As a wee lad, I remember musing: Should I really be taking stock picks from Motley Fool co-founder Tom Gardner? OK, my actual words might have been "Can a Shakespeare nut in a Fool cap really pick stocks?" Yikes.
Did I really say that out loud?
Yes, I did. See How to Beat a Choppy Market for the grisly details, including how I first met Tom and his brother, David; how long I've been tracking their results; and how reluctantly I came to conclude that Tom Gardner really can pick stocks.
If you'll bear with me, I'll support that with some numbers from Tom's work at Motley Fool Hidden Gems. But for now, you can either trust me or do as economists do and make an assumption. Assuming Tom -- or any investor, for that matter -- can consistently beat the market, how on earth does he do it?
The Inefficient Market Hypothesis
For years, I bought into what was -- and probably still is -- called the Efficient Market Hypothesis. I have since purged my pea brain of the details, but essentially this EMH asserts that stock prices instantly reflect all public information, or for the real believers, all all information.
The ramifications of so much efficiency are uniformly arcane. One, however, is not. Specifically, that no individual investor will consistently beat the market over meaningful periods, except by taking on more risk or by virtue of pure chance. You can imagine why stock analysts and fund managers are not big fans of EMH.
I can't believe I was either. After all, it contradicts everything else I've learned. People are not rational, for one thing (and remember investors are people). People are nuts. Even assuming that thousands of screwball buyers and sellers might process diverse and often contradictory information and arrive at a rational conclusion, will they really do so efficiently? Hard to imagine.
Am I crazy...
I think I swallowed the efficient market pill to begin with because stock prices just seemed so... random. Investors I knew personally -- even those who were paid a lot of money for their efforts -- really did beat the market, it seemed, by taking on more risk or by virtue of chance. At least as far as I could tell.
Historical figures, whether vaunted or vilified, seem to have done consistently well in certain markets and consistently terribly in others. When I started in this business, high-growth consumer outfits such as Coca-Cola (NYSE:KO) were sprouting entire cities of millionaires. Then it was Cisco (NASDAQ:CSCO) and Sun Microsystems (NASDAQ:SUNW) that you had to be in. Then it was energy and smokestack value.
In the end, it's a wash. So maybe markets are ruthlessly efficient, digesting "information" you only think you possess before you can reach the phone and place an order. Or are they irrational and random, at least over seeable periods? Maybe stock prices -- especially absent dividends -- reflect the whims of irrational investors, reaching some fundamental fair value not instantaneously but never at all.
Or am I so sane you just blew your mind?
I opened today with a nod to Tom Gardner, who I hinted has crushed the market since I began tracking his returns in early 2002. Tom insists this is because he works like a dog -- screening thousands of companies constantly, the best of which he "values." In time, the markets grudgingly "wake up" to the "fairness" of his valuations.
Sounds familar. This is precisely the rap you hear from the herd that covers General Electric (NYSE:GE) and Intel (NASDAQ:INTC). Fundamental analysis based on chats with suppliers and buyers beget earnings projections and, in turn, fair valuations based on expected market multiples confirmed by discounted cash flow analysis. All of which culminates in a one-, two-, or five-year target price.
Right. I suspect that analysts would do as well to simply predict the future stock price and bypass the equally tenuous predictions of future cash flows and the appropriate "price multiple investors will award that cash flow growth." If there is evidence that analysts --or anybody else -- have meaningful skill in predicting any of these things, I haven't seen it.
But this trick just might work
I have another idea. I think that Tom's gang at Hidden Gems is merely digging up great companies with solid management and strong growth prospects. I think their stocks appear "undervalued" simply because people aren't buying them right now. Pros call this a liquidity argument, but it's really just supply and demand.
This happened with builders like Pulte (NYSE:PHM) during the bull market. Did the market for housing subsequently improve? Sure. But did these stocks really leap toward some "fair" valuation or simply run up because they got hot and more and more people wanted to own them? I mean business wasn't bad for the builders when I bought Pulte back in the dog days of 1998.
It's a tricky position, but you could argue that old-line tech growth a la Oracle (NASDAQ:ORCL) is approaching a similar situation today. Or how about the major drug stocks? True, neither group looks as cheap by traditional methods as the old-economy stocks appeared in 1999 -- but neither did those stocks at the time. Hindsight makes the obvious apparent.
Now let's get small
In the case of hidden gems, folks ignore them because they are too small for mutual and pension funds to mess with. If the funds can't mess, the analysts don't cover. If the analysts don't cover, CNBC won't feature. But once these stocks do hit Wall Street's radar, often by way of some small regional research shop and a few smart cookies, their prices tend to spiral higher in a process that feeds on itself.
That's the sweet spot for lackeys like us. We can buy these stocks now, even in odd lots. If management is honest and industrious, the business strong, and conditions ripe, the valuations (I should say the prices) creep higher until the big boys start nibbling and the sell side starts buzzing. We can't know that any of this will happen, but it seems a far sight more sensible than waiting for the market to "wake up" to some equilibrium valuation.
Are you all about the numbers?
Earlier, I promised to demonstrate that Tom has beaten the market fairly consistently. Here goes: Dating back to June 2003, Tom and his team have locked in 46 small-cap picks. Of those, a solid majority -- 30 out of those 46 -- are currently in the money. Taken together, the 46 Hidden Gems picks are up on average 23.6% versus 4.2% for the S&P 500.
Of course, two years is a blink of an eye in investment time, but I don't chalk that up to blind luck (though it is theoretically possible). In fact, as I slog through this column, I grow more convinced that I have identified a root cause: Valuation be damned, these are solid companies with a lot on the ball -- and stocks people are going to want to buy.
The trick is finding them, but it can be done. Still, if that sounds to you like work -- or if you just want to know more about small-cap investing -- Tom is offering a special 30-day free trial. He can probably explain his recent win streak better than I can. Click here to give it a whirl.
Fool writer Paul Elliott promises to keep you posted on Tom Gardner's progress at Motley Fool Hidden Gems. All picks and results are posted on the Hidden Gems website and can be viewed immediately with a 30-day free trial. He owns none of the stocks mentioned. The Motley Fool isinvestors writing for investors.
