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 that 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 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. Software titan Microsoft (NASDAQ:MSFT) sold more than $41 billion worth of products and services in the past 12 reported months. For its business to grow 20% during the next 12 months, it would need to add more than $8.2 billion in revenue. That's akin to Microsoft having more revenue growth than Google (NASDAQ:GOOG) has total revenue. It's an extremely tough challenge to meet; even Microsoft's more optimistic analysts don't think it can sustain growth at that rate.
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 biotechnology pioneer Flamel Technologies (NASDAQ:FLML). With its $23.6 million in trailing reported sales, it needs a mere $4.7 million in additional revenue to grow at a 20% clip over the next year. For a sense of scale, that full year's growth is about as much cash as Microsoft collects in an hour. Small companies can become big companies, and they can grow much faster than their larger counterparts. Shareholders who buy a stake while a successful company is still small can be richly rewarded for their patience during the firm's growing pains.
Cheap stocks don't stay that way forever
The other reality that the efficient-market theory hasn't fully explained is the simple truth that sometimes stocks get priced at a discount to their true worth. 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 Portfolio Recovery Associates (NASDAQ:PRAA), a debt collector. Wall Street had discarded this company, a member of an ugly and unpopular business line that, ironically, had seen its own share of bankruptcies. At the time it was selected, its shares traded at an amazingly low 11 times free cash flow -- that practically defines the term "value stock." Sure enough, Portfolio Recovery has soared, just about quintupling the return in S&P 500 index trackers like the SPDRs (AMEX:SPY) since it was picked.
For perspective, this chart shows how Portfolio Recovery has left formerly overhyped and overpriced companies like online travel purveyors Travelzoo (NASDAQ:TZOO) and Sabre Holdings (NYSE:TSG) in the dust. Imagine that -- a company in the rough and old-fashioned business of debt collection dramatically outperforming firms once touted as providing the next big thing in travel. It shows the power you can get by buying the right company at a value price.
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 to uncover those types of companies for subscribers. The team's picks, on average, have beaten the S&P 500 by more than 28 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.
At the time of publication, Fool contributor Chuck Saletta owned shares of Microsoft, a Motley Fool Inside Value recommendation. The Fool has adisclosure policy.
