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 let my opportunity to pick up shares of Advance America (NYSE:AEA) -- for mere pennies on the dollar -- slip through my fingers. I read about the company when it was picked for Motley Fool Inside Value, and I was intrigued. It dropped a bit after being selected, and I had my eye on it as it flirted with its lows around $12 a stub. Rather than happily buying what was clearly a bargain, I got greedy and hoped for $11.50. That price never materialized. So, as a result, I got shut out of what turned out to be an approximately 28% gain in just about six months.
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 Fidelity Low-Priced Stock (FUND:FLPSX). With nearly $40 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 Fidelity Low-Priced Stock 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 homebuilding giant DR Horton (NYSE:DHI). At 2.97% of its last reported assets, that's approximately $1.15 billion invested in a single company. For perspective, the fund's position in DR Horton is more than 14 full days' worth of average trading volume in that stock! Should the fund's managers decide that DR Horton's prospects as an investment look poor because of a nationwide slowdown in the housing market, getting rid of the position would be difficult. Selling out would be an expensive and time-consuming proposition, and it would certainly cause DR Horton'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 to you, the individual 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 Inside Value) get excited. It was during just such a sell-off that Inside Value Advisor/Analyst Philip Durell recommended used-car superstore CarMax (NYSE:KMX).
The tremendous difficulties facing carmakers Ford (NYSE:F) and General Motors led them to offer some of the largest incentive discounts in their history. As a result of consumers taking advantage of things like employee pricing, the number of used cars absolutely skyrocketed. That sent fears of depressed selling prices for used car dealers like CarMax and archrival AutoNation (NYSE:AN). That fear drove down CarMax's stock below its true worth.
Yet Philip saw the value in its strong, cash-generating assets, and he was confident that its no haggle, fair-price business model would have long-term staying power. As a result, he was able to suggest that subscribers buy CarMax before its shares rocketed upward. And rocket they have -- up some 25% in a period where the S&P 500 only gained 3%. 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 service 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's selections have 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. If you want to minimize the number of those mistakes that belong to you, 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.
This article was originally published Nov. 4, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team memberChuckSalettaowned shares of General Motors. The Fool has adisclosure policy.
