Take a Stand Against the Herd

Russell Carpenter, a.k.a. TMFEldrehad, discussed in a recent article some of his favorite picks in The Motley Fool's CAPS investment community. Russell says that despite his massive score and some really big hits -- he's ridden Pegasus Wireless and Conversion Solar down for more than 95 points and Northfield Labs and Akamai up for more than 60 -- he's most proud of some of the calls he made that went against the grain.

He mentions companies such as Ann Taylor, on which he made the first "underperform" call on CAPS, and Dell, which was a one-star stock when he gave it the thumbs-up. Though the point totals he gained from these two stocks aren't the primary reason that he currently sits atop the CAPS rankings, his willingness to follow his own instincts in these cases may be a key ingredient in his success.

The CAPS community is still young and growing, but we already have more than 3,000 rated stocks and in excess of 17,000 members slapping on those ratings. Many of the stocks rated in CAPS have had a lot of traffic and a lot of opinions -- Dell, for instance, got stuck with its two-star rating after more than 2,000 ratings. Others have had far fewer ratings, and there are still many that don't have even a single vote against the rest of the crowd.

Have you herd this one?
Research has looked extensively into the idea of herding behavior. Out in nature, the advantage of the herd, and in particular being in the middle of the pack, is obvious: Mid-herd, you are much safer from the hungry lion than on the outskirts or, worse, out by your lonesome. The idea translates pretty well to the stock market, where investors typically feel safest moving in the same direction as the rest of the market.

As the Internet bubble showed us, though, when the herd gets frothy, it can sometimes end up going in the wrong direction -- like, say, off a cliff. From that perspective, then, it's good to always keep a reality check on what the rest of the crowd is doing and make sure that things aren't getting out of control.

As CAPS continues to develop, it could show some of the dynamics we see in the stock market, with similar herd-type movements as players go after picks that proven, successful players have given the thumbs-up to. Don't get me wrong: I wouldn't bet against the vast majority of the five-star stocks in CAPS -- especially when the components of the CAPS five-star tracking index rank in the top 10% in the CAPS system -- but there certainly could be more stocks out there like Russell's Ann Taylor or Dell.

Against the crowd
The question is whether many of these unchallenged five-star stocks are really all they're cracked up to be. Of stocks with more than 75 ratings, a handful have had just one lonely CAPS member step up and put his or her thumb down against a sea of outperforms -- among them aQuantive, CBOT Holdings, and Norsk Hydro.

There even are a decent number of stocks about which CAPS members are even surer -- they don't have a single underperform on them yet:

Heck, maybe there's no reason to give any of these stocks a thumbs-down -- maybe they're just that good. But maybe, just maybe, one stock up there won't manage to outpace the S&P and doesn't deserve that unblemished five-star rating. For instance, maybe China Telecom will get the 3G license from the government that investors are expecting, but do any of us really know what to expect from the Chinese government at this point? Or maybe VeriFone, already up 54% over the past year, could be ready to cool off a bit. If you have the feeling that the rest of the crowd is a little too optimistic, go ahead -- let them know.

CAPS has more than 600 five-star stocks, so the ones we've mentioned aren't the only ones where you can take a stand against the herd, though these are definitely some of the most highly esteemed of the five-stars. There are also 600 one-star stocks in the system, so it's just as easy to give a thumbs-up in the face of upside doubters. After all, though being a full-time contrarian may not be your forte, really successful investors typically find some time in their career when they just have to look around and say, "Man, you guys are all crazy!"

Get even more Foolish with CAPS:

• A look at seven upside surprises.
• Cash is king.
• What about Ditka?

Dell is a recommendation of Motley Fool Stock Advisor and Motley Fool Inside Value . Norsk Hydro is a Motley Fool Income Investor pick. You can check out any of these newsletter services free for 30 days.

Fool contributor Matt Koppenheffer tries to stay mostly with the crowd and away from sharp objects. He owns shares of Dell but does not have a stake in any of the other companies mentioned. The Fool's disclosure policy is popular with the herd and contrarians alike.