It’s a feature of a competitive market that over the long
term a company without competitive advantage will not earn a return above its
economic cost of capital. Even if a company has a competitive advantage those supra-normal
profit margins will attract competitors who will try to erode that competitive
advantage over time.
It is for this reason that so much of successful investing
is about identifying companies that possess a sustainable competitive advantage. That is a competitive advantage
that cannot be attacked by competitors or it’s difficult to do so due to
network effects or legal monopolies like patent protection. A lot of literature
is written on the subject. Warren Buffet has become a multi-billionaire mainly
due to his ability to identify companies with a wide competitive moat. Even more
quantative investors like Joel Greenblatt try to use metrics like ROCE
to identify those companies that possess a sustainable competitive advantage,
with varying degrees of success.
While understanding the competitive advantage of companies
can be a vital part of success as a stock-picker many people forget to apply
the same principle to their own investment practice. Simply put if you are a
good analyst but don’t have any competitive advantage in investing then you
will earn the market return minus costs. If you are an active investor these
costs are likely to be large enough for you to underperform the market. If you
are a bad analyst you will significantly underperform the market.
As an individual investor (and for most professionals too) the
following are NOT sustainable
competitive advantages:
I am more intelligent
You may be clever. Most investors I know are. However you
are unlikely to be the cleverest person to trade stocks. If your strategy requires
you to know a large cap company (even the one you work for) better than a full
time analyst with a PhD and access to the management you will lose.
I am quicker
However quick a decision-maker you are, you will never
compete with a high-frequency trader. In this realm microseconds are becoming
the norm for news reaction and machine readable news aggregation is becoming
the way that economic news like interest rates or non-farm payrolls are
integrated into pricing. Very few hedge funds even can afford to compete in
this space and the incremental returns to speed have probably already reached a
plateau. If you are not already one of these few you are unlikely to become one
of them. They possess the moat not you.
I work harder
If investment returns were proportional to the man-hours put
into it then you are always onto a loser. No matter how many hours a week you
personally put in another investment firm can simply hire more analysts to
out-work you.
I have a good gut feel
The problem with basing an investment strategy on your feel
for the markets is that it is very hard to get effective feedback on how good
you actually are. We all suffer form a form of attribution bias where we
remember the successful investments we make and forget the losing ones. Even if
you keep detailed performance records of your investments it takes a lot of
data to be able to show that your gut feel adds any value. And since the market
is a complex adaptive system your gut feel may stop working. You can lose a lot
of money until you realise that things have changed.
Although it is unlikely that you will be a successful
investor unless you are clever, work hard and are able to make quick decisions based
on your accumulated experience, these are only necessary conditions not
sufficient.
In his latest book ‘David & Goliath’ [1] Malcom Gladwell
points out the underdog doesn’t always lose. When the David’s of this world
choose to fight unconventionally rather than face a much stronger opponent head
on they win a surprising number of battles.
So what are the unconventional
sustainable competitive advantages that an individual investor can possess?
I am able to invest
with a longer term horizon
This is an area where a private investor can have a real
advantage. Most professional investors bear significant ‘career-risk’. That is
they are likely to be fired or lose mandates if they have a period of long
underperformance. Outperforming the market by definition requires doing
something different to everyone else and hoping that you are both right and
that the market comes round to your viewpoint. This takes time and the more
different you look to everyone else e.g. by refusing to buy tech stocks in
1998/9 the more likely you are to be fired for a period of underperformance. As
Lord Keynes said ‘worldly
wisdom teaches that it is better for
reputation to fail conventionally than
to succeed unconventionally.' For this reason most professionals prefer
to chase small relative short term outperformance than true long term
outperformance. When you manage your own money you don’t report to anyone but
yourself. You can focus on mis-pricings that may take years to correct without
the fear that short term under-performance will hamper your ability to retain
capital or your job.
Find areas where the market is excessively myopic. For
example a company may warn on profits dues to delayed contracts and be marked
down significantly. However the reporting period of a company is essentially
arbitrary. If you can be confident that the contracts are delayed not cancelled
and the delay won’t cause financial issues for the company you may be able to
buy at an undervalued price from investors who are overly focused on the next
set of financial results only.
I am willing to bear
risk that others aren’t
Bearing risk alone doesn’t guarantee return since if it did
then everyone would bear more risk to get that return and the excess return
would be arbitraged away. What we are looking for is situations where other
investors won’t take a given risk at any price. One example is that historically
if you bought non-Investment grade bonds after they have been downgraded from
an investment grade they outperform. The reason is that a lot of bond funds
have rules that say they can only own investment grade bonds so after the downgrade
you have forced sellers. An individual bond is still risky (hence the downgrade) but on average across all recently downgraded bonds the forced selling has taken the price below the level that balances risk & reward.
It is price insensitive sellers in spin-offs that Joel
Greenblatt describes taking advantage of in ‘You
can be a stock market genius.’ You have shareholders who end up with a
small spun-off holding that is insignificant compared to their other holdings
and in an industry they maybe didn’t want to own. The spin off company will also
have limited financial history so few new investors want to bear the risk of
buying the spin-off immediately creating a price anomaly.
Find areas where price insensitive sellers and a lack of
buyers willing to bear risk creates opportunities.
I can invest in smaller
and less liquid stocks.
This is an area where hard work can pay off. When you get to
the small and micro cap part of the market then professional investors would
struggle to get enough stock to make any meaningful impact to their performance
no matter how compelling the investment case. Hence it is simply not worth them
researching these smaller stocks and equally it is not worth brokers producing
research since no one will pay for it. Although the previously held belief that
smaller stocks outperform simply due to being small is probably weak [2] it is that lack of competition that means being willing to work hard in this area can pay off.
Academic studies suggest that the average individual
investor makes very bad investment decisions [3] . So if these are your only competitors you stand a good chance of success.
Assuming of course that you don’t fall for the same poor behaviours and biases that lead this set of investors to underperform on average. e.g. [4]
Find good companies that are not well understood by the
average small cap investor and are priced cheaply. Work hard to understand
those companies better than the market.
So you see that the individual investor ‘David’ can win against the professional ‘Goliath’, but if you want to be successful you have to learn to fight unconventionally - where you have the competitive advantage.
