All About Edge
Richard Beddard recently wrote a blog post about company strategy. And Nate Tobik recently wrote one about how you – as a stock picker – have no edge. I’d like you to read both those posts first. Then, come back here. Because I have something to say that combines these two ideas. It’ll be 3,000 words before our two storylines intersect, but I promise it’ll be worth it.
Stock Picking is Like Playing the Ponies – Only Better
Horse races use a pari-mutuel betting system. That is, a mutual betting system where the bets of all the gamblers are pooled, the odds adjust according to the bets these gamblers place, and the track takes a cut regardless of the outcome.
At the race track, a person placing a bet has a negative edge. He places a bet of $100. However, after the track takes its cut, it may be as if he now “owns” a bet of just $83.
At the stock exchange, a person placing a buy order has a positive edge. He places a bet of $100. However, after a year has passed, it may be as if he now “owns” a bet of $108.
All bets placed at a race track are generically negative edge bets. All buy orders placed at a stock exchange are generically positive edge bets.
In horse racing, the track generally has an edge over bettors. In stock picking, the buyer generally has an edge over the seller.
In the Long Run: The Buyers Win
The Kelly Criterion is a formula for maximizing the growth of your wealth over time. Any such formula works on three principles: 1) Never bet unless you have an edge, 2) The bigger your edge, the more you bet and 3) Don’t go broke.
In theory, the best way to grow your bankroll over time is to make the series of bets with the highest geometric mean. Math can prove the theory. But, only in theory. In practice, the best way to prove whether a system for growing your bankroll works over time is to back test the strategy. Pretend you made bets in the past you really didn’t. And see how your bankroll grows or shrinks as you move further and further into the back test’s future (which is, of course, still your past).
Try this with the two “genres” of stock bets:
1) The 100% buy order genre
2) And the 100% sell order genre
Okay. You’ve run multiple back tests. Now ask yourself…
Just how big was your best back test able to grow your bankroll over time by only placing buy orders – that is, never selling a stock. And just how long did it to take for your worst back test to go broke only placing buy orders.
Now compare this to back tests in the sell order genre.
Just how big was your best back test able to grow your bankroll over time by only placing sell orders – that is, never closing a short position. And just how long did it take for your worst back test to go broke only placing sell orders.
What you’ll find is that generally a 100% buy order approach compounds wealth faster and bankrupts you less often than a 100% sell order approach.
Over a long series of bets, one generic strategy can outperform another generic strategy by: 1) Placing more bets with an edge, 2) Making bigger bets when your edge is bigger, and/or 3) Making smaller bets when your edge is smaller.
Here, the reason a stock buying strategy outperforms a stock selling strategy is because the buy strategy bets with an edge more often than the sell strategy.
Why All Stock Buyers Have an Edge
In stock markets: sellers generally have a negative edge and buyers generally have a positive edge, because the asset being given up by sellers (a part interest in a business) is of higher quality than the asset being given up by buyers (cash).
This is not a unique feature of stock markets.
We can see the same concept illustrated by a hypothetical barter trade involving two commodities. Party A wants to be rid of his holdings of aluminum; Party T wants to be rid of his holdings of timberland. Like cash and stocks, aluminum and timberland are both assets. And like cash and stocks, aluminum and timberland are assets of differing quality.
Generally, swaps of cash for shares favor the side getting shares and giving cash. And, generally, swaps of aluminum for timberland would favor the side getting timberland and giving aluminum.
Some specific sales and specific systems for the sale of stock for cash favor the seller and some specific trades and specific systems for the trading of timberland for aluminum would certainly favor the party trading away his high quality timberland for low quality aluminum. However, the special edge the trader of timberland for aluminum would need to juice his returns on any one deal to the point it was a net profitable trade for him would be big. Likewise, the special edge a seller of shares would need to juice his returns over a buyer of shares to make any one sale a net profitable trade for him would also have to be quite big.
Excellent selection and timing of which stocks to sell when and which timberland to sell when could allow you to make a trading profit. However, in the real-world excellent selection of which races to bet on, which horses to bet on, and how much to bet on those horses in those races really does allow some bettors to profit at a race track even though the generic strategy of betting on horses is still a bad one.
