Three Edges to Beat Mr. Market

Around 93 percent of the U.S. students estimated to be “above average” drivers. And 68 percent of the faculty at the University of Nebraska rated themselves in the top 25 percent for their teaching abilities. Majority of the students and faculties sincerely believe that they are better than the average. But the iron law of mathematics is that everyone can’t be above average. The reason for this belief is their overconfidence.

Most of the investors, including myself, believe that the odds of them beating the market indices over the long term is greater than 90%. But the truth is that 90 percent of them will fail. What should one do to beat the market? Last year I attended a value investing course at Stanford. You can read about it here. In it, I learnt that to beat the market one needs to have an edge. There are three ways by which an edge can be created. They are informational, analytical, and behavioral. In this post I will write about these edges in detail.

1. Informational Edge

Informational edge gets created when you know about a company better than anybody else. Regulation Fair Disclosure mandates that all publicly traded companies must disclose material information to all investors at the same time. In that case how can one create an informational edge? There are couple of ways by which informational edge gets created. The first method is to trade the stock by using insider information. Since this is not legal let’s not bother about it.

The second method is to study businesses that are not covered by any analysts. This is the case for micro caps, small caps, and spinoffs. For these companies you won’t find a lot of information in their annual reports. And to gain informational edge you need to do grassroots research, also known as scuttlebutt or kicking the tires. If you follow the advice of Buffett given below then you will gain informational edge.

If I were looking at an insurance company or a paper company, I would put myself in the frame of mind that I had just inherited that company, and it was the only asset my family was ever going to own. What would I do with it? What am I thinking about? What am I worried about? Who are my competitors? Who are my customers? Go out and talk to them. Find out the strengths and weakness of this particular company versus other ones. If you’ve done that you may understand the business better than the management – Warren Buffett

Take a look at the metrics given below for Kitex Garments. From 2010 to 2014 the company compounded its sales and operating profits by 16% and 24%. It reduced its debt and compounded its earnings per share by 33%. But the market didn’t rerate the stock and it was selling at 7 times earnings. Why is that? There was no institutional ownership and none of the analysts were following the company. So not a lot of information was available about the company. The only way to get an information advantage is to do grassroots research. Did someone do it?


You can find the telltale signs of grassroots research here and here. Spend some time to go through the research and you’ll learn a lot from it. The price chart given below shows the advantages of having an informational edge.


2. Analytical Edge

Analytical edge gets created when the same information is processed differently by someone to gain unique insights. This is similar to a commander who was able to sense that the house is about to collapse due to fire beneath the basement.

The psychologist Gary Klein tells the story of a team of firefighters that entered a house in which the kitchen was on fire. Soon after they started housing down the kitchen, the commander heard himself shout, “Let’s get out of here!” without realizing why. The floor collapsed almost immediately after the firefighters escaped. Only after the fact did the commander realized that the fire had been unusually quiet and his ears had been unusually hot. Together, these impressions prompted what he called a “sixth sense of danger.” He had no idea what was wrong, but he knew something was wrong. It turned out that the heart of the fire had not been in the kitchen but in the basement beneath where the man had stood. – Thinking Fast and Slow

Take a look at the metric given below for Google. From 2010 to 2014 the company compounded its sales at a healthy rate of 22%. But operating income and earnings per share compounded only at 12%. A person with an analytical edge would question why did the operating margin go down from 35 to 25 percent. Upon analysis he would find that the company has been spending heavily on R & D non-related to core advertising. And it doesn’t add anything to sales for now. So he would look at the normalized expense instead of looking at a single year expense.


At a normalized operating margin of 35% the economic EPS in 2014 would have been around $28. At one point the stock was selling for $500 which gave it a price-to-earnings ratio of around 18. This is cheap for a company growing it sales at 22%. The price chart given below shows the advantages of having an analytical edge.


In the video given below watch from 29:00 to 32:00 minutes to see how Whitney Tilson applies analytical edge to analyze Google.

