4 Ways to Outperform the Stock Market
Interested in throwing your hat into the ring and starting to invest in stocks? We share four important tips to outperforming the stock market.
1. Buy Stocks With Low Price-to-Book Ratios
Companies with price-to-book ratios in the bottom 10 percent of the market have consistently outperformed stocks with price-to-book ratios in the top 10 percent of the market.
The reason for this excess return is that investors consistently underrate the ability of poorly performing companies to turn it around, and consistently overrate the ability of companies with high expectations to meet those expectations.
If an investor is disciplined enough to buy companies that appear to be on the verge of death, and the investor diversifies among many such companies, the investor has a good chance to outperform the market in the long run.
If the investor also has the ability to short stocks, the investor can build on this long-term trend by building long-term short positions in companies with high price-to-book ratios; this can sometimes be accomplished in the options market. However, investors who short stocks are reminded of the old saying that the market can remain irrational longer than you can remain solvent.
2. Find Motivated Sellers
Another way to achieve superior long-term performance in stocks is to buy stocks from motivated sellers. Motivated sellers are sellers who are driven to sell stocks for reasons other than the underlying fundamentals of the business.
For instance, if a stock is removed from a widely held index, many index funds and institutional investors will have to sell the stock without regard for the fundamentals of the underlying business. As a result, the supply of stock available can sometimes greatly exceed demand. A shrewd investor can purchase such stocks for less than the intrinsic or long-term value of the stocks.
Another example of motivated sellers are spin-off opportunities, particularly where a relatively small company is spun off from a much larger one. Again, many institutional investors will be required by their strategy to sell the spun-off shares, and this could create a buying opportunity.
3. Don't Overpay for Growth
One of the biggest, and easiest, mistakes to make is overpaying for growth. Growth brings investors hope of greater profits for future periods, and investors generally are given to overpaying for growth. It is easy to fall into this trap because of group-think; everyone seems to be hyping and buying a company's shares. And, at least for a while, everybody seems to be making money on them.
Most investors have heard that “This time is different,” but believing that this time is different and paying now for years of growth in the future is bound to be painful.
When considering a stock with high levels of hype, take the current stock price and the current earnings and use a discounted cash-flow analysis to calculate what the market is pricing for growth for the next 5 or 10 years. It is not uncommon to see the market implicitly expecting 20 percent annual earnings growth for 10 years or more in high-priced stocks. Yet such growth has rarely if ever been achieved by a publicly held company.
Avoiding mistakes is key to outperforming the stock market, and overpaying for growth is perhaps the most common mistake made by investors.
4. Don't Panic, Don't be Greedy—Have a Plan
One major source of underperformance is an inability of investors to buy or avoid selling in a panic, and to sell or avoid buying in a bubble. However, superior stock market performance is not possible without at least sometimes moving against the market.
It's easy for investors to let emotion get the better of them and to fall prey to excesses of greed or fear. One way to avoid this pitfall is for the investor to make an advance plan to buy stocks when they fall below a certain point and to sell stocks when they rise above a certain point, and to implement the plan. This allows an investor to consider and coolly think through buying and selling decisions without having to make them in the heat of a market panic or the heady greed that prevails in a bubble.
By avoiding market group-think, the investor can succeed or fail on the merits of his or her own analysis, instead of rushing along with the crowd and guaranteeing poor performance.
