The No. 3 Key to Beating the Market

Doc's note: "Beating the market is a three-step process," says Rob Spivey, director of research at our corporate affiliate Altimetry.

Today, Rob explains the three steps you should take before picking an investment and why step No. 3 is the most critical...

Putnam Investments' research office was the stuff of legends...

In the late 1990s, Putnam's Boston-based office was famous among investors for a massive sign near its research stables. At the top of the sign, it said, "We Invest in Change."

Below that was a list of "changes" it deemed buy signals. The list included changes in management, products, regulations, and any other factors the market might be missing.

Investors liked this way of thinking... and poured money into Putnam's funds. Its assets under management grew an average of 29% per year from 1991 to 1999, reaching more than $400 billion.

And its success stemmed from its ability to understand one crucial tenet... that business models aren't as black and white as they seem.

Bad businesses that find ways to beat expectations can be amazing investments. And great businesses can become so highly valued that they'll never meet expectations.

Today, I'll take a closer look at the most important stock-picking ingredients... and how Putnam used one of them to grow like crazy.

Beating the market is a three-step process...

When picking a stock, you first have to ask yourself...

1. What does the market expect this company to do?

This is just another way of saying you need to look at valuations. The price-to-earnings (P/E) ratio, which measures stock price versus earnings per share, is a basic way to value a company.

The second question has two parts...

2. Can the company do something different from what the market expects? And why am I confident about this?

This step requires you to question the market. For instance, after looking at a company's valuation, you might realize investors' growth estimates are a lot lower than yours.

But it's the third and final question that Putnam mastered... and it's the one investors tend to struggle with the most.

3. What is going to change to make the market realize it's wrong?

One critical change can send your investment on a one-way trip higher. Without this catalyst, you're playing a waiting game that can take years... if it ever happens at all.

Change is responsible for one of our all-time greatest hits...

Online real estate manager eXp World (EXPI) offers a virtual solution for real estate brokers to interact with clients and manage their businesses.

Investors thought eXp would never take off. But then the pandemic hit... one of the biggest changes we've seen in decades. Suddenly, homebuying demand surged, and folks were looking for virtual ways to enter the housing market.

Those virtual platforms became far more popular... and so did eXp stock.

We recommended eXp to our Microcap Confidential subscribers in July 2020. In a little more than a month, it doubled. By February 2021, subscribers who followed our advice were up 860%.

And it was all because the market scrambled to embrace a key change in the business environment...

We were so successful with eXp because we embraced what Putnam knew – one of the most powerful ways to invest is by observing change.

The market is largely efficient...

Investors do a good job of understanding what a company is worth right now, if it keeps doing what it's doing. Most of the time, they've priced in any data that's already out there.

But let's say a business is looking to stave off bankruptcy by restructuring or refinancing... and investors expected it to go under. If it succeeds, anyone who was paying attention could make a lot of money.

It doesn't mean the company is great. It was simply priced to go bankrupt... and then it didn't.

You're investing in the idea behind the change – not necessarily the idea behind the business. If you can't find that key catalyst in an investment, you might as well pass on it. The market might never realize it's wrong.

What you're looking for can come in many forms, whether it's change in management... change in business strategy... change in capital structure... change in macro trends... change in competition... or change in customers and vendors.

But no matter what it is, when you see something big brewing, that's when you should pay attention.

Because that's when the market will start to pay attention, too.


Rob Spivey

Editor's note: Right now, you might be tempted to follow the old adage, "Sell in May and go away." But our good friend Joel Litman says that if you have a brokerage account and a calendar, you have the chance to double your money on regular stocks by June 28 – simply by buying and holding. Click here for all the details.