3. Behavioral Edge

Behavioral edge is the most important edge you need. Its ok to not have informational and analytical edge. But if you don’t have behavioral edge then you’re doomed to fail. In the video given below watch from 00:00 to 1:00 minutes to see Munger talk about behavioral edge.

I think its in the nature of long term shareholding that the normal vicissitudes in worldly outcomes and in markets the longterm holder has his quoted value of his stocks go down by fifty percent. If you’re not willing to react with equanimity to a market price decline of fifty percent two or three times a century then you are not fit to be a common shareholder. And you deserve mediocre results you’re going to get compared to people who do have the temperament. – Munger

Behavioral edge can be obtained by following a process and sticking to it through thick and thin. Each one of us are different and there is no one process that would apply to everyone. The key is to have a process. The one that I follow to obtain behavioral edge are (1) identify 50 high quality compounding machines that I would be proud to own for a long time (2) study them throughly (3) sit patiently and wait for the right pitch. As Buffett tells – Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.

Given below is the P/E chart of MasterCard. From 2011 to 2014 this excellent franchise compounded its sales and earnings per share by 14% and 22%. During the entire 2011 the stock was available at a bargain price of 17 times earnings. Anyone with a behavioral edge would have identified this opportunity and loaded up on this franchisee.



36 thoughts on “Three Edges to Beat Mr. Market

  1. Well, not such an intelligent question, but after the insights as you said are discovered, is it not time to buy it, but to look for other undiscovered ones. Lets say Kitex as you looked at it, I did not buy it at 2 digits, hence had to pay 400+, I bought it and in 2 months it more than doubled, then went down now, I am willing to pay more and buy KITEX as its a discount to prev. highs, now at a DCF level one can never calculate what these generate, hence are you saying buying stories cheap before discovery is the only key or is one of the keys!! If its the second then i’ll breathe and not call myself a fool

    • Aravind,

      No I’m not saying one shouldn’t buy. The odds right now is very different from the odds when someone paid single digit earnings.

      Here is an analogy to explain this concept. Imagine a very fat lady and one guy is asked to tell if she is fat or not (someone paying single dight earnings). And he will get it right most of the times.

      The other person is asked to tell the weight of the women to the fifth decimal place (someone paying 50 times earnings). He might get it right. But it’s hard to tell if it’s luck or skill.


  2. Thank you for the post.

    I think the problem of most investors not beating the market is mainly on the behavioral site.

    I have been writing extensively on my blog about. Coincedently I just published a post touching on that subject today.

    You have to develop a feel for the market and company. The Japanese call it reading the air when it comes to social conformity. But I think the concept has interesting implications for investing too.

    Anyways. Thanks for your work.

  3. I keep checking your blog everyday for new posts. ALways something new you got in it, which on reading makes me analyse things more deeper and in a different perspective. Great work Jana

  4. Good work Jana, congrats. You have attended the Piramal AGM, can you please share the insights in some form. Thanks.

  5. Excellent post Jana as usual. But I feel from such a vast universe of potential stocks how does one zero down on a shortlist? I meant reading 500 financial pages a day as mentioned by WB is not possible for partime investors. Plus the sheer number of numbers to be looked at numbs the mind. Most of the time you latch on to something after its been pretty well identified by the market and than like you rightly said you’re reduced to guess the fat lady’s weight to the 5th or 6th decimal points!

    If you use screeners i dunno how well they would help because some of the names that crop up will be one offs. How to screen investments is what I’m stuck at most of time. And that’s one subject where very less material advice is there. I mean Prof. Bakshi has never explicitly mentioned how he comes about his ideas i.e. how he zero downs on potentials.

    If you think about it. you’ve yourself said that till now you’ve analysed companies which have been already identified by others. Don’t get me wrong but you analytics are par excellence. But imagine if you had to look at a universe of 100 or 150 companies. How would you zero down to at least 10 of them for further analysis. You need some handle to do that. I mean with the current household moats are so extensively written about that the prices have always factored in the growth premium in them. And hence you again reduced to guessing the exact weight.

    I would love to read you thoughts on the subject. As that the 1st place I get stuck at.

