How to Profit When the Market Overreacts

In the long run the stock market may well be a wise predictor of future corporate earnings. In the short term it has all the wisdom of a herd of drunken buffalo.

A simple example: Stocks dropped from the S&P 500 often fall sharply, while those added rise. Membership in an index has nothing to do with a company's outlook, but when a stock falls out of the S&P, hundreds of funds automatically sell—and that gives a savvy investor a chance to buy cheaply.

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Spin-offs are another example. Investors often shun jettisoned businesses, assuming there's a reason for being kicked to the curb. Yet studies show that spun-off firms often outperform, as they're overlooked and underappreciated.

A new twist on value

This sounds like the essence of bargain hunting, but traditional value funds look for long-standing misjudgments. There are now some funds that take advantage of this type of short-term silliness, and they even have a name: "event driven" funds. Guggenheim Spin-Off ETF , for instance, owns shares of mostly small and midsize companies that were unloaded. Over the past five years the fund gained 11.3% annually, outpacing peers by nearly two points a year.

Emerging opportunities

Some funds don't just look for bad situations; they seek out corporate moves that have historically led to opportunities, such as mergers. Investors have long profited by betting on the modest gap between an acquisition target's current price and the deal price. When investing in announced mergers, the return has typically been about 5% to 7%, says Mark McKenna, manager of BlackRock Event Driven Equity . But he thinks that will rise to 10% as the pace of mergers increases.

Arvind Navaratnam, manager of Fidelity Event Driven Opportunities , also looks at mergers, among other incidents. He scooped up shares of Journal Media Group when it announced plans to merge its broadcast assets with E.W. Scripps. (The companies also spun off their print divisions into a new company.) The stock popped more than 40% when Gannett announced that it was buying Journal Media last October.

As with all forms of value investing, there are risks. Navaratnam also held a big stake in Valeant Pharmaceuticals, a serial acquirer whose shares have sunk more than 80% in the past year. Despite that, his fund has beaten 80% of its peers in the past 12 months.

There's one other benefit beyond performance. Because they look for quirky buy and sell signals, event funds tend to be poorly correlated with the broad market, making them good diversifiers.

Columnist John Waggoner is the author of three books on Wall Street and investing.