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.

Monday, May 16, 2011

Avoid the Market to Attain Superior Investment Results, Part 1

I would say that attaining an investment edge is, in all probability, the most highly pursued activity of investment managers today. After all, the reason anyone should be actively investing money is if they can outperform, net of expenses, the passive benchmark returns over a satisfactory period of time measured in years, not months.

Unfortunately, the amount of time spent in pursuit of an edge is not directly correlated with how successful one becomes at attainting that “edge.” I would argue - and I speak from experience learned from my earliest days investing as a teenager - that often, an investor is incorrectly pursuing this approach by focusing on the little details rather than what matters most.

There are really only two ways to under-perform the passive market indices. The first is by selecting investments that under-perform the benchmark index. The second way is to make market beating investments but under-perform as a result of investment expenses. With respect to the latter, Gad Partners Funds, has eliminated this anchor. By charging no asset management fee and choosing to charge all non-administrative fund expenses (office rents, subscriptions, travel, etc.) to the General Partner (that’s my fancy title), we maximize the amount of the capital available to participate in the awesome power of compounding.

In this business, a little means a whole lot. Consider what a 50 basis point difference in expenses would mean to performance and ultimately, the value of your hard earned wealth. Over a ten year period, $100,000 compounded at 9% per annum is worth just under $237,000. Under the same conditions, but with an 8.5% rate of return, the ending result is $226,000. This 50 basis point difference, or approximately $11,000, represents 11% of the original amount invested. Over a twenty year period, the difference is nearly $50,000, or 50% of the original invested capital. Such is the beauty of the little, but incredibly lucrative nuances of this business.

But in the real world of active money management, fees and expenses are much higher and lead to even greater reduction in value creation. A typical hedge fund with a 2 and 20 fee structure has to significantly outperform the market in order to create value for investors relative to a passive index fund. A 10% performance from such a fund results in a net performance of 6.4% for investors, or a 36% “fee haircut” to investors! In a business where approximately 85% of active money managers under-perform the benchmark market indices, it’s virtually impossible for the vast majority of the industry to truly deliver value for investors under the existing fee parameters.

The primary way to outperform markets is to select securities that overtime, will outperform the market. In order to beat the market, you first have to make successful investments - buying at one price and selling at a higher price.

A successful investment involves two principle considerations. The first is the intrinsic quality of the business being invested in. The second factor that determines whether or not an asset will be a good investment is price. Taken together, a successful investment entails determining the intrinsic worth of a business and then buying at a price that is less than that intrinsic worth.

In attempting to make successful investments, investors go in search of an edge, or an insight they feel they know that other market participants do not yet know or understand. Trying to gain an informational advantage over thousands of other rational and intelligent market participants is extremely difficult. Over the years, as more and more people have entered the market, the result is and added push towards general market efficiency. More market participants do mean that when markets behave irrationally, they tend to greatly over exaggerate as well, providing the enterprising investor with incredible opportunities. The crowd is not always right, but they are often more right than wrong.

As a result, attempting to gain an edge by being smarter than the crowd is not a path to consistent above average results. On the other hand, simply being a contrarian as way to gain an edge is no guarantee of investment success either. Only when backed by rational analysis, is being a contrarian indeed a prudent and profitable approach. Just ask those who continued to short the market in 2009 who correctly based their reasoning on things like continued high unemployment, declining real estate prices, and various other macroeconomic factors.

A contrarian is rewarded by being optimistic when markets are pessimistic and cautious when optimism has taken over the market. This ability does not require above average intelligence. It requires, as Warren Buffett asserts, temperament.

“The most important quality for an investor is temperament, not intellect... You need a temperament that neither derives great pleasure from being with the crowd or against the crowd.”

Investing should be an agnostic process, devoid of emotion and temptation to swing for the fences. A long-term successful investment track record can never be attained by ignoring risk in hopes of hitting a homerun. A baseball player is likely to maximize the longevity and value of his career by focusing on his batting average and not the number of home runs he can hit.