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 differ from the ones we individual investors follow. 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 expectations. As a result, Wall Street institutions live and die by their relative performance against their indexes 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 Fidelity Magellan (FUND:FMAGX) lost the position it once held as the largest mutual fund.
Because of their excessive focus on short-term results, these institutions tend to panic-sell whenever the news is even remotely bad. Take the case of Amerco (NASDAQ:UHAL), the parent company of U-Haul, and its recent earnings miss. While its per-share earnings came in below expectations, they were substantially higher than last year's levels. Since last year's comparable quarter included a huge refinancing charge, Wall Street had expected this year's number to be even higher than the 63% gain it turned out to be. As a result, after the company posted earnings, its shares fell as much as 25% from where they were immediately before the announcement. The stock got hit -- hard.
Likewise, semiconductor titan Intel (NASDAQ:INTC) has been facing significant pain as of late. Its slowness in deploying the newest processor lines, combined with a summertime price war with archrival Advanced Micro Devices, has thrown the company for a loop. Earnings have been disappointing, and near-term guidance looks scary, knocking its shares well into the cellar.
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 its true 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; when the stock returns to its fair value, you'll gain some extra returns for your patience.
This is precisely the strategy we employ at Motley Fool Inside Value, and it's why lead analyst Philip Durell's picks have outperformed the S&P 500 over the life of the service. We even have an online cash flow calculator available here (if you're not yet a subscriber, 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 not only contains Intel but also sports companies such as mortgage giant Fannie Mae (NYSE:FNM). The company's derivatives accounting problem and subsequent need to restate earnings caused its shares to absolutely implode. Yet the core business remains solid, and once the books are straightened out, its shares should recover, giving a nice boost to those who held on through the rough patch. We individuals are rarely quick enough to get out of a stock before an institutional panic sale. We can, however, be patient enough to outwait Wall Street's short-term focus and profit from the inevitable rebounds.
Unwritten rule No. 2: Too much of a good thing is bad
While underperforming its index and 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! 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
That sort of calculation led me to sell specialty chemical company KMG Chemicals (NASDAQ:KMGB) early last year, at a price that was more than 30% above its recent valuation of $7.72 per stub. I missed the absolute peak, but I sold for well more than the business was really worth at the time. Likewise, you probably would not have been able to sell business intelligence software firm MicroStrategy (NASDAQ:MSTR) at precisely its Nasdaq-bubble peak. You could, however, have used such a cash flow 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 of Intel. The Fool has adisclosure policy.
