What’s Your Edge? (2)

Diego Delso [CC BY-SA 4.0 (http://creativecommons.org/licenses/by-sa/4.0)], via Wikimedia Commons

Sleep per Day: (Target) 7h30m / day (Actual) 7h15m  / day (56 day average)

What’s Your Edge series – Part 1 Part 2 Part 3

In the last article I borrowed an analogy of poker from a Seeking Alpha article called “The Sustainable Active Investing Framework: Simple, But Not Easy” where the key to beating the market is dependent on:

  1. Know the fish at the table (opportunity is high)
  2. Know the sharks at the table (competition is low)
  3. Find a table with a lot of fish and few sharks (sectors of market and overall market conditions)

The findings from the last article indicated that for the institutional investors, the breakdown of investing philosophies were as follows:

  • Passive is 50.75% of the sample
  • Value is 15.54% of the sample
  • Growth is 14.70% of the sample
  • Non-Equity is 9.82% of the sample

So what are the implications?

Let’s first talk about the 50.75% population rooted in Passive Investing (aka Market Cap Indexing). Regardless of whether the index funds are only focused on large caps (S&P 500) or the whole stock market (Total Stock Market), the implication of adopting Market Cap Indexing means that about half of the institutional universe is blindly buying high and selling low.

How so?

When you track a Market Cap Index, the weighting you give to each stock is based on Market Cap, which makes the Larger Caps get larger investments and Smaller Caps get smaller investments. With more and more money flocking into Passive Investing, this creates a positively reinforcing loop of Larger Caps getting larger and larger, which is why Passive Investing is buying high and selling low.

For retail investors, this means that barring severe bear markets where Passive Investors are forced to sell due to non-investment reasons (eg. dealing with job loss or inability to withstand volatility), most of the time its very hard to find bargains in the Large Cap space.

Therefore, if there’s an intention to play in the Large Cap space, a retail investor should adopt a 21st Century Charlie Munger esque investing style, where you rarely invest at all unless its a severe bear market such as the 2008 Financial Crisis. That’s exactly what Charlie Munger did, “sitting around with cash at the Daily Journal for a decade” before taking 71% of Daily Journal’s cash to invest in Wells Fargo and another Fortune 500 company (strongly rumored to be US Bancorp). This move and also the investments in “two non-U.S. manufacturing companies and another Fortune 200 company” during 2011-2012, saw Daily Journal’s equity portfolio cost $45 million but valued at $112.3 million by July 2013.

Besides the methodology of how to play in the Large Cap space is explored, there needs to be explanation of why a retail investor should seriously consider playing in the Large Cap space.

The majority of the world’s best companies reside in the Large Cap [1], which means that you can only have access to companies that can continuously generate good to great returns regardless of market conditions, meaning once you buy a great company at an attractive valuation, you don’t need to sell in order to get good to great returns anymore.

Another catch to why retail investors want to play in the Large Cap space is because any Large Caps that becomes severely undervalued due to events such as a severe bear market will quickly rebound back to full or become overvalued due to the Passive Investing effect, where Index Funds will come back with a vengeance that blindly up-bids the Large Caps back into lofty valuations. This means that Large Caps itself have an inherent catalyst to drive stock prices up in short time frames when under-valued, thus reducing the risk for investors.

But of course, this is dependent on your ability to be patient, even to the point of being patient for a decade in Charlie Munger’s case, because the only time the Large Cap space is extremely fun to play in (think of the aforementioned analogy of finding a table with a lot of fish and few sharks) is when there’s a severe bear market.

If not, a retail investor must be content with either dabbling in individual stocks or index funds while hedging with lots of cash to take advantage of sudden severe bear markets, or to pursue high return investment strategies (eg. net nets, small caps, spin-offs) and hope to earn enough returns to withstand the inevitable drop in stock prices and see the stocks’ underlying non-world class companies get decimated (eg. bankruptcy) during the next bear market.

And I’ve only talked about the implications for retail investors with around half the institutional universe being in the Passive Investing camp. I’ll explore the implications of other Investment Philosophies for retail investors in beating the market.

[Notes]

[1] As a reference, a good proxy of whether a company is world class or not is the presence of a wide moat. Using Morningstar’s Wide Moat Index (Dec 31st 2014 figures), you can see that the $79.8 billion dollars weighted average market cap of the index’s Wide Moat stocks is comparable to the S&P 500’s weighted average market cap of $132.1 billion dollars.

[Disclaimer]

Not advice. No offer. Do not rely. May lose value. Risky. Conflicts hidden/obscured. (Borrowed from Terrence Yang‘s Disclaimer on Quora)

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