3 Picks to Beat the Stock-Market Beauty Contest

In an article earlier this month, my fellow Fool Morgan Housel kicked off with a look at the recent volatility we've had and stacked that against historical market volatility. Looking at his data, you wouldn't be wrong in applying any number of extreme adjectives, including "crazy," "wild," "mind-blowing," "gut-churning," ... I think you get the picture.

But why the maniacal roller-coaster ride?

There are plenty of folks who have put forward ideas -- the existence of high-frequency traders, which didn't exist until relatively recently, is one that I like, but it doesn't fully explain the issue since we've had high volatility in the past without HFTs. Another explanation that I liked came from Yale Professor Robert Shiller, who exhumed the thoughts of economist John Maynard Keynes for The New York Times.

Keynes compared the market to a beauty contest in which participants were asked to pick the six prettiest faces from a set of photographs and the winner would be the voter whose list most closely matched the average view of all voters. Shiller wrote:

The best strategy, Keynes noted, isn't to pick the faces that are your personal favorites. It is to select those that you think others will think prettiest. Better yet, he said, move to the "third degree" and pick the faces you think that others think that still others think are prettiest. Similarly in speculative markets, he said, you win not by picking the soundest investment, but by picking the investment that others, who are playing the same game, will soon bid up higher.

Nothing new under the sun
Obviously, this view on the source of market wackiness and volatility is nothing new -- Keynes wrote the above in 1936. As I reminded readers in August, value-investing forefather Ben Graham had a similar view, and -- to paraphrase -- said that "in the short run, the stock market is a voting machine, but in the long run it's a weighing machine." The contribution of Keynes' view is significant, though, since it highlights the meta aspect of the voting process -- that is, voters are not necessarily voting with their own views, but their view of what the next guy's view is, or even what the next guy's view of what the still next guy's view is.

But it really doesn't matter whether we're focusing Graham's view or Keynes' more mind-bending one. The bottom line is that this voting process is a short-term one that confounds even the shrewdest stock-market gunslingers and is a good part of the reason that my fellow Fool Rex Moore recently said that "market timing is a joke."

There is a solution
As Graham noted, over the long term the market is a weighing machine. Investors feeling burned out by the recent volatility may be hesitant to believe such an assertion, but the good news is that this isn't an article of faith. The fact that the market acts as a weighing machine in the long run is a matter of logic and necessity. Let me explain.

Take Procter & Gamble (NYS: PG) , for instance. In June of 1990, P&G's stock traded at $87.12 per share. For the company's 1990 fiscal year -- which ended in June -- it earned $4.21 per share. At that time, the company was also paying a $1.80-per-year dividend. Fast-forward to today and -- after adjusting for splits -- P&G finished fiscal 2011 with $31.31 in earnings per 1990-era share and is currently paying $16.80 in annual dividends per 1990 share.

If P&G's stock hadn't drastically increased in value between those dates, then investors today would get an immediate 36% return on their investment in terms of earnings and a 19% cash, straight-in-your-pocket, dividend payout. So either the market was going to boost the share price or investors were going to get insanely low valuations and huge dividends. But what's clear is that one way or another, investors were bound to reap a tidy return from P&G's stock.

The same holds true for the future -- investors may knock around P&G's stock on a day-to-day or even month-to-month basis, but as the company continues to increase earnings and dividends, it sows the seeds for a higher stock price over the longer term.

Those three picks
Unless you're some sort of weird savant or mindreader of the masses, trying to play this voting machine-cum-meta beauty contest is not a good idea. Your better bet is finding great companies like P&G with solid fundamentals behind them that will tip the scales on the weighing machine over time. Here are three more companies that I believe -- along with P&G -- will do just that.

  1. Alcoholic-beverage giant Diageo (NYS: DEO) .
  2. Industrial and military giant United Technologies (NYS: UTX) .
  3. Fast-food king McDonald's (NYS: MCD) .

Why these three? There are two primary reasons. First, the numbers for all of them -- that is, the returns earned for shareholders, growth, and valuation multiples -- look good currently.

Second, and maybe more importantly, each of the businesses has a competitive advantage that protects the returns it earns and makes it more likely that investors will continue to see those above-average returns well into the future. Superinvestor Warren Buffett has referred to competitive advantage as "the key to investing."

Each business does, of course, have competitors -- Mickey D's wrangles with the likes of Yum! Brands' (NYS: YUM) brand stable, while United Technologies has to stack up against other industrial giants such as Honeywell (NYS: HON) . However, the special sauce that these companies possess -- the Guinness and Smirnoff brands for Diageo, for instance -- not only help them compete against other large, well-entrenched competitors, but also make it exceedingly difficult for some upstart with a wad of cash and dreams of being king of the hill to topple them.

To be sure, these aren't the only companies out there that can help you get beyond the stock market's short-term beauty contest. If you're looking for a handful more that may fit the bill, check out these five stocks that The Motley Fool owns and thinks you should own, too.

At the time this article was published The Motley Fool owns shares of Diageo and Yum! Brands. Motley Fool newsletter services have recommended buying shares of McDonald's, Procter & Gamble, Yum! Brands, and Diageo. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.Fool contributor Matt Koppenheffer owns shares of McDonald's but has no financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter, where he goes by @KoppTheFool, or on Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


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