ETF Investing Guide: How To Beat the Market

It’s not impossible to beat the market by picking stocks. But to beat the market, you have to think carefully about which areas, in principle, to focus on, and what the implications are for your investment strategy.

The possibility of consistently beating the market through stock picking - known in the money management business as generating “alpha” - is correlated with the level of market inefficiency. If information is freely and widely available, enough investors are interested, and a stock can be easily and cheaply traded, then all known information is rapidly reflected in the stock's price. As a result, there is no opportunity for an investor to obtain unique information and thereby beat the market.

On the other hand, if information is not freely or widely available, a stock is relatively illiquid, or investors are uninterested in a stock and fail to act on the available information, then the potential to outperform the market is greater. Where greater information inefficiencies exist, fundamental analysis that uncovers valuable new information can give the stock-picker a real advantage.

So the key question for would-be stock pickers is: Which areas of the market have the greatest information inefficiencies? Well, the market for large capitalization US stocks is clearly the most efficient. Armies of analysts cover the stocks, numerous hedge funds and mutual funds buy and trade them, and in any case any new and unique information gleaned by an investor may not be material to the company’s business given its size. Not surprisingly, money managers who focus on large cap stocks do not beat the market in aggregate. (More about that when we discuss mutual funds.)

Are there any areas of significant information inefficiency? David Swenson, manager of the Yale endowment and the recognized guru on portfolio management, is relatively pessimistic. In his 2000 book Pioneering Portfolio Management, one of Seeking Alpha's must-read investment books, he states that most securities markets exhibit semi-strong efficiency; namely, that no publicly available information allows generation of risk-adjusted excess returns. “Mispricings,” he writes, “become more prevalent in the less-well-followed small-capitalization and foreign securities markets, with the emerging markets providing the richest set of active management opportunities.” His conclusion? “Only in the emerging markets, which reside at the least efficiently priced end of the continuum, do investors find clear justification for active management.”

I’m more optimistic about information inefficiency in the US stock market than Swenson was when he wrote his book. Here’s the most striking example: since early 2003, the number of stocks covered by Wall Street research is currently in free-fall, reducing the information-efficiency of the market. In February 2003, The Wall Street Journal reported that 58% of NASDAQ-listed stocks were covered by one, or no, Wall Street analysts. Since then, the largest investment banks have continued to reduce the number of research analysts they employ, and have further reduced the number of companies they cover.

What’s causing this? In response to allegations of research bias, the leading investment banks have stopped subsidizing their research departments with investment banking revenues. Research is now funded by revenue from stock trading only. But smaller stocks have low trading volumes, and therefore cannot generate enough trading revenues for the investment banks to justify the cost of research coverage. As a result, the investment banks are dropping coverage of smaller stocks.

At the same time, by late 2002 many small technology and Internet stocks were becoming more interesting from an investor's perspective. After two and a half years of the post-bubble technology recession, many small technology companies reduced their operating expenses to the point where they reached GAAP profitability, or at least generated positive cash flow. And because numerous technology companies raised capital from bubble-IPOs, many of them had strong balance sheets, with ample cash and no debt.

Yet most investors, having been burned by the stock market over the last five years, were unwilling to buy smaller stocks at that time, since they were perceived as riskier than larger stocks. In many cases, small cap tech stocks declined to the point where they are trading below the net cash on the companies’ balance sheets.

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