Isaac Newton once humbly explained his scientific accomplishments by stating, "If I have seen a little further it is by standing on the shoulders of giants."
In other words, his scientific research was built upon the knowledge accumulated by all of the masters of the past.
It's no different in investing. The best investors heed the experience and advice of past masters. The players, technologies, and market environments certainly change, but the basic secrets to beating the market largely stay the same.
In this spirit, I've compiled the four investing secrets that will help you beat the market. Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) CEO Warren Buffett has used each of these secrets to amass his fortune, but I've also brought in back-up from other investing giants, because he's not alone.
Secret No. 1: Expect that the future will differ from the past
"I often remind our analysts that 100% of the information you have about a company represents the past, and 100% of a stock's valuation depends on the future."
-- Bill Miller, who beat the market for 15 straight years
It's important not to rely too much on trailing data to predict the future. It's very easy to see a low P/E ratio or a high dividend yield and mash the buy button, but we must also analyze the business and anticipate changes.
Here's an example. Annaly Capital (NYSE: NLY ) has both a low P/E ratio of 5 and a high dividend yield of 15.2%. Impressive historical stats, but it's not that easy. Annaly's made a killing in Fannie Mae- and Freddie Mac-guaranteed mortgage securities because of the current favorable interest rate environment.
The big risk it faces is not hedging correctly for rising interest rates. That's why the market is pricing it so cheaply. There may be opportunity, but predicting Annaly's future is a lot more complex than marveling at its trailing performance data.
Secret No. 2: Go against the crowd
"If you want to have a better performance than the crowd, you must do things differently from the crowd."
-- Sir John Templeton, groundbreaking international investor
I've written in the past about how Wall Street analysts can be wildly wrong about stocks. And my colleague Tim Hanson has explained why buying the stocks everybody else is piling into can be a big mistake.
Getting agreement from Wall Street and your friends is comforting; it's lonely being a true contrarian. But the stock market isn't the place to get your warm fuzzies ... at least not if you want market-beating returns.
Secret No. 3: Avoid "win small/lose big" situations
"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."
-- George Soros, whose hedge fund generated 30+% annual returns
I'll admit that this is a tough one. No criminal commits a crime expecting to get caught, and no investor buys a stock expecting to lose money. But sometimes we let the potential upside for a business blind us to how richly its stock is valued -- and set ourselves up for a fall.
I'll give you an example. A few months ago, a doctor friend asked me to research a small drug company called Optimer Pharmaceuticals (Nasdaq: OPTR ) . It has a promising late-stage antibiotic drug for a common hospital infection (Clostridium difficile, if you're curious). I smelled underfollowed opportunity.
After investigating further, I liked its chances for success. Yet neither of us bought into Optimer. Why? In our upside scenario, the drug would be approved, and it would steal significant market share from the incumbent treatments. Unfortunately, the market was already pricing Optimer for a high likelihood of success. So the big upside was already priced in. Meanwhile, failure would mean a big downside.
This is the kind of win-small/lose-big scenario we need to avoid.
Secret No. 4: Buy in at a good price
"I've never bought a stock unless, in my view, it was on sale."
-- John Neff, whose fund consistently beat the market over 31 years
Whether you're a growth investor or a value investor, the goal is the same -- high returns from where you bought.
This is where the market's volatility comes in. Even the most stable, boring companies have significant price movements. Over the last few months, savvy investors bought Procter & Gamble (NYSE: PG ) , UPS (NYSE: UPS ) , and PepsiCo for 25%-30% lower than the high bidders. At today's prices, a reasonable buy argument could be made for all three. But at 12, 13, and 14 times recession-addled earnings, respectively, they were bordering on no-brainer territory.
And those are the big, stable companies -- it only gets more volatile from there. In other words, we need to take advantage of the market by identifying great companies and then waiting for favorable stock prices before buying in.
How to beat the market
Remember these four secrets of the investing giants:
- Expect that the future will differ from the past.
- Go against the crowd.
- Avoid "win-small/lose-big" situations.
- Buy in at a good price.
Following these four investing secrets, compiling a watchlist, and patiently picking off the stocks you want to own is how you beat the market.
Let me send you off with one stock pick care of the analysts at our Motley Fool Inside Value investing service, who have made an art out of following these tenets. Apollo Group (Nasdaq: APOL ) is breaking through past conventions to offer a college education via the Internet. Its flagship school, The University of Phoenix, is the largest private university in the U.S. with more than 400,000 students. At today's prices, our analysts believe it's selling for a significant discount to its intrinsic value. I invite you to see all of our analysis on Apollo Group and view the other Inside Value recommendations by clicking here for a free 30-day trial.
Anand Chokkavelu owns shares of Berkshire Hathaway. Apollo Group and Berkshire Hathaway are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor selection. PepsiCo, Procter & Gamble, and United Parcel Service are Motley Fool Income Investor recommendations. The Fool owns shares of Berkshire Hathaway. The Fool has a disclosure policy.