A critical component of generating investment outperformance, known as alpha in industry parlance, is to uncover insights that the market has overlooked. As Peter Lynch famously said of investing: “The person that turns over the most rocks wins the game”. The harder one works, the greater the chances of them finding insights about a company that can contribute to investment gains. But is working harder, and digging deeper on the analysis of individual stocks a sure-fire way of maximizing investment success? Probably, but not always.
There are different depths of analysis an investor can perform on an individual stock, ranging from a superficial perusal, to months of rigorous analysis and fact-finding. Surely a so-called “deep-dive” on a stock is better than a mere cursory glance, and thus more likely to produce successful investment results? Most times the answer is yes, and the Montaka team firmly believes in the benefits of hard work in uncovering valuable insights that contribute to investment outperformance. However, the question is more complicated when viewed in the context of opportunity cost, and allocating finite investment team resources.
Seth Klarman, in his book Margin of Safety, pithily summed up this conundrum when he said: “…information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. The value of in-depth fundamental analysis is subject to diminishing marginal returns”. In other words, while having the luxury of spending long stretches of time to uncover all the insights sounds appealing, in reality we are all constrained by the bounds of time. There is an obvious opportunity cost in the form of forgone investment opportunities elsewhere if one were to spend too much time looking at a single stock. Besides, it’s impossible to uncover all the insights (I will cover this in a subsequent blog post).
A dichotomy exists between efficiency (which in this discussion would mean ruling out unappealing ideas quickly, and moving on to more prospective investment opportunities) and investment rigor (the deep dive analysis where a potentially endless amount of time could be spent uncovering further pieces of information). So when does it make sense to move analytical efforts on to another stock?
Reallocating one’s efforts to a different stock makes sense when it can be concluded that either: (i) the investment is unappealing, and should thus be passed on; or (ii) a sufficient level of insights have been gathered to form the view that investment success is likely, after which a position will be taken in the stock. The point in time where a conclusion can be reached on a stock is in turn dependent on an investor’s own knowledge and experience as it relates to a business and industry, as well as the stock price.
Let’s take the example of an investor who had previously analyzed Caterpillar for a decade. Despite not having looked at the business for some time, he or she is able to return to the stock and might conclude that it’s an attractive investment opportunity after just 2 hours of work. For someone who has no background in looking at the stock, it might take them two months to reach a similar conclusion, in which case the mispricing is likely to have dissipated or vanished altogether.
The price of a stock is also a critical input into the decision on how much time to spend researching an investment, for it determines whether the implied growth assumptions for a company are optimistic or pessimistic. If, for example, a stock has been heavily sold off, negative investor sentiment could mean that the revenue and earnings growth implied by the stock price are unrealistically low. In other words, the heavy stock price selloff has generated an apparent mispricing which might require only minimal incremental work before allocating capital to the opportunity. In comparison, a stock that on the surface appears fairly priced may require much deeper analysis to uncover a variant perception that suggests there’s further upside.
Time management is an important, yet perhaps underappreciated element to maximizing investment success. An oil exploration firm might have the best drilling rig, but it’s of little use if put to work in an area devoid of oil. With this said, investors should remain cognizant of when diminishing marginal returns for detailed research start to kick in. On the flipside, it might be possible to draw solace from the fact that incremental work, even if it does not result in an investment being made, is not a waste of time. Stock prices fluctuate day-to-day, and there’s always the possibility that that past knowledge, along with an amount of capital, can be put to good use in the future.
George Hadjia is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.