The stock market is an inherently adversarial place. For every share bought, there's a share sold. In each trade, there are two people, with largely the same data, coming to completely contradictory conclusions about the exact same company. Think about that the next time you're buying a few shares of a company. Those shares are available to you only because the person on the other side of your trade decided that your cold, hard cash was worth more than that stock. Ask yourself what that person knows that you don't.
The fact is, one of you is wrong. That means, of course, that half of all trades are the wrong ones to make. Sure, we all make mistakes from time to time. For instance, I'm the one who suggested that my wife pick up shares in real estate mortgage company MFA Mortgage Investments (NYSE:MFA) almost exactly when the lending environment started to really get nasty. Sure -- there will always be people buying homes and taking out mortgages, but no company is immune from the external market realities affecting its business. The company simply has succumbed to the ugly yield curve that has affected the entire industry.
If you want to beat the market, you have to understand that when you buy, you're buying because someone else is willing to sell to you at that price, and when you sell, you're selling to someone who's willing to buy from you at that price. Otherwise, you'll likely find yourself going up against people who are not only aware of that fact, but have also taken the appropriate steps to tilt the odds in their favor (that is, against you). In the exchange of money for shares, one side ends up with the better end of the deal every time.
One of the largest actively managed mutual funds is Fidelity's Magellan (FUND:FMAGX). With some $51.2 billion in assets under management, you'd better believe that there are some well-educated, highly informed people on its payroll looking to take whatever legal advantage they can find. If you're not careful, you can easily end up on the losing end of a Wall Street deal. If you want a shot at beating these folks, however, you need to know what makes them tick and what their weaknesses are.
The professionals' Achilles heel
Despite their size and market power, these giant funds have some easily exploited weaknesses that we mere mortals can use to our advantage. Their largest weakness is the fact that these huge funds can't make a move without making an impact on a stock. For example, one of Magellan's largest holdings is insurance giant American International Group (NYSE:AIG). At 2.89% of its last reported assets, that's approximately $1.48 billion invested in a single company! For perspective, the fund's position in AIG is more than three full days' worth of average trading volume in that stock. Should the fund's managers decide that its prospects look poor due to lingering effects of the insurance scandal that hit both AIG and insurance broker Marsh & McLennan (NYSE:MMC), getting rid of the position would be quite difficult. Selling out would be an expensive and time-consuming proposition, and it would certainly cause AIG's stock to drop.
To add fuel to the fire, if one fund finds a reason to sell a company, in all likelihood others will as well, making the exodus that much larger and more pronounced. There sits one of your advantages as an investor. When large funds make the decision to sell, they can depress a company's price far below any reasonable measure of its worth. When tremendous sell-offs like that happen, value investors (like those of us at Motley Fool Inside Value) get excited. It was during just such a scandal driven sell-off that Inside Value Advisor/Analyst Philip Durell recommended money market and mutual fund manager Federated Investors (NYSE:FII). Revelations that the company had been allowing privileged investors to profit by trading mutual fund shares after the official cut-off time had absolutely battered the company's stock.
While the news was bad, it certainly wasn't fatal, in spite of the stampeding herd running away from the shares. That mass exodus knocked Federated's stock well below its true value, allowing Philip to snap up the beaten-down shares as they were poised to rebound. Federated is up around 33.7% since being recommended last March, compared to an approximately 6.3% move for S&P 500 index trackers like the Spyders (AMEX:SPY). That shows just how well you as an individual can do by digging around the market's dumpster for companies that the big funds have thrown away.
Your primary weapon
The most powerful tool in an individual investor's arsenal is a clear understanding of what a company is really worth. We call that "intrinsic value;" it's a measure of the expected earning capacity of the business over time. When a company is trading below that true worth, it's a sign that it is undervalued, and that it has the potential to provide you with a bonus gain when the company not only grows over time but also takes the one-time leap back up to its fair price. In order to determine that value, there's a bit of math involved in a process known as a discounted cash flow (DCF) calculation.
To simplify the number-crunching, Inside Value has an online DCF calculator available here (for subscribers only). If you're not yet on board, click here to start your 30-day free trial and take advantage of both the calculator and the Inside Value team, which is standing by, ready to help you with your analysis. Philip Durell uses just such a tool to dig up market-beating picks like Federated. His selections have easily outpaced the market throughout the life of the service. That success shows the power you can have over the giants of Wall Street by exploiting their biggest weakness -- the very size that makes them so powerful.
The Foolish bottom line
At the end of the day, half of all trades turn out to be mistakes. If you want to minimize the number of mistakes you make in your investing, you have to keep a firm grasp on what a company you're considering is really worth. Keep that valuation first and foremost in your mind, and you'll master a key weapon that you can use to not only take on the market's largest sharks, but also beat them over time.
This article originally ran on Nov. 4, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta had no individual ownership stake in any of the companies mentioned in this article, though his wife owns shares of MFA Mortgage Investments. The Fool has a disclosure policy.
