Active investing in publicly traded securities is an inherently competitive activity, and people are looking for an investing edge. By definition, active asset management in aggregate produces, gross of fees, the same returns as passively managed money (ignoring frictional costs and other fees). This must also be the market’s return because active and passive managers combined are the market. The idea that active management is a zero-sum game is explained in more detail by William Sharpe in his 1991 paper “The Arithmetic of Active Management.”
Anybody who embarks on the venture of actively investing to make money (as opposed to entertainment) must ask him or herself critically: What is my investing edge? How will I get above-average returns when others do not?
The ideas of “competitive edge” and “alpha” are closely related. In simple terms, “alpha” indicates how much of your performance cannot be explained by risk exposure you have taken on. From a statistical perspective, it has always been difficult to differentiate between true skill/alpha and random statistical outcomes in the performance of portfolio managers. However, real alpha should stem from a defined and definable competitive advantage.
Finding Your Investing Edge
Finding alpha and your investing edge is an art, rather than a science, because it hardly follows a defined process. Risk management, as a defined process, is a science. The same can be said of transaction cost management and even baking a cake, for that matter. Finding alpha is different because of a paradox, like the Lucas critique, whose basic intuition in my opinion holds valid in many situations. If there is a provable and implementable process to get excess returns, people recognize it quickly and compete aggressively for it until the opportunity dissipates.
If you “discovered” that stocks rise every Friday, other people would quickly recognize the same pattern and buy on Thursday evenings until the pattern does not work anymore. The very understanding of a new “rule” changes the behavior of its participants, and consequentially, the game itself. Therefore, an edge must be either a hard-to come by situation, a soft and non-obvious factor, or simply an edge exclusive to the specific investor that is difficult to duplicate.
Types of Investing Edge
There are three different sources of a true investing edge:
- Information advantage
- Analytical advantage
- Strategic advantage
While the first two are well understood and explained in many excellent articles by practitioners, the third factor might often be too narrowly interpreted and deserves more attention.
Information advantage means that you know something others do not. The information advantage is hard to get and highly competitive. Investors are constantly gathering information and it is rare to possess critical and obvious information meaningfully ahead of the rest of the other market participants. In many circumstances, possession of certain information ahead of the market can be illegal (insider information).
In an ever-better-connected world in which information is widely disseminated almost instantly, gaining an information edge becomes increasingly difficult. Even the smallest of companies, as well as companies that are international, are followed by an astoundingly large number of investors who have likely already discovered and digested the most obviously relevant pieces of information relating to an investment in the company.
How likely is it for you to have better information than the rest of market participants? I personally find it to be hard-to-come-by, but there are numerous investment shops that have successfully gone this route. For example, GeoInvesting’s work in abroad such as China gains an information edge by comparing international and US filings with on-the-ground due diligence research in difficult to access markets. Combined with a local experience, it becomes a research methodology that is hard to duplicate. GeoInvesting also takes advantage of inefficient information dissemination in micro-cap markets and seeks to digest information more quickly and efficiently than others.
What makes information valuable? There are a few key aspects to the value of an information edge:
- How exclusive the information is: how widely has the information already been recognized and priced in?
- How obvious the information is: how likely will dispersion of the new information lead other market participants to alter their views and consequentially move the stock price?
- How significant the information is: to what degree will market participants alter their opinion about the value of the stock?
The best information to possess is exclusive to you, highly significant, and is fairly obvious once known. Also, you must be legally allowed to distribute the new information or know when the information will be widely dispersed to maximize your information advantage.
An analytical advantage allows you to better interpret the information at hand and draw conclusions that other market participants fail to do. To gain an analytical advantage, you are trying to know how the market will perceive information in the future. In other words, you are simply working to outsmart the market. It is important to note that the investor’s analytical views must be eventually accepted by other market participants, or the price of the security in question may not adjust.
Imagine you conclude that a new acquisition increases the value of a business whose stock you own more meaningfully than the stock price reaction indicates. Based on this finding, you buy more stock. If the market does not accept the premise of increased value, convinced by better financial performance or a change in sentiment catalyzed by other factors, the stock price does not appreciate and the investment might sour. This is a unique risk in the microcap space due to lack of investors participation.
Gaining superior analytical insights into businesses is also an activity I consider highly competitive. The obvious insights are most likely already priced in to the stock. The not-so-obvious insight might stay neglected for a long time, which makes gaining an edge from analytical insights challenging. If you want to bet on your analytical edge, I strongly recommend developing a firm understanding of why your analysis should be eventually accepted by the market. Will better financials convince the other market participants to adopt your view? Will a strategic buyer unlock the value of the investment?
