Last week, I looked at how
a small investor could gain an advantage in the market by understanding the
other players. The most important other players are institutional
investors such as hedge funds, pension funds, mutual funds, and investment banks
who have considerably more resources and valuation skills than the individual
investor, and so trying to take them on directly to beat them at their own is
likely to be an expensive exercise in futility.
Two Exploitable Weaknesses
On the other hand, I argued that institutional investors have certain
handicaps and biases which do allow small investors to enter the market on
our own terms, and not compete directly with the institutions. These
include:
- Too much money.
- A focus on quantitative as opposed to qualitative analysis, which leads to
a focus on the past.
I listed several other weaknesses last week, but these are the two I focus on
when doing my own investing. While the overall returns of some money
managers are hurt by the agency problem (looking out for their jobs rather
than their client's returns) and the like, I have not come up with methods of
taking advantage of these weaknesses. In fact, I think that there are a
bunch of other traders and hedge fund managers out there doing just that, and
the last thing I want to do is go up against hedge funds.
I'll deal with just these two, and point to some tactics a small investor can
adopt in the pursuit of an edge in beating the market. The underlying
theme is always the same: in order to beat the market, we have to identify
mispricings: instances in which the value most market participants place on a
security differ from its true value. Small investors, with far fewer resources
than institutional investors, should focus on securities that institutional investors
are ignoring, or analyze securities in ways institutional investors do
not. If you can think of other ways to exploit weaknesses of institutional
money managers, all the better: you won't be in competition with
me, either.
Too Much Money
To a small investor whose biggest financial decision in life so far has
probably been the purchase of a house, the idea of having too much money may
seem laughable. Nevertheless, too much money is a very serious handicap for institutional money
mangers, and the only handicap they all share. If you have $50 million
dollars to invest (the size of a small mutual or hedge fund), and you're looking
for a stock that will add 0.1% to your returns if its price doubles, you are
going to have to invest $50,000 in that stock. That won't be a problem if
you want to buy Archers Daniels Midland
(NYSE: ADM) for exposure to
ethanol and biodiesel, because your trade will barely be a drop in the daily
volume of stock traded. On the other hand, if you want to buy $50,000 of Earth
Biofuels [OTCBB: EBOF],
which has a market capitalization of less than $100,000, you could easily wind
up doubling the price of the stock in the process, greatly reducing or even
eliminating any potential gains.
In other words, in order to make any profit on a stock, that stock must have
some degree of market capitalization, and trade enough volume to make a substantial
investment at a reasonable price. In other words, institutional investors
are compelled by their size to invest only in companies that are (at least to
some degree) reasonably large and liquid.
There are no particular cut-offs on what makes a stock large or liquid enough
for institutions, since institutions come in all sizes.
Because large investors can buy them, shares in highly liquid securities
often trade at a higher price than they would otherwise (called a liquidity
premium), and hence illiquid securities have, on average, higher long
term returns. More importantly for our discussion, there are few or no
analysts trying to asses the value of illiquid securities, and so a diligent
individual investor is more likely to be able to identify an under priced
security. If you want to find a rare coin, you have a much better chance if you
look through a jar of pennies found in the attic than if you look in your loose
change jar.
With a liquidity premium comes liquidity
risk: the risk that, should you want to sell an illiquid security, you will not be able to sell
at a reasonable price, or, on occasion, at any price. I have a personal
rule not to put more than 1% of a portfolio into an illiquid stock, especially
ones that trade off the regulated exchanges, and even then, I'll also limit the
fraction of the portfolio devoted to these sorts of stocks. Nevertheless,
given the low professional interest in illiquid stocks, most of them are
mispriced: the trick lies in finding the ones which are substantially
undervalued rather than overvalued. It's not uncommon to see a stock go up
many times in a single year. On the other hand, it's not uncommon to see
them plummet to nothing in the same period.
Given the prevalence of over the counter stocks that are little more than an
excuse to part investors with their money, I only look at companies that I read about
in the non-financial press.
I think of it this way: if a company's purpose is to sound good to investors,
they will target investors with their public relations. On the other hand,
if they are out in the world solving real problems or providing necessary
services for paying customers, then I'm much more interested. A company that's talking about its great business plan to solve a problem I had not
thought of on my own is much less appealing. Worse yet are companies
setting out to solve a problem that everybody is talking about,
which I take as a sign that a company is trying to hop onto a bubble bandwagon. Companies which are actually out making news (as opposed to
generating PR news releases) are much more likely in my mind to have something
customers want, and these are the companies which deserve further research.