You can make money betting on a horse race. And you can make money selling a stock. But, a generic strategy of not betting on horse races outperforms a generic strategy of betting on horse races. And a generic strategy of buying stocks outperforms a generic strategy of either selling stocks or neither buying nor selling stocks.
Generally, buying stocks works. As a result: stock buyers have a “dumb money” edge.
The 3 Levels of “Edge”
At a stock exchange, there are 3 levels of edge:
1. Generic edge: The “dumb money’s” edge. Since buying stocks generally works better than selling stocks or not owning stocks, a constant buyer of stocks – such as an investor in an index fund – has an edge over other kinds of operators (non-investors, investors who hold mixed portfolios with bonds, market timers who sometimes hold cash, and long/short investors).
2. Special edge: the “factor investor’s” edge. Since buying certain kinds of stocks (high quality businesses, cheap stocks, and stocks rising in price) works better than buying other kinds of stocks (low quality businesses, expensive stocks, and stocks falling in price) an investor who systematically bets in order to maximize certain factors (like high quality, good value, and positive momentum) has an edge over both operators who systematically bet in order to maximize other factors (low quality, poor value, and negative momentum) and operators who don’t bet systematically.
3. Unique edge: the “stock picker’s” edge. This is the kind of edge Nate is talking about when he says “You have no edge. Get over it.”
Does the Stock Picker’s Edge Exist?
There is no debate over whether the generic edge an index fund has and the special edge a factor based fund has exists.
A generic strategy that bets in favor of stocks is a better generic strategy than one that bets against stocks. And a special strategy that systematically bets in favor of quality, value, and momentum is better than a special strategy that systematically bets against quality, value, and momentum.
For example: a “dumb money” stock index fund outperforms a “dumb money” bond index fund. This is due to the generic edge that buying stocks has over not buying stocks.
And: A semi-smart system like Toby Carlisle’s (low EV/EBITDA) “The Acquirer’s Multiple” outperforms a “dumb money” strategy like putting everything in an S&P 500 index fund.
How to Win a Coin Flipping Contest – Play Against Humans
Of course, the dumb money approach will outperform the semi-smart money approach over some series of years. That’s irrelevant. Picking heads 0% of the time at better than even money odds will outperform picking heads 100% of the time at worse than even money odds over some series of coin flips. As a rule: bad bets sometimes outperform good bets. This has nothing to do with the stock market. It has everything to do with betting.
So, is the dumb money approach to winning a coin flipping contest – that is, not betting because I have no edge – neither better nor worse than the semi-smart strategy? The semi-smart strategy would be accepting even money odds on coin flips and then just trying to make the best bets you can.
I know what you’re thinking: not betting and betting the best you can on coin flips will tend toward the same outcome.
That’s true if you’re playing against the house and the house is offering even money odds.
But, what if you were participating in a pari-mutuel coin flipping contest. Remember, there is no “house” in stock picking. There is no “vig”. It’s like playing the ponies – only better. The stock market isn’t like a coin flipping contest. A coin flipping contest is usually modeled as having fixed even money odds.
There’s actually a really big assumption in coin flipping models. The assumption is that whoever is giving you odds on coin flipping consistently applies his best available strategy on every flip.
It’s true you can’t win a fixed even money odds coin flipping game even if you use your best available strategy for betting. But, that’s only because the other player is also using his best strategy available. He’s “selling” you coin flips at even money odds on both heads and tails. That’s literally the only move he can make that guarantees you can’t take advantage of him. If he ever makes any other move, you can beat him.
Real Games Don’t Really Work This Way – Real Players Don’t Really Play This Way
This is an ideal opponent fallacy. It’s a fallacy in the “begging the question” sense. The question is: “Can you profit from a coin flipping contest?” And the unstated argument is: “You can’t profit from a coin flipping contest, because your opponent in a coin flipping contest must always make the best available move.”
A coin flipping game is so simple that we tend not to realize we’re assuming the argument “because your opponent in a coin flipping contest must always make the best available move.”
Is that really how a large group of humans would play a coin flipping game?
Let’s simplify it down to one guy. You and an opponent. Would your opponent always offer you even money odds on both heads and tails?
What if he doesn’t? What if he makes a mistake?
You’re Always Playing the Player
Why do I have a negative edge when I sit down to play blackjack at a casino?
