Investors who want to beat the market aim to make good investment decisions. To do that they need a) access to good information and b) they need to assess this information correctly.
Today there is lots of useful information available to investors. The problem with that is, everybody has access to this information.
As a result, information alone is unlikely to help them beat the market. Doing a better assessment however will.
To perform a better assessment than the market, an investor may want to focus on those areas of investing where he or she can best apply his strengths and experiences.
What is your edge over the market?
If an investor wants to generate a return just like the market, he or she is best off buying an index fund, instead of investing in individual stocks. Which is is a wise decision for many people. But since you stopped by this blog, you are probably one of the folks who go the extra mile to analyze individual stocks. From that I conclude that your aim is to generate above market returns. To achieve those returns, you need to differentiate from the market. In a positive way of course.
I’m pretty sure that you apply a lot of useful tools and newsletters which help you in your analysis. I am also confident that you that you have read Benjamin Graham’s “The Intelligent Investor”, Peter Lynch’s “One Up On Wall Street”, and the likes. So you are all set, that’s great. But let’s face it. The rest of market has access to the same resources. All of the information that you are happy to have discovered will be available to most investors as well.
I am asking you, how exactly can you differentiate from the rest of the market? To answer that I would like to take a step back and take a candid look at the bigger picture. The good news is, you will have some experiences and strengths that will enable you to understand a certain type of investment opportunity or business better than most other people do. You can gain an edge by adjusting your investment style accordingly. If your strength were arts in high school, you probably wouldn’t choose accounting as a major in college. The same goes for investing. Choose the areas where you can apply your skill-set best.
Early on in my career I worked on a due diligence in the chemical industry. Back then I worked for a consulting company which provides private equity clients with due diligence advice. The chemicals company we analyzed had several business units, which operated in a variety of end-markets. Each of the business units had lots of chemical products, which all sounded like Greek to me. Even thinking about it today makes my head spin. I’m not going to lie to you. Once the project was finished, I still hadn’t fully understood the products, which this company sold. To this day I am not sure whether my colleagues had more luck or skill in understanding them than I had. In any case, since that day I have stayed away from chemical companies. I also don’t like to analyze companies that consist of a labyrinth of many different end markets, business units and products.
In contrast, I worked with a portfolio company in the media space for five years. I like media, because you need to understand end consumers, because new products can be launched rapidly and because the market space is changing quickly. I feel like I understand the dynamics of such an industry.
These are just two examples, but step by step I have build my favorite lists of industries, business types, and investment thesises. Likewise I have my list of situations I like to stay away from, like chemicals.
And where can you best apply your strengths?
Now how do you figure out where your skill-set works best? Remember how we explored that your approach to analyzing a company is determined by the investment thesis in the previous post? Well, naturally, different approaches also demand different skill-sets. Once you find out which approach suits your skill-set best, you might already have an edge over the herd.
Let’s go back to where we left off in the previous post and take the investment strategies of growth investors and value investors as an example to better understand what might suit you best.
…is it Growth Investing
Growth investors tend to invest based on an investment roadmap. They try to identify themes that will drive the growth of companies, such as technology trends, demographic trends or other drivers. In that sense, timing is important. Those investors who are able to identify these themes and the companies that benefit from them ahead of the curve will win. They want to spot them early in their lifecycle, before the crowd appreciates their prospects. At earlier stages the growth opportunity will not yet be fully reflected in the stock price. As a result, the fortunate investor will be able to invest in tomorrow’s stars at low prices.
Yet they still will have to pay a higher stock price for the company’s stock. To some extent, the share price will reflect growth expectations. In order for growth investors to make a solid return on their investment, it is not sufficient that their portfolio companies grow. Their growth needs to meet or exceed the growth expectations that were already factored into the stock price. If growth doesn’t meet expectations, then the stock price will deflate, as disappointed investors sell off. This is not helpful for returns.
To be successful in assessing growth prospects, they develop in-depth knowledge of specific sectors that will benefit from those drivers. Growth investors need to understand the size and drivers of the potential market and how the company’s products fit into that market. Developing a good understanding of the product roadmaps of those companies is key.
