There's Hope for the Little Guy

 | Jan 13, 2012 | 2:30 PM EST
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The other day a reader left a comment on one of my columns, lamenting that I did not hold out much hope for small traders and investors. I didn't mean to create that impression at all. There's a lot of hope for small traders and investors -- providing they are willing to do the work.

My intent was to paint a picture of what the markets are like today and outline what not to do as an investor. To find success in the market, you can't do what everyone else is doing. You have to think differently and learn to profit by doing the opposite of what the large pools of money that dominate financial markets are doing.

Let's look at stock trading. The little bit that I do is arbitrage-related selling of options (with a value flavor) and using puts to create short positions on overvalued stocks. If I were to engage in short-term trading, the first thing I would do is take a refresher course in higher math with an emphasis on statistics and probability, or hire a math whiz. The vast majority of successful traders I know rely heavily on this type of market analysis.

Given the enormous amount of money being channeled into exchange-traded funds and other index products, I would focus on building models devoted to the mean reversion of index components and dispersion trading. A large amount of money flowing into these products regardless of component valuation has to create mean reversions of the components that can be exploited by traders. Adjusting for index weightings and other factors is a daunting task. But if it was easy, everyone would be doing it. Trading success does not come from an off-the-shelf product. It takes original thought and lots of hard work.

If index-valuation components occasionally get out of line and forced back to the mean by money flows, options on the underlying components would be subject to the same pricing mechanisms. If I were interested in shorter-term trading, I would have option-dispersion models to spot the volatility and pricing anomalies in an attempt to benefit from the eventual correction and re-pricing. Again, if it was easy, we'd all be rich.

To succeed you have to think differently and find ways to exploit what the larger pools of trading capital are doing in the marketplace.

The key for a long-term investor is to avoid distortions caused by large pools of capital in search of non-existent alpha and edges. Doing the same thing and owning the same stocks as every large institution or hedge fund is not going to yield results much different from the averages. This is true no matter which approach you use to invest in the market.

In my experience, all successful long-term investing is based on either value or momentum strategies. I have written more than once about how avoiding over-owned stocks in the major indices improves value investing. But does it work for momentum-based trades? I ran a quick momentum screen to see if it turned up any viable ideas. I found some that should interest momentum investors who are not heavily influenced by index traders.

Look at Heritage-Crystal Clean (HCCI). The industrial and hazardous waste company's stock is in a few broad indices but none of the popular ETFs. It's close to a 50-day high and up 21% year to date. Earnings have grown by 51% this year and are projected to triple next year. Earnings per share have grown by an average of 34% over the past five years and the stock is above all its moving averages.

HCCI has all the characteristics of a momentum stock but it's only 26% owned by institutions, so you are not going to see the price distortion caused by their daily activity. If anything, you'll get new buying when the big players discover the stock. It's a momentum investor's dream stock.

My momentum screen has dozens of stocks like this. My value screens of smaller companies also have candidates that should trade purely on fundamentals, not the whims of a black box or short-term index traders. That should increase the odds of investment success.

The key for small traders is to exploit what the black boxes and index traders are doing with huge pools of levered capital. For these small investors, the answer lies in swimming where the big fish can't follow and finding stocks to own on their own merits.

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