These Unloved Stocks Are the Best Buys

Chasing performance is one of the biggest mistakes that mutual fund investors make. Often, the stocks that earn winning funds their high returns typically fall from grace after their time in the sun. By that logic, should you instead pursue the sectors that didn't do well?

Searching where others fear to look
Morningstar recently tested the hypothesis that investors would be better off chasing what it called "unloved" sectors, instead of the hot fund categories toward which so many investors are drawn. Between 1994 and 2009, it found that buying funds from out-of-favor categories outperformed the average annual returns of the S&P 500 by nearly a 2-percentage-point margin. Meanwhile, if you bought the categories that were the most popular, you would have lost to the market by about 1.5 percentage points annually.

The Morningstar study defined its "unloved" categories as those that had seen the most outflows among investors over the preceding 12 months. However, Morningstar did say that those categories tended to be the previously worst-performing ones as well -- again, because most fund investors tend to chase performance.

What's cold right now
By that logic, Morningstar reports that large-cap stocks are the place to invest right now. Both growth and value funds that specialize in big companies are poised for a rebound. In addition, world stock funds -- which tend to combine U.S. and international stocks within a single investment -- also count themselves among out-of-favor categories right now.

Although Morningstar only looked at funds, I think it's equally valid to apply the same logic toward picking individual stocks. Throughout the market's rally, many have noted how remarkable it is that low-quality, high-risk stocks seem to have gotten all the attention, along with some huge gains.

Meanwhile, even after a huge run-up in the S&P 500, you can still pick up good values among well-known big-name stocks -- many of which also sport amazing dividend yields. Here's a quick sampling:

Source: Motley Fool CAPS. As of March 2.

By several different measures, these stocks aren't too pricey, and they have healthy payouts. Only a couple of these stocks have even outperformed the S&P over the past year, and several of them have hardly seen any share gains at all.

Why it makes sense
If this strategy seems intuitively obvious, it may be because you already use something similar. Moving some of your money out of winning sectors and into beaten-down ones is exactly what you do when you rebalance your portfolio. Investments that have risen in value end up comprising more of your assets than they originally did, requiring you to switch some of those assets to investments that have lagged behind.

Admittedly, it may be difficult for you to follow a strategy like this, especially if you don't have much money allocated to the winning sectors. Despite the big gains that emerging-market stocks have enjoyed recently, for example, most advisors believe that it's important for you to have at least some of your money invested in emerging markets -- even if that means buying in now at elevated prices. Similarly, most people would suggest that small-cap stocks have a definite role in any investor's portfolio.

The key, though, is focusing the bulk of your efforts away from the "in crowd." Because hot investments cycle in and out of favor, you'll always have time at some point to catch up on areas on which you've missed out. If you have the patience to wait for a pullback, you'll be rewarded by more reasonable valuations. If you don't, well -- you'll likely get trampled along with the rest of the herd.

Do it now
If you're looking for great investments right now, be sure to check out areas on which other investors have given up. You're far more likely to find more promising stocks away from the limelight.

Great investors always find ways to put their money to work. Morgan Housel has the scoop on why Warren Buffett is buying stocks right now.