What Is Investing?
A First Principle Interpretation Of Answering The Question “What is Investing?”
What Is Investing?
Investing is the positioning of capital to profit from future outcomes. We live in a world where the future is uncertain and unknowable. From one discrete present, there are a range of possible outcomes. This applies equally from making a daily mundane decision such as crossing the street (you could get hit by a car, not get hit at all, trip and fall or cross the street safely; all are possible outcomes) to deciding which financial security to deploy capital to (various events can happen that affect the price of the security in the future).
The Spectrum of Public Equity Investing
There are many forms of public equity investing. On one end of the spectrum, you have quantitative investing where the investor uses quantitative models to form a view of the range of possible outcomes of a stock and decides whether to allocate capital to it. Firms like DE Shaw and Renaissance Capital are successful examples of such quantitative investing funds.
On the other end of the spectrum, you have fundamental equity investing where the investor uses their knowledge of economics and business fundamentals to form a view of the range of possible outcomes for the stock. There are various types of investors under this category. The key differentiating factor is investment time horizon.
On the shorter end of the investment time horizon spectrum, we have investors in multi-manager platforms like Balyasny and Millennium. They use a combination of economics, business fundamentals and stock technical knowledge to form views on quarterly earnings. On the longer end of the spectrum, we have business owner investors like Pershing Square Capital and Berkshire Hathaway. They form a multiyear view on the business, trusting that over time the stock price will reflect the fundamentals of the business.
There are no right or wrong approaches to investing in the public markets. There are just different approaches. The desired outcome is to earn an attractive rate of return over long periods of time and all three of Renaissance Capital, Balyasny and Berkshire Hathaway have a multi-decade track record of delivering just that.
Successful Decision-Making Process Is The Goal Of Investing
Great investing is earning attractive returns on capital over long periods of time. To achieve that, an investor needs to make good capital allocation decisions. Every deployment of capital into a security is a decision. Behind every decision is a decision-making process which assesses the range of possible outcomes. Therefore, the goal of every investor is to have a successful decision-making process.
A successful investing decision-making process must be accurate, repeatable, and ideally scalable. The process must accurately assess the range of possible outcomes for the stock. As we have established that the future is unknowable, a good decision is one where the range of possible outcomes is disproportionately skewed to the upside. Therefore, the process must determine the stock’s range of possible outcomes with an acceptable level of accuracy to determine if it has an attractive risk-reward.
Over long periods of time, the investor will repeatedly face capital allocation decisions hence the investor must repeatedly make good decisions. As such, the process needs to be repeatable. The process must be accurate not just in one instance but in many future instances to earn attractive returns over time.
Lastly, as capital compounds due to repeated good decisions, the investor’s opportunity set will shift to larger stocks hence the process will need to be scalable to continue earning attractive returns on capital. Otherwise returns will decay, which is common in the industry where fund managers chase larger AUM and management fees at the expense of investment returns. Alternatively, the investor can cap his capital pool to avoid decaying returns.
A successful decision-making process is the key to successful investing. This is true for all investing approaches. Understanding this is the starting point of great investing.
Investing Edges Drives Returns Outperformance
There are three key edges in public equity investing, namely 1) informational edge, 2) analytical edge and 3) behavioral/capital edge. There are an additional four edges in private equity investing, namely 1) company control, 2) financial leverage, 3) deal sourcing and 4) deal terms. Here, we will focus on the three edges in public equity investing. These edges are sources of return outperformance. A stock where an investor has an edge is mispriced. A mispriced stock offers an attractive risk reward as its range of possible outcomes is skewed to the upside.
An investor has an informational edge if the investor has public material information that is not known by the market. This allows the investor to assess the security’s range of possible outcomes more accurately than others. Given the speed of information dissemination powered by the internet and financial media, this edge is rare in well followed stocks but can be attained in smaller cap and less followed securities.
An example is using alternative data to form a view of a company’s financials. Given the prevalence of data, the frontier of this edge is constantly moving. For example, gleaning information from credit card spending data used to be an edge but it is now widely available. There is a sub-industry of vendors that specializes in alternative data collection through methods like web scraping and collating of alternative data. Sometimes, large funds with enough internal resources have their own data team for proprietary data gathering.
Analytical edge is an edge where given the same set of information, the investor arrives at a different but more accurate conclusion versus others. An example is quant investing. Quant investors uses publicly available data like financial markets and economic data (sometimes in combination with proprietary data to obtain an informational edge) and proprietary analytical models to arrive at a more accurate conclusion than other market participants. Other examples are event driven strategies like merger arbitrage. Given the same set of publicly available information, an investor with superior legal and M&A knowledge may arrive at a different but more accurate conclusion versus other market participants.
