Supporters of this notion want you to wave the white flag and give up on trying to beat the market. Why? They don’t believe it’s possible. Instead, they believe that rational, self-interested investors incorporate every bit of material information into the share prices of pubic companies, as soon as it becomes available. The market is so efficient, they argue, that it is futile to attempt outperforming it, since share prices will always reflect everything that can be known about the future prospects of a business.

Let’s think about this. We’re all self-interested, yes. But rational?

Is a young woman thinking rationally when she marries the troubled guy who promises to change his ways and hew to the straight and narrow? Is a young couple thinking logically when they buy more house than they can afford so they can live up to a certain image of success? Is a balding, middle-aged man thinking rationally when he plunks down for an expensive convertible to impress women half his age?

Perhaps not.

And now we have more than just anecdotal evidence.

Efficient Market Hypothesis vs. The Mind of The Market

We have Michael Shermer’s excellent new book “The Mind of the Market.” Shermer, a columnist for Scientific American and author of nine previous books, writes that, “We are remarkably irrational creatures, driven as much (if not more) by deep and unconscious emotions that evolved over the eons as we are by logic and conscious reason developed in the modern world.”

He backs up this claim with plenty of examples from the new science of behavioral economics. Studies show, for example, that most people are willing to drive five blocks if they can buy a $100 cell phone for half price. But they are far less willing to drive five blocks to save $50 on a $1,000 plasma TV. Why? After all, fifty bucks is fifty bucks, no matter how you spend it – or save it. But, according to Shermer, “mental accounting” makes us reluctant to make the effort to save money when the relative amount we’re dealing with is small.

Or take the “sunk-cost” fallacy. Objectively, a company with lousy business prospects is not worth holding, no matter what you paid for it. Yet many investors will hold on to losing investments for years, even when it’s clearly unprofitable. Shermer correctly points out that, “Rationally, we should just compute the odds of succeeding from this point forward.” Yet investors who have sunk a lot into a stock – including a fair amount of ego – have trouble doing this.

Mental accounting and the sunk-cost fallacy are just the tip of the iceberg. Shermer shows that consumers and investors also fall prey to cognitive dissonance, hindsight bias, self-justification, inattentional blindness, confirmation bias, the introspection illusion, the availability fallacy, self-serving bias, the representative fallacy, the law of small numbers, attribution bias, the low aversion effect, framing effects, the anchoring fallacy, the endowment effect, and blind spot bias. (And you thought most people only had a couple small glitches upstairs.)

Efficient Market Hypothesis & The Stork Theory

By the time Shermer is done exposing all the flaws in our mental machinery, you feel inclined to put the efficient market hypothesis right up there with the “stork theory” in sex education.

Okay, maybe I’m exaggerating… a little. Every experienced investor knows that shares of most publicly traded companies are fairly efficiently priced most of the time. But that’s a whole lot different than saying all shares are efficiently priced all of the time, the foundation stone of efficient market theory.

Was Priceline.com Inc. (PCLN) efficiently priced at more than $150 in May 1999 and then again at roughly $1 eighteen months later?

Of course, the real hurdle for efficient market theorists are not arguments like these. Rather, it’s the audited track records of men like Warren Buffett, Peter Lynch, and John Templeton, who have shown they can beat the market not just from one year to the next – which efficient market types attribute to “luck” – but over decades.

And they did it not by deciding whether to be in the market or out, but by deciding which companies were mispriced and then loading up on them. That’s exactly what most investors should be doing in these uncertain times.

Buffett summed our view up nicely – if not entirely accurately – when he once remarked, “I’d be a bum on the street with a tin cup if the markets were always efficient.” And that’s not hindsight bias.

Alexander Green walked away from a prestigious position with one of the country’s leading money-management firms at the height of the stock market boom in the late 1990s – retiring from Wall Street after 16 years at the ripe old age of 43. That’s when he became Investment Director for Investment U‘s premium stock advisory service, The Oxford Club – a private financial organization dedicated to building and preserving the wealth of its members, independent of Wall Street’s dubious influence. To learn more about Investment U, please click here.

