Three Ways We Can Beat Mr. Market

A subscriber to StockInvestor recently asked me how exactly I plan on managing the Tortoise and Hare to continue to beat the market. I replied that I planned to continue focusing on companies with wide economic moats that will compound in value over time, and then only buy those companies if they trade at significant enough discounts to our estimates of intrinsic value to provide a margin of safety. It's a simple strategy that has served us well. Yet there are a few other ways we can manage our portfolios to maximize returns:

Take Advantage of the Market's Inertia
Newton's first law of motion essentially states that an object in motion will stay in motion unless acted upon by another force. As applied to stocks, it is my experience that equities also carry momentum, for a little while at least.

No, I don't plan on suddenly switching gears to play the "greater fool" game, buying the market's hottest stocks at high valuations and hoping to sell even higher. Quite the opposite. My plan is to take advantage of this momentum when it causes stocks to not reflect the intrinsic value of the underlying businesses they represent.

Usually a stock starts to fall when a company announces some bad news. But then investors start to get concerned about their paper losses, worrying that they perhaps missed something, and the selling continues. This additional selling begets more selling, with everyone fearful they are about to lose big. Momentum and fear have taken over, and the stock price often disconnects from the fundamentals.

When Mr. Market goes into a panic like this, there are often bargains to be found. Although it may not have been a screaming panic, consider  Wrigley . Sure, the company hit a speed bump with its acquisition of some of  Kraft's (KFT) old brands, but was a few pennies in lost (or merely delayed) earnings per share really worth the stock falling by more than $10 per share in 2006? I think not.

I will also look to take advantage of inertia on the upside. When a stock I own starts to rise merely because it has recently risen and then trades well above our estimate of its intrinsic worth, that is when I will consider selling. (Early year 2000, anyone?) One might say I will attempt to take Warren Buffett's advice and be greedy when others are fearful, and fearful when others are greedy.

Inertia not only applies to things in motion, it also applies to things that are stationary. As Newton's law tells us, an object not in motion will remain not in motion, unless acted upon by another force. But in this case, Newton's first law is not always obeyed by Mr. Market, and the only force that matters in the long run is cash flow. Sometimes, the fundamental forces of an improving competitive position and growing profits apply a strong force on a stock, yet the stock does not move. This is a time to buy.

I've described this scenario before as a "pressure-cooker" situation, and at the moment, there appear to be many opportunities of this type. Take  Berkshire Hathaway (BRK.B) and  Wal-Mart (WMT), both of which we currently own in the Tortoise Portfolio. These companies have steadily improved their core businesses and grown their profits in the past couple of years, yet their stocks have a lot of stationary inertia and have not gone much of anywhere in years; Berkshire Hathaway has only recently shown signs of life. In my view, it is only a matter of time before the forces created by the cash flow will be felt and these stocks will rise even further.

Maintain a Long-Term Focus
The stock market today is dominated by a lot of participants who are extremely motivated by and receive incentives based upon their short-term performance. Highly paid hedge fund managers need to show stout monthly or quarterly results, lest their investors put their money elsewhere. Much the same goes for mutual funds. Money generally flows freely into the "hot" funds and away from those that are struggling, even if those struggles are short term in nature only. Moreover, Wall Street analysts largely get scored (and paid) on how well they predict quarterly results, and rarely do they project out more than a year or two.

With all this focus on short-term results, those of us with a long-term focus can take advantage. We don't need to be concerned about what the dollar-rupee spread in India is going to do to  Coca-Cola's (KO) results next quarter, or what the yield curve will do to  J.P. Morgan (JPM) for the rest of the year. In the bigger picture, these types of things tend to even out, and they really do not matter. Being a long-term investor gives us the luxury of focusing on what's really important--how a company's competitive position will allow it to generate cash over the next five, 10, or even 50 years. In other words, we can afford to be penny foolish if we are dollar wise.

Think of it this way--if we were assigned the task of measuring the volume of water in a lake, we would not stand on the shore and worry only about the height and timing of the waves. This is the equivalent of what many market participants do. Rather, we would carefully measure an average depth over a wider space and a longer time. Of course, we should not be afraid to take advantage of the disparity often caused by Mr. Market's over-reaction to the waves' peaks and troughs that inevitably will occur. (See my earlier comments about inertia.)

Realize Not All Earnings Are Created Equal
A dollar is arguably the world's most fungible commodity, freely flowing and easily spent around the world. But I'm here to tell you that if we are to beat the market, we have to realize that not all the cash flows being generated by companies today are created equal. In a nutshell, we should value those businesses that are going to steadily generate cash far into the future over those businesses that are merely "one-hit wonders." A company that creates a dollar in profit today and will create a little more than a dollar in profit tomorrow is worth much more than a company where tomorrow's dollar is in jeopardy.

Back in the mid-1990s, I was invested in a company called Iomega , which created removable Zip disk drives for computers. The Zip drive was a truly revolutionary product that, at the time, was a significant improvement over the floppy disk drives that had been the primary means of storing and transferring data. What's more, it was a classic "razor and blades" business. Sell the razor (the drive) once, and sales of blades (the highly profitable removable discs) effortlessly followed. I spotted the attractiveness of this product early and made some big returns investing in the stock before the profits became evident to the world.

But it was not more than a year or two before competing products and technologies caught up, and Zip was no longer competitive on a price/performance standpoint. The relevance of Zip quickly scaled a wall and then just as quickly fell off a cliff. When was the last time you've seen a Zip drive (that is, if you've ever seen one!)? Iomega had no real follow-up to its hit, so the profits it earned from Zip were purely a flash in the pan. I was fortunate enough to realize the lack of a second act and sold not too far from the top (against the strong opinion of my colleagues at my former firm), but I wish I would have realized this even sooner.

In Morningstar parlance, Iomega had no economic moat, and its profits were not durable over the long term. You can make money owning no-moat firms, as I did with Iomega, but this is often a very dangerous game to play. Had I been just a bit slower in selling Iomega, I could have lost all my profits, and then some. This experience with Iomega etched in my brain the importance of the sustainability of cash flows. So when I own Coke, Wrigley, Berkshire, and every other company in the portfolios, I can rest assured that the cash flows these businesses will produce will have a strong degree of protection from competition and persist far into the future.

Wrapping Up
After losing money in the South Sea Company, the largest financial bubble of his time, Newton said, "I can calculate the movement of stars, but not the madness of men." To be successful in the market, there is no need to figure out exactly when the market will fall (or rise); all you need to do is be able to recognize the extremes and keep your head when everyone else is losing theirs.

Join us as we announce the winner of our CEO of the Year award live on CNBC. Pat Dorsey will announce the winner around 10:45 a.m. EST on Thursday, Jan. 4, 2007.

An expanded version of this article appeared in the July 2006 issue of Morningstar StockInvestor. A version of the article also appeared on Morningstar.com on Oct. 11, 2006.