When I listen to investors and clients talk about investing, I am constantly surprised by the lack of understanding. In fact I do not think I have ever heard any investor really grasp the cause of great returns or poor results. So whether you are a client or an investor, please read on. Once I explain this, things will make a lot more sense.
Q1 2021 hedge fund letters, conferences and more
Investing is like any other Industry - But Worse!
In biology and in business we hear a lot about competition and even hyper-competition. Basically, everyone is looking to get more for themselves; which means they have to beat others. That is really difficult when everyone else is trying really hard. For example in the natural world, only around 20% of lion cubs will survive to two years, while less than one in a billion tree seeds will grow into an actual tree. It is similar in the business world. According to data from the U.S. Bureau of Labor Statistics, about 20% of small businesses fail within the first year and half of them fail within five years.
In the investment world it is much the same. Everyone is trying to make more than everyone else.
We all know that less than 1% of professional managers beat the index by 1% or 2% over twenty years or more, and that over 90% don’t beat it at all. In highly competitive environments, that isn’t surprising.
One way to generate superior returns is to have barriers to entry, or ‘moats’ as Warren Buffett calls them. In some industries, moats can protect you from competition. This is where investing is even tougher! No industry has barriers to entry as low as investing. You can open an account with a few hundred dollars and start trading instantly. Regulation requires that inside information is made publicly available. Even compared to becoming an Uber driver or opening a café, the barriers are low.
The 64 Million Dollar Question
So if there are no barriers to entry, the likelihood is a long-run real return of a few percent, even in high return assets like stocks. That’s not to say there won’t be really strong periods; but there’ll be tough times too.
The only way to do better is to have a Competitive Edge. That is, something that the competition (i.e. other investors) cannot or will not do.
Few people appreciate this. Ask an investor to define their edge, and they will stay something like ‘I invest in quality stocks’ or ‘I buy stocks on low P/Es.’ That is not an edge. That is a description. There is nothing to stop anyone else doing that.
Here’s the thing, and it’s really important: If an investor cannot define their edge - that unique thing others cannot or will not do – their long run returns will be at best, average.
Investment Moats
There are three ways an investor can deliver outsize returns:
- Access to capital at pinch-points: If you can get hold of fresh capital during crises, such as 2009 or March 2020, you can deliver great returns, because you can buy from forced or panicked sellers. These pinch-points do not tend to last long, as central banks will typically step in to provide liquidity. Furthermore, to have fresh money at these moments probably means being underinvested the rest of the time, meaning lower returns beforehand.
- Flexibility or Nimbleness: Sometimes there are temporary dislocations that allow the minority who are able to take them to achieve an excess return. These are often obscure or illiquid securities, or where a specific event has caused a dislocation. For example, last year Donald Trump forced many large investment managers to divest stocks with links to the Chinese Government. In some cases, forced selling on a large scale caused share prices to collapse, with some perfectly decent companies trading on negative Enterprise Values.
- A Conceptual Advantage: This is where an investor understands the world in a different way to the market. For example, a decade ago some successful tech investors saw the potential for exponential growth in certain business models. Some quality investors realised that the market was undervaluing strong franchises with strong balance sheets. Back in 2007, a number of hedge funds spotted the overvaluation and vulnerability across residential real estate.
BUT Competitive Advantages Don’t Last!
Two ground-breaking studies by Robert Wiggins and Timothy Ruefli[i] examined nearly 7000 companies across forty industries, to see how many held a long term competitive advantage, evidenced by persistent above-market returns. They found that competitive advantages are rare and very short-lived: only 5% of companies enjoyed a competitive advantage period of 10 years or more. Only 0.5% managed 20 years, and only 0.04% managed fifty years. They also found that during those competitive advantage periods, the competition increased and the advantage diminished.
So what was the secret of the tiny minority (the one in two hundred!) who managed to sustain a long-term advantage? It turns out these companies did not rely on a single constant competitive edge. Instead, they concatenated an ever-changing series of different advantages. For example a successful pharma company might win thanks to its Patent back-book at one time, then its salesforce at another time... a few years later it’s the distribution network... then it’s the R&D team or the database...
