Before I get to typing I have to warn you that the title of this post is a little misleading. You see, I’ve been reading “How to Invest” books for many years now and I would like to let you in on a little secret. Most of these books are deceiving. It’s not that they don’t have value investing theory correct, they do. It’s that they make it sound much easier than it is. Even Joel Greenblatt’s “The Little Book that Beats the Market” (which I highly recommend) makes the strategy sound much easier than it is, and it doesn’t get much easier than buying stocks off of a list once a year.
The average “how to” investment book teaches you the basics (a stock is a piece of a business, Mr. Market is crazy, buy companies on the cheap) but they don’t tell you that you are up against some serious competition. Think of the stock market like a sport, say boxing. With a little training the average person may have a chance against the local tough guy, but get in with the big boys and you may be drinking your food through a straw for a while.
I believe the average investor has a few significant advantages over the institutional investors but one of those advantages is not in the “analysis” department. So why do all these books try and teach the layman valuation analysis, especially of large and well-known companies? Do you really think you will know more than 20 full time analysts? Remember that every time you buy a stock, someone is selling it. What makes you think that you know more than the other guy? How has the universe made this value apparent to only you? (hint: it hasn’t) On average the individual investor’s main strengths over the top analysts are two: small amounts of capital, and the ability to weather periods of underperformance. The former doesn’t sound like much of an advantage but just trust me on this one. The latter can be quite the challenge without a systematic, replicable, and disciplined approach.
Implied in the “small amounts of capital” advantage is the ability to search in areas of the market that the big guys can’t play. Of course if the big guys aren’t playing there then there are more likely to be gamblers in that area, not intelligent analysts. (Warren Buffett tells a story about when he was on his honeymoon in Vegas and at a casino. He says he remembers looking around the room at hundreds of well off fools participating in various mathematically unfavorable activities with their hard earned money and thinking to himself “if this is who I’m up against in life, I’m going to be rich.”)
In order to pay for a good analyst a mutual fund or hedge fund must be managing a relatively large amount of money, since this is where they pull their fees from. A relatively large amount of money is usually more than a few hundred million dollars and often a few billion dollars. So pretend you are a mutual fund and you have $1B. One day you are combing through financial statements and you stumble upon a ship builder in Louisiana that is selling for $40m. It has about $28m in cash, another $28m in receivables, $10m in inventory, another $15m in other current assets, and has normalized earnings of about $20m. Not only that the company has existed for more than 60 years, generates average returns on capital of 20%, has 50% insider ownership and only $5m in debt. You begin to get excited because this company is silly cheap. You could buy it at $7 and it must be worth at least $15, maybe more. There are a few problems though.
$40m is 4% of $1B. If you buy the company and the price doubles you will have made 4%. That’s good. The problem here is that you have no chance of buying that entire company for $40m. As Dr. Michael Burry has written:
“…I buy common stocks for the portfolio as if I were buying pieces of businesses.
In fact, at all times I strive to buy stock at prices per share that no acquirer could ever pay for the whole company – not because the prices are too high, but because the prices are so low that a potential acquirer proposing them would be laughed out of the boardroom. Such is the opportunity afforded by the very human market for common stocks.”
With 50% insider ownership and low liquidity you would have to pay much more than $40 m for that business. Also, you are a mutual fund. Mutual funds are restricted by law from owning more than 10% of a company’s outstanding shares. So at most you could buy $4m dollars of this company. That is .4% of your fund. So a doubling of the stock price gets you .4%. There may be issues with buying 10% of the company also. Because of the infrequent trades in a small company like this where owners hold 50% of shares, your buying is likely to move the share price quite a bit. Depending on your fund, you may also be restricted from buying illiquid companies like this. So even though it is a no-brainer investment, you have to pass.
There aren’t many disadvantages to having a fat wallet but here we have found one. This means that all of the people with fat wallets (read as “talented analysts”) are forced to play in the big companies. If thousands of very talented analysts who manage trillions of dollars are constantly combing for bargains in the big companies the survival chances of a weekend stock picker are slim… if they compete head to head.
To beat the big guys you must be more patient and also try and be in the areas that they can’t (or wait for another 2008 when panicked investors force a manager’s hand). I’m not saying that buying large companies is always out of the question, I’m just saying that you will be competing with some very skilled people and to think that you might be buying shares from Jeremy Grantham or David Einhorn is a terrifying thought.