2 Things You Need to Beat an Efficient Market

There are two types of investors in this world: Those who think the market can be beaten, and those who think it can't. But does that debate really matter?

Frankly, no.

That said, if you do decide to dig into the debate surrounding the market's relative beatability, you'll discover that even diehard adherents to the Efficient Market Hypotheses (i.e., those who don't think you can beat the market) acknowledge two anomalies. And if everyone agrees you can beat the market by exploiting those anomalies, wouldn't it be downright silly not to?

Are you suspicious of sure things?
Of course, you'd also be right to be cautious. After all, literally thousands of "can't-miss" and "heavily backtested" trading strategies stop working when it's your hard-earned money on the line. For a plan to really make a difference in your wallet, it'd better be based on a sustainable advantage -- one that won't mysteriously vanish as soon as you try to exploit it.

That's why the two anomalies uncovered by the folks who otherwise believe in an efficient market matter so much. They're based on factors that are easily recognized, but are largely inaccessible to the legions of institutional investors dominating the market's trading.

So, what are the two anomalies you should be exploiting each and every market day? Without further ado ...

Get exploiting
The first is value. In essence, every company has a true worth that may or may not be reflected in its stock price. If you can recognize those times when the market is offering you a tremendous discount, and invest accordingly, you can wind up ahead.

Why it lasts: Of course, you may be wondering why you would have special powers to recognize when a company is dirt cheap, yet the rest of the market wouldn't. In truth, you don't. What you do have, however, is an advantage over the professional money managers. That advantage is simple: They earn a living by managing other people's money. The easiest way for them to get fired is to buy a hot-potato company and then underperform their peers while holding that hot potato.

Nobody, for instance, wanted to own mortgage giants Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM) when their accounting scandals broke. In the wake of Enron, with the wrath of Congress breathing down their necks, they became classic hot potatoes. Anyone who bothered to do a little estimating based on what was publicly known could have seen that, at the worst of the scandals, both traded extremely cheaply. Yet those money managers whose jobs depend in large part on staying out of trouble were forced to stay away.

Similarly, professionals were wary of EOG Resources (NYSE: EOG) -- a company once affiliated with Enron -- as Enron unraveled. The stench from its past association was appalling, and it kept the shares artificially low. Since 2003, however, the stock is up nearly 300%.

Think small to win big
The other factor you can exploit is the fact that you're not managing tens of billions of dollars. That gives you the chance to buy small, fast-growing companies with tremendous long-term potential.

Why it lasts: Money managers of large funds have to focus their efforts on big companies simply because their size won't let them effectively invest in smaller firms. There are two main reasons for this: liquidity and size. The manager of American Funds' Growth Fund of America (FUND: AGTHX) -- an $88 billion fund -- simply can't go around buying stakes in tiny companies. Consider how long it would take for the fund to invest just 1% of itself in each of these billion-dollar companies -- and how much of them it would own by doing just that:

It would take a controlling stake in any of those companies just to invest 1% of the fund. Plus, it would take at least several weeks of monopolizing the firm's entire trading volume just to get that position built. Worst of all, after all that effort, if one of the companies happened to double in size overnight, it would still only mean about 1% to the fund's total return.

Press your advantages
As an individual investor, your ability to buy small-cap and value-priced stocks gives you a tremendous edge over the giants that dominate Wall Street. You'll do best, however, if you buy stocks that are both small and cheap.

Those are precisely the issues Fool co-founder Tom Gardner and senior analyst Bill Mann seek in Motley Fool Hidden Gems. Their record -- up 53%, versus 27% for the market since the service's inception -- speaks for itself and shows just how well you can do by exploiting the advantages that only small investors -- investors like you -- have.

To get started doing just that, join Tom and Bill at Hidden Gems free for 30 days. There is no obligation to subscribe.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned. Fannie Mae is a Motley Fool Inside Value selection. The Fool has a disclosure policy.