Exploit the Market's Mistakes

Pardon me as I begin with a timely basketball analogy. (Ahem.) During the NBA Finals, coaches turn into master tacticians, looking to exploit their opponents' mistakes. That's because every point and every defensive stop is crucial to capturing the title.

For example, the Miami Heat defense tends to get disorganized in transition. So Dallas Mavericks coach Avery Johnson wants his team to push the ball up the floor quick.

In high-level basketball, you win by exploiting mistakes. The same is true in the stock market. All it takes are three simple steps to help you capitalize on the market's missteps. Here they are.

1. Act long term
Contrary to popular opinion, the market, as a whole, thinks long-term. Its participants, however, tend to act based on short-term influences such as news headlines, constantly changing prices, and, for many money managers, performance incentives.

I know you've heard this before, but to beat the market, it's crucial to keep a long-term view. That can be difficult with prices bouncing around every day, but when times get tough, just think of master investor Phil Fisher.

Could you follow his example? Fisher started buying shares of Motorola (NYSE: MOT  ) in the 1950s and never sold. That patience -- sometimes excruciating -- rewarded him with remarkable returns.

If you not only remember Phil Fisher, but also follow his long-term strategy, your results will be rewarding. Promise.

2. Be rational, not emotional
Phil Fisher's got company when it comes to valuable investing lessons. Master investor Ben Graham teaches us that when Mr. Market is depressed, buy; when he's ecstatic, sell. After all, that's the key to the old investing adage "Buy low, sell high."

Here's an example: Decreasing poultry prices, compounded with the avian flu scare, sent Sanderson Farms' (Nasdaq: SAFM  ) stock price from $49 to $20 in seven months. That certainly wasn't rational. With cooler heads now prevailing, the stock's back up to $28.

The lesson? Always be rational. That alone should put you on the winning side of a trade more often than not.

3. Lather, rinse, repeat
I recently re-read John Kenneth Galbraith's A Short History of Financial Euphoria and was again amazed that financial bubbles happen time and time again. It seems that almost every few years, investors get excited and overvalue stocks.

So here's what we need to do: Remain steadfast to rules No. 1 and 2. If the market wants to make the same mistakes repeatedly, we'll profit each time.

As value investors, that means discerning when the market is euphoric, then staying the heck away. Because when prices get overblown -- as they did with Internet Capital Group (Nasdaq: ICGE  ) just a few years ago -- they tend to come back down ... hard.

At the same time, we need to recognize when the market is distraught -- and we must be ready to profit from it. A few years back, the market got stupid with companies such as AES (NYSE: AES  ) , Williams Companies (NYSE: WMB  ) , Corning (NYSE: GLW  ) , and E*Trade (NYSE: ET  ) . Temporary difficulties sent the stocks to ridiculously low prices. But smart investors who bought at those lows have since been richly rewarded.

The Foolish bottom line
Back to my NBA analogy. NBA coaches get paid to recognize and exploit opponents' mistakes. And to generate great returns, we (as investors) have to be on our game each and every day, ready to spring forward and take advantage of the market's blunders.

That's what we try to do at Motley Fool Inside Value. We know the market is always making mistakes (and will continue to make 'em), so we hunt for ways to capitalize on them. Advisor/analyst Philip Durell shares two opportunities each month with Inside Value members. Click here for 30 days of free access to Inside Value and the entire scorecard of undervalued stock ideas. Making money off a (sometimes) stupid market is only a few steps away.

Fool editor David Meierowns shares of AES but does not own shares in any of the other companies mentioned. Sanderson Farms was formerly a Motley Fool Stock Advisor pick. The Motley Fool has adisclosure policy.


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