Finding value when the market misbehaves

June 18, 2013

Chicago Tribune

Traders are nervous as Wall Street waits for the Federal Reserve to reveal its next quantitative easing move. Last week marked the third week out of the last four in which major indexes turned negative. What if you ignored the market’s mood, though? Would it make a difference?

If you can find managers focused on buying and holding the best stocks – no matter how the rest of the market is behaving – you might reap higher gains over time. C. Thomas Howard, professor emeritus at the University of Denver’s Daniels College of Business, has found that managers who invest in what he defines as the “best markets” for overall stock performance and the stocks that represent the “best ideas” will outperform market indexes. Howard identified hundreds of companies that fit his criteria and could have been bought at bargain prices.

Examining a period from April 2003 to March 2013, Howard found in a recent paper that his “best idea” group of 400 stocks, which includes Google, Ethan Allen Interiors and MasTec, gained almost 17 percent, compared with 9 percent for the Russell 3000 Index.

The “best market” group did even better: It was up 27 percent, versus 9 percent for the Russell 3000. Leading that pack are stocks in developed international markets and small U.S. companies.

The reason for such outperformance? Managers made “emotionally difficult” decisions to buy out-of-favor stocks, ignore short-term volatility and hold their picks through market swoons.

These managers generally run smaller funds like Invesco Endeavor A, which focuses on small- to mid-cap stocks and is up 33 percent for the past year through June 14, or Bridgeway Ultra Small Company, which focuses on companies with an average market cap of $225 million and has gained 50 percent during the same period. But most investors can’t stomach such a contrarian approach and gravitate toward older, brand-name funds that mimic the market and focus on bolstering assets.

“Perverse industry incentives and emotional investors combine to incent funds to invest in other than best idea stocks and so performance declines accordingly,” Howard told me in an email. “Funds underperform not because of the lack of skill, but because of the incentives they face.”

In other words, managers often feel compelled to own popular stocks in order to build fund assets, although it may not be the most profitable long-term strategy.

THE DEEP-VALUE STRATEGY

If some of this theory sounds familiar, it’s because it echoes the work of contrarian, deep-value investors who specialize in identifying quality stocks they think the market has underpriced, then hold them for years.