The stock market is an inherently adversarial place. For every share bought, there's a share sold. In each trade, there are two people, with largely the same data, coming to completely contradictory conclusions about the exact same company. Think about that the next time you're buying a few shares of a company. Those shares are available to you only because the person on the other side of your trade decided that your cold, hard cash was worth more than that stock. Ask yourself what that other person knows that you don't.
The fact is, one of you is wrong. That means, of course, that half of all trades are the wrong ones to make. Sure, we all make mistakes from time to time. In fact, I'm starting to wonder right now whether my purchase of ailing automobile titan General Motors
If you want to beat the market, you have to understand the simple truth that when you buy, you're buying because someone else is willing to sell to you at that price, and when you sell, you're selling to someone who's willing to buy from you at that price. Otherwise, you'll likely find yourself going up against people who are not only aware of that fact, but who have also taken the appropriate steps to tilt the odds in their favor (and, therefore, against you). In the exchange of money for shares, one side ends up with the better end of the deal, every time.
The largest actively managed mutual fund is American Funds' Growth Fund of America
The professionals' Achilles heel
Despite their size and market power, these giant funds have some easily exploited weaknesses that we mere mortals can use to our advantage. The largest weakness is the fact that these huge funds can't make a move without making an impact on a stock. For example, one of Growth Fund of America's largest holdings is retailer Target
To add fuel to the fire, if one fund finds a reason to sell off a company, in all likelihood others will as well, making the exodus that much larger and more pronounced. There sits one of your advantages as an investor. When large funds make the decision to sell, they can depress a company's price far below any reasonable measure of the firm's worth. When tremendous sell-offs like that happen, value investors (like those of us at Motley Fool Inside Value) get excited. It was during just such an episode that I bought a stake in employment and income verifier TALX
Your primary weapon
The most powerful tool in an individual investor's arsenal is a clear understanding of what a company is really worth. We call that a firm's "intrinsic value"; it's a measure of the expected earning capacity of the business over time. When a company is trading below that true worth, it's a sign that the firm is undervalued and has the potential to provide you with a bonus gain when the company not only grows over time but also takes the one-time leap back up to its fair price. In order to determine that value, there's a bit of math involved in a process known as a discounted cash flow (DCF) calculation.
To simplify the number-crunching, Inside Value has an online DCF calculator available here (for subscribers only). If you're not yet on board, click here to start your 30-day free trial and take advantage of both the calculator and the Inside Value team, standing ready to help you with your analysis. Lead analyst Philip Durell used just such a tool to dig up lottery services company GTECH Holdings
The Foolish bottom line
At the end of the day, half of all trades turn out to be mistakes. If you want to minimize the number of mistakes you make in your investing choices, you have to keep a firm grasp on what a company you're considering is really worth. Keep that valuation first and foremost in your mind, and you'll master the key weapon you can use to not only take on the market's largest sharks, but also to beat them over time.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of General Motors and Talx. The Fool has a disclosure policy.