The Game is Rigged... But In Your Favor

by David Eller

Can you get an edge over the analysts on Wall Street?

Peter Lynch thinks so. In his book One Up On Wall Street, he devotes the introduction and the second chapter to highlighting the advantages an individual investor has over professional investors. Two constraints really handicap the pros, and you can take advantage of them: Group Thinking and Timing Constraints.

Professional investors have people looking over their shoulders on a daily basis. If the risk manager, director of research, peers, or key investors don’t understand a position, they have to take time to defend their choices. This takes a lot of time and energy from someone who would rather be on the golf course. Rather than finding a small, but growing company that’s creating a new market, why not just direct investment dollars to stocks that are growing faster than the S&P?

In 2001 as a young analyst, I was working for a tech-focused hedge fund. I remember pitching the idea of a search company called Overture, which was relatively unheard of at the time. The idea was so exciting... I met the company’s CEO at a conference and walked away believing that revenue growth would be much greater than people believed.

Unfortunately, the paid search industry was so new, people didn’t understand the opportunity.

I discussed the idea with our portfolio manager, but the upside was so dramatic, that as a newbie, I couldn't get him to believe it. I was literally screamed at for not knowing how to model the company properly. There were no specific errors, but the numbers were just so far from consensus that I must be wrong.

My numbers turned out to be too low and the stock price exploded. Overture went on to beat expectations in future quarters and we still didn't buy it because we missed the early trade. Eventually, Overture was bought by Yahoo! (Nasdaq: YHOO) and became the basis for its paid search business. I made nothing on the trade and was yelled at a second time for not being convincing enough.

So from then on, instead of going out on a limb, I took the politically correct, safe route. In 2002, when internet opportunities were exploding, I was pitching ideas like PeopleSoft and Siebel. Big, slow-moving companies that a former hardware analyst (my portfolio manager) understood and was comfortable with. I went on to collect a pretty decent paycheck while producing mediocre investment ideas that were safe.

This might be the most embarrassing period of my professional life – but I wanted to share it because this happens every day.

Companies like Amazon (Nasdaq: AMZN), Citrix Systems (Nasdaq: CTXS) and MicroStrategy have been periodically misunderstood and offer huge opportunities to people who understand their businesses. These are no longer fringe companies, as each has traded up 10 times since 2002.

Hedge funds are paid a percentage of the assets they manage. This is what they live on. A firm holding $500 million of investors’ money will likely have $10 million in upfront fees. This is a strong incentive to keep the lights on and not rock the boat.

But opportunity is out there, even in a down market. If you have insight into the adoption of electric vehicles – for instance, Tesla Motors (Nasdaq: TSLA) – or new payment methods – such as eBay’s (Nasdaq: EBAY) PayPal – or social media tools like Facebook (NYSE: FB), you might be close to finding your next 10-bagger.

Rather than run into the crowd, you can look for the outliers.

Where were you when people began chucking their Blackberries for iPhones? Apple (Nasdaq: AAPL) used to be one of these outliers and savvy consumers picked up the stock while many professional investors rode Research in Motion (Nasdaq: RIMM) down from $130.

Finding niche companies is one method to build a high-growth portfolio if you have the time and experience. However, you can still trade in the S&P names and expect a decent return if you don't have time constraints. This is a huge advantage to individual investors over the pros.

Mid- and large-cap stocks rarely disappear because there’s an established market for the company's product. It may miss earnings because of cyclicality, overspending, or a product failure, but management (if it’s any good) will change the structure of the company to make earnings grow again.

Stocks like Google (Nasdaq: GOOG) and Chipotle Mexican Grill (NYSE: CMG) have been decimated recently, but there will be a time to buy them. And it’s likely going to be when all of the professional investors have been scared out! The pros just can’t take the time to let the company rebound if they want those big bonuses! As an individual investor who may be investing for retirement, you have the luxury of time.

Wait for a fat pitch. This may be your biggest advantage. You don’t have to invest. You don’t have three strikes before you’re out. Professionals do. You can wait until the idea is so obvious that if professional investors won’t buy the stock, a competitor will.

Let the professionals play their games. If you stick to the fundamentals and invest in cheap companies that are growing, it’s likely the stock prices will go up. Either the professionals will come in and buy shares or a competitor will buy the whole company.

Avoid group think when selecting stocks, but if you do like a widely known, expensive company, wait for the professionals to be forced to sell. It may take time, but time is on your side.

Good Investing,

David

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