In short, it is impossible to sustain high returns in the corporate world unless you keep adapting to find a new edge.
Now let’s extend the analogy from industry to investing. What happens when an investor makes a lot of money?
- Firstly, they have more money to reinvest in whatever is working. More capital at work on the same opportunity set means lower returns.
- Secondly, other investors will copy them. And they will! Successful investors love to boast or hit the marketing trail, so soon their strategies get known widely. And there are quants running thousands of factors every minute, looking for any opportunity. While other quants can reverse back-test and clone successful investors.
So never believe the investor who says ‘the market consistently underestimates...’ They are either lying or delusional. The industry is full of Fields Medal and Nobel Prize winners, quantum physicists, concert pianists and so on. They are all searching for that opportunity. They are perfectly capable of grasping even the most difficult concept.
Put it all together, and just like any other industry – capital will quickly flood into whatever profitable market opportunity there is. Overinvestment and imitation destroys the advantage and the profits.
In Investing it is Worse... Returns Don’t Fall, they Collapse!!
In a normal industry, high returns encourage existing capital to be reinvested and new capital to flood in; then returns fall. At this point, capital either exits or stops coming in and the industry normalises.
However, investing isn’t normal – it’s worse! High returns cause capital to flood in: but the very act of capital flooding in pushes up the prices of the relevant securities, meaning even higher returns, and hence more capital! Thus, a successful investment opportunity turns into a self-reinforcing bubble, with more and more capital driving consistently higher paper profits. The way these bubbles burst is that eventually, all this new capital completely swamps the underlying business, industry, or economy. With too much money chasing the opportunity set, returns don’t just fall back, they completely implode! At that point investors flee, the bubble bursts, and the losses are huge.
Electric vehicles are a good current example of this process in action. Valuations are so high and there is so much new capital flooding into the industry, that, even assuming stellar growth, everyone will have to suffer a decade or more of oversupply and hyper-competition. It is unlikely anyone will sell an electric vehicle at a profit for ten or twenty years. By which time, many of today’s new enterprises will have gone bust.
What You Need to Know and Why it Matters
It is extremely hard (some would say impossible) to make great long-run returns in investing because of the hyper-competition. Like other industries, investing has low barriers to entry, plus loads of brilliant people and powerful computers incentivised to copy what works.
The only way to stand a chance is to recognise that there are no long-run competitive edges in investing. No strategy, insight or style will consistently deliver.
In fact, those strategies that have made the best returns of the past 5-10 years always end up overinvested. That overinvestment causes a collapse in fundamentals as well as a collapse in prices. Then investors lose a fortune and it takes a long time to recover. Think TMT in 2000, over-leveraged value stocks and real estate in 2006, or commodities and energy in 2008. Meanwhile a different, emerging approach will be making others rich.
For active investors, the lessons are:
- Define your edge. Know how and why you are taking a different position from the crowd.
- Be humble. Others can understand and execute whatever it is you are doing just as well as you. If it works, they will come.
- Be ready to refresh your edge. Just like successful businesses, successful investors need to concatenate a series of competitive advantages rather than rely on one.
That means being omnivorous. Value investing works well providing you can go where the value is. If you can develop the tools to fish in different ponds – EM, small caps, liquidation plays, quality franchises, and even high-tech growth – that gives you huge advantages. You can go wherever the opportunities are. - If you have a strong style, have an exit strategy. Successful approaches get spotted, then they become self-reinforcing bubbles, then they blow up. Look out for abnormally high valuations or consensual thinking. And be prepared to move on to something else.
About the Author
Andrew Hunt is a global deep value investor and author of “Better Value Investing: A Simple Guide to Improving your Results as a Value Investor.”
Footnote
[i] “Schumpeter’s Ghost: Is Hypercompetition Making the Best of Times Shorter?” October 2005, Strategic Management Journal, Robert R. Wiggins and Timothy W. Ruefli.“Competitive Advantage: Temporal Dynamics and the Incidence and persistence of Superior Economic Performance,” 2002, Organization Science, Robert R. Wiggins and Timothy W. Ruefli.
