Today I’m going to discuss one of the most powerful investment concepts used by the greatest value investors in history. It’s simple to conceptualize, but incredibly difficult to practice – and it could be the most important.
Among investing friends and colleagues, I have referred to this concept for years as “What I know that the world doesn’t.”
Nothing is more powerful than information. Information provides an edge and is the basis of all investment decisions. How you obtain information and when is critical.
Unfortunately, there are those that try to obtain information illegally, and that’s a shame. By that I mean insider trading, from Ivan Boesky and Michael Milken in the late 1980s to today’s wide-ranging culprits associated with Raj Rajaratnam and the hedge fund Galleon Group.
But great fundamental investors don’t have to break the law to get their edge. They uncover, analyze and interpret public (i.e. legally obtained) information to make decisions about stocks that will generate great returns well above the market average. (In technical investing terms, this is called generating alpha.)
How does information factor into long-term returns? First, let’s look at a little investment theory that is fairly straightforward but interesting.
The Inefficient Mr. Market
For the past century, economists and experts have researched, analyzed and theorized about information and the market. In fact, depending on which camp you fall in, you either think fundamental (e.g. detailed, in depth, firsthand) research and active investing is either plausible and valuable or a waste of time and effort.
Great money managers (and active investors like you and me) believe that Mr. Market is not perfectly efficient – otherwise all efforts would be rendered useless. We believe that we can generate good (e.g. above market) returns based on finding pricing discrepancies, i.e. the inefficient relationship between price and information.
But there are those theorists, investors and economists who espouse what’s called “the efficient market theory.” Of late, they have been silenced this past decade given the market’s tumultuous ups and downs.
Thankfully, Mr. Market is sometimes grossly inefficient. And that creates opportunity.
Now, we could have a long discussion about efficient vs. inefficient markets, but in short, an efficient market is one that always reflects the true price or worth of a security. This theory states that there is little room for generating above-market returns because assets, e.g. stocks, are (always) properly priced and all information about the asset is fully known.
Economists and strategists refer to different levels of market efficiency, but the past several decades have illustrated that it’s hard to prove a strongly efficient market exists. We all know by now, for better or worse, that markets overshoot on both the downside (e.g. March 2009) and on the upside (e.g. 2001 or 2007).
As an active investor, I fall into the camp of seeing the market as inefficient. An inefficient market means that perfect or full information about a stock, and the company behind it, is not fully reflected in the stock price. This mispricing creates an opportunity.
Think about last fall when the world looked like it was coming to an end. Back then, Warren Buffett wrote an editorial in the New York Times talking about how attractive (i.e. mispriced) U.S. equities were. He encouraged folks to buy, believing over the long term it would be a great investment. It’s a great piece worth reading. In his own words, Buffett talks about the opportunities created by inefficient market levels and mispriced securities. The prices were not reflecting true information; they were too irrationally low.
So, when I uncover this misinformation, what’s next? One of the most effective ways to make money in a stock is to own it before other buyers jump aboard or Wall Street analysts recommend that stock, thus moving the stock price up.
In a way that’s what Buffett was stating: Buy mispriced stocks before their true value is acknowledged. Of course, the same applies for a stock that you think will drop in price by selling the stock (going short).
Well, the hard part is figuring out accurate information about a company and whether it is reflected in the stock price. That’s what I do constantly, and that’s what all the great value investors do.
One Step Ahead
Of course, you have to do your homework to figure out what will make the stock go up beyond current expectations. As stated earlier, the great ones are relentlessly looking for information, data, news and financial footnotes that will give them information that others haven’t uncovered.
When looking for investment opportunities, I have to work harder, dig deeper, and ask more questions than my peers. And if I analyze investments with a longer-term perspective, or look at the bigger picture or take a more global perspective than everyone else, then I should find stocks that will deliver superior returns. That’s my goal. It’s kind of like beating “the competition” to the punch or uncovering nuggets of information and analysis before the Street does. That’s the essence of fundamental research.
ABC Analysis
To summarize the core steps behind my “What I know that the world doesn’t” approach, I’m calling them
ABC Analysis. (Yes, I know, how generic. But it works!) Let’s look at what the acronym stands for:
A stands for
“Ahead of the Street”
The whole goal of uncovering relevant information is to do so before the rest of the world does so. If I know that sales of the new Kindle book reader are going to be triple the level of what Wall Street estimates, then I have valuable information regarding Amazon and its earnings. If I buy a stock because I believe sales or earnings are better than expected, then when sales do perform better, analysts and investors have to increase their future earnings expectations. Then investors will buy more of the stock – thus raising the stock price.
