William Goldman is not a stock market analyst. He is the screen-writer of Butch Cassidy and the Sundance Kid, Marathon Man, and numerous other well-known motion pictures. William Goldman is also the author of a brilliant and entertaining book, Adventures in the Screen Trade, in which he coined a memorable phrase that summed up everything he’d ever learned about the movie business.
Here it is: “Nobody knows anything.”
What Goldman was saying was that you could take all of the sophisticated market research, all of the experience of studio heads and producers, all of the box office grosses of predecessor films, and all of the marketing savvy of the best distribution people, and throw it all out the window. If all of the widely available information known to everyone in the movie business meant anything, everyone would be making nothing but successful movies—and that sure isn’t happening.
Says Goldman:
•If anybody knew anything, B.J. Thomas’s advisers would not have been so upset after the first sneak preview of Butch Cassidy and the Sundance Kid. After hearing Thomas’s new song, “Raindrops Keep Falling on My Head,” in the context of Butch Cassidy, they were convinced that Thomas had made a potentially fatal career move.
•If anybody knew anything, Raiders of the Lost Arkwould not have been turned down by every studio in town before Paramount decided to make the film.
•If anybody knew anything, Columbia Pictures would not have told Steven Spielberg that it decided not to make E.T., even after the studio spent a million dollars developing the film. (E.T.wound up at Universal.)
•If anybody knew anything, Paramount Pictures would not have offered The Godfatherto 12 directors (all of whom turned it down) before they got around to offering it to Francis Ford Coppola, and they would not have offered the role of Michael Corleone to Robert Redford, Warren Beatty, Ryan O’Neal, Dustin Hoffman, and Martin Sheen before they got around to offering it to Al Pacino.
Now, if you think about it, you can apply William Goldman’s premise to the stock market, but with a slight variation.
In the stock market, when everybody knows everything, nobody knows anything.Overall, the evidence seems to indicate that the stock market, as a whole, is a pretty good “discounting” mechanism that takes into account everything that is knowable at any given time. The more analytical attention that is focused on the market or on a sector of the market or on any given stock, the more “efficient” the market becomes at determining a fair value.
This being the case, I would argue that the only way for an individual investor to get an “edge” on Wall Street is to go off the beaten path and to focus on areas of the market where analytical attention is slim or nonexistent. It also follows that there’s no “edge” to be had in terms of trying to outguess the general market, since virtually every analyst and investor is looking at the same information, which will therefore be pretty well discounted, just as William Goldman’s movie studio executives are all poring over the same current and historical data regarding box office grosses. If all of this “macro” publicly available information meant anything, everyone would be making the right move all of the time—and they’re not. This strongly suggests that the way to hit a home run is to take a left turn when the lemmings are turning right—to take the road less traveled, as it were. The same holds true for large-cap stocks. A1999 study by Peter Schliemann, a money manager formerly with David L. Babson & Co., revealed that stocks with a market capitalization of more than $4 billion had an average of 17 analysts following the company, while stocks with a market cap of less than $100 million had an average of less than one analyst following the company. This means that some of these companies with a market cap under $100 million had no analytical coverage at all.
In terms of large-cap stocks, you can see how efficient the market is and how difficult it is for any investor to get an edge on the competition by the way these stocks react to surprisingly good or bad information. When a widely followed stock trading at $66 misses its earnings estimate, there is no chance for anyone to sell at anywhere near $66. Every analyst in town lowers his or her earnings estimate and downgrades the stock, and your $66 large-cap stock simply opens at $50. That is how the efficient market works with widely followed stocks: Everybody immediately takes the new reality into account and the market adjusts its perception of value instantaneously.
Since everybody expected earnings of, say, $0.60 for the quarter, everybody knew everything—therefore, they knew nothing. Now that everybody knows earnings came in at, say, $0.50, everybody knows everything once again—but they still know nothing since there is no way to take advantage of that information to avoid the stock price decline.
