What is the source of investment outperformance?
How do you beat the market and not merely follow it?
To achieve outperformance, you have to be unique in some way. Unique in insight, strategy, or timing.
Outperformance is coveted by many but attained by few. That’s just how it goes.
As the great economist Paul Samuelson wrote decades ago:
‘What logic can demonstrate is that not everybody, not even the average person, can do better than the comprehensive market averages. That would contradict the tautology that the whole is the sum of its parts.’
It would be a crime against logic to assert that everyone can beat the market. Equally, it would be incorrect to claim the average investor can surpass their statistical fate.
Outperformance lies in the extremes.
To gain an edge over the market, you must be at the edge of the market.
The market versus you
Investing often feels like a solitary game.
You research an industry. You run some screens. You whittle down stocks to a watchlist. You compare financial ratios. You check multiples. You assess current valuation to your earnings projections.
You, you, you.
But investing isn’t a solo game…it’s multi-player.
If you’re seeking outperformance, it’s you versus the market.
If your solitary research yields an investment idea the market already incorporated into the price, then outperformance will elude you.
As Michael Mauboussin wrote in Expectations Investing (emphasis added):
‘The way astute investors can earn superior returns is by anticipating shifts in a company’s competitive position and the resulting changes in cash flows that the current stock price does not reflect.’
Great investment ideas take account of what the market has already priced in…and what it hasn’t.
An idea that is not yet reflected in the stock price is the idea most likely to lead to outperformance.
By the way, as I mentioned last week, Greg Canavan and I have started a podcast inspired by this point.
The podcast, What’s Not Priced In, covers investment stories and ideas with an eye on what the market has already discounted…and what it hasn’t yet.
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Horse racing offers a great example of the benefits of this approach.
Let me explain.
Stock picking and horse picking
What does betting have to do with investment outperformance? Successful betting shares the same logic as successful investing.
Steven Crist, a well-known punter on horses who was inducted into the Hall of Fame for the National Handicapping Championship (yes, that honour exists), published multiple books on betting.
But it’s his short article on finding value in bets that concerns us here.
In the short piece, Crist hammers home the point that betting shouldn’t just be about finding the horse most likely to win.
It is the mismatch between odds and likelihood of outcomes that matters:
‘Even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds.’
Compare that statement with Mauboussin’s in Expectations Investing:
‘The stocks of businesses with excellent long-term prospects do not always deliver superior shareholder returns. Shareholders of a company with a stock price that fully anticipates its performance should expect to earn a market-required rate of return.’
(Does Nvidia’s [NASDAQ:NVDA] stock price now fully anticipate its long-term performance? Check out Ryan Dinse’s discussion of this in yesterday’s piece.)
Crist thinks most punters focus only on finding winners without taking odds into account (emphasis added):
‘This is the way we all have been conditioned to think: find the winner, then bet. Know your horses and the money will take care of itself. Stare at past performances long enough and the winner will jump off the page.
‘The problem is that we’re asking the wrong question. The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory.
‘Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.’
So, what’s Crist’s big takeaway?
‘The only path to consistent profit is to exploit the discrepancy between the true likelihood of an outcome and the odds being offered.’
Variant perception is the key to outperformance
We can transcribe Crist’s takeaway to investing by arguing outperformance depends on:
- Figuring out the odds being offered — that is, what the market has already priced in
- Identifying a discrepancy between the outcome reflected in the current price and the outcome you think is most likely
The second step is difficult — and risky — because it entails disagreeing with the market, the average consensus.
No wonder many great investors say you need a contrarian streak to succeed in this game.
The second step is often dubbed variant perception by industry insiders.
Here’s asset manager Ron Rimkus, writing for the CFA Institute (emphasis added):
‘Many analysts labour under the belief that the game is about getting the cash flows right. It’s not. Alpha is not in your cash-flow estimates. It’s not in your discount rates. And it’s not in your cheap multiples. The game is about our variant perception — our ability to distinguish our perceptions from the market’s and successfully bet when there is a material difference.
‘Divergence between your perception and that of the market is where you should dedicate the lion’s share of your work. This is where true alpha comes from. Everything else is beta in disguise.’
Outperformance stems from accurate variant perception about what should be priced in by the market but currently isn’t.
Everything else is beta in disguise.
Hope you tune in to this week’s episode!
Regards,
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Kiryll Prakapenka,
Editor, Money Morning
