How to Beat a Choppy Market

Is it me, or has it been a while since we trotted out that blindfolded chimp with the darts? You know, the little fellow who routinely outwits the typical Wall Street money manager with blind daggers and a stock table. Cute story. But is it true?

And if it is true, why? Or should I say how? And where does this leave a bunch of Joe and Josephine Odd Lots like us? I mean, holy cow, if the billionaire boys' club can't hack it -- with all their computers and contacts -- what chance do we have of beating that pesky chimp?

The sad and happy truth
Now, assuming he actually hits a stock with every dart, it's all pretty much true. The chimp's presumably unbiased approach (hence, I suppose, the blindfold) keeps him spot on the market average -- no better, no worse -- which is something most active money managers can't seem to manage.

That's the bad news. The good news is that it really doesn't matter. Not if you're managing your own stock portfolio. Not if you use independent sources. Certainly not if you ignore Wall Street research. Though counterintuitive, this last distinction is one I confirmed myself while working daily with Wall Street's institutional "buy side."

Ironic, huh? Now for the really good news...

You can beat the market
I met Motley Fool co-founder Tom Gardner when he, with his brother David, was launching Motley Fool Stock Advisor, the brothers' first advisory newsletter in nearly a decade. That was a few years back, and I'll admit I was skeptical. Should this guy really be charging subscribers for his research? I mean, could a Shakespeare nut in a Fool cap really pick stocks?

Fat chance. I'd spent the previous five years working for a peddler of broker data and "analytics" to Wall Street. And here's the irony: This interaction with the sell-side analysts and their buy-side money manager clients convinced me that -- lacking real inside information -- you simply cannot beat the market picking individual stocks.

I had heard of the nifty fifty. How in the 1960s, you couldn't go wrong buying Kodak (NYSE: EK) or Xerox (NYSE: XRX). How you could safely stock up on Coca-Cola (NYSE: KO) at any price. At least the old-timers kept pace with a market they were essentially buying and holding. Not so with the new-economy gunslingers. These I saw firsthand, with my own eyes.

It was in the 1990s that Wall Street cranked it up a notch and really started trading, swapping Corning (NYSE: GLW) for JDS Uniphase (Nasdaq: JDSU) and back. At one time or another, everybody -- and I mean everybody -- owned Nortel (NYSE: NT) and Lucent (NYSE: LU), but how many people made money? James Cramer gave them a catchy name -- the stocks everybody loves.

By constantly rounding up and turning loose the usual suspects, investors sealed their fates. Those that didn't overtrade did all right in the boom years but got creamed in the bad. They almost never beat the market -- few ever really outperformed. Certainly not enough to justify the fees that investors (we) paid them.

The secret to picking winners
By the time Tom started his new small-cap newsletter service, Motley Fool Hidden Gems, I was coming around. The results were admittedly green, but for Stock Advisor, Tom was consistently picking stocks that were outperforming the market. And to my surprise, he was doing it using good old-fashioned legwork and bottom-up fundamental analysis.

Now, granted, many of the criteria he applied -- and that are still applied at Hidden Gems -- were no secret to Wall Street. The numbers were right there in the financial statements. The techniques were passed down to us as finance majors and in books, from Benjamin Graham through Walter Schloss, Bill Miller, and Peter Lynch. They were the true masters, but we were all looking for:

1. Solid management with significant stakes
2. Great, sustainable businesses
3. Dominant positions in niche markets
4. Sturdy (if not sterling) balance sheets
5. Strong free cash flow

And true, Tom Gardner screens hundreds of stocks each month and has great instincts, but surely something set his performance apart from the market pros I'd known. Turns out it was two somethings: (1) Tom wasn't jumping into and out of stocks, sectors, or markets, and (2) I hadn't heard of most of the stocks he was recommending. Eureka!

Anatomy of a winner
Little Middleby makes ovens -- commercial ovens, of all things. When Tom floated the idea and then formally recommended it in Hidden Gems last November, the business and financials looked solid. But the markets are at least somewhat efficient, I thought; surely, anybody could see what Tom and I saw.

But here's the catch. I ran the name on Multex and Bloomberg, even First Call. Nothing. The sell-side analysts didn't care, so the buy-side money managers -- the guys who really move the markets and who buy the sell-side research (gasp! too often with soft dollars) -- didn't, either. Now that the stock's up more than 180%, guess who's sniffing around? Wall Street.

Much the same had happened with FARO Technologies, which Tom had tossed out the previous month. FARO makes state-of-the-art measurement systems used in a wide range of manufacturing. Another niche market -- and again, no Wall Street coverage. FARO is up 118% since, but like most small-caps, it is volatile. In other words, the stock gives little guys like us lots of opportunities to buy.

I know better than to draw conclusions from a few examples. And not all of Tom's picks are three- or even two-baggers. Still, as of March 15, a full 32 of the 42 stocks recommended in Hidden Gems are in the money. And taken together, they're up on average more than 36%. Compare that with about 10% for the Standard & Poor's 500.

What I can do for you
It takes a lot to persuade an efficient market adherent like me. But I'm sensing a trend. Mark Hulbert, who watches the newsletter industry like a hawk, offers evidence that some guys (and gals) can pick stocks. But this Hidden Gems deal I'm seeing with my own eyes. Whether it's up or down from here, I'll be watching. Rest assured, I'll keep you posted.

Until then, I opened with Peter Lynch -- and the chimp -- for a reason. Unlike your typical Wall Streeter, both throw their darts at any stock on the board. Market cap too small? No such thing. No Wall Street coverage? Bring it on. No convoluted relationship with big investment banks? All the better. Never heard of it? Bingo!

Lynch made a killing on stocks that were followed on Main Street but not Wall Street. Some of his biggest winners weren't all that common even on Main. The point being, companies that can reasonably rise five, 10, or even 20 times or more in value (1) are small but growing, (2) are well-run, and (3) operate in great industries. To which I'd add, they (4) are run by founders with large personal stakes in the business.

What you can do now
Can I guarantee you can become a great stock-picker? No. But I can be pretty darn sure you don't want to be relying on Wall Street research. You don't want to be shuffling around the week's most actives, or even buying and selling this week's TiVo (Nasdaq: TIVO). Most importantly -- as much as I knock the market pros -- you don't want to be taking the other side of their trades.

In a choppy market like this, there's only one way to make real money with stocks. That is to buy where Wall Street isn't looking. If you want to learn more about Tom Gardner's approach to finding undercovered and undervalued stocks, Tom is offering a special 30-day free trial. Click here to learn more.

This commentary was originally published on Nov. 10, 2004. It has been updated.

Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Motley Fool Hidden Gems. All picks and results are posted on the Hidden Gems website and can be viewed immediately with a 30-day free trial. He owns none of the stocks mentioned. The Motley Fool isinvestors writing for investors.