    • Ankit,

      Come up with the 20 well run companies that you would be proud to own. Study them throughly and wait for the right pitch patiently. When you get a chance load up.


    • just to post my opinion.Ankit what you have asked in a very practical question.initially what we can do is create a list of stosk that are analysed here and some other sites and zero in on the sectors or similar competitors. And slowly keep adding too as per our knowledge.

  6. I m extremely motivate your thought process n good article post here so how u can do this ? Reading reading n reading or any other tools u follow … sorry ask for this type of question

    • Gaurang,

      Yes reading a lot and re-reading great books definitely helps. I have been writing for the last 2 years and that’s helping me to get better with every post.


  7. Also appreciate that you take the time to respond to all comments, even when it’s a simple ‘Thanks’.

  8. Thanks for letting me link to my post. I still think that your firefighter example, which was excellent, belongs to the behavioral section to investing though. But i might be very well wrong.

  9. There is a third way to gain an information edge.

    It’s kind of like two guys walking into the same party. The first guys sees only a few people, no music, people standing around with their hand in their pockets, and he leaves. The second guy sees two cute girls all the way in the back giggling, goes over, introduces himself and has a great time. Same party.

    When I read a 10K, I’m looking for different things than analysts.

    Take into account almost all analysts are trying to predict earnings (or another profit metric) and the stock price for this quarter or year. Besides being an impossible task, they are not trying to value the business over the long term.

    So if you are a value investor, just by looking for the long term capacity for a company to drive earnings is an edge over the analysts who are looking for short term drivers. It’s all publicly available, I know, but “Mr. Market” generally ignores the girls in the back.

    Did Warren Buffett really know more about PCP, or Burlington Northern than everyone else?

  10. Hi Jana,
    Thanks for your post. Very informative. I am regular reader of your blog.
    My query is, after you do through analysis and bought a stock. After the purchase the Market doesn’t recongises the value of the stock and remains in the same price range for long time. At these moment how do you feel. Either you are wrong or the market is correct. How long to wait for market up movement. Have you come across this scenario

    Best Regards

    • Prabhu,

      Before you buy any stock write a one page thesis on why you’re buying the stock. As long as the thesis holds good then you can hold the stock.

      How long should one wait? It depends on the person. A guy like Buffett is willing to wait on his big bet on IBM for almost 4+ years. What is his thesis? He believes that IBM will come out unscratched on the shift to cloud. And meanwhile the management is buying back shares below its intrinsic value and increasing the per share earnings and percentage of ownership for Buffett.


      • Jana,

        Thanks for your reply. Yes, I do write my thesis or tell my mom or to wife about the company I am going to buy. I think , I am evolving as a investor, market teaches lot of new things. Good to learn a lot of scenarios which will guide in the future. Thanks Jana , for your writings.


  11. nice post! What you express is 100% correct. BUT it is not easy to do.

    I own MasterCard and Visa both in good size. When I bought them, there was disaster in their worlds. Banks were actively cutting credit lines for existing cards, cards were being revoked, new card issuance virtually stopped and people were often paying with cash. It was very, very serious. I myself had two credit card lines forcibly reduced and I am a very good credit, pay everything to zero monthly. None the less, they cut down the credit lines. Simultaneously there was the emergence of competitors like Google Wallet and Paypal etc creating uncertainty about the future competitive landscape. Concurrently there was a big set of litigation regarding the ability of MA and V to maintain their fees (which were cut).

    Although MA an V had a good record, the appearance was that their worlds were going to implode. It is very, very difficult not to look at all the prior analysis and not say, “well, yes, it was good THEN, but NOW……????

    Hindsight bias makes it look obvious, but it was not that obvious.

    It is worth developing some sort of mental training to envision disaster and yet keep buying. That is just an idea, I do not know how to do this.

    Your post is a very good framework for developing knowledge. I like the idea of lining up a “dream team” group of stocks that you might like to own at a price. Good information, well done.

  12. Very well-written. Those are really the only edges an individual investor has in the market – the behavioural being the most important. If he realises he has no particular edge, he should decide not to play the stock-picking game – as mutual funds will do the job for him.

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