A few weeks ago I read an investment write-up on a large-cap blue chip stock that is one of the largest and most followed in the FTSE 100 There was a comment that basically asked the following question: “What is your edge with this stock?”
The implication of this question is that there isn’t any edge to be had with stocks of large and well followed companies, but there is an edge to be gained with small, under-followed stocks.
The commonly held view among value investors is that you need to seek out stocks that are under-followed, in hopes of gaining bits of information that the market is not currently pricing into the stock. This is a well-intended strategy, but I think the presumption that there is a lot of informational advantage to be had in small caps is vastly overstated. This doesn’t mean I believe the market is efficient, I just think that attempting to gain an informational advantage is not the most effective way of finding value, given the wide availability of easily obtainable information in today’s market.
When it comes to stock market investing, there is primarily three main advantages to be had:
- Informational Advantage
- Analytical Advantage
- Time-horizon Advantage
Most investors only focus on the informational advantage—and this is the advantage that is most competitive.
Finding information that others don’t have is the primary reason why many investors prefer small-caps over large-caps. They think they’ll uncover something that the market currently under appreciates. In Warren Buffett’s early days, he was turning the pages of Moody’s and found Western Insurance. This stock was a profitable, well-managed insurance company with a clean balance sheet. The stock was trading between $15 and $20 that year, and had $16 per share of earnings. In other words, it had a P/E of 1. This was not a bad quality business with a bad balance sheet, it was a profitable business with real earning power and had a stable future as a going-concern.
It probably took Buffett less than a minute to realise this was a good deal. And this was an example (albeit an extreme example) of information arbitrage. He found information that the market at large didn’t have. It was simply because Buffett was willing to turn the pages of Moody’s. He was doing work that others weren’t doing. Some of the stocks he found were almost certain winners. I think a lot of the low-hanging fruit has since been arbitraged away because the breadth of information and the ease with which we can access it has levelled the playing field. Everyone is out looking for bargains now.
That said, I am completely in favour of working very hard to locate undervalued ideas. And I’m completely in favour of looking at small caps for investment ideas. But unlike so many other investors, I’m just as willing to look at widely-followed large caps for ideas, and I think widely-followed large caps can become very mispriced at times.
I also think that many investors think they have found information in small-caps that others don’t have. One of the advantages of writing a blog is I hear from a lot of readers, and in the past when I have mentioned small cap stocks, I’m amazed at how many people have already researched the company I’m looking at, and have found the same information I found. There might be 100 analysts in the city following Unilever, but there are probably 500 or more small investors following every small-cap stock, which as a percentage of the market cap and trading volume probably equals or exceeds the coverage of the average large cap.
In other words, I’m skeptical when someone claims to have found information that the market doesn’t already have. I’m skeptical of people claiming they have an edge in the small cap space.
Again, I don’t want to imply that it’s not worth looking at small caps. I just think the gap between small-caps and large-caps in terms of publicly available information is much smaller than many realise.
Informational-Focus Goes Hand-in-hand With Short-Term Focus
Also, investors that do focus on trying to gain an information edge are typically focused on short-term information. There was a recent article I read which mentioned how hedge funds are analysing traffic patterns at retailers like Walmart and Target by counting cars in the parking lot to gain some sort of informational advantage.
This type of information might be useful in predicting whether or not a company will “beat expectations” in the next quarter, but it isn’t all that much of an advantage in determining the long-term value of the enterprise or its longer-term competitive position (we’ll get the same data the hedge funds collect, we’ll just get it later).
So much focus is on the short-term – trying to uncover information before the market – and using this to trade in and out of stocks. This creates an advantage for investors who choose to focus on a different potential advantage, and that is namely time-horizon advantage.
So my answer to “what is your edge” with XYZ large cap stock is not some hidden piece of information, but it’s simply my willingness to view the business through a different lens than the majority of investors (or should we call them speculators). And I think this is a real edge. I think it’s also a sustainable edge, and one that is likely to increase as investment timeframes continue to get shorter and shorter (50 years ago the average investor held a stock for 14 years. Today the average investor holds a stock for 8 months. Crazy).
So I think this hyper-focus on generating short-term results, analysing quarterly data, and emphasising “catalysts” all help to increase the edge for those who are willing to buy good companies and hold them for long periods of time.
As an individual investor, time arbitrage is factor you should be definitely including in your market strategy. Just by looking more than a quarter or a year in advance, you can buy into good businesses that will give you great returns.
Time arbitrage is one of the reasons I bought G4S stock over a year ago. At the time, investors couldn’t see past the next quarter and were concerned that the debt load was too high. Management had come out with a strategy to reduce debt but the time horizon of a year was too long for many investors. Being a long-term investor, I was willing to be patient and have since been handsomely rewarded. I am up over 60% in under a year on that stock !
I think the time arbitrage advantage will only get stronger in the coming years. As the market structure changes and people begin to hold stocks for shorter and shorter periods, those with longer horizons will be well rewarded. Time arbitrage will increase for the very reasons why informational advantages have decreased: technology, the ease of gathering information, the short-term focus of market participants).
In short, I think the biggest advantage an individual investor has is being disciplined and having a long time horizon – as opposed to knowing more than everyone else about a specific stock. Thinking long-term is a commonly talked-about as a potential advantage, but one that is much less often acted upon. As an investor you need to capture this long-term edge and give yourself a great platform to go on and outperform.