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Should you pick up stocks that mutual funds are buying?

Should you pick up stocks that mutual funds are buying?

No, don't invest in a scrip just because it is in a fund's portfolio. Fund managers can also make mistakes, especially when valuations are at peak levels. A good share bought at a high price is a bad investment.

They analyse a company threadbare, are guided by the long-term potential of stocks, shun momentum investing and don't keep all their eggs in one basket.

They seem just the right kind of people to emulate when you invest in stocks, right? Wrong. Fund managers can also make mistakes, especially when valuations are at peak levels as they are now.

"Telecom stocks have not performed well in the past three years because of a fall in average revenue per user, thinner margins and high capital expenditure."
Ashok Jainani
Vice-President, Research & Strategy, Khandwala Securities
The top 10 stocks on which mutual fund managers were placing their bets three years ago have given abysmal returns. More than Rs 46,000 crore of investors' money has languished in these high-priced bets during the past three years.

Reliance Communications has been the biggest wealth destroyer. It has lost more than 37% every year in the past three years, dropping from Rs 718 to Rs 186 now. Grasim, Bharti Airtel and Reliance Industries are the other black holes that have given negative returns. Fund managers had not seen this coming.

In fact, in November 2007, they were busy adding these precious lemons to their fund portfolios.

Between October 2006 and 2007, Reliance Communications was picked up by 74 new funds, taking the total mutual fund investment in the stock from Rs 1,515 crore to Rs 4,471 crore. Fifty-seven more funds picked up Bharti Airtel, pushing up the mutual fund investment in the company from Rs 1,757 crore to Rs 4,495 crore.

The construction and realty sector was another hot favourite, with stocks such as DLF, Unitech, Parsvnath and Ansal Properties, finding prime positions in mutual fund portfolios. The Sensex has bounced back and crossed its January 2008 levels, but some realty stocks are still trading at 75-80% below their 2007 peaks.

In 2007, it was almost as if the fund managers were bent on making all the wrong moves. L&T jumped up from 15th position in 2006 to No. 2 in 2007 in the list of stocks most widely held by mutual funds. ICICI Bank rose spectacularly from the 23rd position to No. 3 as funds raised their exposure to this financial powerhouse.

At the same time, funds were getting rid of out-of-grace gems. As the dollar slipped to Rs 39 on the back of massive FII inflows, 31 funds let go of Infosys and TCS. ITC and Hindustan Unilever were also kicked down the ranks.

These have been among the biggest wealth creators in the past three years. This doesn't mean that fund managers deserve to wear a pointed cap. After all, they are human.

At the height of the dotcom boom, many mutual funds were holding shares of Himachal Futuristic Communications. In March 2000, the share peaked at Rs 2,420. It is now trading at Rs 14, down almost 99.5%.

What you really need to do is sift the chaff from the grain. A good mutual fund will usually outperform the broader market, thanks to the winning bets in its portfolio. In recent times, the small- and mid-cap stocks have given spectacular returns. But don't invest in a company just because it is in a mutual fund's portfolio.

You need to check the valuation before taking a call. As the table shows, even blue-chip shares bought at high prices can prove to be bad investments.

Contrarian investing is the best strategy
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