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One investment edge is good but four are better

Investing is a highly competitive marketplace and, if you want to outperform there, you will need an ‘edge’ over the competition. Fortunately, value investing offers the prospect of edges across four different areas

24/05/2018

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

The moment you invest in the stockmarket, you sign up to participate in what is known as a ‘zero-sum game’ – in essence, for you to make a gain, somebody else has to suffer a loss.

That simple idea has some profound implications. It means, if you want to outperform the wider market, it is not enough simply to be a nice person or to try your hardest or even to be, as the leader of the Free World might put it, ‘like really smart’.

As all your gains are funded by somebody else’s losses, you are operating in an extraordinarily competitive marketplace and so, if you want the potential to outperform over time, you need an advantage over your competition. In short, you need an ‘edge’.

An edge can come in many different forms or flavours but, at its heart, an edge boils down to the difference between skill and luck. 

Here on The Value Perspective, we would suggest there are four broad categories, across which investors could  enjoy an edge if they are prepared to put in the work – informational, analytical, behavioural and organisational.

Furthermore, while a good investment process should, where possible, have an edge in all four areas, the best will have a number of each type embedded throughout the strategy.

The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.

 

 

#1 - Informational edge

Let’s start at the very beginning then – the sourcing of ideas – an area in which today’s investors suffer from an embarrassment of riches.

Thanks to the internet, all that separates you from the sum of all human knowledge is a few keystrokes into your search engine of choice. What that means, of course, is that any informational edge to be enjoyed nowadays relates not to the data you can find but how you use it.

If you were to ask most professional investors how they make use of all the information potentially at their fingertips, they will tell you they will scour The Economist or the Financial Times, say, or they will read the research reports produced by company analysts or they will go to meet the management teams that run the businesses they are thinking of buying into.

The touble is, if that is what most people are doing, it cannot be an edge.

For any aspect of an investment process to count as an edge, it must have two distinct qualities

  • It should be different to what everyone else is doing and;
  • It needs to work.

Rather than taking the comparatively scattergun approach of seeking investment ideas in the media or in broker reports or wherever, we simply focus our attention on the cheapest stocks in the marketplace – whether that be the FTSE All-Share index in the UK or the appropriate European or global indices – and we believe you will gain a significant edge if you do too.

This is starting point of a value investment strategy - the art of buying stocks which trade at a significant discount to their intrinsic value. 

And as we often point out, here on The Value Perspective, there is now more than a century of data showing that, if you buy into the cheapest companies in the market, you should outperform (although past performance is not a guide to future performance).

Focus on the cheap stocks

Of course, if it really were that simple, everybody would be doing it – but just look at the sorts of businesses a valuation filter currently identifies as the cheapest 20% of the market.

Banks, mining companies, retailers … yes, we can picture you recoiling from your screen as you read those words.

But that is the point – these are sectors very few are willing to look at these days – and that is why most people do not use a valuation filter.

The fact they do not, however – twinned with the fact a valuation filter works – means, for the few who do use one, it certainly constitutes an investment edge.

 

#2 - Analytical edge

Once again, this is easier said than done because, at this company-analysis stage of the process, what value investors are trying to do is to separate those businesses that are cheap temporarily from those that are cheap permanently – and for a good reason.

If you can tell those so-called ‘value traps’ (companies that are cheap for good reason) from the real deal, you will have a significant edge over everyone else who are filtering companies by valuation. But how can you set about effectively differentiating between the two?

Lots of angles to consider

 When you start analysing businesses, you will find there are all sorts of different angles to consider – balance sheets, company strategy, competitors and suppliers, to name just a few.

And with any cheap company, there will always be upsides and downsides to the investment case. For example, at the most basic level, the money you could make versus the money you could lose after buying in.

Human nature being what it is, investors will tend to focus on the more interesting ‘headline’ part of that equation – the potential reward – while skimming over the ‘small print’ – the associated risks.

As human beings themselves, value investors are well aware of the allure of a good headline but they also know reading the small print can make all the difference in the world.

Process...check!

In other walks of life, where the devil is in the detail, people build checklists into their process. For example, pilots like to make sure they have enough fuel to complete their journey, surgeons that they are operating on the right part of the body and so on.

As professional investors entrusted with other people’s money, we feel we should be similarly disciplined and so, here on The Value Perspective, we have built ourselves our own checklist.

This takes the form of seven questions we ask in relation to every single cheap company we analyse and which help us distinguish those likely to remain permanently cheap from those whose share prices have the potential to bounce back.

Addressing these questions helps flag up the companies to avoid. These relate to:

  • The quality of a business
  • The strength of its finances
  • The degree of ‘structural change’ it is facing in the area in which it operates. 