If you're considering investing in small, illiquid companies, no matter what
sort of analysis you intend to do, I suggest you limit yourself to investing in
no more than one third to a half of the companies you analyze. This will
discipline you into making hard choices, and prevent you from putting money into
a company simply because you feel that all the hard work you did researching it
deserves to be rewarded. The market does not reward hard work: it rewards
good judgment (a much rarer commodity).
Quantitative Analysis, and a Historic Bias
Much of my article last week was devoted to making the case that institutional
money managers focus too much on quantitative analysis rather than
qualitative analysis, and I won't repeat that argument here. When
considering the same companies that large investors analyze, we should not spend
much time doing traditional valuation: it's already been done by many other
people who spend days analyzing one company, and poring though the
footnotes.
When looking at big companies, the small investor's potential advantage is
lateral thinking, leaps of intuition that become less and less likely
the more analysts delve down into the footnotes of a financial
statement.
The stock market, and history as a whole, is prone to breaks and sudden
reversals. When everything is going well, it becomes harder to see dangers
lurking in the corner. When the roof seems to be caving in, it becomes
hard to see the light at the end of the tunnel. Aggravating this is the fact
that financial statements are historical documents. Typically, when an
analyst wants to project the future of the firm, he will start with this
historical data, and see how all the factors he can identify have interacted in
the past, try to guess what these factors will be in the future (often by
extrapolating existing trends), and see what comes out.
But what if the key to the future is not contained in the past? The millennium
bug was a disaster that everyone saw coming, and because of that, they took the
necessary steps to deal with it, and when 2000 rolled around, the whole thing
was a fizzle. On the other hand, Long
Term Capital Management failed because their sophisticated mathematical
models of the complex relations between a wide variety of different
financial assets failed when those relationships broke down during the Russian default in 1998.
Such Black
Swan events are, by their nature hard to predict. But, to beat the
market, we don't have to predict the unpredictable, but only to make a
prediction that most other people have not yet made. Some events defy
prediction by their very nature, but more defy prediction because of our
psychological biases. Put simply, few people predict things that should be
obvious because they don't want to see them coming. For instance, you
probably know someone who was in a doomed relationship, but absolutely refused
to acknowledge the relationship was ending until long after it was over.
That happens all the time in the stock market. People did not believe that
the stock market was overvalued in 2000 (despite repeated warnings) because they
were too attached to making 15-20% a year on their investments. They were
flipping condos up until a year ago despite the fact that both the ratios
of home prices to rents and home prices to median income were at historic highs.
These were predictable changes in the market, which people did not see because
they didn't want to see them.
I spend a lot of time trying to think about the unthinkable. What
could happen that would totally change the rules of the game? What is
the disaster that no analyst is building into their projections because it's
too difficult to contemplate or quantify? What are the chances that these
things might happen anyway?
To beat the market, we need to "think outside the box." It's
a cliché, but it's still a lot easier to talk about than do. And there's
no instruction manual.
Conclusion
Neither of these tactics is simple or easy to implement. If beating the
market were an easy task, everyone would do it. Before you even try, you
should first ask yourself if there is some reason you may be better than anyone
else, because if you're not better than most people who try, your results won't
be any better either, and you'll end up losing money. Last year, I
put together a quiz, with a very serious purpose: to help
people self-assess if they might actually have an investing edge (or at
least if they don't have many of the traits that cause people to fail.)
It's not very scientific, but I like to think that it will help someone who
shouldn't be trying to beat the market to decide to index their portfolio, or at
least persuade someone who is bound to try any way to dip their toe in rather
than diving in head first.
I believe it's possible for a small investor to beat the market over the
long run, but I don't think that most, or even many, small investors have much
of a chance. It's human nature to believe that we're the exception to the
rule, and in some ways it's rather ridiculous for me to be telling you to take a
hard look at yourself before you try: I wouldn't have taken that
advice.
What we need to decide for ourselves is how much of our confidence is
actually overconfidence. Most of us who try to beat the market will fail,
but I like to think that I've helped a few small investors along the way to success.
DISCLOSURE: Tom Konrad and/or his clients have positions in
the following stocks mentioned here: ADM.
DISCLAIMER: The information and trades provided here are for informational
purposes only and are not a solicitation to buy or sell any of these securities.
Investing involves substantial risk and you should evaluate your own risk levels
before you make any investment. Past results are not an indication of future
performance. Please take the time to read the full disclaimer here.
Our final stock is getting its first mention on Gold Stock Bull today. Despite being the darling of the ethanol investment community and attracting funding from none other than Bill Gates, we have been hesitant to recommend Pacific Ethanol (
.)I consider this approach "number crunching":
gather data, analyze carefully, and take action. 
