I never attempt to make money on the stock market. I buy on the assumption that they could close the market the next day and not reopen it for five years. — Warren Buffett
Can you beat the stock market? Many investors don’t think so. They feel any attempt to do so is a waste of their time — or, worse, a sure way to lose money. Their thinking is one of resignation; you can’t beat the market, so why try? Generally, those who subscribe to this idea do so out of unschooled or unsophisticated thinking.
But there exists a more sophisticated version of this thinking — one based on a theory known as “the efficient market hypothesis.”
Proponents of the efficient market hypothesis base their belief on what they feel is a carefully worked-out theory, rather than a pessimistic outlook. The theory states that markets are “efficient” since stock prices are already set through publicly-known information, making it impossible to improve on average returns on a risk-adjusted basis. For a rough analogy, picture a poker game in which players expose all cards face up on the table. No one player has the advantage — any possible game, in this example, was over before it begun.
If you’re looking to generate 40% to 400% investment returns, you’re going to have to wear work shoes.
Sounds reasonable, doesn’t it? Well, not quite. The problem with the efficient market hypothesis is that the market isn’t always as efficient and pristine as the theoreticians would have you believe. During the infamous Black Monday in 1987, the Dow declined by over 20% in one day. There were specific reasons for the decline, but one thing is clear: many stocks fell below their fair value on that single day.
Further indication of fallibility in the efficient market hypothesis can be seen in the spectacular success over many years of Warren Buffett’s holding company, Berkshire Hathaway. Buffett and his longtime investment guru and vice chairman, Charlie Munger, didn’t build an equity empire by throwing darts at a tavern dartboard littered with the names of companies. They exhaustively sought out and studied undervalued companies according to guidelines Buffett learned from his mentor and teacher, Benjamin Graham, “the father of security analysis and value investing.”
Graham’s core principle was to buy a stock beneath its ostensible value for cents on the dollar. Graham’s theory — better to say Graham’s practice, actually — gave rise to the concept of value investing. The concept of value investing flies in the face of the efficient market hypothesis. Here’s why: a true value investor works very hard to uncover information that’s not readily available to the general public, and that therefore doesn’t serve to adjust a company’s stock price according to market conditions.
You can make the argument that in the age of Internet information and professional market analysts, it’s virtually impossible for information about any public company to go undiscovered. Look at this way though. The number of companies listed on U.S. exchanges rose to 5008 at the end of 2013.
No matter how many young stock market wizards call Wall Street home, that’s one helluva lot of companies for them to have to keep track of.
The good news is that once you avoid all the tips, hype, and glitzy IPOs, and once you develop some personal criteria for what constitutes a good company, you can do very well. Warren Buffett himself counsels investors to remain “within their circle of competence.” He uses Berkshire Hathaway’s purchase of Gillette stock as a prime example.
“Gillette is an example of a great business. Shaving has been around forever. Men are always growing beards, and they don’t switch brands very much. The shaving industry isn’t going to change a lot in the future. It is a very comfortable feeling to imagine two-and-a-half billion males growing beard while you sleep.”
In a way, Buffett’s example is unfair, since Gillette was a well-known company when he bought the stock. Still, he bought the stock at a price he knew was undervalued by the market.
Can you discover the next Gillette? Probably not. It’s kind of difficult to locate a fledgling company that will soon turn out a product that will be used by two-and-a-half billion consumers. But you can come up with a range of criteria according to which you evaluate companies.
For example, in their book Value Investing in Growth Companies, authors Rusmin Ang and Victor “That’s not a typo” Chng set themselves the task of investing in companies that had grown by 15% in each of the last five years.
They give themselves other marching orders too: “understand the power of compound interest,” “be a long-term investor,” “never leverage to invest in the long run,” and “know the competition.”
The challenge of investing in companies hidden from the public eye is that you have to dig, and dig deep. You might have to make calls or visit companies, and ask hard questions. Author Peter Richiutti says it all in the title of a book similar to the one written by Ang and Chng. He says you have to look “under rocks.”
Visiting companies, making phone calls, and looking under rocks are not everyone’s cup of tea. But if you’re looking to do what Ang and Chng suggest in the subtitle of their book — “generate 40% to 400% investment returns” — you’re going to have to wear work shoes. Tips on trends from brokers, colleagues and the financial press won’t help you. They’ll serve only to distract you from a more disciplined approach. In fact, they could lose you money.
But if the work entailed in discovering undervalued growth companies isn’t for you, not to worry. Invest in a few rental properties, sock away some gold coins, and buy a few index funds. These are perfectly respectable options for the conservative investor who has better things to do than to look for companies under rocks.