Regular Fool readers already know that I have a certain obsessive fascination for applying the laws of physics to equity analysis. (Take a brief stroll through the fourth dimension of stock picking.)
One theory that I have been musing on for awhile is the relationship between a company's intrinsic value and the potential for the company's stock price to increase -- and how the latter can be affected by how many people are examining the former. The fact that a stock's price can rise just by virtue of it appearing on investors' radar screens has been on my mind ever since I wrote aboutLifeway Foods
At the time I wrote about the company, its stock price was around $7 (split-adjusted), and the one analyst following Lifeway had it pegged as likely to be worth $9 by the end of 2004. So if the company was 22% undervalued at the start of the year, and the market as a whole rises about 11% per year, why in heaven's name was no one buying Lifeway?
Ask Werner Heisenberg.
"I believe that the existence of the classical 'path' can be pregnantly formulated as follows: The 'path' comes into existence only when we observe it." -- Werner Heisenberg
To paraphrase, the only way to know with any certainty how fairly valued a stock is, how likely it is to appreciate in value over time, one must observe it. Unless I run the numbers, there is no way for me to say with any conviction whether Coca-Cola
The problem is that, with large-cap companies like Coke and Pepsi, I'm far from the only investor working these numbers. Each of these companies has a fan club of about 18 professional analysts following their movements and prospects day and night. Really, what are the chances that I am going to find out something that these guys aren't going to find out first -- and blab to the entire investing universe in an "analyst downgrade" or "analyst upgrade" announcement that sends the stock climbing or tumbling in a nanosecond? Not much.
If you really want to find a bargain of a stock, an unloved and underappreciated diamond in the rough, you need to head to the stock market equivalent of Altria's
"The more precisely the position is determined, the less precisely the momentum is known in this instant, and vice versa." -- Werner Heisenberg
By and large, small-cap land is a place devoid of analysts. Not convinced? Compare the 13 analysts who cover large cap Nike
Which begs the question: If over the past year, little Saucony proved itself much more than twice as good an investment as big ol' Nike, why are all the analysts poring over Nike's financials, while no one is following Saucony?
"In the sharp formulation of the law of causality -- 'if we know the present exactly, we can calculate the future' -- it is not the conclusion that is wrong but the premise." -- Werner Heisenberg
Once more, what holds true in physics proves just as true in investing. The problem is not so much that the analysts failed to notice that Saucony was a better value than Nike, and failed to predict Saucony's ability to deliver outsized returns. The problem is... the analysts themselves!
The essence of the Heisenberg Uncertainty Principle is this: Whenever you attempt to measure the location of a particle, the act of measuring it changes the particle's momentum. So too, with stocks. The very act of measuring a stock's value affects the stock's ability to appreciate in price. The more analysts measuring a stock, poking and prodding its financials, issuing "buy" and "sell" recommendations about it -- and acting on those recommendations by buying or selling the stock -- the lesser the chance that the stock will increase in value in the future. By more accurately assessing the stock's value, they force its price to reflect that value, squeezing inefficiency out of the stock's price and limiting the stock's ability to appreciate further.
So it should come as no surprise that Nike turned out to be an inferior investment to Saucony. With a baker's dozen analysts following Nike, the company's stock price naturally presented a much more accurate reflection of the company's true value. In contrast, with no analysts following Saucony, the chances that the stock might remain unnoticed and undervalued increased substantially. And so it came to pass.
Conclusion
Which is precisely the reason that Hidden Gems investors focus on small caps. The greatest gains from stock investing are to be found not among the Googles
Fed up with being the last to hear which large cap was a great stock to buy... three weeks ago? Ready to find the next winning small cap before its price goes nuclear? At Hidden Gems, every month Tom Gardner cranks up his electron stock-o-scope and gives you two small cap value ideas that Wall Street won't hear about for months. The profits are only a nanoclick away.
Fool contributor Rich Smith owns no shares in any company mentioned in this article. The Fool has a disclosure policy.
