSmithKline (orange), Abbott Laboratories (yellow), Eli Lilly (blue) and Bristol-Myers Squibb Company (black).

Notice that Lilly is at the bottom and GlaxoSmithKline is at the top. Yet, except for those two the other four are very bunched together. You can even see that the “nooks and crannies” of each line seem to match-up. This is actually a very good example of how the market works.
Let’s say you’re a hedge fund manager and you only have these six stocks to choose from. Since you’re being paid a lot to manage people’s money, you want to stand out from the crowd. As a result, you’re not so much looking for the best investments first, but you’re looking for the least-correlated investments. What attracts you is Lilly falling away at the bottom and Glaxo soaring above at the top.
For the hedge manager, the ideal trade would have been to be long Glaxo and short Lilly—hence the overall line would have been somewhat smooth and this trade probably would have been done with a great deal of leverage. Remember that leverage hates volatility. If you’re leveraged up 20-to-1, then a small 5% decline wipes you out.
Let’s say that you’re a mutual fund manager and you want quick-and-easy exposure to the major drug sector. You can buy an ETF but that makes you look lazy. You can also aim to get one of the four stocks in the middle. That way, you have the exposure and as long as you stay away from the worst performer, you’re fine.
Now let’s take a step back. Here’s the same chart except it goes back to the beginning of 2008.

Now we see a different story. The lines really do separate from each other. The only winning trade is Bristol-Myers, and Glaxo goes from the best stock to the third-best.
The point is that these companies aren’t the same despite near-term correlation. Even after less than three years, we can see major price discrepancies among these stocks. The lesson is that quality wins out, but it does take some time.

Posted by Eddy Elfenbein on September 8th, 2010 at 11:06 am

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