To take one highly topical example, over the last 18 months, Carillion (the failed facilities management and construction services company) kept on cropping up as one of the cheapest companies in the UK – and kept on falling foul of our checklist.

Carillion failed our questions in relation to its financial strength, the quality of its business and whether it turned its profits into cash and so, despite its undoubted cheapness, we did not own it in any of our portfolios, here on The Value Perspective.

And if you have a process that can – on a consistent basis – help you to weed out such companies that deserve to be cheap and only pick the ones that are temporarily so – that rebound – then, once again, you have an edge over your competition.

 

#3 - Behavioural edge

You can be the best company analyst in the world but it is the specific investment decisions you make that determine whether or not you outperform the market and your peers.

Did you buy or did you sell a stock? At what point? How much of it did you choose to trade? And, most important of all, how consistent were your decisions this time compared with every other time you have bought or sold a business?

Leave emotions at the door

Say you had decided you wanted to buy into a company yesterday but do not like the look of it so much today, then you have more than likely allowed emotion to encroach on your investment process – and emotion is the enemy of an edge.

To have an edge in this part of your process, you need to have a consistent decision-making framework – and that means acknowledging the human behavioural aspect of investment.

It is totally understandable why emotion can creep into any investment process. The decision of whether or not to buy into a company is an extraordinarily difficult one.

You are looking to evaluate all sorts of things about the business – its valuation, its financial strength, the quality of its management, competitors, suppliers and so on – and trying to distil all that into a simple yes/no answer. All in your head. Your human head. 

Beware the human brain

The trouble is, the way the human brain has evolved over so many thousands of years means that, when we are faced with a difficult question, it will perform a little sleight of hand.

Behavioural psychologists such as Daniel Kahneman have shown our brain will switch the question from ‘Should I invest in this company?’ to ‘Do I like this company?’ – and it does this so subtly you do not even notice.

Unless of course you understand in advance that is the sort of trick your brain can pull and so take steps to make the question simpler and thus your investment process more consistent. When we are looking at companies here on The Value Perspective, for example, we split the question into two:

  1. What are the associated risks of buying into a business?
  2. What are the potential rewards?

This has the effect of turning that initial, key question – ‘Should I invest in this company?’ – into a much easier decision to make and one that can be made in a much more consistent way.

It is this sort of consistent process and reducing the potential failures of human behaviour that, we would argue, could give you an investment edge over others. 

 

#4 - Organisational edge

Over the course of the last 12 months, here on The Value Perspective, we have analysed roughly 300 different businesses and yet, ultimately, we ended up buying a very small proportion of those for our portfolios – somewhere in the region of 3% or 4%.

At first glance, that might seem odd – after all, pretty much any other organisation or business that was 4% efficient would soon cease to function.

Clearly a restaurant that only used 4% of the ingredients it bought would rapidly go out of business while a factory that was anything less than 80% efficient, say, would likely be shut down by its owners.

Should they be of a mind to, however, investors can afford to be very picky about which companies they do and do not buy into – indeed, here on The Value Perspective, we would argue the pickier the better.

That said, what we absolutely would not want to do is to lose all the work we have done on the various businesses we do not buy because if, rather than using a fraction of that work, we can use it all, that would lead to an edge.

Creating our edge  the archive 

The way we do that ourselves is by keeping a database of every company we look at, with all the information held in a consistent format – in effect, putting all our analysis in cold storage until such time as we need it again.

As we touched on in Value investing skills #3, we use a methodology that considers not only the potential rewards of buying into a business but also the associated risks of doing so.

Operating an archive of all our conclusions on these two aspects across hundreds of different companies allows us to do two things. The first is to monitor our portfolios, if we wanted to, on a minute-by-minute basis to assess the potential upside for every single company we own. That hardly counts as an edge, however, because every single investor with access to market data should be able to do exactly the same thing.

Using the archive

No, here on the Value Perspective, the real edge stems from all that work we carried out on the stocks we did not buy – all those businesses where we have calculated what we believe to be a fair valuation and therefore a suitably attractive ‘target price’ at which to buy in.

These profiles are sitting and waiting in our database should, at any point and for whatever reason, a company’s share price happen to drop significantly.

At that moment, we can dust down our existing analysis, update it for the new news and immediately be ready to go to work.

Thus, for example, when Provident Financial suffered a second profit warning last summer, all we had to do was update our existing analysis and in a matter of hours, having satisfied ourselves about the company’s new risk/reward profile, we were out in the market and building up a position.

That rapid response to changes in the market represents a significant edge over our competition – and is one we now enjoy in relation to the more than 800 different companies the team has analysed over the years.

What is more, as we continue to put ever more businesses under the microscope, that edge is only going to grow bigger.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Ian Kelly, Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans and Simon Adler, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated. They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.