The best of Both Worlds

The Best of Both Worlds
By Chuck Saletta (TMF BigFrog)
February 17, 2006

There's a major debate in the world of finance. Is the market efficient or isn't it? Are stocks always accurately priced for their risks or aren't they? Can the market be beat?

The truth is, if you play your cards right, it doesn't really matter. Even the most die-hard adherents to the "efficient market hypothesis" -- the folks who believe the market always reflects what is known about a company's stock -- admit there are two "anomalies" that can't be fully explained by their theory. If you learn what those anomalies are and how to take advantage of them, you raise your chances of beating the market.

Small stocks grow faster
The first thing that you can use to your advantage is the fact that small stocks tend to outperform their larger brethren. That's the "small stock anomaly" in a nutshell. If you think about that for a minute, it makes perfect sense. Retail titan Wal-Mart (NYSE: WMT) sold more than $305 billion worth of products and services in the trailing 12 reported months. For its business to grow 20% next year, it would need to add more than $61 billion in additional revenue. That's akin to adding a company larger than its formidable competitor Costco (Nasdaq: COST), in less than a year. It's an extremely tough challenge to meet; even Wal-Mart's more optimistic analysts don't think it can grow that quickly.

The faster a company grows, the faster its stock can grow. It's easier for a smaller firm to grow at a faster rate, simply because there's more wide-open room for it to expand. Consider the case of Motley Fool Hidden Gems selection and educational software provider Blackboard (Nasdaq: BBBB). With its $130 million in trailing reported sales, it needs a mere $26 million in additional revenue to grow at a 20% clip over the next year. For a sense of scale, that full year's growth is about as much cash as Wal-Mart takes in during any given forty-five minute period. Small companies can become big companies, and they can grow much faster than their larger counterparts. Shareholders who buy their stake while a successful company is still small can be richly rewarded for their patience during the firm's growing pains.

Cheap stocks don't stay that way forever
The other reality that hasn't been fully explained by the efficient market theory is the simple truth that sometimes stocks get priced at a discount to their true worth. If you can identify and purchase those companies before the market realizes its mistake, you can take advantage of the inevitable rebound as the shares recover. Take fellow Hidden Gems pick United Fire & Casualty (Nasdaq: UFCS). A smaller player in the insurance industry, it's easily dwarfed by giants such as Allstate (NYSE: ALL) and State Farm.

In spite of its small size, United Fire & Casualty has an extremely strong financial picture, albeit one that was largely ignored by Wall Street. It practically defined the term "value stock," trading at about twice the cash on its balance sheet when it was selected for the newsletter. Sure enough, United Fire & Casualty has rebounded, more than doubling the market's return since it was first picked a little under a year ago.

For perspective, this chart shows how United Fire & Casualty has recently left formerly overhyped and overpriced companies -- such as technology solutions provider CMGI (Nasdaq: CMGI) and Baidu.com (Nasdaq: BIDU), the company often hyped as China's answer to Google -- in the dust. Imagine that, a company in the simple business of helping folks get back on their feet following a disaster that radically outperforms high-tech wizards in the market.

You win either way
Small companies can become big companies. Cheap businesses recover their worth. Find a company that is both small and cheap, and you have yourself a bona fide Hidden Gems candidate. Even the intellectuals who think the market is generally smarter than its investors admit that those are exactly the types of firms with a real chance of ending up on top. Fool co-founder Tom Gardner and his team constantly scour the market, uncovering just those kinds of companies for subscribers. The result is evident in the quality of their product. Their picks, on average, have beaten the S&P 500 by more than 26 percentage points since the service's inception two and a half years ago.

Even if the market is generally efficient, those two "anomalies" -- small size and value prices -- give Fools the edge. If you'd like to join us, click here to start your 30-day free trial and see for yourself just how it's done.

Costco is a Motley Fool Stock Advisor pick. This article was originally published on Jan. 19, 2006. It has been updated.