Imagine sitting in a football stadium. Tens of thousands of rabid fans surround you.
You sit quietly while the home team’s fans cheer goal after goal. You wait, and wait…until eventually, the umpire makes an awful call that goes against the home team.
The crowd hoots, howls and boos. They hate it. And at that moment, you stand up in your seat. You cheer wildly, clapping and carrying on.
You’d feel pretty foolish, right? You might as well paint a big red target on the back of your head.
Well, if you want to reap the biggest gains from the stock market, you’d better get used to that feeling…
You have to be brave to go against the crowd. The temptation is always to go with what’s popular and fashionable.
But if you buy stocks that are deeply unloved, history shows that you tend to make a great long-term return.
It’s a lot like the analogy we drew a month ago when we brought you the news about Ferrari’s initial public offering .
The single most important factor in investing is valuation. If you pay too much for a stock, you might lose money even if the company does well. And the easiest way to pay too much for a stock is to buy what other investors already love.
The most popular stocks on the Aussie share market are frequently overpriced, because everybody loves them. On the other hand, the least popular stocks are frequently underpriced.
Investing in these ‘glamorous’ stocks might seem like a safe bet. And they might be fun to chat about at Christmas parties. But owning them is a lot more dangerous than you think. Chances are they’ll erode your wealth.
The chart below clearly shows that potential wealth erosion. It comes from a study by renowned economists Eugene Fama and Ken French.
Using data from 1951 to 2013, Fama and French tested the annual and compound returns for more than 2,000 US stocks. They were interested in the performance of the cheapest 10% (in terms of price-earnings ratio) and the most expensive 10%.
As you can see, hated stocks (the green line) clearly outperform the loved ones (the red line) over 60 years.
This is not to say stocks with high price-earnings ratios can’t go up in good times. But if emotion and ‘crowdthink’ have driven up that P/E, you’re setting yourself up for a fall.
You don’t even have to look at a long-term study to witness this effect in motion. It happens year after year.
Another simple way you can gauge love and hate for stocks is to look at their average analyst rating. That’s the sum of all recommendations by the analysts who research these stocks on behalf of stockbroking firms and investment banks.
At the end of 2013, MarketWatch examined the ten stocks that analysts hated most at the start of the year. These were the companies with the most ‘sell’ ratings and the fewest ‘buy’ recommendations. They also looked at the other end of the spectrum — the ten stocks that the market loved most.
Over the course of 2013, the ten most hated stocks gained an average of 67%. That return thrashes the favourite stocks, which rose 40% in a bull market.
There are very simple reasons for this. Most mainstream investment analysts don’t aim to pick the next big stock that could transform your wealth. They just aim to keep their jobs as mainstream investment analysts.
That means they stick with the herd. They avoid putting their necks on the chopping block — and in doing so, they miss great bargains.
Pay attention to the din of stock love from the pin-striped suit brigade if you must. But know that if you want to make real money in the share market, you have to go out on a limb. Focus on what everyone hates — and chances are, you’ll find a stock that will reward you handsomely.
for the Daily Reckoning Australia
Editor’s Note: This article was originally published Money Morning.