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Pulling the Curtain Back on Window Dressing

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With October 31 marking the end of many mutual funds' fiscal years, expect to see some significant market action leading up to that date.

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MINYANVILLE ORIGINAL Some mutual fund managers routinely clean up their portfolio holdings before the end of their fiscal year, selling stocks with large losses and exchanging them for those with large gains, in order to present a fund with more winners than losers. This can, and does, happen on a quarterly basis -- but when the end of the quarter and the end of the fiscal year coincide, as it does this year on October 31, the stocks held are published in the all-important annual report to shareholders.

This so-called "window dressing" is done not just to reassure current fund holders of the manager's stock-picking prowess, but to entice new investors by presenting a list of winning stocks (at least at the time).

If there's a winning stock out there that a fund doesn't hold, the fund manager can take a stake in the stock even on the very last day of the quarter and legitimately report it as part of the fund's quarterly earnings. The inverse is also true; selling the losers to erase any trace of having held them can be done. This works because the funds are not obliged to report the date of the initial material position nor the date of the most recent material sale. Nor are the funds required to show the average purchase and sale prices of each transaction, which would quickly reveal what percentage was made or lost.

Even without those pieces of information, one sure giveaway is when a fund buys a hot stock that is patently outside of its stated objectives. Unfortunately, the opposite is also true. A tech fund could have held mining stocks all quarter, switching them out for Apple, Google, and Microsoft at the last moment to appear on course.

And those are just the simple versions of window dressing. A more devious tactic involves buying up an illiquid, otherwise worthless stock and then buying the float at the end of the month. Another technique is to buy funds that have the best five- or 10-year returns. Of course, the manager may or may not hold those winners long enough to capture the long-term returns and a fund's average return may end up being lower than its indices even though it appears filled with stocks that have beaten those indices.

While window dressing is of dubious value to the fund holders, the practice can actually be a boon to retail investors who pay close attention.

For instance, selling typically puts downward pressure on stocks; once the adjustment season is over, the stocks sold historically reverse course. Therefore, an investor could screen stocks and make very educated guesses on which stocks are likely to be on fund managers' radars.

For the sake of argument, I set up a Google stock screen to show stocks by price/earning (P/E) ratio, 52-week price change, to see if I could identify stocks that might see increased selling or buying volume next week. I disregarded ADRs.

The screen quickly brought up Marvell Technology Group (NASDAQ:MRVL). With a market cap of $4.12 billion, Marvell has a low P/E ratio (9.47) relative to its peers, shows a negative 52-week price change of 43.20%, and is currently trading within pennies of its 52-week low ($7.36). Voilà -- a candidate for selling. In the mid-cap range, Diamond Foods (NASDAQ:DMND) showed a low P/E (8.20) relative to its peers, showed a negative 73.85% price change over the past 52-weeks, and is currently trading at a price ($18.23) some 12% above its 52-week low. (I used 15% bounce back as my cut off.)

Flipping my screen around, I see that $3.4 billion market cap Six Flags (NYSE:SIX) has a P/E ratio (89.27) higher than most peers, has shown a 52-week price change of +120%, and is currently trading 113% higher than its 52-week low. Perfect candidate to buy. American Vanguard (NYSE:AVD), with a market cap of $224.33 million, boasted a 34.37 P/E ratio, which is higher than most (but not all) peers. American Vanguard has made a 239.30% price change in the past 52 weeks and is trading at $23.80, which is 233% over its 52-week low . Genius.

We will follow up to see what really moves next week.
No positions in stocks mentioned.
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