"What is your edge?"

Water Cooler Investing
#1

It’s often asserted (and I agree) that if you can’t identify your investing “edge,” you shouldn’t attempt active management. But then trying to figure out what edges are real and what edges are simply marketing spin is really tricky. It’s also a useful question to figure out what are the kinds of edges you can develop through practice, work, and study, and which simply depend on who you are and the organization where you work.

So I figured it’d be useful to poll people on what kinds of things seem like legitimate edges and which ones tend to be fluff, and how one might go about detecting the real from the BS.

I’ll start with some of my thoughts:

It seems to me that edges fall into a few categories: informational, process, unique risk tolerances, and execution.

So, INFORMATIONAL EDGES would be something about having unique industry knowledge, or faster (hopefully legal) access to material information,

PROCESS EDGES are things like having a better quantitative model or portfolio construction method, having a system to neutralize investor biases, or react before others can,

UNIQUE RISK TOLERANCES are generally institutional (or sometimes client type) features that allow a manager to stay in a market that others are running from (and thus buy when others are forced to sell). So endowments, for example, have longer term time horizons than individual investors and can afford to buy when others are forced to sell.

EXECUTION EDGES are about things like high frequency trading, access to dark pools, and reducing execution costs by being able to negotiate directly with counterparties or use derivatives.

This is what I can think of off the top of my head … what do others see as legitimate (or bogus) edges?

#2

My edge is time horizon. I plan on holding for years, if not forever, so I just simply do not care what firms report on a quarterly basis, and rarely read earnings releases or listen to conference calls, even if the firm is 10%+ of my portfolio. I find it amusing when people trim or increase positions based on short term movements.

#3

That is a perfectly reasonable edge (I would categorize that as a risk-tolerance type edge, you have staying power that others may not, which allows you to buy at a discount when others are panic selling).

I know, however, that lots of wealth clients say that they are long term investors and there for the long term, but in practice, they try to pull the plug the moment things are bad. Of course, not having clients is one way to neutralize that.

#4

Thank you for starting this thread.

#5

Can we link to blogs on here? There’s a good piece about this topic that I think is a great read.

#6

The edge of having a small portfolio: My trade volumes mean nothing in the market and therefore I can buy/sell whatever I want without worry. It allows me to buy/short companies that may not be covered as much by mainstream analysts/funds and therefore there may be information inefficiencies that can be exploited.

I also have the advantage of being located in Canada… I find many firms here are covered less than those south of the border, again, potentially giving me an analysis advantage. I can’t build a model that can outsmart the Street on P&G or J&J, but I can understand small/mid cap firms here (especially in the industry where I work my day job) better than some of the coverage that exists.

Buffet once said that he could generate far superior returns if he had less money to invest. I think this to be true.

That’s my edge: ability to play small caps, local market is less efficient than US market.

#7

Time horizon is a big edge in a myopically focused stock market, as Palantir suggested.

Preserving your mental capital can also be a big edge. It is taxing, inefficient, and generally suboptimal to run a concentrated portfolio. There is a false premise started by a really smart guy who said you will not get rich owning your 7th best idea. There are thousands of stocks in the US alone. Are we really to believe that only 5 are inefficiently priced at any one time? Why bother?

The problem with owning just a few stocks is that you lose sight of the big picture and become overly emotionally attached. I own stocks like trading cards. I still do digligence on all of them, but to me, they are not personal… I own them because I want to make money, not because I love the underlying company and feel it represents me as a person (the way many people who own AAPL do).

Small caps are also an edge but the biggest gains come where large institutions cannot play, which is under $500mm, and this is also the swamp. There are some real gems here but you can also lose your shirt in a hurry.

#8

Nice post. I agree with playing in the small cap arena where there is less coverage, less knowledeable investors, and therefore potentially larger dislocations. Weirdly the companies are usually less complex both financially and productwise, so it makes analysis a bit easier IMO. And time horizon, which I see referred to a lot now as “time arbitrage” which is a term I totally hate but the fact remains if you can stick with a holding longer then you can let some good things happen.

My execution is garbage.

Curious to Bromion on what he/she believes is deemed concentrated? I’m usually in a dozen names which I dont think is overly concentrated.

#9

As long as it’s relevant to the discussion, blog posts are fine.

If someone repeatedly posts links to a marginally related blog in a thinly-veiled effort to drive traffic there, rather than to enrich discussion here, that’s a different story.

