There's a major debate in the world of finance. Is the market efficient or isn't it? Are stocks always accurately priced for their risks or aren't they? Can you beat the market?
The truth is, if you play your cards right, it doesn't really matter. Even the most die-hard adherents to the efficient market theory -- the folks who believe the market always reflects what is known about a company's stock -- admit there are two anomalies. If you learn what those anomalies are and how to take advantage of them, you raise your chances of beating the market.
Small stocks grow faster
The first thing you can use to your advantage is the fact that small stocks tend to outperform their larger brethren. That, my friends, is the small stock anomaly in a nutshell. But if you think about it, it makes perfect sense. Oil juggernaut ExxonMobil
The faster a company grows, the faster its stock can grow. It's easier for a smaller firm to grow at a faster rate, simply because there's more room for it to expand. Consider the case of Motley Fool Hidden Gems selection and real estate marketing company HouseValues
Cheap stocks don't stay that way forever
The other reality that hasn't been fully explained by the efficient market theory is the simple truth that sometimes stocks get priced at a discount. If you can identify and purchase those companies before the market realizes its mistake, you can take advantage of the inevitable rebound as the shares recover. Take fellow Hidden Gems pick and industrial laser provider Rofin-SinarTechnologies
In spite of its small size, Rofin-Sinar has (and has had) an extremely strong financial picture. When it was selected as a Gem in September 2004, it was trading below 15 times its owner earnings -- practically defining the term "value stock. " Sure enough, Rofin-Sinar has soared, more than quintupling the market's return since it was first picked.
For perspective, this chart shows how Rofin-Sinar has left market trackers like the Nasdaq Cubes
It's a win-win
Small companies can become big companies. Cheap businesses can recover their worth. Find a company that is both small and cheap, and you have yourself a bona fide Hidden Gems candidate. Even the intellectuals who think the market is generally smarter than its investors admit that those are the firms with a real chance of ending on top. Fool co-founder Tom Gardner and his team constantly scour the market, uncovering those types of companies for subscribers. The team's picks, on average, have beaten the S&P 500 by more than 23 percentage points since the service's inception just a few years ago.
Even if the market is generally efficient, those two "anomalies " -- small size and value prices -- give Fools the edge. Start your 30-day free trial today and see for yourself just how it's done.
This article was originally published on Jan. 19, 2006. It has been updated.