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Crowds Don't Love Them, But You Just Might

NEW YORK ( TheStreet) -- This year shareholders have been dumping health funds and buying funds that specialize in the emerging markets. Should you follow the crowd? Maybe not. According to a long-running study by Morningstar (MORN - Get Report), it pays to buy the least-popular equity fund categories and shun the sectors attracting crowds.

Fund flows are a good indicator because investors tend to embrace hot performers. All too often the crowd arrives just as sectors peak. Unloved categories are frequently near a trough. Make no mistake, the contrarian approach does not work every year; investors need to be patient and hold unloved categories for some time.

To exploit unpopular categories, Morningstar developed a simple strategy. You start by buying funds in the three equity categories recording the most withdrawals for the past 12 months. Then you hold the funds for three years. From 1994 through last year, the approach generated an annual return of 8.1%, compared with 6.2% for the S&P 500. Investors who bought the most popular funds would have returned 4.8%.

Even if you don't buy all the least popular categories, it is still worth monitoring flows. They can suggest some intriguing contrarian plays. Consider that in 2000 the unloved categories included precious metals, Latin American stocks and convertibles. At the time, technology stocks were the rage, and the least-favorite categories all seemed unlikely candidates to deliver top returns. Gold was widely shunned, selling for $282 an ounce, while Latin American economies seemed hopelessly backward and convertibles looked like stodgy instruments. All three categories went on to star in the next decade, topping the S&P 500 by wide margins.

This year the least-favorite categories are large growth, large value and world stock, which is dominated by large stocks. The funds may be suffering because large stocks have lagged recently. During the past three years, large value funds lost 8.2% annually, trailing small value by 5 percentage points. But odds are good that large stocks will take the lead in the next three years. Categories that received inflows in the past year include real estate and midcap blend.

To go against the crowd, consider a top large-growth fund, such as Madison Mosaic (MINVX). Portfolio manager Jay Sekelsky looks for companies that can grow consistently for years. He aims to buy when shares have dipped a bit below prices of competitors. The portfolio includes some fast growers, such as Google (GOOG). Other holdings are steady blue chips, including PepsiCo (PEP) and oil-services giant Schlumberger (SLB).

Another large-growth champion is Calvert Social Investment Equity (CSIEX). The fund focuses on companies with strong balance sheets and long histories of delivering earnings growth. Lately the portfolio has held a big stake in reliable health companies. Holdings include biotech giant Gilead Sciences (GILD) and Stryker (SYK), a maker of orthopedic implants.

For a top large-value choice, try American Century Value (TWVLX). Portfolio manager Phil Davidson seeks unloved companies with strong cash flows and little debt. The cautious strategy shone in 2008 when the fund lost less than most competitors. The portfolio has big stakes in familiar names, including AT&T (T) and Chevron (CVX).

Conservative investors should consider Pioneer Cullen Value (CVFCX). Portfolio manager Jim Cullen looks for discounted stocks that have the potential to increase earnings in the future. Because the portfolio includes many companies with strong balance sheets, the fund has performed well during downturns. Holdings include insurer Chubb (CB) and defense contractor Raytheon (RTN).

Funds in the world stock category invest in the U.S. and abroad. A top selection is Oakmark Global (OAKGX). The portfolio managers want solid stocks that are depressed because of temporary problems. Holdings include troubled Spanish bank Banco Santander (STD) and software giant Oracle (ORCL).

A low-risk world choice is Tweedy, Browne Value (TWEBX). The portfolio managers favor steady companies that dominate niches. Holdings include many consumer staples leaders, such as Diageo (DEO), which produces Johnnie Walker scotch, and Unilever (UN), maker of Wish-Bone salad dressing and Dove soap.

>To submit a news tip, send email: tips@thestreet.com.

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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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