Boy, it's been a while since we trotted out that blindfolded chimp with the darts. You know, the little guy who routinely outwits the typical Wall Street money manager by throwing daggers 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
It's pretty much true. The chimp's unbiased approach (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 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. Though counterintuitive, this last distinction is one I confirmed myself while working daily with Wall Street's institutional "buy side."
Ironic, huh? Now for the really good news ...
You
can beat the market -- like this
I met Motley Fool co-founder Tom Gardner when he and his brother David launched Motley Fool Stock Advisor, their first advisory newsletter in nearly a decade. That was a few years back, and I admit I was skeptical. Should this guy really be charging subscribers for his research? I mean, could a Shakespeare nut in a Fool cap really pick stocks?
Fat chance. I'd spent years working for a peddler of broker data and "analytics" to Wall Street. And here's the irony: My interaction with the sell-side analysts and their buy-side money manager clients convinced me that -- lacking real inside information -- you simply cannot beat the market picking individual stocks.
Remember the nifty 50? How in the 1960s, you "couldn't go wrong" buying IBM
That was the 1990s, when Wall Street cranked it up a notch. Itchin' to swap Juniper
But how many people really outperformed? In fact, by constantly rounding up and turning loose the usual suspects, investors sealed their fates. Those that didn't overtrade did OK in the boom years but got creamed in the bad. But few ever really outperformed. Certainly not enough to justify the fees that investors (we) paid them.
The secret to picking winners
By the time Tom started his new small-cap newsletter service, Motley Fool Hidden Gems, I was coming around. Tom was consistently picking stocks that were outperforming the market. 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. It was all right there in the financial statements -- the "secrets" passed down to us from Benjamin 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 true, Tom Gardner picks over a hundred stocks each month and has great instincts, but surely something set his 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!
How to find a winner
Tiny Middleby makes ovens -- commercial ovens, of all things. When Tom floated the idea and then recommended it in Hidden Gems last November, the business and financials looked solid. But the markets are efficient, I thought; surely, anybody could 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 research (gasp! too often with soft dollars) -- didn't, either. Now that the stock's up more than 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 Nov. 15, they are up on average more than 28.3%. Compare that with about 10% if you'd bought the Standard & Poor's 500 instead.
What this all 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 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 throw their 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 made a killing on stocks that were followed on Main Street but not Wall Street. Some of his biggest winners weren't all that common even on Main. Here's my point: 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 (4) are 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 I am pretty darn sure you don't want to be relying on Wall Street research. You don't want to be shuffling around the week's most actives, or buying yesterday'sCapstone Turbine
In a choppy market like this, there's one way I know to make real money with stocks: Buy where Wall Street isn't looking. If you want to learn more about Tom Gardner's approach to finding undercovered and undervalued small-cap stocks, you can take a special, 30-day free trial.
This commentary was originally published on Nov. 10, 2004. It has been updated.
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. Paul owns none of the stocks mentioned. The Motley Fool isinvestors writing for investors.
