In my previous post, I wrote that to achieve outperformance or above-average returns, your investment process has to be ‘unconventional’ compared to the majority. And that can only be achieved through originality, independent or contrarian thinking, and making connections from disparate information.
Bill Miller, the former Legg Mason portfolio manager, emphasizes the importance of making connections, “Everyone tends to see the same things, read the same newspapers and get the same data feed. The only way to arrive at a different answer from everybody else is to organize the data in different ways, or bring to the analytic process things that are not typically present.”
Let’s think from a company’s point of view. How does a company achieve above-average returns? It has to have some form of competitive advantage or moat, right? If not, competitors would chip away those superior returns over time (mean reversion). Then, how does a company build its competitive advantage in the first place? A good strategy. A good strategy tells a company what to do and what not to do. And through sensible capital allocation, the strategy enables a company to build its competitive advantage, produce superior returns and defend its market position.
Similarly, to achieve long-term above-average returns as an investor, you need a strategy to have an edge. An edge is like a moat, it prevents other investors from doing the same thing.
A great strategy
How do we find the right investment strategy? Most people would pick a proven strategy and apply that to their investing. This is the top-down approach. But most top-down strategies rarely ‘works’.
Take magic formula, an investment strategy introduced by Joel Greenblatt in The Little Book that Beats the Market. The strategy is straightforward: rank companies by earnings yield and return on capital, own 10-20 of them, and rebalance the portfolio each year. Greenblatt shows that the magic formula delivered 30.8% annual returns over 17 years (1988-2004) and works in many countries. But how many investors apply it over the long-term?
Make no mistake, the magic formula is a great strategy. But a strategy is only as good as your ability to stick to it. And there’s no surprise a strategy like the magic formula remains ‘great’ for a long time because there is some psychological ‘costliness’ build into it. Greenblatt wrote that “The magic formula often doesn’t work for several years in a row.” Which is why it works because 99% of investors can’t tolerate several years of underperformance. It isn’t free for all. Otherwise, the mass would have turned it into a mediocre strategy. If someone ever tries to sell you a strategy that works all the time, run as fast as you can. Therefore, a great strategy has to be one that works in your context; one you can stick to in the long-term. Or put it differently, a dumb strategy that you can follow will outperform one that sounds great on paper but burn you out fast.
Under your nose
So instead of asking “what is the best strategy out there?”, a better question would be “what’s the unfair advantage that I have over others?” This is the bottom-up approach to develop an edge. You start with your context—what you already know and what’s around you. This approach minimizes friction because it is a natural extension of what you do every day.
We can start with your career. Whatever your profession is, what you do 5 days a week is your circle of competence; a treasure trove to find investment opportunities. If you’re a doctor or pharmacist, you would have a good understanding of the industry from pharmaceutical companies, generic manufacturers, distributors, to pharmacies, hospitals, and the health care providers. Who has the lion’s share of the industry profit and why? Are there any patented drugs you’re familiar with? That might be something worth looking into. That’s your edge. It doesn’t have to be drugs. It can be the medical devices you use or the pathology collection centers you relied on for results. Who make those devices? What’s so special about them? How hard would my work be if that device is unavailable?
It is about being curious and ask questions. Who are your company’s suppliers? Do you have to source from them? What about your customers? Are they dependent on your products/services? What about your competitors? What makes them better than your company? And are they listed?
This isn’t limited to your work. Whenever your kids get sick, do you go for a generic or branded medicine? Chances are, you would go for a trusted brand that has worked before. If you intuitively acted this way, others might be doing the same. That’s an insight worth pondering. It also teaches you something about branding. Can you extend this insight into other areas like confectionery? If you like KitKat as I do, the natural question would be who makes KitKat? Nestle. What other brands does Nestle own? Can they tell you something about Nestle being a compounder? And talking about brands, what’s your favorite beer or liquor? What makes you like it? Does it change your behavior? Who owns Johnnie Walker, Tsingtao, or Corona?
It doesn’t have to be consumer brands either. If you enjoy gaming i.e Fortnite, PUBG etc, that’s your edge. You have a faster learning curve that others who aren’t into games. Which game publisher makes those titles? And what makes them successful? If you follow any sports such as the Premier League or NBA, who are the broadcasters? Is there any smartphone apps that you used all the time? Who’re the developers? If your spouse has any peculiar buying habits, pay attention. If you notice something that everyone does without questioning it, start asking questions.
Silly questions
You might think there is nothing special about all these. Everyone knows KitKat, Johnny Walker or Instagram. How can I have an edge? Think it this way. Your unfair advantage doesn’t come from knowing, but from asking questions to uncover insights and make connections. Most people don’t like to ask questions. Especially silly questions that make them looks dumb.
