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.