We are often asked whether investing in out of favour equities is as low risk as other investment styles. After all, say the doubters, stocks can stay out of favour for some time. Even worse a few of them may go bust. And perhaps even worse than that, it is claimed that it is possible to lose a lot of money by continually averaging down and buying more of these ‘losers’.

Let’s look at each of those points in turn. It is true that stocks can stay out of favour for some time. However, most out of favour stocks do pay a decent dividend (as the price has fallen, the yield has increased) and therefore the investor receives useful compensation for waiting. Of course, most portfolios are well spread across a number of companies and sectors, all of whose share prices are driven by different factors. It would therefore be surprising if they all remained out of favour simultaneously. Of course, despite this diversification, in some periods out of favour stocks are tarred with the same brush (think ‘old economy’ stocks during the internet bubble) but we would argue this simply provides investors with more bargains than usual.

(The opposite of staying out of favour for a long time is perhaps worse. After all, it is only about a year since some clients were wondering if private equity, by purchasing unloved companies, were stealing all our best ideas! It would appear that for the time being at least we can all stop worrying about that threat!).

Although investors tend to remember the out of favour stocks that lost most of their value (e.g. Marconi) this is perhaps an example of selective memory. It is very easy to be emotionally scarred by bad experiences and therefore believe that that an occurrence is actually far more common that it is. The list of out of favour companies which have been restored to full health is much longer than the failures. However, the successful stories are far less exciting and traumatic and therefore appear to lose prominence in investors’ minds. We have a number of simple checks with which to try and limit our exposure to financially strained companies; we tend to avoid those built hurriedly via acquisition, through the use of debt and with little long-term history.

If most out of favour stocks do eventually perform well over a complete holding period and few go bust, then any worries regarding averaging down should be minimised. In fact, averaging down will work as a positive. What it is important to do is to avoid becoming obsessed with stocks or building an unnecessarily dogmatic approach towards a company’s prospects. If a share falls after we have purchased it, we always revisit the arguments for buying it. Have we learnt anything new which we should build into our analysis or is our assessment of fair value unchanged? Remaining flexible, willing to admit mistakes and knowing when to stop averaging down all minimise the risks of investing in out of favour stocks while ensuring we have full exposure to an investment style that has produced good returns over the long term.