MW Why investing in the market's dogs can pay off more than today's hot stock
By Mark Hulbert
How a contrarian bet vs. a sure thing can make you more money
To beat the market, you must be willing to buy stocks that are out of favor and unpopular. Few investors are willing. To find out if you are, ask yourself which of the following stocks you would be more interested in purchasing:
1. A stock with a year-to-date gain of 174.1% and a trailing price/earnings ratio of 56.6.
2. A stock that is down 59% so far this year and has no P/E, having lost money over the past 12 months.
If you're like the vast majority of investors, you would choose the first stock. But, according to a new study, you're more likely to do better with the second one.
These two stock examples are in fact real. Stock No. 1 belongs to Nvidia (NVDA. ) Stock No. 2 belongs to New York Community Bancorp $(NYCB)$ (NYCB), which plans to change its name to Flagstar Financial effective Oct. 25 - the same day as its third-quarter earnings report.
If you find it difficult to imagine passing over Nvidia - the darling of the AI world and currently riding a wave of immense popularity - in favor of a banking company struggling to recover from its brush with bankruptcy, then you almost certainly are not a contrarian investor.
The best-performing investment newsletters monitored by my auditing firm have no trouble passing over the crowd favorites to bet on turnaround situations. And according to this new study, it's no accident that their performance is so good. Three of them currently are recommending NYCB, in fact.
Entitled "Finfluencers," the study was conducted by Ali Kakhbod and Dmitry Livdan of the University of California at Berkeley, Seyed Kazempour of Rice University and Norman Schurhoff of the University of Lausanne. "Finfluencers" is shorthand for financial influencers - "individuals who provide unsolicited investment advice on social media platforms."
The researchers analyzed the stock recommendations made by 29,000 finfluencers on a major social-media platform between 2013 and 2017. They found that the recommendations from the vast majority of them did not beat the market: 16% of the finluencers were judged to have no ability (neither beating nor lagging), while 56% were judged to have "anti-skill"-significantly lagging the market.
While these results are hardly surprising, given how notoriously difficult it is to beat the market, another of the study's findings was especially revealing: "Anti-skilled" finfluencers have a significantly larger following, on average, than the skilled ones. As you can see from the chart above, there is a strong inverse correlation between a finfluencer's probability of beating the market and the number of his or her followers.
Being a contrarian is lonely, in other words, and it's not for everyone. Many, if not most, of us would rather be in synch with the crowd, following the herd rather than questioning conventional wisdom even if it means our performance is no better than average. Though most of us don't like to admit it, we'd rather fail conventionally than succeed unconventionally.
Stock picking and horse racing
To make money with a stock, it isn't enough for the company to turn a profit; it must beat investors' expectations.
Many non-contrarian investors object that companies like Nvidia will make more money over the next 12 months than firms like New York Community Bancorp. And they're almost certainly right. But to make money with a stock, it isn't enough for the company to turn a profit; it must beat investors' expectations.
Since Nvidia's stock is currently priced to near perfection, it is entirely possible that the company may report huge profits in the coming months, but still come up short of expectations - and its stock would decline. Investors currently have extremely low expectations for New York Community Bancorp, in contrast, so it won't take much improvement in its business for it to surprise on the upside.
One way of understanding this point is with a horse-race analogy: Consider a 10-horse race in which you're allowed to bet on all 10 horses, with one a crowd-pleaser widely expected to win and another expected by the crowd to come in dead last. Imagine further that the crowd-pleaser finishes second and the unpopular horse comes in seventh. In such a case, you would most likely end up making more money by betting on the horse that came in seventh than the one that came in second - even though the second-place horse was much faster than the one that came in seventh.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
More: How the CEO of this upstart Nvidia rival hopes to seize on the lucrative market for AI chips
Plus: This stock market rotation is the 'lifeblood' of the bull market as S&P 500 logs record
-Mark Hulbert
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October 26, 2024 14:14 ET (18:14 GMT)
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