#10

This is kind of like MBA vs CFA of the value investing world. There’s lots of discussion on this, but the answer depends on what do you want to do?

Personally, I like to take concentrated positions. Say about 10 stocks, and allocate a big portion of my portfolio to them. But that’s when I’m investing in the GOOG, AAPL, and MSFT of the world. For microcaps, I invest 5% of my portfolio.

#11

I think it also depends on the category of investing. Are we talking about our retirement funds and 401k or our PA? This is going to sound hypocritical, well it is, but for the former I take the thesis that I am not privy to any edge and thus allocate amongst mfs and etfs statically. For my PA, i believe i have an edge with respect to superior research and risk tolerance and thus take a highly concentrated positions for short term gains - well until my compliance department layed down the law.

#12

(and this is why I chose the path that I chose)

I don’t have an investment edge. In fact, I’m not really sure that an edge exists anywhere–at least not in the world of investments. If it does, I don’t know about it.

I have another edge, though, because I’m a tax-practice CPA. I can take advantage of tax codifications to increase total wealth. Plus, I can become a “one-stop shop” for all their wealth needs.

EG - Client A does not invest with us. He has his brokerage account with Edward Jones and does his own taxes every year. He has $2m in his brokerage account, and wants to give $1m to his son. The securities have a tax basis of $800k.

Client A opens up a new account for his son, and transfers $1m of securities to his son. But since the securities were gifted, the son’s inherits his father tax basis. Potential tax hit = $200k x .35, or $70,000. And the client has used $1m of his $5m estate tax exemption.

Client B does invest with us. And because we also do his personal return, we realize that he had two rental condos that were destroyed in a fire last year. As such, he hasa $650k capital loss carryforward. So we sell the securities to eat up the capital loss carryforward. We immediately buy them back (kinda like a reverse wash sale), and transfer them to a limited partnership where Dad is the GP. Then we value the LP at $650k, taking a 35% discount for lack of control. We gift the LP to Junior.

What’s the result? Dad has used only $650k of his exemption, and Junior has zero unrealized gain in his stock portfolio. Client B’s future tax bill is $122,500 lower than Client A’s (because he still has an extra $350,000 in exemption remaining), and Junior’s future tax bill is $70,000 lower. Total saving to Client B is ~$200,000. The exact same underlying transaction took place, but the client is $200,000 richer.

You could say, “That’s something that could have been done with good planning, even if the CPA and adviser were not the same person.” And while that’s true on paper, it doesn’t happen often in real life, and the second process is much more seamless.

#13

^Wow, what a sexy story, sign me up lol. Or congress could rewrite the tax code and make this nonsense completely obsolete but i digress, psych 9 9 9. Koch, err, Cain for prez.

#14

I dont disagree that proper structuring is important, in this case some sort of tax planning (I didnt read it all to be honest). Similarly, I dont put munis in my tax-deferred accounts, etc. But at a certain point I cant really structure anything better and then it comes back to investing.

I used to be lik Whats said, but then I realized if its good enough for my PA its good enough for the 401k (which is the larger component)…so now to the extent I can I apply similar strategies.

#15

There’s a difference between personal capital and institutional capital. In a PA, 12 names is fine if that’s the way you want to run it. The fund I used to work at owned around 500 stocks worldwide where about 300 were long and 200 short. Is that an index fund? No. The firm smashed and I mean SMASHED the market over a 15+ year period (more than tripled the market average over the time period).

There is another fund which I believe is one of, if not the best, performing fund under $1B of assets over the last 4 years that has made their returns with ~5 stocks in the portfolio at any one time. They have a hard time scaling though and have topped out at $150mm of assets because people don’t want to invest in that model. Still, the founder is in the 8 figures now so you can hardly say it’s a bad business model.

Personally, as an institutional model I’m aiming for around 150 stocks all in with around 75-100 longs and 50-80 shorts. In my PA, I’ve historically owned far less than that.

#16

I agree completely that the tax code is whack and needs to be comprehensively overhauled. But this is the reality of the world we live in. Making fun or ignoring it doesn’t make it go away.

LOL all you want–I earned this not-entirely-hypothetical client an additional $200,000 with absolutely zero additional risk. Can Bromion’s long-short fund do that? Can Palantir’s concentrated positions do that? Can your “superior research and risk tolerance and thus take a highly concentrated positions for short term gains” do that?

