Is it me, or has it been a while since we trotted out that blindfolded chimp? You know, the little fellow who outperforms the experts 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 that 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 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 at the market average -- no better, no worse -- which is something most money managers can't manage. At least not once you deduct their fees.
The good news is that it just 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. It sounds kooky, but I confirmed this myself while working with Wall Street's institutional "buy side."
Now for the really good news ...
How I know you
can
beat the market
When I met Fool co-founder Tom Gardner, he and his brother David were launching their first newsletter in a decade. I admit I was skeptical. Should this guy really be charging 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 to Wall Street. And my run-ins with the sell-side analysts and buy-side managers convinced me that -- lacking real inside information -- you simply cannot beat the market picking individual stocks.
I'd watched too many crash and burn. These were seemingly rational folks rotating in and out of the same old plays. Back then, there were two camps: The hotshots scalping Qualcomm (NASDAQ:QCOM) and Ciena (NASDAQ:CIEN) in telecom, pausing to dabble in CMGI (NASDAQ:CMGI) for a little "Net" excitement.
In the other corner, you had the conservative, "so 1995" crowd -- haggling over old-line tech like Microsoft (NASDAQ:MSFT) and Oracle (NASDAQ:ORCL). Or waxing even more nostalgic with IBM (NYSE:IBM) and Xerox (NYSE:XRX). Who could have guessed they'd all go down the same drain?
It turns out that by constantly rounding up and turning loose the usual suspects, they all sealed their fates. Most made money in the boom years and got creamed in the bad. But they almost never beat the market -- few ever really outperformed over the long haul. Certainly, not enough to justify the fees and bonuses (we) investors paid them.
There had to be a better way!
For all that, it looked as though Tom Gardner really could pick stocks. He was consistently pointing me to companies like Moody's, which has more than doubled since I added it to my IRA. And to my surprise, he was doing it using good old-fashioned legwork and bottom-up fundamental analysis. So, by the time he launched his small-cap newsletter, Motley Fool Hidden Gems, I was really coming around.
Even more surprising, the criteria Tom was applying were no secret to Wall Street. They'd been passed down to us as finance majors and in books, from Benjamin Graham through Bill Miller and Peter Lynch. Smart investors 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.
But, surely, something set Tom's 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 solid. But the markets are efficient, I thought; surely anybody could see what Tom saw.
So, I ran the name on Multex and Bloomberg, even First Call. Nothing. The sell-side analysts didn't care, so the 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 300%, guess who's been sniffing around? Wall Street.
Of course, you know better than to draw conclusions from a few examples. And not all of Tom's Hidden Gems picks have tripled -- or even doubled. Still, as of June 20, the 60-plus stocks recommended in Hidden Gems are up 27.0% on average, many times better than the 7.9% turned in by the S&P 500. And, yes, the recent sell-off has created some remarkable bargains.
What this means for you
Even Mark Hulbert, the investment newsletter-industry watchdog, admits 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. I'll keep you posted.
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 stocks like Home Depot and Gap long before they were followed on Wall Street. Some of his biggest winners weren't all that common even on Main Street.
He knew that 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 that they (4) are often run by founders with large personal stakes in the business.
Can I
guarantee
you'll become a great stock picker?
No. But I'm 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, either. 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. And that is to steer clear of the beaten path and buy where Wall Street isn't looking. You can do it. But you need to get your hands on some solid, objective research.
Why not do what I did and put Tom Gardner's secret to finding underfollowed stocks with solid fundamentals and real earnings to work for you? In fact, you can test-drive Tom's complete Hidden Gems service for 30 days right now without spending a cent (of course, there is never any pressure to subscribe). To find out more, click here.
This article 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 at Hidden Gems. All picks and results are posted on the Hidden Gems websiteand can be viewed the instant you sign up. Moody's and Gap are Stock Advisor recommendations. Home Depot, Microsoft, and Gap are Inside Value picks. The Motley Fool isinvestors writing for investors.
