Personal Investors
managing their own portfolio looking for greater than market returns, while willing to take on additional risk and increase their time involvement during the investment
process.
Summary Points to Take Away
* Invest in companies with the greatest potential for a share price that widely differs from the actual share price value (i.e. the imperfect betting line).
* Follows the similar understanding alongside the economics theory of abnormal profits, which is, the more competitors the lower probability of beating your competition and earning profits above market (i.e. abnormal returns).
* Look for new, small cap (capitalization below $300 million) and boring stocks as a starting point for investment opportunities with abnormal earnings potential.
Analysis
Most personal investors and those within the investment community focus on companies which are popular and easy to research (i.e. lots of info and easy to analyze). Given that stock prices are made up of the actions of the investment public (and under the assumption that investors are rationale) – the more individuals following a stock, the more likely the stock price will move with the real value of the company.
This theory is based on the economics theory of how firms earn excess profits (i.e. those above similar businesses facing similar risks, etc.). In areas where barriers of entry are low, abnormal profits will be eliminated by competitors moving in till the point abnormal earnings go to zero. The only way to sustain abnormal profits is to create barriers of entry to prevent the entry of competitors from reducing the opportunity for earnings above market.
The point to draw from this is the more players the lower the chance of making abnormal profits. So in theory investors who are following large companies such as Google (ticker: goog) are competing with thousands of other investors; thus, making it very difficult for the average investor to earn abnormal profits due to the number of players in this game. If the investor were to switch the focus to a new small cap company – competition is significantly lower; thus, abnormal profits are possible, which will be eliminated with more players beginning to follow the stock raising the stock price to the benefit of those investors who seeked it out while it was small and the competition from other investors was less.
Peter Lynch (famed author of “One up on Wall street” and “Beating the Street”) has a similar philosophy where one of the factors he examines when reviewing an investment opportunity is obtain an understanding of how many analysts are following the stock in question. The less competing analysts the better the opportunity to beat the market. Once the stock gets discovered, analysts make a recommendation on it, which causes institutional clients to buy up the outstanding float; thus, brining the share price in line to the real price; thus, earning an abnormal return for investors who sought out this opportunity prior to its discovery.
Typical companies that have the largest probability of having the share price differ from their real value are the following: new companies, small capitalization stocks (<$300 Million) and those companies that are boring to the investing public. For example, some would argue that solar energy companies are given a higher value than waste management companies because cutting edge energy technology is more interesting to an investor than collecting garbage.
Where to go from here?
Overall theme is to play in the area with the largest potential for the imperfect betting line (i.e. largest difference between stock price and actual price). If you’re going to make a bet, you want to make it in a stock where the investment public is the least informed about, which provides an opportunity for the average investor to get an edge. This requires greater tolerance for risk as small, undiscovered companies could face lengthy situations where the share price is not moving in the same direction of the fundamentals of the business. Investors going with this approach will need to have a strong stomach. The other point to keep in mind is information is likely less available and harder to analyze; thus, requiring more time from the investor as compared to following a standard blue chip stock.
Simon Giannakis is the founder and creator of www.THATSTOCKGUY.NET. He currently is a Senior Accountant within the Assurance and Advisory group at Deloitte & Touche LLP in Toronto, Ontario. He has a BBA degree from Wilfrid Laurier University and is currently pursuing both CA and CFA designations. Simon can be contacted through thatstockguy.net@gmail.com.
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