Wall Street is a tremendous pressure-cooker, with billions of dollars changing hands every single day. Most of that money is managed by institutions -- organizations that invest other people's money. Largely because of that, Wall Street runs by a set of unwritten rules that are different from the ones we follow as individual investors. If you know these rules, you can exploit their weaknesses for your personal advantage -- and end up ahead.
Better yet, the way these unwritten rules work in practice, the less time you spend trying to beat the market, the better your chances become. Of course, market-beating investing is not an entirely passive business. You will have to tend your portfolio like a gardener. There will often be weeds to pull and excessive growth to cut back. In general, though, planting the right seeds and simply letting nature take its course is the best way to long-term success.
Unwritten rule No. 1: The short term is all that matters
Institutional investors' biggest problem is that they're managing other people's money. Ultimately, those other people control the purse strings, and they can yank their cash out if the institution fails to live up to their expectations. As a result, Wall Street institutions live and die by their benchmarks against their respective indices and peers.
The reason is simple. If a mutual fund falls behind those benchmarks, money starts to flow out of the fund. If too much money cashes out, the fund could be forced to sell its positions, often at inopportune times. Selling stock at the wrong time often worsens underperformance, which leads to even more investor redemptions. It's a vicious cycle, and it's one of the primary reasons why so many gigantic funds like American Century Ultra (FUND:TWCUX) have managed to trail the market over the long haul.
Because of their excessive focus on short-term results, these institutions tend to panic-sell whenever the news is even remotely bad. Take Acusphere's (NASDAQ:ACUS) recent test report on its flagship compound AI-700. In spite of a largely positive result, the company's stock was pummeled on the news, down nearly 29% in the next trading session. Why? While the test results were pretty good, they were less than the utter perfection the market had expected.
This result added sufficient near-term uncertainty to the product's prospects, despite its still-legitimate potential for long-term success. Yet in typical Wall Street fashion, a setback that affects next quarter's numbers matters more than preparing to compete and survive 10 years from now. As such, Acusphere's stock got hammered -- and hard.
How you can exploit it
Because the institutions focus so heavily on the short term, any weakness in a company's results or outlook triggers an exodus from its shares. Fortunately for you, that round of selling gives you the opportunity to absolutely crush the market. When a stock drops quickly, there's a very good chance that it will fall below what it's really worth. As an individual investor not bound by the short-term time frame, you can then buy it on sale. From that point, you simply wait for the panic to subside and for the stock to return to its fair value, giving you some extra returns for your patience.
This is precisely the strategy we employ at Motley Fool Inside Value, and it's exactly why lead analyst Philip Durell's picks have outperformed the S&P 500 index over the life of the service. We even have an online cash flow calculator available here (for subscribers only -- if you're not yet on board, click here to start a 30-day free trial) that will help you calculate a company's true value.
It's also why the Inside Value portfolio contains companies such as home-improvement titan Home Depot (NYSE:HD). Archrival Lowe's (NYSE:LOW) has recently been cleaning Home Depot's clock on a few key metrics, driving fear into the hearts of Home Depot's Wall Street investors. Yet these two firms have a history of learning from each other's successes over time. If and when Home Depot regains its footing, the panic sale should end, rewarding investors who held through the rough patch.
Unwritten rule No. 2: Too much of a good thing is bad
While underperforming its index and its peers causes too much money to leave a fund, doing too well can cause the opposite problem. Believe it or not, in the mutual fund world, there is such a thing as having too much money. Remember all the money pulled out of the funds that underperformed? For the most part, it gets immediately reinvested -- in the funds that recently outperformed their benchmarks or peers.
So why is this bad? For the most part, cash handed to a mutual fund must be invested. After all, would you pay someone 1% of your money every year to have it sit in a savings account at your local bank? Of course not! So these same funds that panic-sell on bad news are forced to buy even more stocks if they're doing well. And which companies do they buy? Ones that have done well, of course -- stocks they already own that have strong recent price-performance numbers.
Your edge
Just as panic-selling can cause a stock to drop below its true value, too much buying can cause it to rise far above that worth. By using that same Inside Value calculator, you can not only tell when a company may be underpriced and worth buying, but you can also tell when it's likely overpriced and in need of being pruned.
That sort of calculation led me to recently sell my stake in specialty foods and ethanol company MGP Ingredients (NASDAQ:MGPI), because the company had simply run up past my estimate of its worth. I may have missed the absolute peak with my sale, but I sleep well knowing I received more than the company's operations were worth. Likewise, you probably would not have been able to sell fiber-optic company Corning (NYSE:GLW) at precisely its Nasdaq-bubble peak. You could, however, have used such a calculator to notice that its shares had reached uncomfortably lofty prices compared to their worth.
With a clear understanding of that fair value, you could have comfortably sold during its several-month run-up before the crash. There was no need to hurry, and no need to spend every waking minute watching the market. In fact, by spending less time following the stock, it would have been far easier for you to take that objective stance and determine that it was time to sell.
The Foolish bottom line
It's quite possible to beat Wall Street if you understand its unwritten rules and learn to exploit their weaknesses. Best of all, because those rules focus on short-term price moves rather than long-run value, you need not be a market junkie. Instead, you can crush the market in your spare time -- with long-term thinking and the power of value.
Do you like the idea of investing to beat the market without spending every minute of every day following stock movements? Subscribe to Inside Value today to start your journey.
This article was originally published on Feb. 2, 2006. It has been updated.
At the time of publication, Fool contributor and Inside Value team memberChuckSalettaowned shares in Lowe's. Home Depot is an Inside Value recommendation. The Fool has adisclosure policy.
