John Maynard Keynes was fond of referring to the stock market as a beauty contest. In trying to pick stocks that will do the best, investors commonly try to pick those equities that, in their opinion, look the most attractive to others. This sort of mindset, according to Keynes, results in the trade of herd behavior that results in extremely crowded trades.
A recent Wall Street Journal article shows that an opposite approach where the most unattractive stocks are selected have actually done better. This makes some sense, as the most sought after positions are the most expensive from a valuation standpoint. Meanwhile, the forgotten bottom tier can represent compelling valuations.
So if the trick isn’t to pick today’s most popular investments, then perhaps the best route to consistent alpha generation is in finding stocks that have the potential to be the “prettiest” in the future. Some potential candidates today may be in mortgage securities (which I discuss in the cover story in the January issue of Investment Advisor), or the beaten down municipal bond sector. To find tomorrow’s beautiful swan, it seems one must be willing to examine a few ugly ducklings.
Individual investors shouldn’t fret that they are often caught in the most popular, but usually less profitable, securities. It seems that professional investors tend to act in the very same way.