Motley Fool's Patented Stock-Picking System: Should the Fools Believe?

Popular investing site The Motley Fool has patented technology it believes has the potential to predict stock performance.

The technology is called Motley Fool CAPS. It works by tapping "the collective brainpower" of more than 170,000 individual investors who rate 5,600 stocks from "one star" for the lowest ranking to "five stars" for the highest ranking. Since its inception in 2006, the five-star-rated stocks have beaten the S&P 500 index by 51 percentage points.

The rankings held up consistently down the line: Four-star stocks beat the performance of three-star stocks. Two-star stocks equaled the performance of the S&P 500, and one-star stocks underperformed the S&P 500 index by 31 percentage points.

A study by Harvard University's Kennedy School of Government gives added credibility to the CAPS system. The well-credentialed authors of the working paper found "consistent evidence" that CAPS stock picks were predictive of future returns and that the excess returns of those picks were "statistically significant."

One Mighty Smart Crowd

These findings conflict with the efficient market hypothesis, which asserts no one can accurately predict future stock returns. The basic tenet of that theory is that publicly available information about a stock is instantly incorporated into its trading price, resulting in a fair price.

The CAPS system takes the contrary view: It holds that the collective view of Motley Fool readers is able to identify undervalued stocks that are likely to outperform in the future.

The argument that large numbers of people can make remarkably accurate estimates has support. It's set forth in James Surowiecki's excellent book, The Wisdom of Crowds. Surowiecki found that, under the right circumstances, crowds can make estimates that are more accurate than the individual estimates of experts.

But the problem with relying on this as support for the CAPS system is that there's an even larger crowd that looked at the same stocks ranked by Motley Fool readers: the entire pool of hundreds of millions of investors. They concluded that the price of those stocks -- and others -- were fair, and that none of those stocks was undervalued.

Which "crowd " is right? My money is on the bigger crowd.

Why Not Start a Five-Star Fund?

Investors in the U.S. can pick from more than 8,000 mutual funds staffed by fund managers and research analysts who are the best, brightest and most highly trained finance professionals in the world. They have huge budgets and can access supercomputers to crunch data. Their mandate is to pick stock winners and beat their designated benchmarks. But only 5% of these pros succeed, and many of their funds go out of business.

Accepting the CAPS stock-picking methodology as effective assumes that mostly untrained Motley Fool readers have better stock-picking skills than these investment pros and that their judgment is superior to that of the larger crowd of investors looking at the same data. Those are major leaps in logic.

If a mutual fund adopted the CAPS stock picks and achieved excess returns over a sustained time period, the CAPS methodology would have far more credibility. The Motley Fool is the fund manager of two funds, The Motley Fool Independence Fund (FOOLX) and the Motley Fool Great America Fund (TMFGX). Neither fund's portfolio is based on the stock rankings of its readers.

If the Motley Fool really believes in the CAPS methodology, it should start a mutual fund based on its stock picks, solicit investors for that fund and report its returns. Think of the possibilities. It could go long on the five-star stocks and short the one-star ones. It would be putting its reputation -- and the funds invested by its readers -- solidly behind its patented system.

Until then, investors would be better off focusing on their asset allocations and investing in a globally diversified portfolio of low-cost index funds, in asset allocations suitable for them.

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