This article is inspired by two articles written originally by John Huber. John Huber runs Sabre Capital Management, a value-focused investment partnership modeled after the original Buffett partnerships (i.e., no management fee, and only charges a performance allocation on profits that exceed a 6% compounding hurdle). I am a regular reader of John's investment letters and articles and admire his fund's investment philosophy, which he describes as “very simple – we invest in undervalued stocks of great businesses. Since these opportunities are rare, we are extremely selective when making investments, which means we tend to own a concentrated portfolio of high-quality companies."
The Risk of Groupthink in Investing
One of the most significant risks in investing: allowing others to indirectly make your investment decisions for you.
In the current investing environment, it pays to have an opinion and to have others buy-into that opinion. Accompanying the rising number of retail investors in 2020 was a new set of market commentators targeting novice investors. Historically, this market was well-regulated, with perhaps Jim Cramer on CNBC acting as the most retail-investor targeted commentator in the industry. Now, there are thousands of individual Youtube, Twitch, and Tiktok channels dedicated to providing investment advice and stock tips. While stock tips are not new, the reach and penetration of market commentators to both institutional and retail investors is noticeably higher. The more an investor is exposed to stock tips and market commentators, the higher the probability that an investor may succumb to the risk of 'Outsourced Thinking' or 'Groupthink'.
To explain the risk of Groupthink, John Huber describes Bank of America's acquisition of Merrill Lynch as a case of outsourced thinking on at an institutional level. In September 2009, during the Great Financial Crisis, Ken Lewis (CEO of BoA) hired two investment banks and numerous advisors to provide their opinions on an acquisition of Merrill Lynch. The advisors, in the full knowledge that Mr. Lewis wanted to acquire Merrill Lynch, provided opinions that favored the $50bn acquisition.
During the same period, Warren Buffet was also approached by Dick Fuld (CEO of Lehman Brothers), asking for an equity investment to keep the bank afloat. Buffett famously requested a couple of days to read Lehman's 10Ks and other financial reports. After reading these public documents, and without seeking advice or opinions of others, Buffett declined the investment based on the business being too hard for him to understand.
Huber argues, Ken Lewis 'outsourced his thinking', whilst Buffet did not.
Most scams, whether related to investing or not, are usually attributed to some form of groupthink. The thought process goes like this: ‘If everyone is doing it or advising to do it, then it must be ok’. In the world of investing, this is not the case. Contrarian investors are one type of investor that attempts to resist groupthink. However, several evidence-based studies show that the majority of people are not independent thinkers. Based on the famous sociological experiment from the 1950s, 75% of the participants chose incorrect answers to basic questions (e.g., which line longer?) because the majority of the group, who were paid actors, picked the incorrect answers. Overcoming groupthink is hard. However, this means independent thinking is rare, and therefore valuable.
As investors, we can improve our independent thinking ability by seeking primary data and data that contradicts the popular opinion. We can also make the individual responsible for investment decisions, rather than decide by group consensus. If decisions need to be made in a team setting, assigning a devil's advocate and recruiting a diverse team helps reduce the risks of groupthink.
Finding Your Edge
I’ve observed over the years that whatever information an investor believes to be unique is almost always understood by many other market participants, and thus is not valuable. The mispricing is not in the stock itself, but in the investor’s own perception of the value of information: it’s worth far less than they believe it is. Information is now a commodity, and like the unit price of computing power that provides it, the value has steadily fallen as the supply and access to it has skyrocketed.
When funds pitch for investment, the idea of 'edge' is an important one. Investors want to know why they should invest in your fund, or what edge you have other funds in the market. Huber argues that one form of edge, the 'Information Edge' does not exist anymore, across any segment of public markets. Information edges in public markets have been eliminated by almost universal and instant access to public information sources. Hedge funds are spending millions of dollars on systems to process alternative data sets and find information edges, yet none seem to consistently beat the market over the long-run.
The book, 'Black Edge', describes the three forms of edge used at SAC capital (before it was closed down for insider trading). Edge, as described by the book, ranges from white edge (public info, not worth much), grey edge (non-public information that was valuable, but potentially not illegal), to black edge (illegal inside information). SAC traders would always seek grey edge to help correctly predict the short-term price movement of stocks around earnings announcements. This type of trading was wholly disconnected from the fundamental long-term approach employed by value investors and did not seem to produce excess returns as consistently as expected.
However, as the information grey edge has declined, another form of edge has benefited. ‘Time-edge’, which is used by investors who are willing to look out over multiple years, appears to be a lasting edge. As more money gets allocated for reasons other than a stock’s fundamental value, there is a higher chance that the short-term stock price will become disconnected from the fundamental value. As markets become faster and more crowded, the liquidity that is provided by short-term traders adds to the volatility of stock prices, which creates more opportunities for long-term investors. This disconnect allows patient investors to use their time-edge to buy undervalued securities and wait for the subsequent re-rating.
Because these short-term distortions are driven by human nature, it is unlikely that this trend will change any time soon. As Benjamin Graham described, the market is "in the short run a voting machine, in the long run, a weighing machine". Investors can use their time-edge to overlook short-run volatility and outperform in the long-run.