Wednesday, February 8, 2012

How to Beat the Market? Avoid It.

If I challenged you to take on Tiger Woods, how would you beat him? You may think I’m asking an idiotic question, but in actuality there is some great value to be learned here. The fact is Tiger is beatable and I know how to beat him: by not playing him in golf.

As long as you take on the world’s best golfer in anything but golf, odds are you stand a good chance of winning. Think about this idea for a moment with respect to the stock market and investing. Your best chance of beating the market is by avoiding it. Let me explain.

Today’s market environment is dominated by institutional money collectively managing trillions of dollars. These large funds demand equity research, analyst estimates, and other investment decision related needs. These services are gladly provided by the hundreds of equity research firms and investment banks who exist solely to cater to these needs.

Because these investment funds are dealing with large pools of capital, they are looking for places to allocate tens of millions if not hundreds of millions of dollars in a relatively short amount of time. As a result, the vast majority of investment capital is playing in the same sandbox. And that sandbox is filled with larger cap companies that most are familiar with. There is nothing wrong with this approach; in fact by default it’s the only approach to follow if you are part of a large pool of investment capital.

Luckily for the individual investor or smaller account (sub $200 - $300 million), you don’t have to play in this sandbox. In fact, in most cases you should try to avoid it because chances are that you will have no edge over the other players. In other words, there is a higher degree of efficiency when you have more participants.

Of course when an opportunity like the financial crisis of 2008 leads to a market wide sell off and everything is on sale, that’s a different story. When you can buy a company like Apple for $90 in the midst of a market panic as you could have two years ago, you pull the trigger quickly. Or when Whole Foods (WFMI) was trading for under $10 a share in late 2008 after having earned $1.30 in 2007, you didn’t need to think hard about the value proposition. But those opportunities don’t come along so often.

Today, financials offer the same home-run type opportunities but will likely take a little longer to play out. I would argue that Bank of America (BAC) for those investors with a 2-3 horizon will profit handsomely at today's current valuation. 

There is ample opportunity, however, where the big boys can't look. A $10 billion investmetn fund is not going to be spending a lot of time looking at companies with market caps below $500 million. And as a result, most analysts who service them aren't looking there either.

Don’t make investing harder than it already is. Leave the big boys to fight over the big fish while you focus on the easy pickings of the smaller and potentially more lucrative opportunities. Happy hunting!

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