The next time you're buying a few shares of a company, think about the following: For every share bought, there's a share sold. Makes sense on the surface. But dig a little deeper and you realize that the shares you're buying are available to you only because the person on the other side of the trade decided that your cash was worth more than that stock. What does that person know that you don't?
Let's start with what we do know. The stock market is an inherently adversarial place. In each trade, there are two people -- with largely the same data -- coming to completely contradictory conclusions about the exact same company. You can't both be right. That means half of all trades are the wrong trades to make.
Take a deep breath. We all make mistakes from time to time. For instance, I picked up shares in mortgage REIT AnnalyMortgage Management (NYSE:NLY) almost precisely when the lending environment started to 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 business. The company simply fell victim to the ugly -- and industry wide -- yield curve.
If you want to beat the market, you have to know what you're doing. Sounds simple enough, right? There are people -- and companies -- who want to make things hard on you, the investor. They have taken the appropriate steps to tilt the odds in their favor (that is, against you).
The Achilles heel
One of the largest actively managed mutual funds is the Dodge & Cox Stock Fund (FUND:DODGX). With some $46.35 billion in assets under management, you'd better believe that there are some well-educated, highly informed people on its payroll looking for any legal advantage they can find. If you're not careful, you can easily wind up on the losing end of a Wall Street deal. If you want a shot at beating these folks, however, you need to know their weaknesses -- know what makes them tick.
Despite their size and market power, funds such as Dodge & Cox have some weaknesses we mere mortals can exploit. For instance, these huge funds can't make a move without having an effect on a stock. One of the fund's largest holdings is computing giant Hewlett-Packard (NYSE:HPQ). At 3.62% of its last reported assets, that's approximately $1.68 billion invested in a single company. For perspective, the fund's position in Hewlett-Packard is nearly four full days' worth of average trading volume in that stock. Should the fund's managers decide that Hewlett-Packard's prospects as an investment look poor because it's being sandwiched by powerhouses IBM (NYSE:IBM) on the technology consulting side and Dell (NASDAQ:DELL) on the computing side, getting rid of the position would be difficult. Selling out would be an expensive and time-consuming proposition, and it would certainly cause Hewlett-Packard's stock to drop.
To add fuel to the fire, if one fund finds a reason to sell a company, others will as well -- making the exodus that much larger and more pronounced. Advantage, 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 sell-off that Inside Value Advisor/Analyst Philip Durell recommended rent-to-own company Rent-A-Center (NASDAQ:RCII). An expensive expansion and store refresh program had depressed the company's earnings, sending its shares into the cellar.
Yet Philip saw the value in its strong, cash-generating assets, and he believed that its restructuring program would have the potential to turn around its ailing business. Philip uncovered it between the time the restructuring was announced and when its results began to show. As a result, he was able to suggest that subscribers buy Rent-A-Center before its shares rocketed upwards. And rocket they have -- up some 48% since the company was picked in October. That shows how well you can do by digging around the market's Dumpster for companies 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" -- a measure of the expected earning capacity of the business over time. A company trading below that true worth indicates that the firm is undervalued and has the potential to provide you with a bonus gain when it grows and takes the one-time leap back 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, the 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 the calculator and the entire Inside Value team, which is ready to help you with your analysis. Philip Durell uses a similar calculator to dig up market-beaters such as Rent-A-Center. His selections have easily outpaced the market throughout the life of the service, thus demonstrating the power you can have over the Wall Street giants by exploiting their biggest weakness -- the very size that makes them so powerful.
The Foolish bottom line
The big takeaway here is that half of all trades turn out to be mistakes. But there's hope. If you want to minimize the number of mistakes you make while investing, keep a firm grasp on a company's real worth. Keep that valuation first and foremost in your mind, and you'll master a key weapon you can use to catch and beat the market's biggest players.
Are you ready to take on the largest players in the fund world and have a good shot of actually winning? A good way to start is to subscribe today. We'll send you a free copy of the Fool's International Stock Report: Around the World in 80 Minutes.
This article was originally published Nov. 4, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team memberChuck Salettaowned shares of Annaly Mortgage Management, an Income Investor recommendation. Dell is a recommendation of both Inside Value and Stock Advisor.The Fool has adisclosure policy.
