Finding an edge

Seth Klarman, one of the great value investing gurus talks about the important of finding their edge at Baupost Group. I also believe this is very important as investing is not that much different from sports, where if you play competitively you are always trying to find an edge over your opponent and in the world of investing, the opponent is the market.

Your edge is a useful concept to think about whether you are investing in the thousands of dollars or billions of dollars. If you can’t identify your edge and be able to play to that strength then it’s highly likely that you wouldn’t be able to beat the market; and if you can’t beat the market then don’t play the game and invest in an index ETF instead.

So I thought I write down what I think my edge (in general) is as a non-professional investor investing small sums of money.

  • A retail investor is not limited by an investment mandate in contrast to an institutional investor. This gives a retail investor huge flexibility over the institutional investor and I believe the big advantages of this flexibility are (i) the ability to invest in any security, be it small illiquid shares which are not an index constituent, (ii) lack of restrictions on diversification, so I can choose to hold 100 stocks or concentrate my holding on a single stock in my portfolio and (iii) lack of restrictions on asset allocation which means I can be 100% invested in shares or 100% invested in cash at any time.
  • Investing small sums of capital provides an edge as it means I can invest in microcap stocks and still be able to get a meaningful return on my capital. Smallcaps and microcaps are mostly neglected by the institutional investors (with huge sum of capital) as it doesn’t move their needle. In the context of the ASX, a large majority of the stocks listed have market capitalisation below A$500 million.
  • No annual benchmarking of performance. Most fund managers are benchmarked annually against some underlying index. This naturally leads to the creation of index hugging portfolios as fund managers may deem it too risky to venture too much outside the index constituents.
  • Another related point is that the annual testing of performance means that fund managers typically have to take a short term view and avoid stocks where returns require a long time horizon. But we know that great businesses take time to build and therefore big returns are played out over a 5 – 10+ year time horizon. Just look at Berkshire Hathaway and the multi decade annual returns of 20% it has generated for its shareholders.  So the point here is that there is no pressure on retail investors who can have the luxury to patiently wait for a stock to generate returns. Fund managers don’t have that luxury as it they don’t perform in the short term, their investors might move their capital elsewhere.

The above points are related to a retail investor’s natural edge over most institutional managers. Other skills which can improve your edge include:

1. Know the limits to your circle of competence
Warren Buffet says the size of your circle of competence matters far less than your awareness of its limits. I believe this is so true. If you think about it, most successful people or businesses never venture outside their core industry.  I can think of Walt Disney with children’s entertainment, Phil Knight with shoes, Frank Lowy with shopping centers, Howard Schultz with coffee, to name a few. From my own personal experience, my biggest losers are from companies where I overestimated my circle of competence.

2. Understand the business
I guess this point is fairly self explanatory. It is important to not only understand the business opportunities but the risks involved, both micro and macro.

3. Form an independent opinion and don’t be swayed by the herd.
Don’t make decisions based on movement in share prices don’t let the herd influence your decision making. This is much easier said than done. But if you can ignore the volatility of the share market then you have gained an advantage. Superior results aren’t generated by following the majority.

4. Be patient and bet big
The market is fairly efficient and opportunities don’t come along that often. So if you have done your homework and found an underpriced security, bet big. It’s no point tip toeing into a position as the opportunity may be gone tomorrow.

5. Fish where the fish are
Look for stocks which have low investor expectations. Studies have shown that these produce superior returns. Good hunting grounds include companies trading at 52 week lows, illiquid companies, spin-offs, securities are removed from indices or esoteric markets.

Investing is like any skill, it takes time to hone and the more you can play to your strengths the higher your chances of winning are.

Any comments or feedback much appreciated.

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