Gaining an Investment Edge

This classic Whitney Tilson investing article was originally published Dec. 3, 2004. Some information has been updated.

Successful stock picking has always been a challenge, but as more and more money and talent pour into the investment field -- it's a deluge right now -- the task is especially difficult. Companies with issues, such as Merck (NYSE: MRK  ) , Marsh & McLennan (NYSE: MMC  ) , and Coca-Cola (NYSE: KO  ) , should all be trading at least $10 lower than they are right now, but everyone's a value guy these days, piling into stocks that have gotten crushed, so they don't fall nearly far enough. Yes, I'm frustrated! (Though not for an instant do I think that the market's regular swings from fear to greed and back again have come to a halt. It's just a matter of time -- and I would bet not very much time -- before something causes fear to return.)

How to beat the market
There are only three ways to beat the market: better stock picking, better market timing, or more portfolio leverage. It seems obvious, to me at least, that the first option is the best one. Market timing is a fool's errand -- I challenge you to show me anyone among the wealthiest Americans who made their fortune doing so -- and if you use much leverage, the market will eventually carry you out on a stretcher.

But with so many smart people with so much money looking for bargains, even the traditional pockets of inefficiency, such as distressed securities, spinoffs, and micro caps, are increasingly picked over. So how can one pick stocks that will outperform? Only by having an edge. If you don't -- if you're the proverbial sucker at the poker table -- you're going to get creamed.

There are many different kinds of edges:

Size edge
If you're an individual investor, your biggest advantage by far is that you're managing a lot less money than almost all professionals, which allows you to invest in the nooks and crannies of the markets, where the greatest inefficiencies lie. At the 1999 BerkshireHathaway (NYSE: BRKa  ) annual meeting, Warren Buffett agreed, noting:

If I had $10,000 to invest, I would probably focus on smaller companies because there would be a greater chance that something was overlooked in that arena. There are little tiny areas where if you look at everything -- and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market -- I think working with a very small sum, there's an opportunity to earn very high returns. I could name half a dozen people that I think could compound $1 million at 50% per year. But they couldn't compound $100 million or $1 billion at anything remotely like that rate.

The argument for focusing on obscure companies makes a great deal of sense intuitively. Do you think a stock is more likely to be mispriced if only a few people have ever heard of the company and not a single analyst follows the stock, or if it's a household name, with dozens of analysts covering it?

Time horizon edge
Money managers are generally evaluated and compensated based on their performance over a relatively short time: at most, one year, and increasingly quarterly or even monthly. This means that if they find a stock they think is really cheap, but there's no obvious short-term catalyst that will cause it to rise, they often won't buy it. So, it's a huge advantage to be able to invest with a three- to five-year (or longer) horizon.

Concentration edge
Investment success is not measured by the number of stocks one buys that go up versus those that go down. Rather, total profits are the amount of profit you make on your winners, minus the losses on your losers, which is not the same thing. For example, if you buy 10 stocks and two double in value and eight go down by 50%, you can still make money -- even with an 80% failure rate -- if the two winners are huge positions (if you started with $100 and the two winners were each, say, 20% positions, then you've made $40 on them and lost $30 on the eight losers, leaving you with a $10 profit).

The ability to bet big when one has maximum conviction about an investment is invaluable, especially given that even the most brilliant investors only have a few good ideas a year. Yet most professional money managers have strict limits -- either formally or informally -- on position sizes. Take a look at most mutual funds: The largest holding is often less than 5% -- a starting position for me -- and managers aren't allowed to hold much cash, so they have to dilute their best ideas with dozens of inferior ones, with the result that the average mutual fund holds more than 100 stocks. If you asked me to manage money this way, I'd give it back to you because I don't think I could beat the market.

Analytical edge
Some investors are -- or at least think they are -- smarter than almost everyone else. They have the same information, yet process and analyze it better -- filtering out the noise and focusing like a laser on the handful of critical issues -- and thus reach more accurate conclusions and make better investment decisions. If you think you're in this category, well, join the rest of us! Seriously, there are so many brilliant people in this business that even having analytical skills in the top few percent isn't going to provide much differentiation.

Experience edge
There's a very wise saying that every investor spends his first five years making mistakes and then spends the rest of his career trying not to repeat the same mistakes. In my early days of investing, I didn't really believe this (OK, I didn't want to believe it!), but with many more years under my belt -- and plenty of scars on my back -- I now know how true it is. Investing is like history: It never repeats itself exactly, but a lot of pretty similar things happen over and over again, so experience is invaluable. My advice in this area is:

  • Try to learn from others' painful experiences rather than going through them yourself, so read about and talk to as many smart, experienced investors as you can.
  • Start your investing career by working for someone else, so you can learn from their experience and make mistakes on their nickel, not yours! (For tips on how to break into the money management business, see this column.)
  • If you're going to pick stocks on your own, do it with a small amount of money until you have some experience under your belt -- and don't confuse brains with a bull market!

Emotional edge
It is well-documented that human beings are hard-wired to be massively irrational when it comes to financial matters. So many investors blindly follow their emotions, run with the herd, pile into the hottest sectors at their peaks, suffer huge losses, and finally panic and sell at the bottom. Thus, investors who can control their emotions can have a substantial edge.

As Buffett once noted, "Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. ... Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing."

Information edge
I find that the best investors often have an information edge. They simply do more work, are more creative in collecting information -- often tapping into valuable "scuttlebutt" -- and/or throw more resources into the research process so that they can occasionally gain some proprietary insights that can lead to big profits. Remember, you need only to have a few big ideas each year to be an extremely successful investor.

Need new ideas for your money? Talk stocks with other investors and our analysts when you give our newsletters a try.

Whitney Tilson was a longtime guest columnist for The Motley Fool. He owned Berkshire Hathaway at the time of publication. To read his columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. Coca-Cola and Berkshire Hathaway are Inside Value recommendations, and Merck used to be an Income Investor recommendation.Under no circumstances does this information represent a recommendation to buy, sell, or hold any security.The Motley Fool is investors writing for investors.


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