The Inefficient Market Reality

Proponents of something called the "Efficient Market Hypothesis" claim that stock prices always reflect all available information about every public company. The logic goes like this:

• No self-interested buyer would be willing to pay more than a company is worth.
  
  
• No self-interested seller would be willing to accept less than a company is worth.
  
  
• Therefore, the only prices at which companies will trade must be fair prices.

In a purely academic context, that theory makes sense. Fortunately, though, there are enough caveats to that claim to allow us mere mortals to profit handsomely in the real world. One of the biggest problems with the hypothesis is known as the "Efficient Market Paradox." You can exploit this paradox to your advantage -- if you know how it works.

Up is down
In essence, the paradox of the Efficient Market Hypothesis is that the hypothesis relies solely on the actions of self-interested buyers and sellers to determine that fair price. If everyone believed that the markets were always efficient, then those same self-interested buyers and sellers would stop wasting resources on trying to determine what a fair price really is. With nobody actively looking to exploit mispriced stocks, whatever efficiency the market does have would be lost.

In other words, the only reason the market may be efficient at all is that there are people out there who are actively looking to make money from those places where the market isn't efficient.

Still with me? Good.

The costs of looking
The problem, though, is that it takes time, money, and research to properly value a company. For your research to be worth its price tag, your investment returns must cover those research costs, and then some. The more you have available to invest, of course, the lower your outperformance needs to be on a percentage basis. If your total research costs are $1,000 per investment, that represents 10% of a $10,000 position, but only 0.1% of a $1,000,000 one. As a result, many institutional investors invest larger chunks of money at a time, to more easily cover their overhead research costs.

To compound the issue further, remember that stock prices are set by the buyers and the sellers of those stocks. If you're an institution looking to invest in $1,000,000 chunks to cover your research costs, you're not going to go anywhere near a microcap company like KMG Chemicals (NASDAQ:KMGB). With about $75,000 of its stock trading hands on any given day, it'd take you nearly three weeks to build your position, and that's if you're willing to monopolize the volume. In so doing, though, your added buying pressure would raise the price of the stock, eating up whatever inefficiency you thought you were exploiting in the first place.

Because of the costs of research and the buyer/seller dynamics that determine price, a whole bunch of research is concentrated in the market's largest companies. After all, with around $1.4 billion worth of ExxonMobil (NYSE:XOM) stock trading hands on an average day, even a $1 million investment is merely a drop in the bucket.

Your edge
With the vast majority of professional time, effort, and valuation research being spent on the biggest companies in the market, those big companies inch ever closer to their theoretically efficient price. On the flip side, though, because so much professional money is focused on the largest companies, fewer people are focused on small companies. As a result, small businesses don't get the constant attention that is absolutely essential to maintaining an efficient price.

This creates an opportunity for you to profit, by scouting out and buying underfollowed and underpriced small stocks. Best of all, this chance is largely available only to people like you, me, and the team at our Motley Fool Hidden Gems small-cap investing service.

This table illustrates the size of the daily dollar-volume disparity between some of the market's megacaps and Select Comfort, one of the Hidden Gems selections that has crushed the overall market.

Flying under the radar
Small businesses such as Select Comfort attract far less attention from the gigantic institutions that dominate Wall Street trading. Not enough dollars trade hands in these companies to let big funds receive the benefits of exploiting any inefficiency that may exist in their prices. Those of us with considerably less to invest, however, are not shut out of small stocks by our size. We can take advantage of the market's inefficient behavior, on a scale that's significant to us, in a way the biggest players cannot.

As an individual investor, I think it's a beautiful thing to watch the little guy triumph. About the only thing that's even more fun is actively taking part in such moves. You can join us to experience the advantage for yourself. If you'd like a sneak peek first to see how it all works, you can try out Hidden Gemsfree for 30 days.

At the time of publication, Fool contributor Chuck Saletta had no direct ownership stake in any of the companies mentioned in this article. 3M is a Motley Fool Inside Value recommendation. The Fool has a disclosure policy.