Don't Follow the Herd Down This Road

It's a well-known secret that investors, as a group, are terrible market timers. When an investment starts to become widely popular with large groups of investors, you can pretty much bet that its days in the limelight are fast coming to an end. And while it may not be surprising that individual investors are more likely to get caught up in of-the-moment trends, new research shows that professional investors may be just as likely to follow the herd.

Setting priorities
A recent study by Massimo Massa and Vijay Yadav at the INSEAD graduate business school examined the holdings of nearly 1,000 mutual funds to determine whether the funds were biased toward or away from "high sentiment" stocks. They found that most funds tended to gravitate toward stock market favorites and away from low-sentiment stocks that were out of favor in the market. This is a problem, since previous studies have shown that stock market darlings tend to underperform low-sentiment stocks over time.

What's more is that investors actually reward fund managers for loading up on popular stocks by channeling assets into those very funds. The study concluded that many portfolio managers are deliberately sacrificing performance in order to create a portfolio that attracts investor attention and boosts assets under management. That's pretty depressing news for the millions of investors who rely on mutual funds to save for retirement.

Blaze your own path
So what can investors do if they want to avoid this trap? Well first of all, this study should serve as an important check for your own investing patterns. Are you buying a stock just because it has been in the news a lot or because your Uncle Bob owns it or because it seems to be really popular among investors? If so, then you need to re-examine your approach. High-sentiment stock market favorites may get a lot of press coverage, but they aren't likely to outperform over an extended period of time. To find the real bargains, you need tolook at unpopular, undiscovered areas of the market and be willing to pass up the favorite stock of the moment.

Secondly, while it may be true that many mutual funds place asset gathering ahead of performance, investors need to take responsibility for their part. After all, fund managers wouldn't tilt their portfolios toward high-sentiment stocks if investors didn't reward them for it! If you're considering investing in a fund because it buys lots of popular, in-favor stocks, think twice before pulling the trigger. In the future, investors will simply need to be more careful with respect to which funds they buy. It will take a little bit more work to figure out which funds place market-beating performance ahead of gathering assets, but there are some managers who do just that.

Thinking outside of the box
For example, take legendary investor Bruce Berkowitz, manager of the Fairholme Fund (FUND: FAIRX  ) . While Berkowitz has amassed a category-beating track record, he has done it by not being afraid to go against the grain and invest in beaten-up, unpopular companies. Right now, he is making big bets on out-of-favor financials AIG (NYSE: AIG  ) ,Citigroup (NYSE: C  ) , and Bank of America (NYSE: BAC  ) . Berkowitz believes that government intervention and years of scrutiny have forced these firms to clean up their balance sheets. Given their current low valuations and their future earnings power, he believes them to be attractive opportunities.

Similarly, Janus Contrarian (FUND: JSVAX  ) manager David Decker likes to invest where others fear to tread. He has long invested heavily outside of the U.S., currently allocating nearly 18% of portfolio assets to Indian companies. Right now, Decker is also big on financials, which account for almost one-quarter of fund assets. Rather than banks, Decker believes mid-sized real estate development companies St. Joe (NYSE: JOE  ) , CB Richard Ellis (NYSE: CBG  ) , and Plum Creek Timber (NYSE: PCL  ) are the best way to play a recovery. Although the fund has encountered some bumps in the road from time to time, over the past decade it has handily beaten 94% of its large-blend peers, thanks to Decker's willingness to invest in out-of-favor and low-sentiment stocks.

I have long warned investors that chasing performance and following the crowd is a losing strategy. While it may provide comfort in the short run, over time all it will do is get you further behind the market. The same thinking applies to investing in mutual funds: Don't chase performance, and don't buy funds because they invest in popular, high-sentiment stocks. If you want to beat the market, you've got to go where the market is afraid to go.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of Fairholme. The Fool has created a covered strangle position on Plum Creek Timber. The Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (10)

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  • Report this Comment On August 31, 2010, at 7:07 PM, BearishKW wrote:

    So true, and not at a more important time in the market.

    Is it really much more safer to buy the select few stocks that EVERYONE is buying now because they're scared and following the crowd? OR is it safer to look for companies reporting good earnings and growth that have bargain basement P/E ratios?

    Which one's will get hit the hardest if we do fall into this "double-dip"? The 20 P/E ratio or the 4 P/E that hasn't come up much from the first crash?

