It's not a competition for the best research, it’s a competition for the best returns.
In this post, I’ll look at an important aspect of my investment process: focus. My investment process is designed to maximise the alpha* generated per hour. Focus helps me improve this.
Focus operates at both a company level and a portfolio level. It’s about dedicating time to the most important aspects of the most promising investment ideas. It also ensures your ideas don't end up "all hat and no cattle".
At a portfolio level, if I’m looking at an idea and it appears unlikely to be mispriced, or would take too long to research, I put my pen down and move on. At the time of writing, there are 10,681 individual equity securities trading in developed markets with a market cap of >USD 500m. There are plenty of good long and short ideas in there, I should go and find them. Similarly, if an idea is flat-out too hard, I remind myself that investment managers get paid in proportion to the alpha they generate, not the difficulty of the problems they solve… and look at one of the remaining 10,680 potential ideas.
At a company level, I operate on the principle that investors will not care that my research is the best in the industry if my long-term returns are poor. I’m an investment manager, not a company expert.
As I’ve said before, all theses boil down to one or two key questions. These questions relate to the key drivers of cash flow to equity holders:
The critical steps in any research process are:
Finding the single strongest driver of cashflows,
Figuring out what the current market price implies about that driver, and
If something different may happen.
For example, if margin is the strongest driver of cash flows, one should focus the vast majority of their research on cost structures and operating leverage (pricing impacts margin too, but I’d categorise that under revenue). For example, if a firm has 4% after tax operating margins and it increases them to 6%, that’s a 50% increase in cash flows, all else equal. How else could a firm increase cash flows by that much? By growing revenue 50% (assuming a 100% variable cost base) - a tall order - or by reducing their investments in capex and net working capital by a large amount - also difficult to do without harming growth prospects. Clearly, margins are the most important driver of cash flows and where additional research can derive the most benefit. The other drivers warrant a far lighter inspection.
I’m not suggesting that research should be superficial, far from it. It needs to be thorough in specific areas. I need to know a lot. I don’t need to know everything. For example, if the margin is the key driver of cash flows at the company I’m researching, I probably don’t need to do intense work on revenue or investment. This is not to say I’ll ignore the latter two. I’ll know what the company and their competitors sell and their investment plans, but probably won’t spend more than a day looking at it – the sellside have probably done a better job than me anyway. The main purpose here is to see if I’ve missed anything and if I’ve correctly identified the key driver.
So why do we see ideas researched to death? I think it’s something of a safety blanket. It makes people feel better about their calls because they know more about the company than just about anyone else. They’re a company expert. They can also pitch it to potential investors who’ll love it. The results are somewhat disturbing: the pupils dilate, the mouth salivates, and the nipples firm. However, I think it’s counterproductive (doing too much research, that is). For full disclosure: I spent a few years trying to be a company expert before I realised there were better uses for my time.
Investment managers are not company experts and they shouldn’t try to be. Becoming a company expert takes an extraordinarily long time. That time could be spent generating alpha with other ideas. Put another way: the cost of company expertise is investment performance.
On that note, I’ve often seen is the following statement:
“We utilise a private equity approach to public markets”.
In my opinion, this statement is so fundamentally stupid that merely reading aloud it will cause neurons to kill themselves in protest, birds to fall dead from the sky, and dogs to faint in the street. It is a statement that fundamentally misunderstands either private equity, or public markets – and realistically both.
I’ve heard stories of analysts being sent to camp outside multiple factories for multiple competitors across Europe and count outbound trucks for weeks on end in an attempt to estimate revenue growth. They were thinking about investing in a brick company with margins far below their peers. Revenue was probably not the key driver, so their time could have been better spent elsewhere. Perhaps in looking at why margins were below their peers or even other investment ideas? Sure, their revenue estimates might be out by a few percentage points for said brick company, but if they’ve identified the key driver correctly, this won’t have a big impact on the cash flows generated.
A small anecdote about knowing the important things. Nassim Taleb, during a rare moment in which he was not calling people “frauds” on Twitter, wrote about an extremely successful green lumber trader. To the uninitiated, green lumber is freshly cut timber (i.e. not seasoned, dried or otherwise treated). This trader had made an absolute killing for years and vastly outperformed his peers. He also believed that green lumber was wood painted green. He had little idea of the underlying product, and he didn’t need to. You don’t need to know everything.
Focus also helps in pitching and monitoring ideas. Focus clarifies my thinking and lends a machete to intellectual thickets. This makes pitching ideas easier because I can highlight the key points in a short space of time. Importantly, any holes in my thinking are more apparent to the investment committee because the mast to which I’ve nailed my colours is abundantly clear. If the committee thinks I’ve chosen the wrong mast, I will have the time to investigate their questions in more detail – because I didn’t waste it in the first place looking at less relevant factors. It can be scary to take a stand like this, but take it from me: it’s better to be slightly embarrassed at an investment committee than lose investors’ money.
Focus also allows me to monitor positions more easily. Tracking all the news on all the companies in the portfolio is like trying to drink from a fire hose. If my thesis is focussed on revenue growth, I’ll be on the lookout for new competitors, new products, and price and volume changes – news relating to anything else can be skimmed pretty quickly.
To wrap it up, investing is not a competition for the best research, it’s a competition for the best returns. Focus helps me do this by looking at only the most important parts of the most promising ideas. It enables me to maximise the alpha generated per hour and that, in the end, is really all that matters.
* Alpha” is a measure of investor skill. It strips out the impact of leverage and market performance, leaving the portion of the return attributable to manager skill.