That warrants some attention.

Why Conglomerates?

One of the best protections for an investment portfolio during times of volatility is diversification. And while one way to diversify a portfolio is to buy several different stocks in various industries, it’s possible to get diversification with just one pick – if you make it a smart one.

Conglomerates are diversified by their very nature because they hold several different business lines within varying industries. If one subsidiary is suffering a slowdown due to market conditions, another might be doing well enough to pick up the slack. By the same token, cash flows from one enterprise could be used to help a struggling operation or finance the purchasing of a new acquisition.

But a sprawling conglomerate can have its disadvantages, too. Peter Lynch, the well-known Wall St. investor, has even coined the term “diworsification” to describe a firm that ventures too far outside of its core competencies.

In fact, a conglomerate’s value often is less than the sum of its parts considered individually. The investment term for the difference is the conglomerate discount. The discount exists because a conglomerate’s network of varying subsidiaries can be difficult to manage and it doesn’t always result in cost efficiencies.

While an unwieldy conglomerate can be a recipe for disaster, one of the shrewdest investment managers in the world has demonstrated that a conglomerate can be the pathway to profits.

The Crown Prince of Conglomerates

Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B) is one of the best modern examples of a well-run conglomerate. When Buffett acquired the then struggling firm in the early 60s, it was a textile manufacturing company.

But now, according to Wikipedia, Berkshire owns such diverse holdings of businesses including candy production, retail, home furnishings, encyclopedias, vacuum cleaners, jewelry sales, newspaper publishing, manufacture and distribution of uniforms, and footwear manufacturing and distribution.

And that’s in addition to the insurance businesses that Berkshire is perhaps best known.

For investors who want to buy a piece of Berkshire, the bar has been set high. Buffett has never allowed a split of the stock, resulting in Class A shares that have traded as high as $151,650.00 per share in the past year. Even the Class B shares, at 1/30th the value, have traded in a range of $3,538 to $5,059 in the past 52 weeks.

If you’re not going to buy Berkshire stock, it still makes sense to pay attention to the conglomerate’s investing moves. According to a recent study, buying what Buffett has bought – even a month after his purchases – is a pathway to superior returns. In fact, over the past three years, this strategy has delivered double the return of the Standard & Poor’s 500 Index, according to research by professors at both American University and the University of Nevada at Las Vegas.

Even with that one-month lag, an investor who mimicked the moves of this market master would eclipse the S&P 500 returns by 14.26%, the study concluded. [Money Morning has an in-depth investment research report on this topic, How Buying Like Warren Buffett Can Boost Your Portfolio Profits. The report is free of charge.]

Recent Berkshire investments include taking an 8.6% stake in Kraft Foods Inc. (KFT), making it the food maker’s biggest shareholder. Berkshire also acquired a $76.1 million stake in GlaxoSmithKline PLC (GSK), Europe’s largest drug maker.

Another Great Conglomerate Example in GE

If you’re looking for a successful conglomerate an investor-friendly share price, look no further than General Electric Co. (GE). The global titan has a presence in over 100 countries and offers a range of products that includes aircraft engines, power generation, water processing and security technology to medical imaging, business and consumer financing, media content and industrial products.

The stock is only up about 2.5% year-to-date, but when you compare that to almost 7% beating the S&P 500 Index has taken, that doesn’t seem so bad. Plus, GE shares offer an attractive 31-cent quarterly dividend.

Money Morning Investment Director Keith Fitz-Gerald is a big fan of income generating stocks, especially during down markets.

GE has its fingers in a lot of pies, many of which will prove to be lucrative over the next several years as the global markets fuel infrastructure development in emerging markets. For the first time, overseas growth and revenue comprised more than half of GE’s fourth-quarter earnings.

The surge of international sales growth in the fourth quarter was fueled by GE’s infrastructure divisions, which accounted for 26% of profit growth. Total orders were up 18% to $27 billion.

GE Chairman and Chief Jeff Immelt said in a statement that the company is built to outperform in an otherwise stagnate U.S. market.

