I was recently reviewing some economics textbooks -- don't ask me why -- and I came across something I had read years ago. George Akerlof, a now-famous economist at The University of California at Berkeley, wrote a 1970 paper titled "The Market for Lemons: Quality and Uncertainty and the Market Mechanism." It's fascinating stuff, and I think it has some relevance for Foolish readers.
Akerlof states that buying a stock is a lot like buying a used car. You have two parties to a transaction, the buyer and the seller. The seller knows a lot more about the quality of the car he's trying to unload. He knows he forgot to change the oil a few times when he should have. He's been feeling the brakes get a little soft. And oh, by the way, that was only a small flood he got caught in last year. Do you think our seller starts the conversation by telling the prospective buyer all the things that might be wrong with the car? No way . it's a cream puff!
Akerlof called this phenomenon "asymmetrical information" and proposed that it leads to an unfortunate market characteristic dubbed "adverse selection." In the stock market, more people will sell lemons than they sell cream puffs, just as people tend to keep their good cars and get rid of their bad ones. With so many lemons in the market, pricing mechanisms will be inefficient. This theory and others earned Akerlof the 2001 Nobel Prize in economics.
Examples of hard-to-find, one-sided, or just plain deceptive stock information aren't hard to spot. Enron was the seventh-largest company in the world in terms of market capitalization just before the 2001 revelation of balance sheet "irregularities." The former CFO has pleaded guilty to wire and securities fraud for his role in the accounting scandal. Enron's accounting firm, Arthur Andersen, was convicted in 2002 of obstruction of justice by impeding the Securities and Exchange Commission's investigation. Enron had a market capitalization as high as $77 billion in 2000, but the scandal wiped it out.
Another familiar example is Tyco
And we all remember New York Attorney General Eliot Spitzer's 2003 accusation that 10 Wall Street investment banking firms served up biased research to garner business. Spitzer's charge led to the largest settlement in Wall Street history and a separation of the brokerage firms' retail and investment-banking business.
It doesn't even have to be outright deception -- how about some garden-variety spin? Three weeks ago, a Wal-Mart
So how do intelligent investors sift through this asymmetric information to avoid souring their portfolio with lemon stocks? Let me suggest four approaches to consider.
Leave it to the market
You can choose to invest in ETFs -- exchange-traded funds. They track common indexes such as the S&P 500, the Dow 30, and the Nasdaq 100. You can trade them like stocks, and they have low expense ratios. They're also diversified, delivering performance equal to the index you choose, which over the long haul is likely to equal most investors' achievements.
Leave it to the experts
You could also go the mutual-fund route. Fees are higher than with ETFs, and you should be cautious not to simply look for whichever fund had the best performance last quarter. Here again, you're back to the information problem; studies show that mutual funds tend to revert back to their average price over the short term. Selena Maranjian has also demonstrated that most mutual funds perform worse than the market average. But with care and a little help, you can find several funds with records of excellent long-term returns. Let Selena steer you toward some of the best.
Leave it to the gods
Need I mention Warren Buffett and Charlie Munger, two investors who have proved their ability to deliver investment returns far superior to the market? You can buy stock in their company, Berkshire Hathaway, and hang with these gods from Omaha. The Class-A shares
Learn from the gods
With a little effort, you can learn the stock-selection philosophies that have made Buffett and Munger so successful. Over the years, this dynamic duo has enlightened us mere mortals with a set of specific principles they employ. Here are a few of my favorites:
Consistent Operating History: Buffett believes that companies that have been a leader in the same industry for a long time deliver the best returns. "Severe change and exceptional returns usually don't mix," he said in his 1987 annual report. Wise advice, particularly to investors who get caught up in chasing turnaround situations. He applied this principle in his 1988 purchase of Coco-Cola
Favorable Long-Term Prospects: Buffett distinguishes between commodities and franchises. He avoids commodity businesses, where anyone can produce the same product, and long-term success depends on economies of scale and pricing. He favors companies that offer a unique product or service, with an established edge over potential competitors. He calls it "a moat." His purchase of Moody's
Rational, Candid Management: Buffett despises managers who are not candid with their shareholders and succumb to the "institutional imperative" of imitating others' "safe" behavior. For example, he runs his insurance businesses very differently from the rest of the industry. From 1986 to 1989, underwriting premiums fell by more than 70% at his National Indemnity insurance subsidiary because he refused to follow the industry lead and underwrite unprofitable business. By the way, National Indemnity is doing quite well today. Buffett will invest only in companies with honest management that runs the business in the long-term interest of the shareholders.
Long Investment Horizon: Buffett prefers not to track the performance of his investments every day. Instead, his philosophy is "I never attempt to make money on the stock market; I buy on the assumption that they could close the market the next day and not reopen it for five years." How many of us can say the same thing about our portfolio? He describes his favorite holding period as "forever."
Only you can decide which approach is best for you. But if you choose to learn from the gods, I suggest you join the ranks of Motley Fool Inside Value subscribers. It's not just an investment newsletter, but a network of investors scouting for tomorrow's winning companies, today. Banish lemons from your list of acceptable fruit. You can check it out free for 30 days.
Fool contributor Timothy M.Otte owns shares of Wal-Mart and Berkshire Hathaway. He avoids lemons except for medicinal purposes, but he welcomes comments on his articles. The Fool has a disclosure policy.