The value of analytical insights is determined by factors similar to those dictating the value of an information edge.
- What is the degree of certainty you have in other investors eventually accepting your analysis, and, when will they do so?
- How exclusive is your viewpoint – are you really betting against the crowd or do you hold the conventional view?
- How different from the market’s view is your analysis?
The best analytical insights are therefore those where you have a very stark divergence of opinion, which could soon be widely accepted with a high degree of certainty.
Many kinds of strategic advantages can help you achieve superior returns and are often interpreted as purely based on time horizon. Strategic advantage, in this context, means that you can do what others, for whatever reason, cannot.
Good examples of strategic advantage are trading costs, access to deals others cannot, and the ability to bear certain risks. For example, an investor with little money is at a clear competitive advantage to an investor with a lot of money from a trading cost perspective. Meaningful positions are easier to take for a smaller investor, and a small investor will, generally speaking, move the stock price less than a big buyer. The small investor might be able to participate in stocks that are so illiquid that they are excluded from the buy list of bigger funds until they eventually show the kind of liquidity institutional investors need. Many institutions are, by their mandates, restrained from dealing in securities listed on certain exchanges or securities that do not meet other arbitrary thresholds, such as market cap and share structure. This means microcap investors do not have to compete with sophisticated institutional investors that have more resources, because they can access opportunities the institutional investor cannot.
An often-discussed strategic advantage to gain an investing edge is permanent capital, as it allows you to operate under a different time horizon than other market participants. An institutional money manager may have to deal with redemptions if he/she is down 50% in a big position, but a private investor might be able to easily withstand this kind of volatility, allowing for more patience with the investment. Considering this insight, a well-drafted LP agreement and trustworthy group of long-term oriented LPs could provide an investor with a competitive advantage.
Another strategic advantage is access to various investment opportunities that are not shared by all market participants. One example could be if you are one of very few investors to get borrow to short a stock in an arbitrage situation because of your great relationship with the only bank that has shares to lend.
Discipline, temper, and patience can also be considered competitive advantages. Can everybody act disciplined and calmly? Certainly, some behave more disciplined than others, which allows them to do things others cannot. A smartly designed system of pre-commitments that forces you to take a disciplined approach can be a source of edge. Patience and discipline allow you to take advantage of a long-term time horizon and endure volatility and temporary losses.
Big Names With An Investing Edge
A strong brand can combine several strategic advantages. Carl Icahn has built a brand over the years. Management boards are more likely to consider Carl’s suggestions because of his reputation. He also has the flexibility to question or approve a deal, as well as propose to make changes to an agreement — he does not have to consult with several committees as most money managers do. This extra flexibility can prove to be an advantage in negotiations.
Bill Ackman has also developed a brand that allowed his fund to sustain major losses for a two-year period without having to deal with major redemptions. Ackman’s reputation arguably allows him to take on more volatile investments and act with a different time horizon than most institutional money managers.
Warren Buffett has a built a brand that stands for continuity. Berkshire Hathaway is a brand that companies and investors like to be identified with. His ability to consummate certain transactions may be heightened when compared to others in similar positions of influence.
There are certainly other forms of strategic advantages, but the value of your edge is generally driven by the exclusivity of your advantage and how big of an advantage it is compared to other market participants. The intrinsic value of your strategic edge might be secondary to how you use it.
To find your strategic advantage, you might want to look at situations when other market participants are forced to buy, sell, or do nothing for non-economic reasons. Non-investment reasons could be technical (forced selling) or emotional (temporary panic). In order to find an opportunistic situation, you want to know clearly why there is a mispricing and what mechanisms will remove the mispricing.
It benefits you to think about why you should succeed and why others should not. You want to have a firm understanding of your kinds of investment edge and keep building on them as you gain more experience.
Some of the mentioned factors overlap. For example, only a disciplined private investor can take advantage of the extra flexibility in time horizon. A reasonable combination of edges might work best, even though the exact opposite strategy, namely concentrating on a single factor, could also prove to be valuable. In the end, the best strategy might be to find the combination of advantages that works best for you and is within your skill set. Certainly, your competitive advantage should be nurtured and undergo an evolution to fit your opportunities, expectations, goals and limitations. Growing assets alone will change the investment landscape dramatically, and you should seek to do what makes most sense given your own circumstances.