How to “Beat the Market.”

Warren Buffet, considered by many to be the “greatest investor of all time,” constantly speaks about his investing style.

“Buy wonderful businesses, at a fair price, and hold them forever.” Simple as that.

That was the way I approached investing in 2021. With some savings, I started buying every great company that I could think of. I bought PayPal (NASDAQ: PYPL), on a dip, because I expected them to continue growing. I bought Nvidia (NASDAQ: NVDA) at $290 because I refused to believe it would stay under $300 a share.

I bought Amazon (NASDAQ: AMZN) for $3350, even after former CEO Jeff Bezos stepped down, because it’s bloody Amazon, the largest disruptor in the world. I even bought Disney (NYSE: DIS) because it’s a brand I will share with my children, and hopefully, even my grandchildren.

So how is my portfolio year-to-date?

All of those stocks are down double-digits, with Disney down 20% and PayPal over 30%. Why did this happen? Because I forgot the second rule of the equation.

Buy wonderful businesses, for a fair price, and hold them forever.

-Warren Buffet (paraphrased)

It hit me while I was watching a lecture by the legendary value investor, Monish Pabrai. There are great businesses, and then there are great investments. Amazon, PayPal, Disney and Nvidia are all wonderful businesses, but at the time of purchase, they weren’t great investments (at least not in the short-term).

Hedge fund managers that beat the S&P year-in, and year-out, understand the market dynamic. They buy a stock when the market isn’t paying attention to it, and sell it when it when it becomes the talk of the town.

Take oil stocks for example. Who bought oil stocks when WTI crude dropped into negative territory? And if they did, who kept them as oil when from $0 to $87/barrel. A few, if even. Most people were too busy focusing on overvalued EV stocks.

So, how do you find such great investments?

1. Buy Low, Sell High

The stock market is the culmination of arrogant degenerates trading shares of ownership in a business for cash. They buy when they think they are getting a great deal, and sell when they think they made a spectacular return on their investment.

The market is not dictated by robots, therefore it is left up to interpretation whether a stock is cheap, or overvalued. Like I said above, the market is made up of arrogant degenerates, meaning that there will always been room for mispricing.

The former Fidelity manager, Peter Lynch, looked at the correlation between share price and earnings to determine whether a stock was mispriced. If the share price of a great business fell under 15x TTM earnings, it was a buy.

Apple was a great business, even in 2012. You could’ve bought Apple’s stock at any point between 2012-2017 and made a killing. Alas, if you buy it now at nearly 30x TTM earnings, are you still getting into a great investment? Possibly, but highly unlikely.

The truth is, most of the time you aren’t going to get a great investment with “wonderful businesses,” even if you buy the stock under 15x TTM earnings. That is, unless you hold them “forever.”

You could’ve bought Walmart (NYSE: WMT) at any point between 2010 and 2011, when the company was trading under a 15 PE, and only be getting back a 200% return today. Compare that with the return of Amazon in the same time span, and you would be looking at a 2600% return at the stock’s 52-week high. What PE multiple was Amazon trading at the start of 2010?

65x TTM earnings.

So how do you find mispriced stocks in the modern day stock market?

The best investors look deeper than the top 100 most popular companies to find spectacular returns. They might see a steel manufacturer trading under 2x TTM earnings and think, “hey that stock should be worth much more than that! I’ll hold it for a few years until the market realizes it.”

They look at OEMs, chemical manufacturers, shipping companies and all sorts of obscure stocks that analysts refrain from covering. Most of these nuggets are trading at absurd valuations. These are companies that investors have given up on, yet they are actually great businesses that the market doesn’t understand.

18-year old Johnny is too busy buying Rivian (NASDAQ: RIVN) while Joel Greenblatt is looking at DuPont de Nemours (NYSE: DD).

Alas, If going through hundreds of obscure companies isn’t your cup of tea, there is another method to beat the market.

Hold Forever

It’s December 1999, and you happen to buy the stock of the hot-flying Microsoft Corporation (NASDAQ: MSFT). What happened when you looked at your returns in 2001? You would’ve been down anywhere between 50-60%.

Was Microsoft a terrible business? Obviously, not. Was it a bad investment? At the time, yes.

It would’ve taken you nearly 16 years to break even, but as of writing this, you would currently up 4x your original investment. Not as good as the guy who bought the stock in 2007 and made over a 2000% return, but nonetheless, better than losing it all.

The point is, if you find a great business that happens to be a bad investment, you can just hold it until it becomes a great investment. It may require a serious case of diamond hands, but it will happen. The market always corrects it’s mistakes.

But this only works if you are the average investor. Hedge fund managers don’t typically have a 30-year time horizon. Their customers want returns today. So what else can you do to beat the market?

Current Events

These days, the market works in tandem with current events. Changes in news or politics can affect stock prices, due to changed expectations regarding companies’ future earnings. Investors, such as George Soros or Ray Dalio, make a ton of money playing the swings in economics.

Take for example, the housing boom in late 2020. You could’ve looked at that scenario and say “hm… they’re going to need a lot of wood to build all those new houses.” You could’ve bought some lumber futures, or even homebuilder’s stocks, and made a great investment, especially with such low supply available.

You could’ve even bought Home Depot (NYSE: HD) or Lowe’s (NYSE: LOW) since home-buyers and homebuilders will need supplies. Appliance companies such as Whirlpool (NYSE: WHR) or appliance retailer Best Buy (NYSE: BBY) would’ve been great bets as well for higher earnings.

Maybe you see Turkey’s President say he wants to lower interest rates, amidst 36% inflation for the year. Short the Turkish Lira! Just pick up a newspaper and read what’s going on in the world.

Inflation is up? Buy companies that have the pricing power to raise prices. Interest rates are going to rise? Buy Banks, sell Tech. Just do it before everyone else realizes what’s happening.

To beat the market, you gotta look ahead of the market.

“By the time it’s in the Wall Street Journal, it’s already too late.”

Jordan Belfort, Wolf of Wall Street

In Summation:

If beating the broader market was easy, everyone would do it. Nobody knows which stocks are going to become 100-baggers, or even 2-baggers, but we can buy great businesses when they are undervalued, or trading at a fair price, and hold them forever.