“Our record performance in such a tough environment validates the strength of our strategy and the talent of our team,” he said.

The Conglomerate that Brought You Post-Its

3M Company (MMM) is probably best known for its ubiquitous yellow sticky notes, but the diversified technology company has a wide-range of products. The firm has six business segments that include: Industrial and Transportation; Health Care; Display and Graphics; Consumer and Office; Safety, Security and Protection Services, and Electro Communications.

Since the company’s founding in 1902, 3M has found ways to innovate and turn initial failures into newfound successes. The firm has many well-known brands including Post-its, Scotch-Brite, Scotchgard, and of course, Scotch cellophane tape.

For 2007, 3M reported a 7% increase in sales to a record $24.5 billion. Excluding special one-time charges, full-year 2007 earnings were $4.98 per share, an increase of 11% over the prior year.

“We made good progress on our growth plan in 2007 and we will continue this effort in 2008. By investing in our many enduring franchises, strategic acquisitions and new plants to streamline our supply chain, we are securing 3M’s future as a faster-growing and more efficient enterprise,” George W. Buckley, 3M chairman, president and CEO, said in the company’s 2007 sales and earnings statement.

Shares have been trading in a range of $72.05 to $97.00 in the past 52 weeks and are down about 4% year to date. But over the past five years, 3M shares are up 24%.  And the stock offers a nice 50-cent quarterly dividend.

A Conglomerate that’s Cashing in on Crops

Fueled by a combination of international sales and a growing demand for genetically enhanced agricultural products, Wilmington, Del.-based E.I. du Pont de Nemours & Co. – commonly known as DuPont (DD) – has emerged as one of the few bright spots in an otherwise gloomy U.S. stock market.

DuPont – a component of the 30-stock Dow Jones Industrial Average – does business in more than 70 countries where the blue-chip company’s array of agricultural offerings is a strong seller. DuPont is a leading developer of crop-protection chemicals and seed hybrids.

Emerging middle classes in China, India and elsewhere are driving the need for commodities. As more people incorporate meat and dairy products into their daily diets, supplies of “double-duty crops” – capable of feeding both livestock and people – continue to fall short of global demand. Drought and floods have also done their part to reduce crop yields, but DuPont is doing its part to try to boost those yields.

“We expect that continued growth worldwide from our Agriculture & Nutrition business segment and growth from all of our segments in emerging markets will more than compensate for a slower U.S. economy,” Charles O. Holliday, Jr., DuPont chairman and chief executive officer, said in a statement.

Earlier this year, the firm received approval for two new herbicides that are designed to protect soybeans and wheat. In addition, farmers using DuPont’s Pioneer brand seed hybrids won top honors in national crop-yield contests for corn and sorghum last year.

DuPont announced that it expects full-year 2007 earnings to be at the high-end of its previously projected range of $3.15 to $3.20 per share. The science-focused conglomerate also boosted its 2008 earnings guidance to $3.35 to $3.55 per share.

Well-Positioned for the Long-Term, Even in a Recession

With a strong portfolio of well-run diversified subsidiaries, strong global presences, comfortable capital positions and AAA credit ratings, both Berkshire and GE are in better positions than most firms to weather an economic storm.

“Considering both their strong credit ratings and their track record for making good investments, I believe that both GE and BRK provide interesting investment opportunities,” said Seeking Alpha’s Dan Braem, who is long on both stocks.

While there might be some short-term volatility in share prices, Braem believes both are good picks for an investor with a time horizon of over two years.
A recent study by global consulting firm, Marakon Associates, placed Berkshire Hathaway and GE in the top quartile of best-performing global conglomerates (3M was in the second).

The study tested the generalization that conglomerates “risk-spreading qualities are of no value to investors who can diversify their own portfolios and because they suffer from intrinsic structural and managerial weaknesses.” The authors, Chris Kaye and Jeffrey Yuwono, found that while that may hold true for some conglomerates, it’s not true for all.

“The high-performing conglomerates have solved this problem by committing themselves to financial discipline rather than operating or strategic visions,” the report concluded.