Consider a silly question like “Why do we brush teeth?” We don’t ask this kind of dumb question because we already know the answer. To keep our teeth clean and healthy. That’s the logical, common-sense answer. But is that so? Could it be that you brush your teeth more for the reason of self-images such as avoiding bad breath or better smile? And why are toothpaste minty? The mint has no cleaning benefit. Its only purpose is to provide the cooling and tingling sensation which act as a reward that turns brushing teeth into a habit. Would you still brush your teeth if the minty sensation isn’t there?
Remember, if conventional wisdom teaches common sense, then the unconventional wisdom is to ask silly questions. If the majority likes to be normal, then being a little eccentric can offer an unfair advantage. If the majority operates on autopilot and act intuitively throughout their lives, then being more deliberate and exercise critical thinking is a huge advantage. If everyone thinks logically i.e iPhone is overrated/overpriced, then it pays to think from the opposite direction. Otherwise, you would have missed out the deeper psychological reasons why people own Ferrari, why do people buy a Dyson vacuum cleaner that’s ‘overpriced’, why do people happily pay more for Starbucks coffee, or why do we fit ourselves in uncomfortable denim pants called jeans. Be careful when you dismiss something as nonsense.
Leverage
There are no specific rules for this strategy to find your edge. But the general guidelines are intellectual curiosity, observant, and don’t be afraid to ask silly questions. Be like a kid. Kids have a wonderful imagination. They don’t care about status or what others think but question everything with a genuine pursuit of knowledge.
It is also about leveraging what you know. Start thinking, what are the things in my day to day life that can help me in my investing? A bottom-up strategy doesn’t guarantee outperformance. At least not on day one. It is a process of incremental improvement. As you pay more attention, observe your habits as well as others, and began to think deeper, you’ll eventually develop your unique ways of finding great investment ideas.
These guidelines are simple and align with your lifestyle. It is something you can stick to in the long run. We often underestimate the importance of having a frictionless investment strategy. As Buffett used to say a person with a 300 horsepower motor and operates at 300hp is better than someone who has a 400hp motor but operates at 150hp. Everyone is focused on finding a strategy that can make the most money in the shortest amount of time. But most failed not because the strategy doesn’t work, but because of the friction. And the only way to find a long term, sustainable investment strategy is to start from what you do every day and extend it into your investing.
Notes
Greenblatt, J. (2010). The Little Book that Beats the Market. John Wiley & Sons.
Duhigg, C. (2014). The Power of Habits: Why We Do What We Do in Life and Business. Random House.
Sutherland, R. (2019). Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life. William Morrow
Bill Miller, the former Legg Mason portfolio manager, emphasizes the importance of making connections, “Everyone tends to see the same things, read the same newspapers and get the same data feed. The only way to arrive at a different answer from everybody else is to organize the data in different ways, or bring to the analytic process things that are not typically present.”
Let’s think from a company’s point of view. How does a company achieve above-average returns? It has to have some form of competitive advantage or moat, right? If not, competitors would chip away those superior returns over time (mean reversion). Then, how does a company build its competitive advantage in the first place? A good strategy. A good strategy tells a company what to do and what not to do. And through sensible capital allocation, the strategy enables a company to build its competitive advantage, produce superior returns and defend its market position.
Similarly, to achieve long-term above-average returns as an investor, you need a strategy to have an edge. An edge is like a moat, it prevents other investors from doing the same thing.
A great strategy
How do we find the right investment strategy? Most people would pick a proven strategy and apply that to their investing. This is the top-down approach. But most top-down strategies rarely ‘works’.
Take magic formula, an investment strategy introduced by Joel Greenblatt in The Little Book that Beats the Market. The strategy is straightforward: rank companies by earnings yield and return on capital, own 10-20 of them, and rebalance the portfolio each year. Greenblatt shows that the magic formula delivered 30.8% annual returns over 17 years (1988-2004) and works in many countries. But how many investors apply it over the long-term?
Make no mistake, the magic formula is a great strategy. But a strategy is only as good as your ability to stick to it. And there’s no surprise a strategy like the magic formula remains ‘great’ for a long time because there is some psychological ‘costliness’ build into it. Greenblatt wrote that “The magic formula often doesn’t work for several years in a row.” Which is why it works because 99% of investors can’t tolerate several years of underperformance. It isn’t free for all. Otherwise, the mass would have turned it into a mediocre strategy. If someone ever tries to sell you a strategy that works all the time, run as fast as you can. Therefore, a great strategy has to be one that works in your context; one you can stick to in the long-term. Or put it differently, a dumb strategy that you can follow will outperform one that sounds great on paper but burn you out fast.
Under your nose
So instead of asking “what is the best strategy out there?”, a better question would be “what’s the unfair advantage that I have over others?” This is the bottom-up approach to develop an edge. You start with your context—what you already know and what’s around you. This approach minimizes friction because it is a natural extension of what you do every day.
