Forced Selling Could Smack These Stocks

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Whenever the market comes crashing down, some stocks become amazing bargains. But what many investors don't realize is just how irrational stock valuations can get. Often, falling markets create a cascade effect that leads to wave after wave of new selling.

One such phenomenon comes from mutual funds. Because of the structure of mutual funds, fund managers facing a revolt from their shareholders may have to do exactly what they don't want to do: sell off their holdings while the market is low.

Below, I'll talk about a couple of funds that have had this problem and the stocks that could be at risk because of it. But first, let's look at how mutual funds get into this precarious position in the first place.

Mutual funds and you
To understand how mutual funds are vulnerable to big downturns, look at the way they're set up. Mutual funds take in money from vast numbers of investors, then pool it into a single pool and buy stocks and other investments with it. Whenever new shareholders buy into the fund, the fund manager has more cash to invest.

Where things get tricky, though, is when shareholders decide to sell. Unlike hedge funds and more sophisticated investing pools, mutual funds give shareholders the right to sell their shares on a daily basis. So no matter what the markets in general or the fund's investments in particular are doing, if a shareholder decides to get out of the fund, fund managers have to come up with that cash quickly.

Typically, that isn't a problem, for two reasons. First, shareholder purchases and sales often offset each other, so a fund can use new cash from a buying shareholder to pay off a selling shareholder. Second, even when selling outpaces buying, funds typically have cash reserves to pay off departing investors.

Big sales
When it does become a problem, though, is when selling gets so heavy that it runs through a fund's cash position. GMO Quality Fund and Fairholme Fund have seen exactly that level of selling, and the next question is what effect it could have on the funds and their investors -- as well as shareholders of the stocks those funds own.

For GMO, the situation isn't as bad. The fund had more than $490 million flow out of it last week, which represents almost the entire 3% cash position that the $16.6 billion fund had as of May 31. That may seem dire, but the good news is that the fund is both fairly well-diversified and has most of its money in the largest stocks in the market. Even if the fund did have to sell stocks to raise cash, it wouldn't have much impact on Pfizer (NYS: PFE) , Microsoft (NAS: MSFT) , or Cisco Systems (NAS: CSCO) , each of which trades an average of 45 million shares or more each and every day.

The Berkowitz reversal
Fairholme, on the other hand, is another story. Its outflows last week were less severe, at $189 million, but it has had 22 straight weeks of net sales that some estimate total to $4.3 billion over the past five months, causing the fund's cash position to fall from a quarter of its assets in February to just 4.4% as of May 31.

Yet in its most recent semiannual report, Fairholme reported that it had doubled its position in AIG (NYS: AIG) to more than 18%. Fairholme manager Bruce Berkowitz also retained big positions in Bank of America (NYS: BAC) , Goldman Sachs (NYS: GS) , and Citigroup (NYS: C) .

It might seem trivial if Fairholme had to sell shares in these companies, since they all have similarly liquid daily trading volume. But unlike GMO, which is hardly the only institution favoring a broad range of megacap stocks, Fairholme is one of the biggest contrarian investors favoring financials right now. Losing Fairholme as a buyer -- for whatever reason -- could be the final blow for a financial sector that's already teetering on the edge.

Watch out
Whether you're a shareholder in these funds or in the stocks they own, paying attention to fund outflows is important. When some of your biggest investors have to turn tail and run, a company's shares can drop in a hurry.

Learn more about big threats to your wealth in this video from The Motley Fool. Not only will it tell you how to protect yourself, but you'll also get a stock choice that has great potential even in a down market.

At the time this article was published Fool contributorDan Caplingeralmost feels forced to buy in a market like this. You can follow him on Twitter here. He owns shares of Fairholme. The Motley Fool owns shares of AIG, Cisco, and Microsoft, and has created a bull call spread position on Cisco. Separate accounts within the Fool both own shares of and have opened a short position on Bank of America. Motley Fool newsletter services have recommended buying shares of Pfizer, Microsoft, and Cisco, as well as creating a bull call spread position in Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policysmacks Wall Street upside the head every day.

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