Five strategies to replace old investing models
Where differential skill pays off
Last time, I looked at why old mental models for investing no long work, likening the shifting paradigm to the distinction between a linear game (like poker) to a non-linear one, which aptly describes investing. But if the old linear game of investing no longer works, what does? With the caveat that investing is not easy and far more multifaceted than poker, here are five “easy games” that might be worth exploring.
1. Wealth transfers go largely unnoticed, but are far more material than most investors realize. Corporations make decisions that lead to large wealth transfers from one group of shareholders to another, namely with M&A-related activities, share buybacks, and equity issuances. Pay attention to which types of activities and groups tend to emerge as the long-term winners. Act accordingly.
2. Compete against participants who trade without regard for fundamental value. Both human decisions and algorithm-driven (“algo”) trading move markets. Participants trade for many reasons. It is important to recognize that markets are not purely event-driven. The vast majority of trading today is machine-led. The good news is that sometimes Mr. Roboto has just as much disregard for fundamental value as his manic-depressive human counterpart, Mr. Market, because some algos are programmed to pay attention only to price and volume. As a result, inexplicable flash crashes and other bizarre market dislocations are becoming more common.
Investors should accept this new reality and be ready to take action on the other side of the trade. Having cash reserves to draw upon in such situations can be lucrative. Sometimes even fundamental investors don’t care about fundamental value during periods of market stress. They desperately require liquidity irrespective of value. Pay attention to fund outflows during market panics, and the fallout from the leverage cycle for potential mispriced opportunities. The well-documented alpha that is generated by spinoffs, which are frequently sold without regard to fundamental value, are also worth studying.
3. Compete against participants who use simple decision rules. The world is complex. Reliance on overly simple and misguided rules of thumb can lead to mispricing. Of note, passive investors are collectively the largest participant in the market by far, and they continue to take share. They have no choice but to follow very simple buy and sell decision-making rules. If fund flows are positive, they must buy. If flows are negative, they must sell. This would not be material if this group accounted for only a small percentage of the total market. But they don’t. And as their share grows, so does their influence as the marginal price setting player.
Flows into niche ETFs, based on the hot and cold market themes of the day, can have an even more pronounced impact on stock prices. It is clear that the rise of specialized ETFs and passive investing has increased distortion in some corners of the market. Be alert for such opportunities.
4. Hiring a specialist when the task requires a generalist. To a man with a hammer, everything looks like a nail. That is wonderful if you have a nail. But in many situations, you need a more diverse toolkit, particularly to evaluate idiosyncratic businesses with no close comparables, firms with multiple business lines, or those pursing opportunities in fast growing, but still nascent industries. In short, compete against the “man with a hammer.”
5. Compete against unsophisticated investors. As the saying goes, a fool and his money will soon be parted. Go and find the games that are subject to the whims of less-sophisticated investors.
It is very difficult to find an analytical edge when competing against a highly educated and motivated army of specialized analysts and smart investors. So, when possible, don’t compete against them!
The difference between markets that are always efficient and mostly efficient is subtle, but important. How do you avoid the most competitive and efficient games? For starters, minimize the amount of time you play at the poker shark table and compete by their rules. Instead, look for games where differential skill might pay off. Seek out the weaker games for a potential unfair advantage.
One of the key tenets of Pender’s investment philosophy is to obtain more fundamental value than we are paying for. Ideally, we want to compete against investors who are playing a different game to us. Some participants are playing mainly for entertainment value, because they love the trading action. Others are trading for reasons unrelated to fundamental value. Still others are forced to play weaker games because of organizational constraints. Don’t mindlessly follow peers.
Keep in mind that conventional wisdom is often long on convention and short on wisdom. Looking for “easy games” is an important part of obtaining an edge to help to stack the odds in one’s favour. It also narrows down a huge universe of potential ideas into a more manageable one.
Again, investing is not easy. And we want to emphasize our view that focusing on potential “easy games” is no sure path to investment nirvana. However, we believe there are corners of the market that continue to be less efficient for structural or behavioural reasons.
Felix Narhi, CFA, is Chief Investment Officer and Portfolio Manager at PenderFund Capital Management. He works alongside David Barr, Pender’s President, in setting the direction of Pender’s overall investment strategy. This article first appeared in the Pender blog. Used with permission.
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