Finding an Edge

The stock ticker is like a tote board. It gives the public odds. A trader who wants to beat the market must have an edge, a more accurate view of what bets on stocks are really worth.

—William Poundstone, “Fortune’s Formula”

Everyone needs an “edge” in both investing and business. If it were just a matter of finding and purchasing a security below its intrinsic value, anyone could go out and buy “The Intelligent Investor” and become great. In other words, value investing, in and of itself, is not a competitive advantage.

An “edge” is any method that gives an investor a leg up over the market by obtaining higher returns with lower risk. (Risk in this case being the risk of permanent capital loss–or the size of potential loss times the probability of loss.)

From what I’ve seen, there are six basic advantages, each of which can give investors an edge over the market:

  1. Psychological – discipline, patience, and the avoidance of common biases and misjudgments. An extremely difficult advantage to have, but is probably the most common among good investors. (Easier said than done.)
  2. Analytical – the ability to look at the same data as everyone else and come to a better, or more accurate conclusion. This is probably the advantage that most investors think they have, but I believe it’s the most difficult one to have an edge in.
  3. Informational – better, or more privileged access to information. Includes information obtained by scuttlebutt, being a company insider, or the illegal use of insider knowledge (of the Ivan Boesky type).
  4. Inefficient Domain – investing in inefficient, less liquid markets. Includes private businesses, micro-cap equities, illiquid bonds, and certain real estate markets.
  5. Risk Management (portfolio) – the ability to limit overall portfolio risk through asset allocation or hedging practices.
  6. Cost of Capital (portfolio) – a bonus advantage of cheaper capital for professional money managers.
    a. Explicit cost of capital: Low-cost debt financing, low expectations from equity investors, or low-cost insurance float (think Berkshire Hathaway.)
    b. Implicit cost of capital: Having investors, partners, or shareholders who don’t equate risk with volatility. The ability to have a rather permanent, long-term capital base.

Some of the great investors like Ben Graham, Buffett, Marty Whitman, and Seth Klarman have an edge in many of the above categories. Some specialize by sticking to specific advantages. Paul Sonkin, manager of the Hummingbird Value Fund, only invests in micro-cap, illiquid securities. Charlie Munger sticks to both psychological and analytical advantages, which leads him to make large but infrequent bets.

Each person can have a different edge as long as it gives them some sort of competitive advantage. If you can’t determine what your edge is in any specific investment, then you are likely to be the patsy at the poker table. If you’re an investor in Apple, you certainly don’t have a psychological edge, and you’re not taking advantage of any illiquidity. In other words, you must believe your edge lies in either better information or a more accurate assessment of publicly available data.

“It is incumbent on investors,” says Seth Klarman, “to try to find out why the bargain has become available.” He further elaborates in his 2005 letter to investors:

We believe that while investors need to focus great attention on the fundamentals, they must simultaneously answer the question: What’s your edge? To succeed in today’s overcrowded environment, investors need an edge, an advantage over the competition, to help them allocate their scarce time. Since most everyone has access to complete and accurate databases, powerful computers, and well-trained analytical talent, these resources provide less and less of a competitive edge; they are necessary but not sufficient. You cannot have an edge doing what everyone else is doing; to add value you must stand apart from the crowd. And when you do, you benefit from watching the competition at work.

3 thoughts on “Finding an Edge”

  1. Fantastic article. I plan to incorporate it into my investment checklist (Charlie Munger style) with the question “What is my edge in this investment?”

    Like

  2. Wouldn’t a couple of better questions be “Of the edges I believe I have, how is this situation dependent on my having them in perfect condition? How could this situation depend on an edge I just don’t have?”

    Like

  3. Thanks for that very good particle. I am preparing a couple of articles on how to use the institutional mentality against them to gain an edge. So many ideas so little time.

    Very good site, glad I stumbled upon it.

    Like

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