What is your edge?
What is your edge?
An analysis of the type of edge you can have as an investor and how to develop it further.
10 minute read
This week I spent a lot of time thinking about what edge I could have as an investor, and how to further develop it.
I identified that edges in investing can be separated into two categories: situational and general based. For example, investors managing a small portfolio in size have the situational advantage of being able to invest in a wider range of opportunities, and overlooked companies. On the other hand, general based edges do not depend on situations. They depend more on the way an investor operates.
I believe the following to be the general based potential advantages :
Informational edge
Time-horizon edge
Analytical edge
Intuition edge
Informational edge
Most people only really consider the first advantage. Movies and TV shows like Wall Street and Billions have popularized the idea that to gain an edge in investing, investors need to have information not known by the market.
The informational advantage could also be earned by looking where other people are not. Buffet and Munger had this advantage when they started simply by looking through Moody’s manuals and finding obscure companies.
Today, the availability of information and the quantity of people analyzing it has largely arbitraged this general advantage away. Turning over stones to find market inefficiencies is harder than before. Opportunities exist, but they are harder to find. Whatever information an investor believes to be unique is almost always understood by many other market participants, and thus is not valuable.
Time Arbitrage Edge
I believe an increase in information availability and investor numbers, which have mitigated the advantage of information, has made it easier for some investors to find a different kind of edge–time arbitrage.
I believe this advantage has always existed because of the law of compounding. The time-arbitrage edge is achieved from owning high quality businesses with durable competitive advantages, for a long time. The latter is very important. Exceptional duration is the foundation of this advantage.
Buying great businesses at sensible prices has always been challenging. However, I think increases in market volatility from short term holding periods have created an opportunity by making it easier.
When Munger and Buffet started, stocks were held over 10 years on average, today the average stock is held for just a period of months. These buying and selling decisions are largely made for reasons other than the intrinsic value of the security in question, and thus create volatility in stock prices that don’t always correspond to volatility in business operations. This increase in volatility makes it easier for investors with a long term time horizon to buy great businesses.
Achieving a time-arbitrage edge might sound simple. Buy a great business at the right price and hold it for many years. In practice, however, it is incredibly hard.
The competitive position of most companies is fragile, being able to determine with a high level of conviction that a company will continue to enjoy superior economics for the next 10 years is the hardest, but most necessary part. Long term thinking on its own means nothing if not combined with durable advantageous economics.
Analytical Edge
Developing a time arbitrage edge begins by being a long term investor, and is seconded by having an analytics edge.
The successful implementation of long term investments requires insights which allow an investor to determine the durability of a business’s competitive position. Without an analytical edge you cannot determine the durability of a business for the next 10 - 20 years, which makes it very risky to buy and hold what seems like a great business today.
The process to acquire an analytical edge is indirect in the sense that the outcome of effort is not predictable. Real insights do not happen linearly. In the sense that you do not get 1 insight per 10 annual reports read. Rather, they emerge on their own from continuous work on a foundation that allows them to come naturally.
Josh Tarasoff wrote a great essay on the difference between direct and indirect approaches, highlighting this process for him as:
To me, this means starting from a foundation of studying the past and present of companies and industries that I find interesting, energizing, and promising—something pursued for its own sake, as a sort of default mode.
Intuition Edge
The quest to develop a time arbitrage edge also requires investors to face a difficult question. What happens when the margin of safety is no longer present?
Long holding periods inevitably lead investors into this situation. The gap between price and value at which they bought the company no longer exists and now the company is fairly valued by the market. What then? A time arbitrage edge is founded on the idea of exceptional duration, but it leads to holding companies that no longer offer a margin of safety.
I think the answer is being able to manage two convictions (implicit and explicit) which co-exist in tension, with intuition. Josh Tarasoff wrote great essay which expands on these two types of convictions. An implicit conviction is like the trust you have in your best friend, it comes from intuition. While an explicit conviction comes from what you can analyze, like a low valuation.
A great example of this dual conflict is Bejamin Graham’s purchase of Geico. Graham is known as the father of value investing for having developed and successfully deployed a strategy of buying undervalued companies which offered a great margin of safety.
His investment firm, Graham-Newman Corporation, operated from 1936 to 1956, achieving extraordinary results. However, it is with surprise that most of Graham- Newman’s profits were attributable to a single investment in a growth company—GEICO, the auto insurer, which now writes $40 billion in premiums—held for the last 8 or so years of Graham-Newman’s life.
This investment was held on even after not affording the initial margin of safety. He writes, referring in the third person to himself and his partner, Jerome Newman:
In the year in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half-interest in a growing enterprise. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.
In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business,” they continued to maintain a substantial ownership of the shares despite the spectacular price rise.
Graham’s decision to buy based on the moderate “price in relation to current earnings and asset value” (explicit conviction), while holding on for a 200x+ gain owed to thinking of the company as “a sort of ‘family business,’” with which they had become “closely identified” (implicit conviction).
Implicit conviction sounds very abstract, and it is, akin to intuition. This is what allows an investor to hold a company even after the margin of safety has eroded. Intuition edge is thus the missing part of the puzzle that allows an investor to reap the fruits of time-horizon edge.
Conclusion
As a small investor, today I have a situational edge of size that affords me a temporary informational edge. I will continue to try to exploit this edge by looking for opportunities in places where other investors are not, such as small companies, different markets and special situations.
Long term, however, I hope to develop a time arbitrage edge. Achieving this edge will take a long time and requires setting the foundations of continuous work to first achieve an analytical and intuition edge. These two sub-advantages are complementary, together providing a far deeper and more complete picture than either on its own.