This idea behind this post is nothing new. I discuss it constantly on this blog. But it’s worth mentioning again because I feel like the principles behind it are so frequently ignored by investors. The idea is simple: if you want to outperform the markets, you need to have an edge in your investments.
Now, edges can come in a bunch of different forms.
For example, I mentioned FRMO in my post on great allocators. Many of their investments center around taking advantage of inefficiencies caused by indexing. Owner-operators (basically, firms still run by their founders who have large stakes in the business) are underrepresented in indexes because of the free float adjustment, which can present interesting opportunities for inefficiencies. There other, more basic inefficiencies associated with indexes, including the forced buying / selling when companies are removed from indexes when removed.
Personally, I think the best edge investors can get is an edge from investing in niches. Most areas of the market are effectively and efficiently picked over by investors, but there are little nooks and crannies that aren’t simply because they aren’t big enough for most investors to consider. I think a great example of this is liquidations. This idea was brought to me by Horizon Kinetics (which FRMO has a big interest in), but liquidations often trade at a ridiculous discount rate compared to the underlying assets. In a vacuum, the excessive discount rate doesn’t make sense, as a liquidation is the perfect asset for a hedge fund to invest in; they’re a lot like M&A, with tight time frames and defined upsides, except the downside is often much lower as there’s no acquisition premium to be lost if the deal ends and it’s almost unheard of for a liquidation to fall through (I believe there are laws that state once a liquidation is on, it can’t be called off), However, liquidations are rare, and they tend to be done by smaller firms. Because of the small size and illiquidity of the liquidation market, it really doesn’t make sense for professional investors to focus on the liquidation market, and that lack of focus creates an inefficiency that I believe investors can take advantage of.
I think that type of inefficiency from lack of focus extends to many micro-caps. Stocks under $50-100m in market cap, especially ones with high insider ownership, simply lack the liquidity for most professional investors to bother analyzing. That means entrepreneurial individual investors who are willing to bring a professional / business-like approach to valuation can gain an edge.
Unfortunately, those edges can only be found in tiny niches. Once you start investing in large caps (the Googles, Microsofts, Intels, etc.), you no longer have the edge that comes from competing against no one. You’re now investing against professional investors who spend their entire lives thinking about a single sector or sub-sector. There’s only one type of edge you can have in those situations: better analysis. Quite simply, you need to be better at interpreting all of the information about a company and saying “the market is assigning this company an 8x multiple. Given all of these facts, I think the market’s wrong and it deserves a 9x multiple” or something along those lines. Some would argue you can have a longer time frame than the market, but I think that the market is normally pretty efficient at incorporating long term results and earnings. Yes, every now and then it’ll miss one (Coke in 1988, for example), but for the most part taking a “long term” view on the value of a large cap company is the path towards average returns.
To me, there’s no edge to be had there. The market might not be perfectly efficient, but it is a tough beast to beat. Next time you’re buying a stock, ask yourself what edge you’ve got on the market. Are you really working with a differentiated opinion? Is the stock you’re buying really likely to generate excess return with less risk than the market? Why? Or are you simply gambling on yourself being a better analyst than 35 highly paid Wall Street researchers who spend all their time thinking about that company’s stock?
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