Investor behavior and the capital pool the investor has can be an edge too. Behavioral/capital edge is attained when the investor can act where others are constrained. Time arbitrage is a classic example. Due to the short-term institutional investing pressure on generating returns, investors may overprioritize avoiding short-term losses or volatility versus achieving long term gains. For example, a company may be undergoing temporary short-term turbulences like an increase in brand marketing investments reducing earnings for the next few quarters or an event that negatively impacts short-term earnings but does not impair longer term earnings power. In these instances, shorter term investors may sell the stock in advance to avoid taking short-term losses, providing a mispricing opportunity for longer term investors. Having a capital base that is similarly aligned is key to exploiting time arbitrage.
Another example is investing in stocks with investing barriers to entry like illiquidity, geographical restrictions, or other technical restrictions. Although the mispricing is clear to investors, institutional constraints can restrict them from exploiting it, leaving the opportunity available for nimbler investors. Lastly, during peak optimism and pessimism in bull and bear markets, staying level-headed and avoiding being swayed by the crowd can be a behavioral edge. This allows you to sell at peak optimism and buy at peak pessimism.
Good process drives good decision making. Understanding the sources of return outperformance helps shapes the process.
Understanding Game Selection
As mentioned earlier, there are many approaches to achieving superior returns over long periods of time. Each approach is a different game and it is important to recognize that different skillsets are needed to succeed for each game. The investor needs to understand which game the investor is playing and focus on the process required to succeed in that specific game. An investor competing in rugby should not be training to be an American football player. While both use an oval ball to play, they require different skillsets to succeed. Here, I define the games by their investment time horizon which I believe is the key differentiating factor.
Intra-Quarter Investing
This is the shortest investing time horizon. Stocks are bought and sold within the quarter, sometimes spanning days or at the extreme, hours. Quant investors are the dominant players of this game.
Edge
The investor employs extensive analytical and sometimes informational edge to make superior decisions. Having a superior quant model that has access to proprietary datasets is key to generating superior returns.
Process
The process is focused on superior data gathering and improving the analytical edge of the quant model. Success requires extensive data collection of relevant inputs and the ability to construct a quant model that is analytically superior to form a more accurate view of short-term stock price movements. The relevant inputs here are largely stock technicals, quantitative measurement of sentiment, correlation to other economic or financial market datapoints. These inputs drive short-term stock movements. Minimal regard is given to business fundamentals.
Quarterly Investing
This is investing for quarterly earnings beats and misses. Stocks are bought and sold with a view of quarterly earnings plus stock technicals. This is the start of the fundamental equity investing spectrum. Examples of players in this game are multi manager platforms or shorter time horizon funds. Some long-only funds may also be players here due to pressure from quarterly redemptions.
Edge
The investor employs plenty of informational edge and sometimes analytical edge to make superior decisions. The informational edge is driven by superior proprietary alternative data gathering or frequent management access to form a near term earnings view.
Process
The process requires extensive gathering of business and economic inputs that drive quarterly earnings and an analytical framework to form an earnings view. Stock technicals will also be incorporated into the process. Datapoints like stock sentiment and market expectation of quarterly earnings are key. Large investors with extensive broker relationships, through frequent trading activity, talk to sell-side analysts and equity sales exhaustively to understand near term sentiment, positioning and flows. Frequent access to companies and others (competitors or adjacent vertical companies) to gather near term datapoints is another focus. This is done directly with companies or through intermediaries like brokers in the form of investor conferences and 1x1 meetings.
1Y Horizon Investing
Most funds who labeled themselves as bottoms up fundamental equity investors are players in this game. Players here have a 1Y view on the stock. Underlying business fundamentals take on relatively more importance to the quarterly investing game as it influences 1Y view of earnings (E). At the same time, stock technicals is important due to the short time horizon of a 1Y view. This influences the stock valuation multiple (P/E).
Edge
Analytical edge is key, that is arriving at a different 1Y stock view to the market. There is also some informational edge to be gained. While undiscovered information can impact quarterly earnings more profoundly, some information can have longer shelf life that is useful for a 1Y earnings or multiple view. Sometimes, frequent access to the company in question can offer an informational advantage when management plans on implementing changes in near term strategies that are underappreciated by the market. Behavioral/capital edge, though less impactful, can sometimes be obtained during extreme market environments that normalizes in a year.
Process
The process revolves around anticipating the anticipation of others. This involves anticipating 1Y earnings views and valuation multiples. 1Y earnings view is derived from understanding shorter term trends in business fundamentals like earnings momentum driven by industry trends (e.g. COVID reopening impacting a consumer company’s earnings), changes in key business inputs (e.g. changes in key input costs or demand drivers), management driven changes (e.g. restaurant management team suspending or resuming advertising & promotion spend or unprofitable tech companies pivoting aggressively to profitability) or changes in competitive landscape (competitors deciding to increase or reduce competition). The goal here is to form a more accurate view of the slope or direction of earnings momentum compared to the market.
Anticipating a 1Y view of valuation multiples requires an understanding of historical range and stock technicals. The stock and its comparables’ historical multiple trading range is a starting point absent drastic changes in market regime or business fundamentals. Stock technicals encompasses sentiment, market thematic narratives and fund flows. Anticipating the market’s reaction to these are considerations to 1Y view of valuation multiples. For example, for the first nine months of 2022, the Philippines equity market saw extensive fund outflow due to both budget and current account deficits, rising inflation, and aggressive US rate hikes weakening the Philippine Peso. This impacted the overall multiple of the Philippine stock market regardless of individual company performance.
