Any young analyst searching for investment opportunities should focus on discovering their edge.
We want to hammer home this point because it is important in developing an investment edge. There are four critical questions you need to ask to determine if you truly have a variant perspective:
- Is your view different from the consensus? You must have a view that is meaningfully different from the market’s view.
- Are you right? Your estimate of value must be more accurate than the consensus because you either possess better information or have performed superior analysis.
- What is the market missing? You can identify why the current consensus expectations are wrong and whether there is an error in dissemination, processing, or incorporation of information.
- How and when will the situation change? You are confident that within an identifiable time period, other investors will realize that consensus expectations are wrong and reprice the stock to correct the mistake and eliminate the inefficiency.
Simply stated, to have a variant perspective, your view needs to be different and correct.
Keep in mind that the market is much more efficient than it used to be.
Paul Johnson: I think the market has become much more efficient. As an example, think about the World Series of Poker. The problem you have in poker these days is that just about all the rules have been worked out. The pros have simulated the game on computers and determined the optimal strategy. The great poker players have written books and given you all the tricks. If I decide I want to become a great poker player, I can read the important books on strategy and then play 1,000 hands a day online. The process of becoming an expert has become simpler and faster. As a result, the game has become a paradox of skill: anybody who‘s not highly proficient has been chased away. Only the greats are left playing the game. There are no more fish for the sharks to feed on — they are gone. As a result, it is sharks feeding on sharks. It‘s the same in investing [emphasis added]. I am shocked at how much more efficient the markets have become in the last 10 years. Everybody talks about the fact that it has become very hard to generate alpha. You‘ve seen some great investors leave the business. They are closing shop because they don‘t want to compete against other sharks. That‘s the biggest change in 10 years. I think the second biggest change is alternative data sets. Now there are sophisticated programs that scrape the web, monitor social media, and generate alternative information like credit card ―exhaust, which is secondary or meta data, and satellite imagery. Alternative data has come a long way in the last 10 years and smart investors are using these unstructured data sets to get an edge. Also, information is now released on the web to everyone at the same time. You even have services like Capital IQ and others that will build your financial models for you. When I was a young analyst, there was an advantage to building better models. That skill no longer gives you an edge.
As an allocator, what questions should you ask your money manager to discover their edge?
Paul Sonkin says these questions could give you valuable insight into your [money] manager’s thinking.
- Do you have have a target range or minimum hurdle for the expected investment return?
- What are your market cap constraints? Large, small, mid, nanocap, or megacap?
- What growth characteristics are you looking for? Is slow growth OK, or do you insist on high growth?
- What are your preferred valuation metrics? Do you look at EBITDA multiples, P/E multiples, or earnings-power value? Are you in search of deep value, value, growth at a reasonable price, or pure growth?
- Are there specific industries you focus on or avoid?
- What geography do you prefer? Domestic or international? Developed countries or emerging markets?
- Do you insist that a company have a strong competitive position or be an industry leader?
- Are you receptive to contrarian investment ideas and turnarounds?
- Do you have any special requirements regarding management? Any requirements regarding corporate governance? How important is the management’s ability to allocate capital?
- Is the composition of the company’s shareholder base a factor? Do you like to be the “only footprints in the parking lot” (meaning very few investors looking at the company), or do you feel more comfortable if there are other well-known investors who hold positions?
- Is there a limit on a company’s financial leverage?
- Do you look for the possibility of financial engineering or other types of restructuring? Do you gravitate toward companies that are takeover or activist targets? Companies where there is the need for a spinoff or divestitures?
- What is your typical time horizon? Weeks, months, years, or forever?
- What are the special characteristics of your portfolio, such as concentration and turnover?
To learn more about the book, listen to Paul Johnson and Paul Sonkin on Capital Allocators.
Post by Marcelino Pantoja