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  • How To Beat The Market 0 comments
    Jun 11, 2012 10:00 AM | about stocks: HCI, HCI

    Whenever you hear someone say they have a way to beat the market, your first reaction should be extreme skepticism.

    If someone claims they can beat the market over time, they should have an audited investment record that proves it. If it is not audited, it is not reliable.

    While many people that claim they can beat the market are trying to scam naive people, there are some people that do beat the market by a large margin over time. Warren Buffett is the most well-known, but there are many others.

    The reality is that there are ways to over-perform. However, you not only have to be very skilled at identifying great investments, you also have to know where to look.

    And in addition to knowing where to look, you must have the right temperament. There are many brilliant people that are not good investors because they do not have the right temperament. I know someone that is very wealthy that pulled all of his money out of the market in 2009 near the bottom of the crash and didn't put his money back into the market until a few months ago. The market is up 100% since the bottom of the market in 2009. Having the right temperament is critical.

    Having the right temperament is something you will have to develop on your own. I can, however, offer you places to look for the best opportunities to find mispriced securities-emerging markets, arbitrage, micro caps, out-of-favor companies or industries, and spin-offs.

    Small-caps and micro-caps. There are only 438 large caps in the U.S. but they are probably responsible for 90% of what the financial media talks about. There are 829 mid caps and 931 small caps.

    What are most of the publicly traded stocks though? They are micro-caps. There are 4124 micro caps in the U.S. If you are not looking at micro-caps and small caps you are ignoring 81% of publicly traded stocks in the U.S.

    Large and talented investors like Warren Buffett cannot invest in a company worth $50 million. The first reason is because it is a waste of time investing $5 million when you have $20 billion in cash to invest. The other is because if you invest $5 million into a small company like that, you will drive the share price up because you are creating strong demand for it by accumulating 10% of the company. It might take 3 months to purchase $5 million of stock without driving the share price too high. For this reason, small companies are overlooked by large investors and can become significantly undervalued as a result. (As a side note, Warren Buffett invested mostly in small and mid-caps when he was a young investor and had a hedge fund. He moved to buying bigger companies because he didn't have a choice)

    Emerging markets. Many investors don't look at investing into specific companies in China, S. Korea, Brazil, and India, even though these places have many very strong companies that are growing rapidly. There is certainly greater risk investing in a foreign country because of currency differences, government regulations, different accounting standards, etc. However, there are many great businesses in these countries with ethical management and these businesses occassionally become significantly undervalued.

    Arbitrage is a good way to earn great returns if you don't do it a lot and only take advantage when there is a great opportunity. An arbitrage opportunity just means there is a way to make a profit from a price discrepancy. An example: A company called Homeowners Choice (HCII) has a preferred stock (HCIIP) that is convertible into common stock at any time (1 share preferred converted into 1 share common).

    A few months ago, the preferred stocks was at $10 and the common was at $12, even though the preferred was technically safer and paid a higher dividend. Arbitrageurs could have bought the preferred and sold short the common, earning a 20% return when the prices of the preferred and common converged.

    People in arbitrage usually use leverage to maximize returns. So imagine you had $100,000 and borrowed $100,000. You put $200,000 into HCIIP and sold HCII short. When HCIIP and HCII converge, you get .2 x $200,000 = $40,000. You only had $100,000 of your own cash, so your return was 40%. Not bad for a few weeks worth of work. Even if you didn't use leverage, a 20% return in a few weeks with almost no risk is pretty good.

    Arbitrage is not easy for non-professional investors. It is very time consuming doing the research to find these rare opportunities and timing is everything in arbitrage. I only find about one great arbitrage opportunity a year, so when I do, I load up on it big time.

    Buy a controlling stake. This is what private equity firms do as well as "activist investors". Activist investors buy enough shares to get seats on the board of directors and then force management to make changes, with the goal being improved efficiency and maximized profits. When you are directly involved in management not only does it reduce the risk of your investment, but it increases the potential for you to make changes you feel will maximize returns. Of course, only very large investors can buy controlling stakes.

    Preferred stocks will over-perform in a flat or declining market. If you are getting 8% a year in dividends from a preferred stock, while the stock market is flat or negative, you are going to beat it. Not only are preferred stocks safer, but they are also smart investments for people looking for income in retirement.

    Investing during crashes. I would never recommend trying to time markets, but if there is a panic and the stock market just declined 20% and you have cash sitting around, that would be a great time to find companies to invest into.

    Spin-offs are a way companies try to enhance shareholder value. Imagine you have a company with two lines of business. One is making $1 million a year and the other loses $500,000, so your total income is $500,000.

    You should sell or spin-off the company that loses money and your profits will double. If your profits double, the share price will likely go up a lot too.

    If there was a spin-off, you'd hold the stock in the company with $1 million in profits and sell the stock from the company that loses money.

    Do not diversify. If you are only allowed to invest into one stock every 5 years, you will make darn sure that stock has a very high probability of doing well before you invest.

    If you are only allowed to invest into 3 stocks, you will make sure they are 3 phenomenal opportunities. After that, if someone says you are now allowed to invest into 30 companies, why would you want to? Why put money into your 29th and 30th best idea? Wouldn't it make more sense to put more money into your top 3 ideas?

    Almost everyone on the Forbes 400 list made their money from one company.

    Stocks: HCI, HCI
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