(In 16th paragraph, corrects the name of Third Avenue Value
Fund from Third Avenue Fund.)
By John Wasik
CHICAGO, June 18 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
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, 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
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
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.
Meir Statman, a professor of finance at Santa Clara
University who read the Howard paper, sees a shortcoming of such
behavioral stockpicking. The common error, he says, is a
hindsight bias, when past results are used to extrapolate future
Investors who choose deep-value managers, you'll need to
stick with them, since value stocks go in and out of favor with
market turns. These stockpickers don't always make money and may
lag the market when others are gaining.
It's equally important to pay attention to the costs of
contrarian stockpicking. Unless you choose a passive value fund
that essentially buys an index, you may pay a relatively steep
price for an actively managed value fund because of research and
The Third Avenue Value Fund, for example, charges
1.4 percent annually for management expenses. It's up 28 percent
over the past year. Top holdings include Wheelcock & Co
, Bank of New York Mellon and Toyota Industries
You may do better by buying an index fund like the SPDR S&P
400 Value fund, which is up 30 percent over the year.
It costs only 0.20 percent annually.
Deep-value representation in the form of a stock fund can
balance out the conventional growth index offerings in your
You never know when value will be in favor. It follows waves
that are considerably less predictable than the Fed's moves.
(Editing by Lauren Young and Douglas Royalty)