The Balance Between Edge and Conviction

The Balance Between Edge and Conviction

By Jack Forehand, CFA, CFP® (@practicalquant)

Developing an edge in the stock market has always been a significant challenge. The collective wisdom of the market is typically correct, and that leads to very efficient asset pricing in most cases. For that reason, most investors who think they have an edge don’t really have one. The long-term underperformance of active managers as a whole is about as good evidence of this fact as you will find.

But that doesn’t mean edges don’t exist. They are just very difficult to come by. And even when you have one, doing the things that it takes to translate that edge into profits in the real world can be much more difficult than many investors think.

But before I talk about why that is it would probably be helpful to first look at the types of edges that exist.

The Major Edges in Investing

Here are the three main edges you can have as an investor.

1 – Informational Edge – This is the best type of edge to have. But it is also the most difficult to get. Its definition is exactly what you would think it would be. If I have an informational edge then I have information that the rest of the market does not. That is only part of the equation, though. For it to be an edge I also have to be able to profit from that information.

To understand why this type of edge is so difficult to obtain, think about all the players that exist in the stock market. Every one of them is trying to get every piece of information that they can to gain an edge.

So what are the odds that any individual player in the market can gain access to information (at least legally) that others don’t have and maintain that edge without others eventually finding out?

It isn’t impossible, but it is very unlikely. Even when new sources of data come online, the owners of that data will typically sell it to as many people as are willing to buy it, which quickly eliminates any edge. For example, satellite photos from Walmart’s parking lots could have given some hedge funds an edge in predicting future results when it first became available, or tracking where company jets are flying to and from could signal some type of big M&A deal, but these edges can get quickly eroded as more and more hedge funds purchase that same data.

2 – Analytical Edge – Another way I can gain an edge is to take the same information that other investors have and analyze it better, or perhaps differently. For example, an investor could take something like financial statement data that is widely available and find a way to analyze it in a different way than everyone else to develop an edge. That is obviously very difficult to do since there are many people analyzing that data, but that would be an example of an analytical edge. Another example may be what Kai Wu of Sparkline Capital, who we had on our podcast, is doing with natural language processing and machine learning to comb through patent data and annual and quarterly reports to try and identify innovative or disruptive firms.

3 – Behavioral Edge – I was listening to an interview Patrick O’Shaughnessy did with Dennis Lynch of Counterpoint Global recently and they discussed this idea in detail. Dennis is probably one of the best investors that most people don’t know about. He discussed his approach in detail in the interview. When asked what his edge is, he said the following

I think in the terms that you’re getting at, it would be more time arbitrage. And I think we’re trying to win through patience and longer-term holding periods. The idea that in the very short-term markets are likely highly efficient, often if you tell me what the results of our company quarterly earnings are going to be, I still won’t necessarily know what the reactions in the market will be.

So we’re trying to win by time arbitrage or having a longer time horizon. I’m looking not this year’s earnings, but three, five years plus out. And then hopefully being able to then have the ability to stick with our positions despite the fact there’s going to be certainly some ups and downs along the way. So I think ultimately it’s a patience temperament edge, we hope, as opposed to something a lot more tactical.

To put what Dennis said in basic terms, a big part of his edge is patience. It is the ability to wait for the market to recognize what they see in the companies they own. And that is probably the biggest lesson I think all of us can learn about getting an edge in markets today.

Dennis doesn’t mention it in his answer, but they clearly have an analytical edge. They have a team of analysts who are able to identify companies that are likely to outperform in the future. They wouldn’t have the track record they do if they didn’t. But even for an investor that good, that edge has to be coupled with conviction to ever be turned into outperformance for his investors. If that is true of an investor as good as him, it is certainly true of you and me.

And the less an edge you have, the more important this quality is. As someone who runs systematic value strategies, I understand that no matter how unique I think my process is, there are certainly many other investors who do something similar. Most of the edge in a situation like that doesn’t come from the process itself, but rather from the ability to give it the time it needs to succeed. The smaller an edge you have, the more difficult that process is likely to be. There is probably no better evidence of that than the decade of underperformance that most traditional value investors have had to endure.

On the other hand, a firm like Renaissance Technologies likely doesn’t need too much conviction because their edge is so big. Their periods of underperformance have been short, which makes their process much easier to adhere to.

The Elusive Nature of Edge

In the end, I think there are two major things that investors seeking an edge need to recognize. The first is that truly having an edge in the competitive efficient markets we operate in is very difficult. In a situation like that, all perceived edges need to receive extra scrutiny to make sure they are truly unique and can be profited from. The second is that unless you are Renaissance Technologies, your edge is likely going to require a high level of conviction in the periods it doesn’t lead to outperformance. Although the first two edges I listed are certainly obtainable, I think the last true edge left in investing for most investors is patience.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.