    Oh and I hope this fear lasts for a while, so I can keep pumping my money into historical big-dividend giants at all-time cheap prices. Check out GNK, ACAS, APL, CIM, and NGPC to name a few.

  • Report this Comment On August 31, 2010, at 9:41 PM, BearishKW wrote:

    I did love it...that is a great counterfeit, black market shoe site. Congrats you parasite!

  • Report this Comment On August 31, 2010, at 10:18 PM, Patphil100 wrote:

    Excuse my ignorance but why is it then that Momentum investing provides one of the best return?

  • Report this Comment On September 01, 2010, at 12:23 AM, BearishKW wrote:

    Patphil you're not ignorant...momentum investing absolutely provides one of the best returns. Just be careful, take profits when possible, and know your company.

  • Report this Comment On September 15, 2010, at 9:32 PM, ronbeasley wrote:

    Not quite up to date - Decker has been selling both St. Joe and CB Richard Ellis, he sold over 30% of his position in the latter last quarter. And with 80% turnover, one never knows where he really is. Further, his ten year returns don't even come remotely close to Berkowitz'.

  • Report this Comment On October 14, 2010, at 3:31 PM, gakushi wrote:

    After reading Einhorn’s presentation, I have a couple of points to make.

    A) What Einhorn is implicitly telling us how much JOE is worth?

    The presentation is focused on total acreage of 6,950 (= 4170 (RiverTown) + 762 (SummerCamp) + 2020 (WindMark) see P106). On P122, the total what-we-can-see value is 38.7M. If we take 38.7M and divided it by the total acreage of 6952 we get $5566 per acreage.

    BTW, Einhorn only included WindMark II on P122. This is because he used the number from P112. BTW WindMark II is only about half of the total WindMark, see P104. And the the source of P40,67,71, & 89 are from 10-K not from 10-Q.

    According to P30, that JOE has 536,000 of Timberland or Rural Land. However, it happens to be that most of them are within 15miles from the beach. If you take a look at P6 of the latest investor Presentation http://files.shareholder.com/downloads/JOE/1037019379x0x3569... you will also see miles of beaches and water front land are still in JOEs holding. Want to know how much a piece of beachfront can be sold at? See P73 of Einhorn’s presentation.

    Let’s say we use the $5566 per acreage (derived from Einhorn’s total what-we-can-see number on P122) times it by 536,000, we get 2.98Billion. Divide 2.98Billion by 92Million shares, we get $32.3 per share.

    In conclusion, Even using Einhorn’s worse numbers we get a per share price of JOE at $32.3

    B) About Impairment.

    Let’s say I agree with Einhorn that we should write down say $242Million (= 280M – 38M) according to P122. In this case, shouldn’t we also update the value of the rest of the land holdings on JOE’s book?

    Let’s say we again use the $5566 per acreage (derived from Einhorn’s total what-we-can-see number on P122) times it by 536,000, we get 2.98Billion which is more than three times higher then the current book value.

    In addition, impairment is just an accounting technique which does not affect JOE cash flow wise.

    C) Burning through cash?

    JOE is not burning through cash. In fact, JOE’s free cash flows for TTM, 09, 08 are $18M, $48M, $46M respectively. As Bruce Berkowitz put it: “You can only spend the cash.”

    In fact, according to Morningstar, “St. Joe reduced its employee base by nearly 90% since real estate's peak in late 2005, exiting noncore businesses in hospitality services, homebuilding, construction, and development. The firm has also shrunk its regional footprint, closing or selling operations in ancillary downstate areas like Tampa and Orlando. St. Joe now boasts a lean staff of just 140 and an intense singular focus on developing its major regional land holdings, a major positive development compared to its prior, more diverse endeavors.”

    C) Conclusion

    Over all I don’t think Einhorn did a complete job on evaluating the company. After - as he claimed - looking into the matter for the pass six years, one would expect he came up with a detailed, complete section by section evaluation of JOE’s holding. In stead he just focused on 1.2% (= (4170 (RiverTown) + 762 (SummerCamp) + 2020 (WindMark) )/ 577,000 ) of JOE’s land. I am wondering if Einhorn is not as intelligent as we think he is or Einhorn intended for something else.

    Good lucking in investing!

    gigakushi@yahoo.com

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