Unpopular Wisdom : Morningstar Sees Beauty in the Ugly Ducklings

If you’ve got money you’re just itching to put into stocks this year--but you’re afraid of the market’s heights--one option is just to wait: Maybe this current pullback will turn into something meaningful.

Or you could take mutual fund tracker Morningstar Inc.’s advice and make what its research shows is a solid bet: Invest in the stock fund sectors that were least popular in 1996--namely, utility funds, communications industry funds and Latin America stock funds.

Morningstar judges popularity not by a fund sector’s investment performance but by the amount of fresh cash the sector receives from investors in a given year.

After calculating annual cash flows for major fund sectors for each of the last nine years, Morningstar then looked at the three most popular and three least popular sectors each year, and how the sectors performed in the subsequent one-, two- and three-year periods.

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The study’s overwhelming conclusion, according to Morningstar analyst Susan Paluch in Chicago: Buy the three sectors that few investors bought the year before, because those ugly ducklings more than likely will turn into swans.

“The least popular equity funds . . . beat the average equity fund over the next one-, two- and three-year periods 79% of the time,” Paluch said.

What’s more, the ugly ducklings’ subsequent performance versus the fund sectors that were most popular in a particular year is even more striking. The ugly ducklings beat those swans 92% of the time in the subsequent three years.

If you had followed this strategy a year ago, and invested equal sums in the three least popular sectors of 1995--gold funds, natural resources funds and European stock funds--your 1996 return based on the average performance of the funds in each category would have been 21.3%, Morningstar says.

That beat the 17% average return of Morningstar’s general stock fund universe, and it also beat the 20.4% average return of a portfolio made up of the three most popular fund categories of 1995, which were technology funds, financial services funds and aggressive-growth funds.

The strategy sounds easy enough, but like most “contrarian” market bets, going against the crowd is mentally difficult, Paluch concedes. “The least popular categories earn their neglect precisely because they seem like such bad investments at the time,” she notes.

Utility funds, for example, gained just under 10% on average last year, or half the broad market return. The electric and telephone utility industries are beset by challenges, including rapid deregulation. And so far this year, rising bond yields are putting more pressure on utility stocks.

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Still, Paluch says, the Morningstar study’s findings are compelling that buying the three sectors that are out of favor is the best way to make money, at least within a three-year time window.

If just one of the three sectors rebounds, she says, “it’s often enough to carry the whole group.”

Morningstar’s individual fund picks within the 1996 ugly-duckling sectors:

* In the utility sector, Fidelity Utilities, Lindner Utility or Franklin Utilities.

* In the communications sector, Flag Investors Telephone, Fidelity Select Multimedia or a closed-end fund, New Age Media (ticker symbol: NAF).

* In the Latin America sector, Scudder Latin America, or two closed-end funds, Latin America Equity (LAQ) and Emerging Markets Telecom (ETF), which Morningstar calls a “Latin America wannabe” because of its heavy investment in Latin phone issues.

January Effect? Remember when smaller stocks used to reliably and significantly beat bigger stocks in January, so much so that the phenomenon became known as the “January effect”? If you remember, you are dating yourself.

The January effect is AWOL again this year. With four trading days left to go in January, the Russell 2,000 index of smaller stocks is up just 0.8% this month, while the blue-chip Standard & Poor’s 500 index is up 3.3%.

Smaller stocks were lagging even before the U.S. stock market entered its latest corrective phase, which began last Wednesday. There’s still time for the S&P; to plunge while the Russell index holds up, of course, but that would probably be a worse bet than the New England Patriots were in Sunday’s Super Bowl.

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The January effect, widely written about in the mid-1980s, was long thought to be a byproduct of year-end, tax-related selling. As some investors dumped under-performing smaller issues in December, unduly depressing many of them, that set the stage for a sharp rebound in those issues in January, as fresh cash flowed into the stock market in the new year and tax selling suddenly ended.

But in recent years, tax selling seems to be occurring earlier--more like November. And for the last three years, blue-chip stocks in general have been broadly favored by investors; smaller stocks have been an afterthought.

The result: The January effect has disappeared. In part, however, it appears to have migrated to December. For the last four years, the Russell index has risen more in December than it has in the following January.

Thank You, Green Bay: No matter what the poor folks in Boston are feeling, Wall Street was quite happy with the Green Bay Packers’ victory Sunday. The well-known “Super Bowl Theory” holds that the stock market will rise in a year when a team from the old pre-merger National Football League beats a team from the old American Football League. Everybody laughs at this, but it’s a nervous laugh: The indicator has an 87% accuracy rate.