Behavioural: The One True and Enduring Edge
Investing wisdom is very clear that you should only invest when you have a clear "edge". This is logical and self-explanatory given the zero-sum nature of returns (in relation to a benchmark at least). Taking positions with negative expected returns is a sure-fire way to damage your portfolio, but what edges are there that are still applicable and realistically exploitable?
I argue that there is only one; behavioural, but the good news is that due to human nature it will always be available.
The other commonly cited advantages include institutional, analytical and informational and have been largely competed away or were always fanciful in my view, at least from the standpoint of a small or retail investor.
Institutional and Analytical
These are closely related and have always been a pipedream. If such an edge existed, the best returns would go consistently to the largest, best-resourced organisations, but the opposite is often the case. This is largely because the constraints of career risk are felt most tightly at the largest institutions.
An army of analysts and hundreds of company visits are not much good if you can only over or underweight slightly in relation to a benchmark, as to not risk underperforming your peers. The need to perform consistently effectively draws these players out of the long-term game and into the mire of trying to be in what will go up next quarter.
I believe the level of detail acquired by having several analysts within one firm follow an industry full-time is counter-productive. A truly attractive investment only has several key drivers and if you need to know the 98th percentile of possible information to get it over the line, the idea is likely not good enough.
Seth Klarman summed it up nicely in Margin of Safety:
"Information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns."
Therefore, as long as a small team or individual investor has the ability to cover the main and consequential points of an opportunity, it is likely that a large organisation will do no better and may even harm themselves due to groupthink, inertia and institutional constraints.
The analytical side covers the interpretation and use of research in a better way than others. An example of this might be a quantitative model or screen and some firms have been able to do this effectively, but are constantly under attack from competitors.
Additionally, I would argue those that implement variant strategies like these successfully, win as a result of the behavioural positions they are therefore able to take, rather than because of the analysis itself. There have been enough rigorous, quantitative methods and screens created by small teams to convince me that many of the hours spent on this analysis by large firms are window-dressing and mostly don't add value for effort (Renaissance Capital excepted, of course).
Informational
For an investor of any size to claim they have an informational edge in today's markets is just delusional or possibly illegal. We are being drowned in a torrent of daily news, data and reports and the intelligent investor's job is to try and extract the few useful pieces from the river rushing by them.
Between social media, screeners, blogs, podcasts, newsletters and google translate, there aren't many companies in the world you can't find the financials for and understand something about. I have become increasingly discriminate about where I source my ideas and research from, as the universe of content is so much bigger than I have time to spend.
This is something of a looking glass into society in general, where the ability to consume constantly is now at our fingertips, but at what cost? For example, without meaning offence to those that work hard to produce content, there are now many more podcasts being produced than there can possibly be quality guests to have on them. I have been astounded at the seeming merry-go-round of guests and hosts doing tours of each other's shows essentially saying the same thing.
Further, never could I have imagined that I would get over hearing Jeremy Grantham interviewed, he is a hero of mine, but he has done at least six podcasts this year and if I hear him say that the land under the emperor's palace was worth more than the state of California during the Japan bubble, one more time, I will leap out the window!
Actively filtering out or ignoring content (not this blog of course though, dear reader) feels wrong at first. We feel we should cover as much ground as possible and to the holder of the most knowledge will go the spoils, but this is no longer correct. They who parse their content to only the very best will likely do better, but this is hardly an unrepeatable edge.
The geographical and size diversity of my portfolio and watchlist today would have likely stunned me 20 years ago and that is a great thing, as my opportunity set is now so much wider- but so is everyone else's. I don't believe an informational edge is possible today given the combined resources at play.
Behavioural
Is a behavioural edge harder to come by than in previous eras? Definitely. The days of a young Waren Buffett knocking on doors to buy National American Fire Insurance at 1x PE are sadly long gone.
Is it still possible and exploitable? I would argue yes, and that it always will be with human nature evolving as slowly as it does.
Exhibit A: during a decade when it became dramatically cheaper and easier to own global companies and access foreign markets, non-US markets have been largely shunned, despite them growing increasingly relatively attractive. Traditional herding has worked two ways, with the masses chasing gains in the US markets and heaping scorn on areas that have dished out losses.
This is not rational. It is widely documented that the cheapness of the assets bought is the main determinant of returns. Historically, the times (like now) when this relationship has seemed broken have been when it is about to matter with a vengeance.
It seems likely that greater connectivity, while allowing the higher information flow earlier discussed, could also heighten the madness of crowds. Before 2020-21, the Dot Com bubble was generally considered the pinnacle of investor idiocy- not anymore.
In the last year we have witnessed AMC, Gamestop, Tesla, ARK, crypto frauds and jokes, NFTs and most companies judged on P/S rise to levels indicating sheer lunacy and many of the participants seem to think the stupidity of the situations (and themselves?) is funny.
The giant ponzi scheme has been enabled to grow much bigger than ever previously possible, due to this network who believe they have done their "due diligence" after watching a youtube video or reading a tweet-thread. The same traits are likely to cause an equally brutal stampede for the exits when valuation and common sense matter again (hopefully soon, but you never know).
The opposite side of the coin is that non-US companies producing real cash-flows, but doing it in an unexciting way are available at very reasonable prices. Owning them, however, means being prepared to see underperformance for several years before being rewarded. Many small, contrarian invetors are ready to do this, many large institutions are not.
Ultimately, a true behavioural edge means complete control over the opportunites you take and the prices you pay for them. Exploiting this and going where others won't is the best advantage available to an investor and by paying a low enough price when the outlook is dire, you nullify the need for any other questionable edges.
Thanks for reading. Five posts in five days has been a stretch, but it looks like NZ will be in lockdown for a couple more weeks, so see you on Monday!
Guy
Please don’t take this as financial advice. Do your own due diligence and consult a professional advisor, if unsure about your finances.
Featured image courtesy of Pixabay.