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You may not realize it, but the annual practice of "window dressing" – a process through which fund managers dump their worst-performing stocks and replace them with high flyers – can create some real bargains for retail investors.
The sleight-of-hand does actually little to improve the fund's performance, but it does keep a fund manager's biggest mistakes of the year out of the annual reports sent to investors. For that reason, most fund managers do some window dressing every December. And in years that the overall stock market has struggled – as it has this year – they're busier than usual.
Indeed, managed funds have actually fared worse than market averages this year. The Merrill Lynch composite index of hedge funds is down more than 7% on the year, and many mutual funds are hovering below such benchmarks at the Standard & Poor's 500 Index. The S&P 500 itself is down more than 1% on the year and more than 2% over the past six months.
In fact, this year's third quarter was the fourth-worst performance in hedge fund industry history.
Playing the Rebound
Even though the types of stocks fund managers sell in December tend to be major dogs, the extent of the selling is so severe that many of them rebound come January.
"Ideally, you're buying these stocks now when the selling pressure is still there and selling them in the middle of January," Pankaj Patel, an analyst at Credit Suisse Group AG (NYSE: CS), told Reuters.
Patel has found that large-cap stocks with prices close to their 52-week lows in November outperform the S&P 500 through the following January. Last year Patel developed a list of downtrodden stocks that beat the S&P 500 by 5.8% over that time frame.
It's a pattern other investing experts have noticed as well. George Putnam, editor of The Turnaround Letter, has for 24 years published a list of downtrodden stocks he believes fund managers have punished disproportionately.
Last year Putnam's picks gained more than 15% on average just from mid-December to mid-January, while the Dow Jones Industrial Average gained only 2.7% and the S&P 500 4.26%.
The carnage left fund managers selling heavily out of some of the worst-hit sectors. Bank of America Corp.-Merrill Lynch (NYSE: BAC) strategist Mary Ann Bartels told the Chicago Tribune that hedge fund managers have dumped 50% of their holdings in financial stocks and 49% of their holdings in industrial stocks.
But the best way for investors to use the annual window dressing dance to their advantage is to peruse the list of abused stocks.
Both Patel and Putnam have identified several promising candidates, although technically any stock trading near its 52-week low in the latter part of the year is a prospect. As always, investors are advised to take a close look at any stock before jumping in. Remember, these stocks became dogs for a reason.
That said, here are the window dressing victims the experts like this year:
Patel is looking at:
He screens for stocks that have been trading near their 52-week lows but still appear to have value. For example, the price/earnings (P/E) ratios of all three of his picks are relatively low: 10.96 for Newfield, 11.59 for Walgreen's, and 9.68 for Ameriprise.
Putnam produces a list of 10 stocks each year he believes will bounce back in January. His picks for 2011 are:
- Alpha Natural Resources Inc. (NYSE: ANR)
- American International Group Inc. (NYSE: AIG)
- Bank of America (NYSE: BAC)
- Computer Sciences Corp. (NYSE: CSC)
- First Solar Inc. (Nasdaq: FSLR)
- Janus Capital Group Inc. (NYSE: JNS)
- MEMC Electronic Materials Inc. (NYSE: WFR)
- Monster Worldwide Inc. (NYSE: MWW)
- Netflix Inc. (Nasdaq: NFLX)
- U.S. Steel Corp. (NYSE: X)
News and Related Story Links:
- Money Morning:
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- Chicago Tribune:
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