Is Stock Analysis Worth It? Finding Your Investment Edge

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Is stock analysis worth your time?

The question boils down to a key academic topic: market efficiency.

If markets are wholly efficient, investment analysis and stock picking will largely be useless.

The only worthwhile activity would be to stick cash into a broad index fund and let the efficient market go to work.

But how efficient are markets really? And what’s an efficient market anyway?

What’s the efficient market hypothesis?

Nobel Prize winning economist William F Sharpe admitted a hard definition of an efficient market is difficult but explained it as:

A market is efficient if there are many very bright, very well-informed analysts constantly searching for securities that are mispriced.

As long as this force is operative, when information becomes reasonably public, it will lead to transactions that will shortly cause prices to reflect the information appropriately.

As a result, the price of a security will rarely diverge significantly for long from its intrinsic value, where the latter is defined as the certain future present value of the uncertain future prospects by a clever, well-informed analyst.

Proponents of the efficient market hypothesis argue that $20 bills don’t lie around stock exchanges for long.

Someone always picks them up, and quickly.

We can relate market efficiency to our own lives by considering our experience with traffic.

When we’re stuck in a slow lane, we switch to a faster one.

But a few minutes later, we realise we’re parallel to the car that was behind us in the old lane.

Despite our best lane-switching efforts, we usually find ourselves at our destination no quicker than if we’d just stuck to one lane.

Why’s that?

As economist David Friedman (son of famed economist Milton Friedman) noted:

To understand why it is so difficult to follow a successful strategy of lane changing, consider that other people are also looking for a faster lane. Cars moving into a fast lane slow it down, just as people moving into a short line in the supermarket lengthen it.

In equilibrium, all lanes are equally slow.

Efficiently inefficient markets

But the story isn’t that simple.

Take the traffic example. While in equilibrium all lanes may be slow, we must not forget — as economist Paul Heyne noted — the ‘active process by which the result tends to emerge’.

The efficient market hypothesis focuses ‘on that state of affairs that occurs after all this activity has taken place’.

But if we focus on the activity of market participants, we get to some startling conclusions.

Going back to the traffic example, David Friedman said (emphasis added):

On average, if everyone is rational, there must be a small gain in speed from changing lanes — if there were not, nobody would do it and the mechanism described above would not work.

The payoff must equal the cost for the marginal lane changer, the one to whom changing lanes is just barely worth the trouble. If the payoff were less that that, he would not be a lane changer; if it were more, someone else would be.

As Burton Malkiel, author of the popular A Random Walk Down Wall Street, himself admitted:

The market cannot be perfectly efficient or there would be no incentive for professionals to uncover the information that gets so quickly reflected in market prices, a point stressed by Grossman and Stiglitz.

Importantly, Malkiel also noted:

As long as stock markets exist, the collective judgment of investors will sometimes make mistakes.

And as we’re about to see, mistakes are crucial if you want to outperform the market.

One’s mistake is another’s gain: investing with Howard Marks

In a stock market, a transaction involves a buyer and a seller.

A great trade, then, involves a seller making a mistake and the buyer exploiting it.

While we’re often told to avoid them, mistakes are key to success.

In a 2021 memo to his Oaktree Capital clients, fund manager Howard Marks wrote that ‘mistakes are all that superior investing is about’.

He reiterated:

In the end, superior investing is all about mistakes…and about being the person who profits from them, not the one who commits them.

Investors swing wildly from optimistic to pessimistic — and from overconfident to terrified — and as a result asset prices can lose all connection to intrinsic value.

In addition, investors often fail to unearth all the relevant information, analyse it systematically, and step forward to adopt unpopular positions. These are some of the elements that give rise to what are called “inefficiencies”, academics’ highfalutin word for “mistakes”.

Finding an investment edge

Finding an investment edge is essential to great investing.

If you don’t have an edge, you’re likely following the majority, using information and arguments the majority is also using.

As Paul Samuelson — often called the father of modern economics — quipped:

What logic can demonstrate is that not everybody, nor even the average person, can do better than the comprehensive market averages. That would contradict the tautology that the whole is the sum of its parts.

To surpass market averages, think differently to the average investor.

Find an edge.

As esteemed fund manager Peter Lynch said:

You must find something that nobody else knows, or do something that others won’t do because they have rigid mind-sets.

That’s why Lynch often advised to look closer to home.

If you worked as a retail store manager and saw lots of customers ask whether you offered Afterpay, you would likely have got wind of the fintech well before the general market.

As Lynch wrote in his book One Up on Wall Street:

If you’re a surfer, a trucker, a high school dropout, or an eccentric retiree, then you’ve got an edge already. That’s where the tenbaggers come from, beyond the boundaries of accepted Wall Street cogitation.

Most important, you can find terrific opportunities in the neighbourhood or at the workplace, months or even years before the news has reached the analysts and the fund managers they advise.

That’s also one benefit of small-cap stocks.

While they are riskier, they do attract less institutional attention. With less analyst and media coverage, small caps have more mispricing opportunities to take advantage of.

What are some other general sources of investment edge?

Josh Wolfe, co-founder of venture capital Lux Capital, offered a great summary of investment edge sources (emphasis added):

Edge is a key element of Lux’s investment philosophy: edge can derive from informational, analytical or behavioural sources.

Get better information about an asset (an entrepreneur or technology), or the same information but sooner; analyze that information differently in a way that leads to a novel conclusion (a variant perception) on the importance or magnitude or timing of the asset’s value; or behave individually and as a team in a way that uniquely leads us to great assets (avoid herds and fads, seek what others don’t, venture out a limb as that’s where the proverbial fruit is).

Ask yourself whether you possess an informational edge, an analytical edge, or a behavioural edge over the market next time you’re thinking about an investment idea.

Do you have superior information?

Does your assessment of a situation differ to the consensus? Why?

What is the market missing that you’re not? And how likely is the market to be wrong over you being right?

What is the market obsessing over right now and is that a worthwhile pursuit? Where should the market be looking that it currently isn’t?

These are just some questions you can grapple with on your way to finding an edge over the market.

Finding an edge in battery tech stocks

My colleague Callum Newman, who’s also the editor of Australian Small-Cap Investigator, has been pondering and researching the battery tech sector for a while now.

Callum’s also taken a different approach to analysing the sector.

He’s been following the Tesla money trail, aiming to identify producers likely to be handpicked by Tesla as it hunts critical materials for its leading EVs.

Callum dubbed these stocks ‘Elon’s Chosen Ones’.

They’re miners that could help a giant EV automaker like Tesla with the looming battery metals supply crunch.

You can read about the stocks and Callum’s thesis right here.

Regards,

Kiryll Prakapenka,
For Money Morning

About Kiryll Prakapenka

Kiryll Prakapenka is a research analyst focusing on investigating the biggest trends in investments. Kiryll brings sound analytical skills to his work, courtesy of his Philosophy degree from the University of Melbourne. A student of legendary investors and their strategies, Kiryll likes to synthesise macroeconomic narratives with a keen understanding…

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