The more aggressive the exit valuation multiple an investor anticipates, the narrower the range of possible outcomes the investor assumes. Finding an edge in anticipating 1Y view of valuation multiple is highly competitive. It requires experience in anticipating investor reactions and sentiments plus nimbleness to trade in and out of stocks as technical improves or deteriorates.
On a separate note, sell side analysts typically have 1Y target prices derived from a DCF valuation model. In my view this is flawed. The drivers of 1Y investing, as laid out above, are not captured in the DCF valuation model hence not incorporated in their process. This results in sell side 1Y target prices that are simply inaccurate. Thoughtful sell side analysts that realize this will tweak their target prices to qualitatively incorporate the key 1Y stock price drivers mentioned above, while still operating within the constraints of a DCF model.
>3Y Horizon Investing
While most funds describe themselves as long term investors, very few put it to practice. Players here have a business owner mindset, viewing stocks as fractional ownership in a business versus pieces of paper to be traded around. They are share-owners, not share-renters. Underlying business fundamentals is the most important driver of 3Y+ time horizon returns.
Edge
Analytical and behavioral/capital edge are the key drivers of superior long-term returns. Analytical edge can be broken down to quantitative and qualitative. Quantitative analytical edge includes the assessment of unit economics, TAM and growth intensity while qualitative analytical edge includes the assessment of business quality, management and valuation. Given the longer investment time horizon, time arbitrage is a key edge.
Process
Firstly, the process should center around the assessment of the business and management to gain an analytical edge. The investor should have a process of studying fundamental aspects of the business covering unit economics, growth runway, competitive advantages, competitive landscape, company financials and management quality. Ideally, this will be a standardized process of due diligence work so the output can be measured across different businesses for comparison. The best players here even become value creating long-term partners to management. They engage with company management to drive aligned value creation. Examples include Overlook in Hong Kong and Pershing Square Capital in New York.
Given the investor’s ability to take a 3Y+ investment time horizon, capital and behavioral edge is crucial. A classic example is time arbitrage. Therefore, the investor must have a process to ensure it has the capital base to exploit it. This can range from saying no to shorter term money in the fund to active transparent communication, especially during bull markets to build trust capital with the fund’s investors. This build-up of trust reserves can then be used during bear markets to exploit time arbitrage.
Lack of institutional constraints can be another source of behavioral edge. Exploiting time arbitrage invariably means enduring short-term pain for larger long-term gains. The investor must have an investing process that builds psychological strength and conviction and an institutional set up that is able to endure short-term pain. The investing process needs to be robust and systematic to drive consistent investing decision making and keep emotions at bay.
Institutional constraints like top-down geographical allocation target, adherence to benchmark index allocation, inability to hold cash (i.e. being forced to always remain fully invested), restrictions on type of stocks the fund can invest in (i.e. liquidity threshold, market cap criteria, etc) or portfolio construction that satisfies fundraising objectives but not maximize returns, limits the investor’s opportunity set and often forces the investor to invest in inferior risk-reward opportunities. Being able to rise above these constraints provides another source of returns outperformance.
Equity Market Investing Comparison Table
I believe every fundamental equity market investment strategy can be viewed through the above framework. Most investors use broad and vague languages to describe their investment strategy, while mostly being unaware of the game they are playing. Others are unfocused or distracted by day-to-day noise, which causes them to drift from their desired game. These behaviors are unproductive as it does not focus efforts to sharpen the necessary skillsets to succeed in the investor’s chosen game over the long term.
Recognizing which game the investor wants to play is an important starting point. Then, the investor must recognize what edges the investor can obtain in the chosen game as that dictates the competitive frontier for returns. After which the investor should focus on building an investment process around the competitive frontier for returns that is accurate, repeatable, and scalable to generate attractive returns on capital over long periods of time.
There are also great investors who are adept at playing different games at different times, skillfully transitioning mindset and investment process from one to another. However, they are the exceptions.
Equity Strategies Not Covered
There are other public market investing strategies that are not covered here which I would like to acknowledge. These are:
Event Driven Investing
These are strategies where the investor invests with a potential near term catalyst that unlocks value. Examples include merger arbitrage investing, investing ahead of an anticipated corporate event or investing in a pharmaceutical company in anticipation of drug approvals. These strategies typically fall in the quarterly to 1Y time horizon. Superior analysis of the catalyst is the competitive frontier for returns.
Cyclical Investing
Cyclical investing is a strategy that sits in the 1Y to 3Y time horizon investing category. Stock mispricing is largely derived from analytical and behavioral edges. Investor invests with a view of a supply driven industry recovery or bust. Calling the cycle bottom to the correct quarter is difficult but being able to position capital for a 1Y or 3Y supply driven recovery or bust is a key behavioral advantage.