In other words, let’s find and buy attractively priced stocks before Wall Street finds them and starts recommending them and buying them.
B stands for:
“Below the Surface”
The second step involves good old-fashioned elbow grease. It takes hard work looking for information that everyone else doesn’t know. For example, it might entail looking at a company’s financial statements and important filings with the SEC (Securities Exchange Commission) to uncover information, red flags or positive clues that regular analysis doesn’t uncover.
Looking below the surface requires substantial effort and diligence, but being an investment sleuth can pay great dividends.
C stands for
“Contrarian Investing”
For me, contrarian investing is the essence of making money and generating solid long-term investment results. Contrarian investing essentially means making investment decisions opposite or contrary to what general consensus is doing or stating. This takes a lot of skill and a lot of confidence – but it’s how you make the greatest amount of money.
Great value investors buy stocks that no one wants to own, or that even sometimes look like their darkest days are ahead of them. Contrarian investors will take advantage of these opportunities to buy stocks, again, waiting for the rest of the investment community to turn favorable on the stock.
“Buying Straw Hats in Winter”
In my Safe Haven Investor letter, I have referred to contrarian investing as “buying straw hats in winter.” Specifically, it means buying a stock that is out of season and priced at a discount.
I recently read an article by an online investment publication discussing how to find stocks. And this well-known publication suggested looking for stocks that have “buy” ratings on them, i.e., stocks that everyone on Wall Street are already on board with. I laughed. Trust me on this. Most top value investors strongly prefer to look at companies that are out of favor by Wall Street.
One way to be a contrarian is to look at analyst ratings. Look for those stocks that have more “Hold” and “Sell” ratings and few, if any, “Buys” on the stock. (The information is readily accessible at various financial Web sites.)
For instance, if you look at the ratings charts for two well-known companies:
Apple (AAPL:NASDAQ) and
Eastman Kodak (EK:NYSE).
Apple is a great company and I would love to own the stock... but analysts’ opinions are now so bullish they can only go one way – down! (Oh, and its intrinsic valuation is way too high for comfort.)
Why would you want to buy a stock after it’s moved up from such buying pressure? Apple’s expensive valuation reflects all the positive (“Strong Buy”) sentiment for the stock.
But with Eastman Kodak, ratings can only go up, and thus the stock price could follow. I’m not suggesting in any way you buy Eastman Kodak – there are many issues with the company – but it’s a good example of a major company with strong “Sell” sentiment. When the consensus opinion changes, what will happen to the stock? It will go up. And then Wall Street will be telling everyone to jump into the stock – after it has already risen.
True value and contrarian investors don’t want to buy a stock after everyone else does. They want it when it is down and dirty and unloved.
In the words of Warren Buffett, a great value investor focused on being ahead and against the Street: “I like to be greedy when others are fearful and fearful when others are greedy.” He has amassed his fortune (in Berkshire Hathaway stock) by sticking to this philosophy.
Simple to Understand, Hard to Execute
So there you have it; the ABC analysis of one of the most important concepts that I call “What I know that the world doesn’t.” It’s not easy to do, because it takes a tremendous amount of work, experience and confidence. But believe me, if you can start to look at investments with these concepts in mind, you are sure to be a much improved stock picker and value investor.
I strongly believe that if you can successfully incorporate these philosophies into your own long-term investing efforts, you can come out way ahead of other individual investors – and plenty of professional ones too.
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Serving as the editor of Taipan’s Safe Haven Investor, and contributing editor to the free e-letter, Taipan Daily, Kent Lucas has over 20 years of financial and business experience centered around seven years as a research analyst and portfolio manager for a leading investment management firm. In that capacity, he actively managed $1 billion worth of equity assets, with particular attention to multi-industrial companies along with auto, construction and farm equipment-related companies.
In addition to his professional asset management experience, Kent also has worked in leading financial institutions’ divisions including Tax-exempt Derivatives, Corporate Trust and Equities Sales and Trading. With a BA in Economics from Harvard University and MBA from Stanford University, Kent brings a fundamentally driven, value-oriented approach going against the crowd to find solid companies at attractive prices.
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