Here's an observation that should come as no shock: GAAP-based accounting systems are insufficient depictions of business. That comes from Swedish economics professor Fredrik Weissenrieder.
And he's right. You can't determine if a company is a good investment or not based on the raw data presented on the income statement, balance sheet, or statement of cash flows.
Unfortunately, that's all we have to go on.
Yes, I know
Sure, Professor Weissenrieder presents alternative frameworks for economic analysis in his paper. And I agree that they're good ones. Though I think he'd agree that they don't tell the whole story, either.
That's the problem with investing that makes it more art than science. There is no definitive place to look nor definitive number to calculate to determine if a stock is a good investment.
So, beyond a series of lucky guesses, how does anyone regularly make money investing in the market?
I'm getting ahead of myself
Actually, hordes of people make money in the market. That's because the public stock markets are among the greatest creators (and sharers) of wealth ever known. The broader market has returned approximately 10% per year on average for nearly the last century -- an achievement that will turn $10,000 into $1 million every 50 years.
So, that's how every investor can make money in the market: Simply buy an index fund such as Vanguard Total Stock Market (VTSMX) and reap the riches of its major stakes in Microsoft, Wells Fargo (NYSE:WFC), Verizon (NYSE:VZ), Google (NASDAQ:GOOG), et al.
But I should have rephrased my questions. I should have asked: So, beyond a series of lucky guesses, how does anyone regularly find the best stocks on the market?
More money, less time
Incredibly, there is a cadre of investors who have demonstrated the ability to outperform the market for decades. Masters such as Warren Buffett, Carl Icahn, Jim Simons, and David Nierenberg -- who have track records of earning 18% or more annually -- can turn that $10,000 into $1 million in about half the time.
Seriously.
How they do it
While Buffett, Icahn, Simons, Nierenberg, and the rest of the outperformers are different types of investors, there is one skill that unites them -- a skill that you can hone over time.
Moreover, I've heard this skill referenced time and time again when these same investors speak publicly. It's also the skill that Motley Fool Hidden Gems small-cap analysts Tom Gardner and Bill Mann cite when asked how they've each been able to post 61% average returns (against the market's 26% average over the same four-year time period), despite their different investment styles.
What's the skill? Pattern recognition.
Not an anticlimax
In terms of picking outperforming stocks, pattern recognition means being able to frame buying opportunities within past market models. Here's an example. When Tom recommended Buffalo Wild Wings back in June 2004, here's what he saw:
- A committed management team that owned more than 10% of shares.
- A rock-solid balance sheet.
- Rapidly growing owner's earnings.
- Dominant positioning in a niche market.
- Serious growth potential from a small market capitalization.
Since that recommendation, Buffalo Wild Wings is up 225% -- and Tom expects an even brighter future.
Why pattern recognition works
While there were some concerns about B-Wild's franchise model and the effect of rising chicken prices, Tom was able to see the potential in the shares thanks to the pattern that those five traits indicated.
Because what other companies possessed those five traits for early investors? Here are a few: Wal-Mart (NYSE:WMT), TD Ameritrade (NASDAQ:AMTD), and the aforementioned Microsoft.
That's how you can use pattern recognition to help yourself outperform the market. But if you'd like to see the stocks Tom and Bill are finding today, you can do that, too. Just click here to join Hidden Gems free for 30 days. You'll have access to all of our research without any obligation to subscribe.
This article was first published on March 2, 2007. It has been lovingly updated.
Tim Hanson does not own shares of any company mentioned. Microsoft and Wal-Mart are Motley Fool Inside Value recommendations. The Fool's disclosure policy must have been a dance commander.
