Wednesday, May 30, 2012

Are these Hedge Fund Darlings Really a Good Buy?

In yesterday’s article, I mentioned the recent study by Goldman Sachs, which listed the most popular stocks held by hedge funds. I’ve already shared with you the names of the 13 stocks that, technically, look the most promising out of the 50 most popular companies held by hedge funds.

Today, I want to talk with you about the 14 stocks that hedge funds can’t get enough of—yet, each one is rated a “strong sell” by my technical parameters.

Company
Symbol
Price ($)
Analyst Reco
Microsoft
MSFT
29.34
2.0
Qualcomm
QCOM
57.45
1.9
Citigroup
C
26
2.3
JP Morgan Chase
JPM
32.96
2.0
BP
BP
37.02
1.6
Anadarko Petroleum
APC
62.24
1.8
Cisco Systems
CSCO
16.39
2.3
Liberty Interactive
LINTA
16.95
1.6
Visteon
VC
41.10
2.4
Valeant Pharmaceuticals
VRX
47.92
3.0
CIT Group
CIT
34.10
2.1
Devon Energy
DVN
59.75
2.0
EMC
EMC
24.03
1.7
Illumina
ILMN
44.33
2.4

You might ask, “Why is the so-called “smart money” in these unpromising stocks”? It’s a good question. And after reading yesterday’s article—where I also noted the analysts’ recommendations on the “buy” and “strong buy” companies, I hope you’ll see a pattern and ask a second question.

In each case—the buys and the sells—the majority of the analyst’s rankings are pretty darn good, with 1 being the best. Your next question should be, why are all the “smart minds on Wall Street giving good ratings to all of these companies?

The answer is not what you are led to believe by the Wall Street hype machine. The big boys—the analysts, the institutions, and their buddies, the hedge fund gurus—all sort of hang out in the same neighborhood, and follow the same kinds of companies—primarily the large-caps.

There are a few reasons for this, and not all of them bad. First, let’s take the analysts and their employers, the brokerage firms and investment banks. It’s generally the larger businesses who need Wall Street’s money and expertise to underwrite their initial public offerings, as well as their secondary equity and debt offerings. Consequently, the research departments for these investment houses will generally have an analyst or two following their clients’ shares, issuing nice buy reports, and trying to get the public to invest in them.

Nothing wrong with that, except when the research and investment bankers get too close—jumping over the “Chinese Wall”, but it is the way that Wall Street does business.

But, as you can see by the narrow range of their ratings on just these few stocks, the analysts’ don’t often go out on a limb to separate themselves from the pack mentality. The majority of their ratings are pretty positive, with few exceptions. After all, they wouldn’t want to make their big clients mad by issuing a sell rating, would they? Consequently, their recommendations are not exactly objective or a clear picture of a company’s potential.

Next, the institutions. Well, who do you think these guys talk to all day? That’s right—the successful analysts and investment bankers. Much of their research is purchased from brokerage houses. So they are predisposed to buying shares in the largest companies—the ones the analysts’ like. Now, in their defense, these guys have a lot of money to throw around, so they do have to be very careful so that their purchases of shares don’t actually move the market for the stock. Hence, they tend to play mostly in the big-cap arena with their largest purchases.

Lastly, the hedge fund managers. Ditto the institutions. The big difference is that the hedge funds will often take very lopsided positions, betting big—either long or short—and that’s where they have their greatest successes, as well as their largest losses. Just ask John Paulson.

You’ll know his name from the mortgage meltdown, as he was a big player who bet short against Goldman Sachs clients who were buying the same securities. He made $3.7 billion in 2007, according to Wikipedia. Last year, his Advantage Plus Fund was down more than 50% and his Advantage Fund lost more than 35%, according to Insider Monkey.

So, when I started this series of articles, I asked if you wanted to play with the big boys. I hope your answer is no.

Even in their good years, the risk the hedge funds take is enormous—much more than an individual investor—unless rolling in the dough—should ever contemplate.

There’s certainly a time and place for investing in large-caps, and as I said in yesterday’s article, some of those names look pretty good, technically speaking, right now. But for most investors, a balanced, diversified portfolio is the optimal way to go.

Next week, I’ll give you some tips on how to structure your ideal portfolio. Just remember, you’re as smart as the “big money” and individual investors can do just as well, or better than the big boys, with lots less risk.

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