So, when it comes to analyzing the general market or the widely followed big-cap stocks, nobody on Wall Street really knows anything at all— or maybe we should say that nobody really knows anything more than any- body else—or anything really worth knowing.
When you’re looking for an edge in an area of the stock market where everyone else is looking, you’ll find that new business becomes old business pretty darn quickly—usually too quickly to be of any use to an individual investor. By the time you hear any new significant information about the market in general or big-cap stocks, it’s a good bet that it will be old business already, no matter how new it seems to you.
Now, compare this instantaneous reaction to new business in the large-cap stocks to the way the market reacted to Laidlaw’s announcement that it would sell 12 percent of ADT Ltd. to Western Resources for $14 a share. Did ADT immediately jump to $20 or $25 a share based on the likelihood that this move would ultimately lead to a takeover bid? No, it did not. The stock moved up gradually, over time, providing numerous excellent entry points for tuned-in investors.
But if, say, IBM were to reveal that it had been buying shares of Dell Computer in the open market and that it had accumulated a 12 percent stake without talking it over with Dell’s management, what do you think would happen to Dell’s stock price? Most likely, the Wall Street analytical community would immediately take its best guess as to Dell’s potential takeover value and the stock would rise toward that level almost immediately.
This did not happen, as we will learn, with ADT. Nor did it happen with Rexel, Inc., even though the parent company, Rexel S.A., methodically bought shares in the open market, giving off a blatant clue that a takeover bid was on the way. With both of these stocks, investors had plenty of time to accumulate shares prior to the eventual takeover because the stock market was inefficient in pricing their stocks in light of this information.
That is the difference between how the market processes information involving widely followed large-cap stocks and less well-followed small-cap stocks. In fact, you can safely say that the market’s efficiency in processing significant information is directly related to the audience for that information—i.e., whether institutional investors and the analysts who are fighting for their commission business are paying attention will determine how accurately the market reflects new information.
You will find, over time, it is important to spend more time researching individual stocks that are off the beaten path and less time thinking about the overall stock market and the popular stocks of the moment.
Two very important points can be made now: First, if you really want to have an edge in the stock market, you can only gain that edge in terms of individual stocks, where it is sometimes possible to notice information and interpret that information in a way that can give you some unique insight into a particular situation.
In other words, where individual stocks are concerned, the prize goes to those investors who go the extra mile, who do their homework better than everybody else. Sometimes this involves digging deeper for information about the company itself. Other times it involves thinking in terms of cause and effect, where a seemingly unrelated news item in the maze of information released on a daily basis has a connection to a stock you are following. For example, when Brylane’s outside shareholder, Pinault Printemps, began rais- ing its stake in Brylane, I saw a connection to the Rexel takeover bid because Rexel S.A., which bought Rexel, was a subsidiary of Pinault Printemps. But how many investors—or professional analysts—would have known that if they had not lived through the Rexel takeover drama?
So, lesson number one is: Research individual stocks—and smaller stocks, at that—and don’t try to predict the market or compete with every analyst on Wall Street tracking the large-cap stocks. The second lesson is that a lot of valuable public information is available out there that is notreflected in stock prices, especially when you’re dealing with stocks that are not widely followed by the mainstream Wall Street analysts.
So, lesson number two: If you reallywant to get an edge on Wall Street, you should focus your attention on smaller-cap stocks that are not widely followed by analysts and their institutional clients. That is where you are most likely to turn up information and see a connection somewhere that is completely public but that has not been properly reflected in the stock price.
This principle explains why stocks like Rexel, ADT, Brylane, and others could easily have been purchased for months on end at bargain prices even though it was becoming increasingly likely to anyone paying attention that a takeover bid was on the way.
When you start to focus more of your attention on individual stocks and less attention on the general market, you’ll be better able to train yourself to think in new paradigm terms. You will notice a subtle change in the way you perceive the news. You’ll think in terms of cause and effect, and see connections between seemingly unrelated companies and events that others do not notice.
The more you think this way, the more likely you will be able to identify potential “superstocks”—and the less interested you’ll become in the daily blather that passes for stock market analysis.