So-called value-oriented investors such as us are fond of dishing out advice about the fallacy of the crowd, being contrarian, and other seemingly nice-sounding bits of advice. Of course, when markets are racing upward and everybody else is seeing portfolio values increase, the value investor is often singled out as being out of touch.
But there is indeed value in avoiding the herd mentality. And it is often true that an expensive price is paid by those who want a cheery consensus. An example of this is happening now. A recent article in the Wall Street Journal reported that many hedge funds have taken a bloodbath over the past few weeks. What caught my attention in the article was not the rate of decline -- some funds were down over 15% in the month -- but the fact that virtually all these purported "hedge" funds were in the same trade.
For example, many hedge funds piled into Shire Pharmaceuticals (SHPG) simply based on a tax inversion bet. The trade got crowded, or as I like to say, very happy. As Shire shares continued to advance, more money piled in. Recently, the suitor, AbbVie (ABBV), decided to pull the plug on the deal. Because the trade was so crowded and fueled by optimism based solely on the deal getting made, Shire shares tanked when the deal fell through. As quickly as the crowd rushed in, many rushed for the exit.
Another crowded bet occurred with shares of Fannie Mae (FNMA) and Freddie Mac (FMCC), which for the past several weeks have been on a roller coaster ride. Ultimately, however, the shares have fallen as a result of an unfavorable government ruling from a suit filed on behalf of investors.
To the masses, the crowd offers protection. But protection does not translate into results. Economist John Maynard Keynes said it best when he remarked that in investing, the mentality is that it is far better to fail conventionally than to succeed unconventionally. However, anytime an investment crowd piles in due to euphoria or other expected event, you can almost bet that fundamentals and cash flows will start to take a back seat.
There is virtually no room for error in a crowded trade, so take heed when participating in one. The crowd often moves a lot quicker than the individual and the result is almost always excessively painful.