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'll 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've become pretty much convinced that my purchase of ailing automobile titan General Motors (NYSE:GM) qualifies as one of mine. The company continues to hemorrhage cash and lose market share to foreign competition, yet its reinvigoration seems to be taking place at a snail's pace. It's almost as if the company believed it had all the time in the world, while the gates were crashing all around it. For some reason, the story of Emperor Nero fiddling while Rome burned keeps coming to mind whenever I think of GM. That can't be a good sign.
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 American Funds' Growth Fund of America (FUND:AGTHX). With approximately $80.6 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 the Growth Fund of America 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 retailer Target (NYSE:TGT). At 1.47% of its last reported assets, that's approximately $1.18 billion invested in a single company. For perspective, the fund's position in Target is just about one full week's worth of average trading volume in that stock! Should the fund's managers decide that Target will be the next victim of discount retail juggernaut Wal-Mart (NYSE:WMT), getting rid of its position would be quite difficult. Selling out would be an expensive and time-consuming proposition, and it would certainly cause Target'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 Motley Fool Inside Value) get excited. It was during just such an episode that I bought a stake in employment and income verifier TALX (NASDAQ:TALX) in December 2004, when it was trading at about half its current price (split-adjusted). While its business has continued to perform well, a significant portion of the tremendous return I've received comes simply from the fact that the company's stock had been abandoned to the cellar, trading well below what its fundamentals justified.
Your primary weapon
The most powerful tool in an individual investor's arsenal is a clear understanding of a company's true 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 that it has the potential to provide you with a bonus gain when 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.
Lead analyst Philip Durell uses just such a calculation to make Inside Value's selections. His picks have easily outpaced the market throughout the life of the service. Not only that, but several of his former selections, including long-distance giant MCI and gaming technologies firm GTechHoldings (NYSE:GTK) have since completed or agreed to a buyout. Those buyouts took place at prices considerably greater than the Inside Value discovery price -- a great advantage for subscribers.
That Philip found them first demonstrates the advantage you can have over the Wall Street giants. Their irrational sales can depress a company's stock so far that it becomes a legitimate takeover target. Yet you can buy while they're forced to sell. When someone with deep enough pockets comes along, notices the discount, and buys out the whole firm, it's you, not the funds, who profit. The net result: You end up exploiting their biggest weakness -- the very size that makes them so powerful.
The key to success
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 that 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 on Nov. 4, 2005. It has been updated.
At the time of publication, Fool contributor and Inside Value team memberChuckSalettaowned shares of General Motors. Wal-Mart is an Inside Value pick. The Fool has adisclosure policy.
