Your Next Great Stock: How to Screen the Market for Tomorrow's Top Performers

Chapter 3. If Stock Picking Strategies Work, Why Haven't They Been Used Up?

In the last chapter I mentioned a stock-picking strategy based on earnings surprises. I noted that it has sharply outperformed the broad stock market for more than 40 years after its discovery. How can that be? Earnings surprises are one of the easiest things for investors to track. Earnings data are listed on most financial Web sites and surprises are often covered in the daily news. If investors know stocks are likely to go up for a long time after companies beat earnings estimates, why wouldn't they buy those stocks right away, thereby pushing their prices up, and thereby rendering the strategy dead?

The answer to that question reveals a key flaw in the efficient markets hypothesis, which says that stock picking is futile. The hypothesis is based on a number of assumptions about markets and behavior. For stock picking to be possible, one or more of those assumptions must be wrong.

The hypothesis assumes that people can buy and sell stocks cheaply and easily. A stock trade today costs $10 and often less and can be made in a matter of seconds, so that seems like a fair assumption. The hypothesis assumes people have equal access to information. I think that's fair to say, too. It's illegal to trade on information that hasn't been made available to the public. Professional money managers might turn readily available information into new, exotic forms—stock-pricing models and such—that the rest of us can't figure ...