We can start with your career. Whatever your profession is, what you do 5 days a week is your circle of competence; a treasure trove to find investment opportunities. If you’re a doctor or pharmacist, you would have a good understanding of the industry from pharmaceutical companies, generic manufacturers, distributors, to pharmacies, hospitals, and the health care providers. Who has the lion’s share of the industry profit and why? Are there any patented drugs you’re familiar with? That might be something worth looking into. That’s your edge. It doesn’t have to be drugs. It can be the medical devices you use or the pathology collection centers you relied on for results. Who make those devices? What’s so special about them? How hard would my work be if that device is unavailable?
It is about being curious and ask questions. Who are your company’s suppliers? Do you have to source from them? What about your customers? Are they dependent on your products/services? What about your competitors? What makes them better than your company? And are they listed?
This isn’t limited to your work. Whenever your kids get sick, do you go for a generic or branded medicine? Chances are, you would go for a trusted brand that has worked before. If you intuitively acted this way, others might be doing the same. That’s an insight worth pondering. It also teaches you something about branding. Can you extend this insight into other areas like confectionery? If you like KitKat as I do, the natural question would be who makes KitKat? Nestle. What other brands does Nestle own? Can they tell you something about Nestle being a compounder? And talking about brands, what’s your favorite beer or liquor? What makes you like it? Does it change your behavior? Who owns Johnnie Walker, Tsingtao, or Corona?
It doesn’t have to be consumer brands either. If you enjoy gaming i.e Fortnite, PUBG etc, that’s your edge. You have a faster learning curve that others who aren’t into games. Which game publisher makes those titles? And what makes them successful? If you follow any sports such as the Premier League or NBA, who are the broadcasters? Is there any smartphone apps that you used all the time? Who’re the developers? If your spouse has any peculiar buying habits, pay attention. If you notice something that everyone does without questioning it, start asking questions.
Silly questions
You might think there is nothing special about all these. Everyone knows KitKat, Johnny Walker or Instagram. How can I have an edge? Think it this way. Your unfair advantage doesn’t come from knowing, but from asking questions to uncover insights and make connections. Most people don’t like to ask questions. Especially silly questions that make them looks dumb.
Consider a silly question like “Why do we brush teeth?” We don’t ask this kind of dumb question because we already know the answer. To keep our teeth clean and healthy. That’s the logical, common-sense answer. But is that so? Could it be that you brush your teeth more for the reason of self-images such as avoiding bad breath or better smile? And why are toothpaste minty? The mint has no cleaning benefit. Its only purpose is to provide the cooling and tingling sensation which act as a reward that turns brushing teeth into a habit. Would you still brush your teeth if the minty sensation isn’t there?
Remember, if conventional wisdom teaches common sense, then the unconventional wisdom is to ask silly questions. If the majority likes to be normal, then being a little eccentric can offer an unfair advantage. If the majority operates on autopilot and act intuitively throughout their lives, then being more deliberate and exercise critical thinking is a huge advantage. If everyone thinks logically i.e iPhone is overrated/overpriced, then it pays to think from the opposite direction. Otherwise, you would have missed out the deeper psychological reasons why people own Ferrari, why do people buy a Dyson vacuum cleaner that’s ‘overpriced’, why do people happily pay more for Starbucks coffee, or why do we fit ourselves in uncomfortable denim pants called jeans. Be careful when you dismiss something as nonsense.
Leverage
There are no specific rules for this strategy to find your edge. But the general guidelines are intellectual curiosity, observant, and don’t be afraid to ask silly questions. Be like a kid. Kids have a wonderful imagination. They don’t care about status or what others think but question everything with a genuine pursuit of knowledge.
It is also about leveraging what you know. Start thinking, what are the things in my day to day life that can help me in my investing? A bottom-up strategy doesn’t guarantee outperformance. At least not on day one. It is a process of incremental improvement. As you pay more attention, observe your habits as well as others, and began to think deeper, you’ll eventually develop your unique ways of finding great investment ideas.
These guidelines are simple and align with your lifestyle. It is something you can stick to in the long run. We often underestimate the importance of having a frictionless investment strategy. As Buffett used to say a person with a 300 horsepower motor and operates at 300hp is better than someone who has a 400hp motor but operates at 150hp. Everyone is focused on finding a strategy that can make the most money in the shortest amount of time. But most failed not because the strategy doesn’t work, but because of the friction. And the only way to find a long term, sustainable investment strategy is to start from what you do every day and extend it into your investing.
Notes
Greenblatt, J. (2010). The Little Book that Beats the Market. John Wiley & Sons.
Duhigg, C. (2014). The Power of Habits: Why We Do What We Do in Life and Business. Random House.
Sutherland, R. (2019). Alchemy: The Dark Art and Curious Science of Creating Magic in Brands, Business, and Life. William Morrow