#17

When I think of my “edge,” I would say it’s two things that are highly ingrained in my own research process: (1) I have a far-above understanding of industry structure and competition and know how to do research around that, and (2) I do a lot of “secord level thinking” to understand what investor sentiment is and what would cause the shareholder base to lose faith in a company that I’m going to short, or regain faith in a company I’m going to go long. [look up some interviews by Howard Marks of Oaktree Capital if you aren’t sure what I mean by “second level thinking”]

Of course, I feel that I am competent among other areas including accounting, corporate finance, strategy and all that stuff simply because I have studied it in school or have spent years working in the industry. However, to truly develop an “edge,” I got to a point where I was disciplined enough to practice this process all the time and always strive to refine it. That is how “process” becomes “edge.”

I get #1 by spending a lot of time really understanding what the companies I invest in actually do and how their business model works. I do a lot of calls through the channel to customers, competitors, suppliers, and so forth, and really think of myself from the lens of a business operator. I spent some time in private equity and got pretty close to some of the operating companies we owned or were looking to invest in, so that’s where I learned how to “ask the right questions” and tease things out of the channel.

On #2, I spend a fair amount of time talking with other buy-siders to understand what the bear or bull thesis is around a particular company. I think of myself as a student of psychology here. I try to understand what both buyers and sellers are thinking, and try to reverse engineer sell-side models to see when expectations have gotten really out of whack. If it seems that it would take nearly a ‘black swan’ event to impair a stock further that has already been bombed out, I look at it as a potential long. If I have to imagine ‘pie in the sky’ scenarios to get to sell-side valuations on a certain stock, I look at it as a potential short. Once I develop a thesis, I basically ask my colleagues around me not to tell me what they like about my thesis, but everything they think could go wrong with it. I want to make sure that my calls are as buttoned-up as possible. That is my “margin of safety.”

Of course, one’s “edge” is only as good as their actual competence. Luck does play a big factor in investing, but if you work hard and if you can develop great business acumen, you can outperform the markets. Efficient markets hypothesis is total bullsh!t and if it were true, I would probably be spending many hours a week banging my head against a wall instead of actually generating alpha.

I’ve spent thousands of hours reading investment books beyond SEC filings, transcripts, sell-side reports, buy-side reports, and so forth and am a better because of it. No shortcuts were taken until I became confident that I knew what a good shortcut was. As a hedge fund analyst, I look at what I do as a lifestyle and not as a job. I think anyone else that is willing to truly commit themselves to this art/science can earn excess returns.

#18

I agree with Greenie. Tax planning is a huge source of return (or perhaps, the prevent of unnecessary loss - tax).

Tax optimization is zero risk (well, depends on how aggressively you define “optimization”) and can provide huge return advantages. Most people I talk to (people managing their own funds) have a horrible grasp of tax efficient allocation. Like dividend stocks in their RRSPs (~= 401k) while holding cash in their non-registered accounts. It’s amazing that someone would honestly throw away 20%+ of their earnings through poor planning.

I think your average advisor definitely understates the importance of this. So many people fall into the trap (like whatsyourgov above) of allocating assets based on short-term/long-term holdings, rather than based on tax efficiency.

I still think I can earn alpha, but tax planning is a huge part of what I’m doing when I’m looking at my portfiolio. Optimizing what assets go where is huge.

#19

I’m just messing with you greenie, i personally use a cpa who is a jd too for this exact reason. I compare this to the guys i play golf with who reached retirement aka are old. They hit the ball off the tee 200 yards max, lay up to the green, chip it close and settle for par whereas i swing for the fences hoping to some how have a ducky on the pound in 1, but end up hitting a provisonal. Long story short, i have all the respect for you and your practice.

#20

Hello bchad. I think this is a good thread. One thing I will add is that certain investors are systematically long or short certain kinds of risk, and this can distort the market to another person’s statistical advantage. For instance, insurance companies might keep buying 10-year SPX puts to hedge their risk from annuities. Thus, they bid up the market for vol and sell down the market for dividend forwards. If you are willing to take the opposite position, you are at a statistical advantage. Other examples might exist elsewhere - for instance, gold miners might have a certain term structure preference in gold futures, or a stock with a large owner might be skewed by concentration risk. If you have access to a market to hedge this risk better than other people, you can make more money.

Maybe this falls under the “unique risk tolerances” category.