The Best of Both Worlds

There's a major debate in the world of finance. Is the market efficient or isn't it? Are stocks always accurately priced for their risks or aren't they? Can the market be beat?

The truth is, if you play your cards right, it doesn't really matter. Even the most die-hard adherents to the "efficient market hypothesis" -- the folks who believe the market always reflects what is known about a company's stock -- admit there are two "anomalies" that can't be explained by their theory. If you learn what those anomalies are and how to take advantage of them, you raise your chances of beating the market.

Small stocks grow faster
The first thing that you can use to your advantage is the fact that small stocks tend to outperform their larger brethren. That's the "small stock anomaly" in a nutshell. If you think about that for a minute, it makes perfect sense. Industrial titan General Electric (NYSE: GE  ) sold more than $166 billion worth of products and services in the trailing 12 months. For its business to grow 20% next year, it would need to add more than $33 billion in additional revenue. That's akin to adding a company the size of Disney (NYSE: DIS  ) , with its theme parks, movie studios, television and cable networks, and its world-famous mice, in just a year. It's an extremely tough challenge to meet; even GE's more optimistic analysts don't think it can grow that quickly.

The faster a company grows, the faster its stock can grow. It's easier for a smaller firm to grow at a faster rate, simply because there's more wide-open room for it to expand. Consider the case of Motley Fool Hidden Gems selection and chicken-wings purveyor Buffalo Wild Wings (Nasdaq: BWLD  ) . With its $200 million in trailing sales, it needs a mere $40 million in additional revenue to grow at a 20% clip. For a sense of scale, that's about as much cash as GE takes in during any given two-hour period. Small companies can become big companies, and they can grow much faster than their larger counterparts. Shareholders who buy their stake while a successful company is still small can be richly rewarded for their patience during the firm's growing pains.

Cheap stocks don't stay that way forever
The other reality that hasn't been fully explained by the efficient market theory is the simple truth that sometimes stocks get priced at a discount to their true worth. If you can identify and purchase those companies before the market realizes its mistake, you can take advantage of the inevitable rebound as the shares recover. Take fellow Hidden Gems pick Alderwoods (Nasdaq: AWGI  ) . While it's well-known in the death-care industry, it's significantly smaller than industry leader and former Peter Lynch discovery Service Corp (NYSE: SCI  ) .

In addition to its size, Alderwoods worked through a painful bankruptcy. As a smaller sized bankruptcy survivor in a slow-growth industry, Alderwoods was simply abandoned by the market. It practically defined the term "value stock," trading at just three times its free cash flow when originally chosen for the newsletter. Sure enough, Alderwoods' stock has easily recovered -- more than doubling since it was first picked a little more than two years ago.

For perspective, this chart shows how Alderwoods has left formerly overhyped and overpriced companies like Amazon.com (Nasdaq: AMZN  ) and JDS Uniphase (Nasdaq: JDSU  ) in the dust over the past two years. Imagine that -- a company in the simple, ancient business of helping folks pay their final respects to their loved ones radically outperforming high-tech wizards in the market.

You win either way
Small companies can become big companies. Cheap businesses recover their worth. Find a company that is both small and cheap, and you have yourself a bona fide Hidden Gems candidate. Even the intellectuals who think the market is generally smarter than its investors admit that those are exactly the types of firms with a real chance of ending up on top. Motley Fool co-founder Tom Gardner and his team constantly scour the market, uncovering just those kinds of companies for subscribers. The result is evident in the quality of their product. Their picks on average have beaten the S&P 500 by more than 20 percentage points since the service's inception two and a half years ago.

Even if the market is generally efficient, those two "anomalies" -- small size and value prices -- give Fools the edge. If you'd like to join us, click here to start your 30-day free trial and see for yourself just how it's done. Subscribe today, and you'll receive Stocks 2006, the Fool's guide to the investing year ahead, absolutely free.

At the time of publication, Fool contributor Chuck Saletta owned shares of General Electric. Amazon.com is a Stock Advisor pick. The Fool has a disclosure policy.


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