Masters Series: The Alpha Anomaly

Editor's note: There's an anomaly in the stock market... and ignoring it could cost you thousands of dollars.

Stansberry Research founder Porter Stansberry believes you could do well buying shares of capital-efficient businesses and companies with "trophy assets."

But there's an even better, even safer way to invest in these companies. This strategy involves less risk than simply buying shares outright... and increases your upside potential.

Porter calls this the "Alpha Anomaly." In today's edition of our weekend Masters Series – originally published in the June 22 Digest – Porter explains how market inefficiency makes this strategy possible...

The Alpha Anomaly

By Porter Stansberry, editor, Stansberry Alpha

Markets aren't supposed to work this way...

Most economists and academics will tell you it can't happen... The "efficient market hypothesis" says it's impossible...

This is the financial theory Professor Eugene Fama developed at the University of Chicago in the 1960s. Fama argued that no one can consistently beat the market because prices on traded assets already reflect all publicly available information... It soon became the conventional wisdom on markets...

Except it's not always true...

If it were, we wouldn't have the opportunity we're going to describe today – it's an anomaly we call simply "Alpha."

The reason ideas like the "efficient-market hypothesis" gain traction is that they offer a kind of symmetry... And people love symmetry. Behavioral studies prove this: People with nearly symmetrical faces are consistently rated as "more attractive." The same is true for architectural designs, like bridges and buildings.

And although we can't prove it, we believe humans innately believe in philosophical symmetry. Most people believe you get what you deserve. They believe in some kind of cosmic balance.

The efficient-market hypothesis offers a kind of symmetry... a balance. The market knows all and accounts for everything... It is always in balance, at equilibrium.

It's comforting... but the real world doesn't work like that.

Asymmetries are found in almost every part of the natural world. Take your body, for example. Your left lung is smaller than your right lung – it's missing one whole lobe. Your lungs are built this way because your heart is asymmetrical, too. The left side is larger than the right. Interestingly, almost all biological organisms are asymmetric in at least one dimension.

In chemistry, certain molecules called "chiral" are asymmetric. They cannot be superimposed upon their mirror image. Fundamental physical asymmetries exist in particle physics, too (known as "parity violation"). We won't get into particle physics, don't worry. But the example is important to remember. The world frequently doesn't work exactly like the models suggest it should. Asymmetry is actually the norm, despite the human preference for symmetry.

In finance, one symmetry we're taught is between risk and reward. This makes sense intuitively. And people want to believe it. It seems fair. If you want to succeed, surely you have to take big risks. But that's complete nonsense. Let's look at some simple examples.

In our studies of highly capital-efficient businesses, we've found that investors who simply reinvest their dividends can consistently earn returns of around 15% a year. That's simply investing in high-quality, low-risk, brand-name stocks like Hershey, Heinz, and McDonald's.

The key thing to understand is that buying into businesses at reasonable prices is just about the safest thing you could ever do with your capital. And 15% annual returns are far in excess of average returns. Pairing this extremely safe approach to investing with the capital-raising power of insurance made Warren Buffett the world's richest man. There's simply no way that would have happened if risk truly equaled reward in finance.

Here's another, real-life example. We know many very wealthy people who made a lot by financing companies directly on terms that were absurdly unfair. The more unfair, the better. Typically, companies that need a lot of capital (say, to drill a new oil well or find a new gold mine) will sell stock directly to individuals at a price that's well below the market price of the stock. So if the shares are trading at $10, the financing might close at $8. Right off the bat, these private financiers are taking far, far less risk than buying the shares in the market.

But that's not the only advantage. They also demand (and usually get) free warrants in the stock. A warrant is like a call option issued directly by the company. As you may know, the price of an option is determined in large part by the expected volatility of the stock. An option on a highly volatile stock is worth a lot. And these folks get them for free as part of the deal. They're taking a lot less risk than regular investors.

In these deals, there's tremendous financial asymmetry. They're buying stock at less than the market price. They're getting a call option for free. If the stock simply stays where it is, they'll make a small gain. If the stock goes up a lot, they'll make a bloody fortune. You don't need many deals like these to pan out well to earn a significant fortune in the market. I happen to know a few guys who've done it... several times.

And that got us to thinking... there has to be a way for regular, individual investors to do the same kind of thing.

And that's where the anomaly we've discovered comes in... We already know the vast majority of you – probably about 90% – will never believe what we've recently discovered. You'll continue to believe that risk is always balanced with reward. That's what makes sense. That's what your broker told you. That's what the finance professors teach.

Well... it's not true.

The anomaly we've found gives almost any investor... at almost any time... on almost any stock he wants to own... the opportunity to invest with lower risk and earn profits that are far greater than what are possible by just owning the stock outright.

We can take advantage of this Alpha anomaly to amplify the gains we make on stock investments... potentially big triple-digit gains on margin. And we can do that while taking on less risk than we would by simply buying the common stock.

Regards,

Porter Stansberry

Editor's note: This week, Porter released a brand-new presentation detailing the ins and outs of his Alpha strategy. It's a must-watch for anyone who is serious about making money in the stock market.

Porter's Alpha strategy lowers your risk while increasing your upside potential. You can use it to generate huge gains on safe, blue-chip stocks, over and over again. Plus, we're giving anyone who attends this educational workshop a free gift and special offer. If you're interested, we suggest you act quickly... This offer closes for good tomorrow at midnight. Learn more here.