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Meeting the Herd

March 25, 2013 | About:
David Chulak

David Chulak

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Investing Guru Seth Klarman discusses the concept of the herding mentality in his masterpiece, “Margin of Safety.” This is the notion where people want to follow the enormous investing crowd into the popular or growth stocks talked about on the popular blogs or financial newspapers and pursue the stocks along their upward path. The belief is that there is safety in the crowd. Ignoring valuations and fundamentals, the herd continuously proffers or bids up higher and higher prices in an effort to join this unseen mass of investors in the hope that someone will buy the stock from them down the road, leaving them a tidy profit.

Klarman contrasts those that consider themselves value investors from those “in the herd,” indicating that investors must make a choice in their style of investing. Those that consider the fundamentals and valuation or intrinsic value of the stock versus those that are caught up in the trading frenzy driving stocks to unheard of values. Klarman goes on to say: “The focus of most investors differs from that of value investors. Most investors are primarily oriented toward return, how much they can make, and pay little attention to risk, how much they can lose. Institutional investors (emphasis mine), in particular, are usually evaluated—and therefore measure themselves—on the basis of relative performance compared to the market as a whole, to a relevant market sector, or to their peers. Value investors, by contrast, have as a primary goal the preservation of their capital.”

Peter Lynch reiterates Klarman’s concept of herding, stating that, “… the herd instinct on Wall Street has produced so many camp followers that fund managers only pretend to pursue excellence, when actually they are closet indexers whose goal in life is to match the market averages.”

William J. O’Neil, founder of Investor’s Business Daily, is well known for his CAN SLIM methodology of picking growth stocks (How to Make Money in Stocks), each letter in the name is an acronym for the process. The “I” stands for Institutional Sponsorship (or herding). CAN SLIM can best be described as momentum investing with just a little bit of value concepts thrown in to verify the choice before taking the plunge. O’Neil notes that it takes large institutional buyers to drive up the price of the stocks, therefore you should follow the demand of these investment institutions. Twenty or so institutional investors is a safe number in his estimation.

It’s important, according to O’Neil, to follow the institutional investors that take new positions in a stock and/or add to their position. An increasing sponsorship by these investors indicates better chance of performance.

So, does one conclude by these statements, that a herd of “value gurus” is acceptable to follow but not to follow the herd of “growth institutions?” Presumably, the answer is yes for value investors. You would have to be foolish not to consider the stock picks of the investing greats such as Buffett, Klarman and a great variety of others.

The answer for the growth investor is that it doesn’t matter. As long as institutions are buying it and it has all the other important elements in choosing the stock, it’s okay to buy. Either way, the institutional investors, whether growth or value, will or can drive the stock upward. But let’s ask a few questions first before we finalize our conclusions about what we have read thus far.

First, who and what are the institutional investors that Klarman, Lynch and O’Neil are referring to?

According to the website, Investing Answers, institutional investors are described as mutual funds, commercial banks, insurance companies, pension funds and hedge funds with sufficient purchasing power to drive the price of the equity up. The problem with this definition is that some mutual funds and hedge funds may be growth oriented or they may be value oriented. For instance, here is a list of institutional investors for Waddell & Reed Financial Inc. (WDR).



You will notice a few of the names of “value” gurus jumping off the page at you such as Royce, Gabelli, Greenblatt and Fisher. The names may lead a value investor to research the equity, but seeing names we are less familiar with may cause us to avoid it altogether. To the growth investor, the list of institutional investors isn’t particularly important because he or she doesn’t care who they are, as long as there are a sufficient number of them buying. The value investor is only looking for names that he’s familiar with as “value gurus” and uses that information as a potential candidate for purchase.

Still, it’s not that easy. Investor’s Business Daily produces every week what they call the IBD 50, or the top 50 stocks with the potential for substantial growth. Typically, one would not expect them to be in the portfolio of those that consider themselves “value investors.”



The majority of these stocks have investing gurus shown on this website as holders of these “growth” equities.

ResMed Inc. (RMD) is a good example. The discounted cash flow intrinsic value from GuruFocus indicates a margin of safety of 24%.



Note the “value” gurus that hold this stock that is listed as a top “growth” stock.



Even Facebook (FB) gets a strong display of “value” gurus.



So what observations can we make of all of this?

1. Either type of institutional investors, value or growth, are capable of driving a stock’s price up.

2. Value institutional investors do not always purchase only value stocks. They also purchase growth stocks.

3. Growth and value stocks can often be described under either label or both.

4. Growth institutional investors sometimes buy value stocks and may cause the impetus for driving up prices quickly.

5. Institutional investors, either growth or value, are often wrong in their choice.

It’s important not to follow blindly. You must know — really know — what you are buying, as Buffett has always admonished. Ultimately, some of the best advice comes from Prem C. Jain’s book, "Buffett Beyond Value."

1. People that don’t know the stock, follow the crowd. Therefore, know what you are purchasing and why.

2. Because the market may rise or descend quickly, know that herding stems from both fear and greed. Investing for the long term lessens the likelihood of panic.

3. Don’t invest because of trends.

4. You are not guilty of herding if you first determine intrinsic value prior to purchase.

As Klarman concludes: “Being a value investor usually means standing apart from the crowd, challenging conventional wisdom, and opposing the prevailing investment winds. It can be a very lonely undertaking. A value investor may experience poor, even horrendous, performance compared with that of other investors or the market as a whole…”

So why would anyone want to be a value investor?

Klarman: “…over the long run the value approach works so successfully that few, if any, advocates of the philosophy ever abandon it.”

Be careful. Do your due diligence, but always remember that sometimes the herd can be us.

Disclosure: No positions in any stocks mentioned.

About the author:

David Chulak
David Chulak is a private investor that uses a value approach to investing in the styles of Graham & Dodd and Warren Buffet. Looks for that margin of safety in an effort to preserve capital and attempts to guard against short term market fluctuations by having clear rules laid down in advance for selling an equity. Likes to visit the company's where his investments are in order to understand the business better.

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