Since growing companies usually invest large amounts of today’s cash to generate future growth, it’s vital to assess how efficiently they use this money. A company, which wants to gain a large share of a new market might heavily invest in hiring a sales force. In the short term, their cash flows will be lower, as they invest today’s money in order to gain a share of the future market opportunity. The challenge is to understand how likely today’s investments will turn out a profit in the future. Growth investors need to develop an understanding of how the company sells and market its products, how efficient the sales force operates, which channels it uses, how much it costs to acquire a new customer, and what profits a customer is likely to generate for the company in the long term. They need to understand customer lifetime value.
Similarly important, growth investors need to be able to make an assessment of whether management will be able to handle the growth of the organization. It’s often underestimated how difficult it is to scale an organization, which will change its structure as well as its culture along its growth path.
This is just in a nutshell. There is more to assessing growth companies. For more details have a look at this post.
…or in Value investing
Value investors on the other hand are more opportunistic than growth investors. They look for companies, which are undervalued. The reason for this undervaluation will often result from an inefficiency of the market. Thus, value investors need to be able to exploit market efficiencies. They need to be able to spot mispriced stocks like a truffle pig.
In order to spot misplaced stocks they use stock screens, company visits and talk to people from industries in which the companies operate or to people from the investment space.
Stock screens are based on financial analysis and valuation methods. Picking the right screens is a first step to success for value investors. There are a number of different value strategies that go along with different screens.
Value investors not only focus on finding undervalued companies, they also focus on market areas “benefit” from market inefficiencies. A poker metaphor, which Howard Marks, founder of Oaktree Capital Management, uses in his shareholder memo “Getting Lucky” explains it best. He states that at some point, a poker player shouldn’t spend his time getting better, but he should spend his time on “finding the weak games”. Similarly in investing there are games where other investors make mistakes and where this leads to inefficiencies. In some market segments people are overexcited. In other segments they are under excited, risk adverse or less skill full than in other areas.
Behavioral finance is a key cause for market inefficiencies. Understanding the emotions of the market is critical for value investors. They need to be able to identify when biases and cognitive flaws result in decision errors. Simply put, they need to recognize when the market gets too greedy or when it becomes too fearful. Vice versa, they need to have the guts and the discipline to follow their strategy, even when the market is going nuts. That means they will often bet against the consensus. There is a huge pressure on us to conform to consensus. If in doubt, just think about the latest fashion trends. Not without a reason you will rarely come across a Beetle’s hairstyle these days. Value investors need to have the emotional stability and guts to stay objective and stick with their strategy.
We know from the previous post that value investors focus on stable cash flows with downside protection. In their assessment of the company they therefore need to be able to evaluate whether a market position of a company is sustainable in the future. We will discuss how to do this in more detail in this post.
Your turn now
What are we talking about here? If we had to sum it up, then value investors are quantitatively driven. They can rely on historical figures to assess a company. Growth investors on the other hand have to bet on the future. They cannot rely on past figures. Therefore, they need to excel in understanding the business model, assessing the management team and understanding how dynamic markets can change. Intuition as well as experience in a particular sector is of vital.
So as the growth investing skill set is different from the value investing skill set, do you know in which field you can rise and shine? When you look at a company, be aware of what kind of investment thesis and strategy you are following. Keep the success factors in mind and adjust your approach accordingly. Do you have any particular strengths that can help you leave the mass of investors behind? Do you feel closer to the Oracle of Omaha or to the Oracles of Silicon Valley? Do you feel more excited by studying annual reports or by following tech trends? In which area can you reduce risk through your better knowledge? Do you have a good understanding of the operations of a business? Do you know specific industries or an industry’s customers very well? Do you have a good overview on macro factors? Try to put yourself in a position in which you can benefit from any skill set you have.
Finally let me remind you to also take into account where the market environment is standing. Different market environments provide different opportunities depending on how risk and upside potential are balanced. Accordingly different investment strategies perform differently across different market cycles.
As a result, you may want to follow different kinds of investment strategies and thesises. In private equity, we did various types of investments as well. But we always were aware what skill set we could bring to the table and what impact the investment would have on our portfolio in different scenarios. Also, our team consisted of different types of investors. Some of them where more quantitatively driven, while some focused more on the business model and the team. This certainly led to opinionated discussions, but in the end it also led to more balanced investment decisions.
In the next post of this series we will move on from this strategic approach and get more hands on. We will explore a little framework that helps you in analyzing companies.
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[mks_separator style=”solid” height=”1″]picture credits cover photo: Neirfy / Shutterstock