Is it me, or has it been a while since we trotted out that blindfolded chimp? You know, the little fellow who outwits the typical Wall Street fund manager 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? After all, if the billionaire boys' club can't hack it -- with their computers and inside information -- what chance do we have?
The sad and happy truth
Now, assuming he actually hits a stock with each dart, it's pretty much true. The chimp's unbiased approach (hence, I suppose, the blindfold) keeps him at the market average -- no better, no worse -- which is something most active money managers can't manage. At least not once you deduct their fees and expenses.
That's the bad news. The good news is that it really doesn't matter. Not if you're managing your own portfolio. Not if you use independent sources. Certainly not if you ignore Wall Street research. I know it sounds kooky, but I learned this last lesson while working with Wall Street's institutional "buy side."
Ironic, huh? Now for the really good news ...
can beat the market
Here's how I know. I met Motley Fool co-founder Tom Gardner when he and his brother, David, were launching their first stock newsletter. That was a few years back, and 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 peddling broker data and "analytics" to Wall Street. But, as I said, it was these encounters with the sell-side analysts and buy-side money managers that convinced me that -- lacking real inside information -- you simply 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. Buying Intel
I recall James Cramer calling them the stocks everybody loves. But by constantly rounding up and turning loose the usual suspects, investors sealed their fates. "Pros" made money in the boom years and got creamed in the bad. But they couldn't consistently beat the market -- few ever really outperformed over time, certainly not enough to justify the fees investors (we) paid them.
There's a secret to picking winners
But by the time Tom Gardner started his new small-cap newsletter service, Motley Fool Hidden Gems, I was coming around. Tom had consistently tipped me on stocks like Moody's
Now, granted, the criteria he applied -- and that he still applies at Hidden Gems -- were no secret. The numbers were right there in the financial statements, the tricks passed down to us as finance majors and in books, from Benjamin Graham through Walter Schloss, Bill Miller, and Peter Lynch. The good ones always look 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 screens hundreds of stocks to recommend just two each month, but surely something more than hard work 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 floated the idea and then recommended it 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 -- didn't either. Now that the stock's up more than 400%, 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 have tripled or even doubled in value. Still, as of Feb. 14, 2005, the stocks recommended in Hidden Gems are up on average 38.4%. Compare that with about 12.2% if you'd bought the S&P 500 instead. And that does include more than half a dozen picks that have doubled or more in value.
What this means for you
It takes a lot to convince an efficient market believer like me. But I'm sensing a trend. Mark Hulbert, who watches over the newsletter industry, 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 made a killing on companies like Home Depot
Can I guarantee you'll be a great stock picker?
No. But I can be pretty darn sure you don't want to be relying on Wall Street research. You sure don't want to be shuffling around the week's most actives. Most importantly -- as much as I love to 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 make real money with stocks: to buy where Wall Street isn't looking. If you want to learn more about Tom Gardner's approach to making money with undercovered and undervalued stocks, take him up on a 30-day free trial. To learn more, click here.
This commentary was originally published on Nov. 10, 2004. It has been updated.
Fool writer Paul Elliott owns Moody's and promises to keep you posted on Tom Gardner's progress. All picks and results can be viewed immediately with a 30-day free trial . Home Depot is a Motley Fool Inside Value recommendation. Moody's is a Motley Fool Stock Advisor pick. The Motley Fool isinvestors writing for investors.