Tuesday, July 5, 2011

Avoid the Market to Attain Superior Investment Results, Part 2

The first part of this two-part article illustrated the importance of gaining an edge in investing. So how do the considerations and thoughts from Part I factor into my thinking with respect to gaining an edge? I can best explain my approach through a simple question: If asked to beat Phil Mickelson, how would you do it? You do it by not playing him in golf. Consider this analogy with respect to the stock market. The best chance of beating the market is by avoiding it. Let me explain.

Today’s market environment is dominated by mutual funds, pension funds, and hedge funds collectively managing trillions of dollars. These large funds demand equity research, analyst estimates, and other investment information services which are gladly catered to by the hundreds of equity research firms and investment banks who exist solely to service those needs.

Because these investment funds are dealing with large pools of capital, they are looking for places to allocate hundreds of millions of dollars in a relatively short amount of time. As a result, the vast majority of investment capital is being spent building castles in the same sandbox. Because asset management fees are paid annually, the goal at the beginning of each year is to be around next year to collect those lucrative fees. By staying in the same sandbox and building castles (portfolios) from the same sand (stock selections), you prosper and perish with the masses. But in the end, they survive another year to earn those lucrative fees.

If one principle characteristic of market efficiency is the existence of many informed participants, then the only possible edge worthy of exploitation is to look and play in areas where the industry pros ignore. Stock prices reflect supply and demand characteristics. An overvalued stock price suggests that demand for that particular security vastly exceeds supply and while an undervalued stock price often confers the opposite condition.

When there is no demand for a particular security, it’s likely due to one of two principal factors. First, the stock may be unknown to the broad investment community. Second, demand is low when a stock is out of favor or in trouble. In both instances, the probability of identifying a business that is trading below its intrinsic value is greatest. Inverting this observation suggests the following: the best way to find a successful investment is by either looking where very few are or finding a business facing problems that are deemed to be temporary and curable. My observation is nothing new:

I am convinced that [investors] with sound principles, and soundly advised, can do distinctly better over the long pull than a large institution. Where the trust company has to confine its operation to 300 concerns or less, the individual has up to 3000 issues for his investigation and choice. Most true bargains are not available in large blocks; by this very fact, the institutions are well nigh eliminated as competitors of the bargain hunter
                                                                      -Benjamin Graham, September 23, 1974

Occasionally, one can find quality issues trading at reasonable valuations. Late 2008 and 2009 was a good opportunity to buy first rate businesses at exceptional prices. Often, however, a great business is already great in the eyes of many and this perception is already reflected in the underlying stock price.

Simply put, trying to beat the market by playing the same game that is under the constant analysis and microscope of tens of thousands of investors, analysts, journalists, and other interested parties is likely to lead to sub-par results. Play a different game: buy when everyone else is selling, look where no else is looking, and be skeptical when everyone is jubilant.

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