It’s not just because I’m playing blackjack. It’s because I’m playing against the casino’s dealer at fixed odds set by the casino. The casino’s dealer has to employ a strategy that is, in practical terms, close enough to ideal. No, it’s not quite the best strategy. But, it’s very easy to apply consistently and very hard to beat with out a lot of extra effort.
Now, replace the casino’s dealer with a third grader and replace the casino’s fixed odds with variable odds – shouted out before each hand – by a sixth grader.
I now have an edge. And it has nothing to do with counting cards. The third grader will not employ a strategy as good as the casino’s dealer was forced to and he will not apply any strategy as consistently. Meanwhile, the sixth grader will get bored and sometimes shout out odds that are more favorable for one hand and then less favorable for the next.
That’s all I need. I don’t need an ideal strategy. I just need a sound strategy that takes advantage of my opponent’s occasional mistakes. If the odds are set inconsistently, I can now profit at the blackjack table without applying any effort. I only need two skills. One: the mental ability to recognize mistakes in my opponent’s play. And two: the patience coupled with courage to bet big when my opponent errs and only when my opponent errs.
In the stock market: you are not playing against the house. You are not facing the ideal opponent. And the odds are not fixed.
So, if other bettors use a negative edge strategy and you use what should (against an ideal opponent) be a zero edge strategy – you’ll win. In a mutual betting system, the presence of losers creates winners. If some bettors bet badly, then bets that should yield you no advantage will instead yield you an advantage.
So: Should You Bet on Coin Flips?
A while back, I asked which of two strategies works better. Strategy A: Never bet on coin flips.
Strategy B: Bet on coin flips in such a way that you’d expect to have very close to zero gain and zero loss after a long series of flips of a perfectly fair coin.
If the odds are fixed, it’s safer and easier to just not play.
But: If the odds aren’t fixed, it’s potentially profitable to play.
If you apply a consistently sound strategy and your opponent’s strategy is either unsound or inconsistently applied – you can profit from a coin flipping contest.
The semi-smart approach of assuming you know there is an equal likelihood of a coin flip coming up heads or tails but you don’t know which particular flips will come up which outperforms the truly idiotic approach of assuming you don’t know what the likelihood of a coin coming up heads vs. tails is and so you just guess (it could be 50/50, it could be 90/10, who knows?).
I know what you’re thinking. No one would bet that way.
But, consider this…
In the Real World: There is No House – And There are Idiots
If you were given a $25 bankroll (free) and the chance to bet heads or tails on a series of flips of a coin that comes up heads 60% of the time and tails 40% of the time, how much money would you bet on each flip? And, would you bet heads every time, tails every time, or some mix of the two?
My last question sounds absurd.
In theory, it is.
But, the real-world experiment – using mostly people who were either currently studying finance or economics at college or who were currently working at a finance firm – resulted in 65% of the participants betting tails on at least one toss. These people had been told the coin was biased to come up heads 60% of the time and tails 40% of the time. And they were eligible to walk away from this experiment with up to $250.
Most people (65%) made at least one negative edge bet (picking tails) during the experiment.
And nearly 30% of the participants ended up with zero dollars. That’s most likely because 30% of the participants bet everything on a single coin toss.
The study wasn’t perfect. The participants knew it was an experiment and knew they had been told the coin would come up heads 60% of the time and tails 40% of the time. This is a pretty close to fatal flaw in the design of the experiment. The way the experiment was designed would certainly prime many participants to suspect they were being lied to.
But, even if that is what happened here (and I suspect it is), that still raises an interesting question. Were some people so afraid of looking foolish that they lost $25 in actual cash and lost $225 in potential cash just to avoid a loss of face.
The result of this study does seem to suggest it’s either one or the other. Either, people believed the experimenters when they were told the likelihood was 60% heads and yet they still made idiotic bets like picking tails or betting their entire bankroll on a single coin toss – or, they thought there was a chance the experimenters were trying to fool them, so they avoided believing a lie at the cost of free cash.
In Practice: The World is Not Like it is in Theory
We often model approaches to asset allocation, position sizing, stock picking, etc. using unrealistic assumptions. For example, we benchmark different investment approaches against an index. However, this assumes an average investor not employing this strategy will get the same result as the index (most likely: he won’t, he’ll get a worse result).
