Proving Wall Street Wrong

As value investors, we at MotleyFool Inside Value search for companies with the potential to provide superior risk-adjusted returns. In truth, we're the real scofflaws on Wall Street, because we're setting out to do what all the academics claim is an impossible task -- beat the market with less risk. And in spite of the tremendous successes of value investors from Benjamin Graham to Warren Buffett, the Wise on Wall Street keep claiming that the market can't be beat, at least not without taking on immense risk.

As Buffett himself once said, "I'd be a bum on the street with a tin cup if the markets were always efficient." Buffett is among the richest men on the planet; it's pretty obvious what he thinks of just how accurately the market predicts the future. The market can be beat, and the way to beat the market is to catch its mistakes -- to find those proverbial "babies thrown out with the bathwater" and snap them up before the market realizes what it did. At that point, it's only a matter of waiting for the market to realize its mistake, bringing the company's price in line with its true worth.

Why the Street is often wrong
One of the biggest mistakes that Wall Street makes is relying on a single number, called "beta," to account for all the risk involved in a company's stock. Wall Street claims that the higher a company's beta, the higher its risk and potential reward, and that the only way to beat the market is by snapping up higher beta companies and hoping that the market carries their prices upward.

Unfortunately for Wall Street (but fortunately for value investors), beta doesn't really measure risk. All that beta measures is volatility -- movements in price. Beta says nothing about a company's underlying prospects, its financial strength, or its competitive environment. Worst of all, beta is entirely a backward-looking number; it only tracks the company's volatility based on how its stock has moved in the past. That kind of mistaken "past is prologue" thinking allowed the Nasdaq bubble to build up so big, before finally popping in 2000.

The challenge
Believing that the fundamental measure of "risk" that drives much of Wall Street's behavior is just flat-out wrong, last spring I issued myself a challenge. My challenge was to design a portfolio that could do what Wall Street claimed was impossible: to beat the market with less risk, using precisely the measure of risk that the Street uses.

In order to have a chance of succeeding, I not only needed companies that had a beta below 1 (the market beta, by definition), I needed companies that I felt had a decent chance of outperforming the market based on the fundamental strength of the business. In addition to looking for companies with betas below 1, I also looked for those with the following criteria:

• Leaders in their industries
• Significant moats against competition
• History of rising dividends
• Strong dividend coverage
• Solid balance sheet
• A value price -- as defined by having a market price below my intrinsic value estimate

In the end, I came up with a handful of companies that I felt were well-positioned to beat the market, in spite of Wall Street's beta suggesting otherwise. If I turned out to be correct, the strength of the businesses would prevail and the stocks would eventually march upward in response. If I turned out to be wrong, then the low beta in the portfolio would protect the account from losing too much. In my mind, it was a win-win scenario. So, without further delay, I bring you.

The companies and results

*Split-adjusted data.

At inception, this portfolio had a weighted beta of 0.38, well below the market's. Were beta an accurate predictor of the risk and expected return of the companies, this portfolio should have earned significantly less than the index. Instead, its performance has absolutely blown the market out of the water, more than doubling the return of the Spiders, an exchange-traded fund that tracks the S&P 500. Remarkably, it shined in spite of holding Fannie Mae, the government-supported mortgage financier that has been hit hard by an accounting scandal and has recently been forced to cut its dividend. If anything, the Fannie Mae story shows the value of diversification done right. Any company can get hit by the unexpected; investors can protect their overall portfolio by buying a collection of value-priced securities, just in case they catch the next hot potato.

The upshot
While Wall Street is busy looking for the next high-beta, quick-moving company, you, me, and other like-minded value investors can focus on the fundamentals behind the companies we're considering buying. Over the long haul, a company's fundamentals and business prospects dominate its daily gyrations in the stock market. How quickly a company's stock moves has little bearing on where the company will end up. As value investors, we focus on what counts -- the business behind the stock and the true value of the company. With that focus, we can beat the Street, no matter what Wall Street's risk-reward calculations say.

Like the idea of owning companies with the potential to beat the market with less risk? A free 30-day trial to Inside Value, the Fool's own market-beating discount stock discovery service, starts here.

Fool contributor and Inside Value team member Chuck Saletta owns shares in Johnson & Johnson and Bank of America. His wife owns shares in General Growth Properties. The Motley Fool is investors writing for investors.