How anyone can beat the street

Is it possible, through a combination of skill and intuition, to make stock market investment decisions with any confidence of future success? Or are such profits merely the rewards for lucky gamblers?

Some would suggest the apparent impossibility of achieving respectable profits in the current depressed state of world markets. Nonetheless successful fund managers are still highly prized and well rewarded by the financial institutions, whilst investment gurus have amassed personal fortunes by following apparently successful strategies.

But can these strategies be adopted profitably by other investors? Intuition suggests not. If an individual possessed a guaranteed winning formula, it would be irrational to disclose the formula to other investors, since they would then adopt it themselves, thereby claiming their share of the profits.

So when investing, or gambling at the racecourse, don't follow tipsters. If their information is that good, they'll keep it, and the profit, to themselves. More likely their information is worthless. Even if based on evidently sound principles, just because an investment strategy has worked well in the past, doesn't mean it will work in the future.

But if the accumulated knowledge of the financial investment institutions has no value to today's decision-maker, why do their fund managers and analysts command good salaries and performance bonuses? The answer is not that the best-paid professionals earn consistently high returns on their investments over and above their competitors. They do however, earn genuine returns on their research activities.

For the practical and even amateur investor, this is a more relevant perspective. How much time are you prepared to invest researching the market and the shares of the companies that are traded in it?

The more time you spend the greater the likelihood of you making profits. But you are still at a disadvantage vis a vis the financial institutions. They possess powerful computerised financial databases and they are often first to receive price sensitive news releases for the companies themselves. That's an important source of their competitive advantage, and their wealth.

So should the ordinary investor abandon research and return to throwing darts at the financial pages? Not necessarily. Applying the principle of maximising potential return on research time, there are still strategies that are rational to follow. The first point to note is that the majority of institutions spend most of their time researching the large companies. Their funds track the performance of leading stock market indexes, so they have to know about the main index constituents.

If you want to pursue this kind of investment strategy yourself, pay the fund manager a commission to do it for you. They can buy the index cheaper than the ordinary investor can. That's another way they make money. This leaves large numbers of smaller companies relatively under-researched. It is more likely that events affecting these firms will not be detected or will not be detected as quickly be the market.

Also, because their shares are more thinly traded, their quotation may not reflect their real value. All in all, there is greater likelihood of under-priced stocks in a population of small firms compared to big firms, so the probability of picking a bargain is greater.

A related strategy is to pick 'value' stocks. These are shares that have performed poorly in the previous period and therefore command low price/earnings ratios. A common rule of thumb employed by analysts is to compare their percentage growth forecast for the company's earnings to the price/earnings ratio. If higher, the rule says 'buy'. Whether the rule earns good returns is another question.

The ratio of market value to the book value of the firm's assets (M/B) is another way of looking at this phenomenon of 'value' shares. A regularity that has emerged from over a decade of international academic work on world stock markets, including recent analysis conducted by Nottingham University Business School is that low priced shares (with low B/M) tend to earn systematically higher returns in following period. This may be because stock markets over-react to bad news. It may also be because share prices cannot be negative. If they fall so far, there is only one way they can go.

If we consider why a company's share price falls to low levels, there are two possible reasons. One is that the firm's profits have been affected by a cyclical downturn. In which case the price earnings ratio or B/M ratio will not have fallen far relative to the sector average.

On the other hand, the firm's profits might be affected by something highly specific. Examples might be a disastrous acquisitions strategy, poor design and marketing, as illustrated by the recent experiences of Marconi and Marks and Spencer in the UK.

Companies in crisis are worth watching closely. Track their share price downwards as events unfold. To rescue themselves, these companies will usually have to take drastic action. Sales of significant assets, replacement of senior management, re-branding exercises are likely to follow.

These are events that financial markets find difficult to price accurately, because they are one-off, highly specific to circumstances and are often isolated from more general economic trends affecting other shares. It is also likely that as market capitalisation falls, the shares disappear from the portfolios and off the radar screens of the professional institutional analysts.

This is the opportunity for the active researcher looking for evidence of the turnaround in significant news events about the company. Careful timing is crucial and is of course, easier said than done. Companies in this situation are necessarily risky investments. But bankruptcies are bad news and most economies provide safety nets for companies to trade out of crisis situations.

This strategy, like all others cannot guarantee profits and the usual health warnings apply. Repeated tests on large portfolios of low market to book value companies show profits for some years but losses for others. On average, however, there are substantially more winners than there are losers. This conclusion is neither science nor alchemy. The shares are indeed mis-priced, but for rational reasons.