How to avoid the bottom 20% of the market

Investment legend Peter Lynch, who ran Fidelity’s Magellan Fund from 1977 to 1990 with extraordinary success, coined the term “ten-bagger” to describe his really big winners. Finding investment ten-baggers, or even ones that merely double 
or triple in value, is certainly a tantalising prospect and most investors are behaviorally hardwired to look for such outsized gains. Our approach is different. Whilst we have no aversion
 to highly positive payouts our focus is rather on avoiding large losses – let’s call it the bottom 20% of the market.

Over the ten years to 2016 had you avoided the worst quintile of the market (MSCI All Country World Index ex-Australia) your investment outcome in AUD would have been 13.6%, a hefty 8.5% uplift compared to the outcome of the total market. In no year was the performance improvement from avoiding the bottom 20% less than 6%. Of course, we only know with hindsight, which stocks were in the bottom 20% for a particular year.

Can we identify characteristics that are, on average, more prevalent in the “disaster zone” than in the rest of the market, and can we use these characteristics to reduce the likelihood of large investment losses in the future? If so, we have an edge.

Below we examine the makeup of companies in the bottom 20% relative to the top 80% in terms of quality and valuation.