Likewise, we frame the concept of edge in terms of special edges (factors) and unique edges (stock picking) without thinking about just how odd it is that stocks have enjoyed a generic edge over other assets even in periods when the investing public knew stocks had historically had this generic edge.
So, what if we discard theory?
What if we put aside a logic based approach (like the one Nate uses in his post about the non-existence of edges) and instead use an entirely empirical (that is, observation based) approach.
To do this, I want to consider one and only one kind of edge.
In his post “Getting Serious About Strategy”, Richard Beddard says:
“…how many investors, people who depend on a company making the right choices actually take the trouble to work out what a company actually does?”
The most valuable edge you can have as a stock picker is to better understand what a company actually does than the person on the other side of the trade from you.
We know stock buying is a better generic strategy than stock selling. So, I’d suggest the best decision you can make as an investor is one in which you – as a stock buyer – know more about what a company actually does than the fellow selling his shares to you.
What Does NACCO Actually Do?
I’m not cherry picking here. NACCO (NC) is my biggest (50%) and most recently added (October 2017) position. Here is an excerpt – courtesy of Seeking Alpha – from the company’s latest earnings call (its first after it spun-off a big division):
Investor: I want to thank you…for completing the spin-off. This has probably been one of the best investments I have made in years. But I have a question about it, even though I have sold almost all of my position, I have a small position left. The value of this stub, which was the parent company less the value of the when issued, spin-off of Hamilton was trading around $20 per share before the confirmation of the spin-off. And then in the brief period since the spin-off, the value of the stub which now is no longer technically a stub, it’s a…stand-alone and its symbol NC (has) gone close to $40 and even $44 which, again, (I’m) very thankful of, because I made lots of sales during that period. Do you have an explanation why the value has gone up over…100% despite the fact that the outlook for 2018 does not appear to be salubrious and that coal prices have been stable to down slightly and (royalties) and production from the mines at North American Coal does not appear to have skyrocketed or has done anything exceptional?
CEO: …why the stock trades up, why it trades down is often a mystery. Your comment about the coal prices, our business model really doesn’t have us with any exposure whatsoever to coal prices. Our unconsolidated mines really operate as a service business and our one consolidated mine has a formula price for the coal it sold. So it’s not like any of this is driven by coal prices.
Investor: …But don’t you agree that the higher coal prices might lead to higher production at the associated mines?
CEO: I don’t know that it’s really connected. Our mines are individually dedicated to a single customer. And it’s really just that customer’s demand for electricity that determines how much coal we sell to them.
I don’t know for sure if I bought shares of NACCO that this caller was selling (though his comments make it sound like we might have been on opposite sides of a trade). And I don’t know for sure if I have an edge in understanding NACCO’s strategy better than this caller.
However, I do know 3 things:
1) NACCO’s strategy is to sell coal at a fixed (rather than a market) price so that its earnings do not fluctuate with the price of coal.
2) If NACCO’s earnings did fluctuate based on the market price of coal, I would not have bought the stock.
3) This caller clearly would have bought the stock even if NACCO’s earning fluctuated with the price of coal.
So, we know that I had one understanding of NACCO’s business strategy and this caller had a different understanding of NACCO’s business strategy. I was a buyer of the stock while he was a seller of the stock. And we know that my buying was based on my understanding of NACCO’s business strategy while his selling wasn’t (it might have been based on his understanding of NACCO’s business strategy, but it certainly wasn’t based on our shared understanding of NACCO’s strategy – because this call makes it clear we don’t share any understanding of what the company’s strategy is.)
Does this constitute an edge?
But, this is the kind of situation I want you guys to focus on.
I Was Cherry Picking – You Should Too
I said I wasn’t cherry picking. But, I was. In most stocks: most big buyers and big sellers of the stock know how the company makes money. In NACCO: some big buyers and some big sellers of the stock don’t know how the company makes money.
There are two things I want you to take away from this post:
1. Generally, stock buyers have an edge over stock sellers. And…
2. Stock buyers have a unique edge in cases where they understand “what a company actually does” better than the person they are buying their shares from.
Therefore, focus most of your attention – and most of your bankroll – on buying stocks where you think you know what the company actually does better than sellers of that stock.