Saturday, 22 April 2017

Know Your Competitive Advantage

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.

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