How to Beat a Choppy Market

Is it me, or has it been a while since we trotted out that blindfolded chimp? You know, the little fellow who outperforms the suits on Wall Street by throwing darts at a newspaper 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, if the billionaire boys' club can't hack it -- with all their computers and inside information -- what chance do we have of beating that pesky chimp?

The sad and happy truth
Assuming he actually hits a stock with every dart, it's pretty much true. The chimp's unbiased method (hence, I suppose, the blindfold) keeps him right on the market average -- no better, no worse -- which is something most active money managers can't seem to manage. At least not after you deduct their fees and expenses.

That's the bad news. The good news is that it just 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. As kooky as it sounds, this last distinction is one I confirmed myself while working daily with Wall Street's institutional "buy side."

Now for the really good news ...

How I know youcanbeat the market
When I met Fool co-founder Tom Gardner, he and his brother David were launching their first newsletter in a decade. That was a few years back, and I was skeptical. Should this guy really be charging for his research? I mean, could a Shakespeare nut in a Fool cap really pick stocks?

Fat chance. I'd spent years peddling broker data and "analytics" to Wall Street. And here's the irony: My run-ins with the sell-side analysts and buy-side money managers had convinced me that -- lacking real inside information -- you simply cannot beat the market picking individual stocks.

Remember the Nifty 50? How, back in the day, you couldn't go wrong with Xerox (NYSE: XRX  ) or IBM (NYSE: IBM  ) ? How you could blindly stock up on Altria (NYSE: MO  ) , formerly Philip Morris, at any price? Hey, at least the old timers kept pace with the market (after all, they were essentially buying and holding it). Not so, the new-economy gunslingers.

In the 1990s, Wall Street really cranked it up a notch. Suddenly, the hedge funds were endlessly swapping high-volume tech stocks like Juniper Networks (Nasdaq: JNPR  ) and Cisco (Nasdaq: CSCO  ) . At one time or another, everybody -- and I mean everybody -- owned a piece of Oracle (Nasdaq: ORCL  ) . James Cramer used to call them the stocks everybody loves.

But by constantly rounding up and turning loose these usual suspects, institutional investors sealed their fates. Most "pros" made money in the boom years and got creamed in the bad. But they couldn't beat the market over the long haul, and few ever really outperformed, certainly not enough to justify the fees we paid them. And not by picking great stocks, either.

Yes, there is a secret to picking winners
Earlier, I mentioned Tom Gardner. Well, by the time he launched his new small-cap newsletter, Motley Fool Hidden Gems, I was coming around. Tom had consistently pointed me to great underfollowed stocks like Moody's, which has more than doubled since I added it to my IRA a few years back. And to my surprise, he was doing it using good old-fashioned legwork and bottom-up fundamental analysis.

Now, granted, the criteria Tom applies are no secret to Wall Street. They've been passed down to us as finance majors and in books, from Benjamin Graham through Walter Schloss, Bill Miller, and Peter Lynch. Smart investors have always looked 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.

But, surely, something else set this 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 recommended it in Hidden Gems in November 2003, the business and financials looked great. But the markets are 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 -- didn't, either. Now that the stock's up more than 300%, guess who's been sniffing around? Wall Street.

Of course, you know better than to draw conclusions from a few examples. And not all of Tom's Hidden Gems picks have tripled -- or even doubled (though 10 of them have). Still, as of April 18, 2006, the 50-plus stocks recommended in Hidden Gems are up 42.3% on average. Compare that with about 14.3% if you'd stuck with the S&P 500.

What this means for you
It takes a lot to convince an efficient market nut like me, but I'm sensing a trend. Mark Hulbert, the newsletter-industry watchdog, admits that some guys 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. I'll keep you posted.

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!

That's how Lynch beat Wall Street. He knew that 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 often run by founders with large personal stakes in the business.

Can Iguaranteeyou'll 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 yesterday's big gainer. 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 I know to consistently make money with stocks. And that is to steer clear of the beaten path and buy where Wall Street isn't looking. But you can do it.

Need help? You can learn all about Tom Gardner's approach to finding undercovered, undervalued stocks with strong fundamentals and real earnings. If you'd like to subscribe, you can try Tom's complete Hidden Gems service yourself. If you're not 100% convinced he's on to something, just cancel within the first 30 days, and Tom will refund every penny. To get started, click here.

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

Fool writer Paul Elliott owns Moody's and 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 the instant you sign up. Moody's is a Motley Fool Stock Advisor recommendation. The Motley Fool isinvestors writing for investors.


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