Is it me, or has it been a while since we trotted out that blindfolded chimp? You know, the little fellow who outperforms the big guns on Wall Street by throwing darts at a newspaper stock table. Cute story. But is it true?
And if it is true, why? Or should I say how? And where does this leave a bunch of Joe and Josephine Odd Lots like us? I mean, if the billionaire boys' club can't hack it -- with all their computers and contacts -- what chance do we have of beating that pesky chimp?
The sad and happy truth
Now, assuming he hits a stock with every dart, it's pretty much true. The chimp's lack of bias (hence, I suppose, the blindfold) keeps him spot-on the market average -- no better, no worse -- which is something most active money managers can't seem to manage. At least not once you deduct the cost of their town cars and vacation homes.
That's the bad news. The good news is that it really doesn't matter. Not if you're managing your own stock portfolio. Not if you use independent sources. Certainly not if you ignore Wall Street research. As kooky as it sounds, this last distinction is one I confirmed myself while working daily with Wall Street's institutional "buy side."
Ironic, huh? Now for the good news ...
You
can beat the market -- here's how
I met Motley Fool co-founder Tom Gardner when he and his brother David were launching their first newsletter. I admit I was skeptical. Should this guy really be charging for stock research? I mean, could a Shakespeare nut in a Fool cap really pick stocks?
Fat chance. I'd spent the previous five years peddling data and "analytics" to Wall Street. And here's the irony: It was my encounters with the sell-side analysts and buy-side money managers that convinced me that -- lacking inside information -- you cannot beat the market picking individual stocks.
I'd seen too many try and fail -- folks who were every bit as smart as I was -- rotating into and out of the same old plays. Swapping Microsoft (NASDAQ:MSFT) for Apple (NASDAQ:AAPL) in tech. Back then, you had to own General Electric (NYSE:GE), but you also held Nortel (NYSE:NT) and Lucent (NYSE:LU), names you don't hear much lately.
James Cramer called them the stocks everybody loves. By constantly rounding up and turning loose the usual suspects, investors sealed their fates. Most "pros" made money in the boom years and got creamed in the bad. But they couldn't beat the market over the long haul -- few ever really outperformed, certainly not enough to justify the fees investors (we) paid them.
The secret to picking winners
By the time Tom Gardner started his new small-cap newsletter service, Motley Fool Hidden Gems, I was coming around. Tom had consistently pointed me to stocks like Moody's, which has doubled since I stashed it in my Roth IRA. And to my surprise, he was doing it using good old-fashioned legwork and bottom-up fundamental analysis.
Now granted, the criteria he applied were no secret to Wall Street. The numbers were right there in the financial statements. They'd been passed down to us as finance majors and in books, from Ben Graham through Walter Schloss, Bill Miller, and Peter Lynch. They were the true masters, but we were all looking for:
- Solid management with significant stakes.
- Great, sustainable businesses.
- Dominant positions in niche markets.
- Sturdy (if not sterling) balance sheets.
- Strong free cash flow.
And while Tom and his gang screen hundreds of stocks each month, surely something set this performance apart from the market pros I'd known. Turns out it was two somethings: (1) Tom wasn't jumping into and out of stocks, sectors, or markets, and (2) I hadn't heard of most of the stocks he was recommending. Eureka!
Anatomy of a winner
Little Middleby makes ovens -- commercial ovens, of all things. When Tom recommended the stock in Hidden Gems in November 2003, the business and financials looked great. But the markets are at least somewhat efficient, I thought; surely anybody could easily see what Tom and I saw.
But here's the catch. I ran the name on Multex and Bloomberg, even First Call. Nothing. The sell-side analysts didn't care, so the buy-side money managers -- the guys who really move the markets and who buy the sell-side research (gasp! too often with soft dollars) -- didn't either. Now that the stock's up nearly 300%, guess who's sniffing around? Wall Street.
I know better than to draw conclusions from a few examples. And not all of Tom's picks are three- or even two-baggers. Still, as of Oct. 19, 2005, the 50-plus stocks recommended in Hidden Gems are up on average 21.4%. Compare that with just 5% if you'd bought the S&P instead.
What this means for you
It takes a lot to convince an efficient market nut like me. But I'm sensing a trend. Mark Hulbert, who watches the newsletter industry like a hawk, offers evidence that some guys (and gals) can pick stocks. But this Hidden Gems deal I'm seeing with my own eyes. Whether it's up or down from here, I'll be watching. Rest assured, I'll keep you posted.
Until then, I opened with Peter Lynch -- and the chimp -- for a reason. Unlike your typical Wall Streeter, both fellows throw darts at any stock on the board. Market cap too small? No such thing. No Wall Street coverage? Bring it on. No convoluted relationship with big investment banks? All the better. Never heard of it? Bingo!
That's how Lynch beat Wall Street and got the jump on companies like Gap (NYSE:GPS) and Home Depot (NYSE:HD). The point being, companies that can reasonably rise five, 10, or even 20 times or more in value (1) are small but growing, (2) are well-run, and (3) operate in great industries. To which I'd add, they are (4) often run by founders with large personal stakes in the business.
What you can do now
Can I guarantee you can become a great stock picker? No. But you sure don't want to be relying on Wall Street research. Or shuffling around the week's most actives. You certainly want to be buying yesterday's top percent gainer. Most importantly -- as much as I knock the market pros -- you don't want to be taking the other side of their trades.
In a choppy market like this, there's only one way I know to consistently make money with stocks: to buy where Wall Street isn't looking. If you want to learn more about Tom Gardner's approach to finding undercovered, undervalued stocks with strong fundamentals and real earnings, Tom is offering a special 30-day free trial. Click here to learn more.
This article was originally published on Nov. 10, 2004. It has been updated.
Fool writer Paul Elliott owns shares of Moody's and 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. Moody's and Gap are Motley Fool Stock Advisor recommendations. Home Depot is a Motley Fool Inside Value recommendation. The Motley Fool isinvestors writing for investors.
