I'm going to let you in on an industry secret. It's going to explain why the stock market -- even in this age of unmatched access to information -- is a self-perpetuating machine for mediocrity.
Now, even though this is an industry secret, you've probably picked up on it. In fact, we get emails all the time from frustrated readers who want it to stop. And we're not even the worst offenders.
The two words you'll never forget
Although the Internet has the capacity to cover every single publicly traded stock, only a handful get consistent media coverage. The stocks that earn this special status do so for a very clear reason: There are enough people out there who want to read about them.
In industry-speak, these are "hot tickers."
Hot what?
They're the only stocks out there that can generate enough page views to support an ad-based financial media model. And they tend to be large, technology-focused companies. That's why you'll regularly find stories -- often unrelated -- about certain companies from multiple sources, including MarketWatch, paidcontent.org, The Associated Press, Reuters, TheStreet.com, BusinessWeek, TechTicker, Fortune, Barron's, Investor's Business Daily, and even The Motley Fool.
We're talking about big names such as Yahoo! (Nasdaq: YHOO), Pfizer (NYSE: PFE), and Comcast (Nasdaq: CMCSA), and they pop up even on slow news days. This phenomenon also explains why stocks with cult followings, such as NVIDIA (Nasdaq: NVDA), are among the most widely reported-on stocks on the market, despite their relative small size and downright paltry long-term performance.
It's a vicious cycle. You want to read about these stocks, so we write about them, and because we write about them, more and more people want to read about them. Yet although big tech companies can be fun to follow, they are not likely to earn you outsized returns.
And I'll back up that claim with numbers
There's a famous chart from Fama and French data that looks something like this:
|
|
Value
|
Growth
|
|
Large Cap
|
12.4%
|
9.6%
|
|
Small Cap
|
15.4%
|
9.2%
|
This chart is telling you that from 1927 to 2004, large-cap growth stocks (the hot tickers) underperformed small-cap value stocks (the stocks you've never heard of) by nearly six percentage points annually.
Part of the reason is that the big stocks are overcovered by the media and analysts, and therefore overbought by investors. And because they're overbought, they remain overcovered. This is the self-perpetuating machine for mediocrity that I referred to earlier.
But you can break from this cycle by being willing to look where others won't.
The flip side
See, even though the system overcovers certain stocks (and renders them pretty efficiently priced), tiny companies such as Willamette Valley Vineyards (Nasdaq: WVVI) and Design Within Reach (Nasdaq: DWRI) can go totally un-covered. In fact, when you quote these names, you generally won't find anything more than press releases, even after earnings or acquisitions are announced.
As a result, no one knows these stocks are out there. Days can pass without shares trading hands. Yet if we're willing to study these companies closely, it turns out that underfollowed stocks like these are the ones we should be buying!
Because they will help you make more money
Mark Hulbert reported on a new study in The New York Times recently that found that from 1962 to 2003, stocks that could go at least a day without trading any shares outperformed stocks that traded every day by more than eight percentage points annually. And that was the case even though the "neglected stock portfolio," as researchers Athanasios Bolmatis and Evangelos Sekeris called it, contains "a disproportionate number of stocks that underperform the market by a dramatic margin."
In other words, even though this part of the market can be an opaque niche, there are multibaggers there for the taking by investors willing to do their own legwork.
But few people are
So while most investors will stick and be stuck with the hot tickers, if you want to outperform the market, you need to start following underfollowed stocks. That's what we do at our Motley Fool Hidden Gems small-cap research service, where I focus my time on companies with market caps of less than $200 million.
You won't find our micro-cap research when you quote your stocks, because there aren't enough people who care to make it a viable business model. But you can read all of our research and recommendations by joining Hidden Gems free for 30 days. Click here for more information.
This article was first published July 3, 2008. It has been updated.
Tim Hanson
owns no shares of any company mentioned. NVIDIA is a Motley Fool Stock Advisor recommendation. Pfizer is an Inside Value and Income Investor choice. The Motley Fool owns shares of Pfizer. The Fool's disclosure policy advises its readers to inflate their tires to get better mileage out of their fuel tank, but not to overinflate, since that can lead to a blown tire and tragic death.
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