On Investing: Creating an Edge

The fox knows many things, but the hedgehog knows one big thing

—Archilocus

We had one once–a hedgehog. Unprepossessing little guy. Hung out in the box we had for him, made a little grumbling sound at night. Quizzical look on his cute little face. You had to be careful when you took him in hand. He wasn’t aggressive, just had very sharp quills. Gave our dog something to think about whenever she got too nosy.

I never gave the animal a moment’s thought while we had him. Later, reading Jim Collins’ Good to Great, his book detailing the common traits of fifteen companies that rose from being average concerns to outstanding performers, I was fascinated by  Collins’ finding that these companies became world beaters through an intense focus on a single product or service which became their entire business.

Over a stretch of time, with much debate, discussion, trial and error, the Good to Great companies narrowed their businesses down to the one thing they were passionate about, that they felt they could do better than anyone else, and that drove their economic engine. Collins termed the trait The Hedgehog Concept, after the mythological singlemindedness of these creatures.

I think that the narrow focus attributed to hedgehogs works well for me as an investor. Here’s how:

Success at investing requires an edge over the uncertainty of outcomes. Hedgehogs don’t control anything other than their own actions. Neither do I. The only certainty is what is right in front of me. My edge, therefore, must be something I can see in the moment. I once heard an advisor tell a group of investors “You get paid to take risk.” I disagree. Warren Buffett, writing about his approach, said, “We try to make the purchase price so good, even a mediocre sale gives a good outcome.” I will devise metrics that allow me to say that the purchase price of my investment gives me better value than cash today, without having to hope for something to happen down the road.

I don’t know what hedgehogs know, but I have some idea about what kind of investing I’m familiar with. A friend once told me he was comfortable with having his portfolio divided between real estate, stocks and gold. I certainly hope that works out for him.

I am familiar with stocks, so that is my singular focus. I buy them when the best companies are cheap enough to provide an exceptional dividend yield. This usually means that they will be worth more down the road, when social mood rises and investors become willing to bid them up.  But I don’t want to depend on it because capital growth is the most uncertain component of investment returns, as millions of investors have found over the past decade.

Even a cursory study of the history of markets will tell the investor that stocks have a cycle in which they range from gross undervaluation to extreme overvaluation and back again. When they reach one extreme, they reverse direction and continue in the new direction until they arrive at the opposite valuation extreme. The edge in this knowledge is that I do not want to own stocks from the time they get to overvaluation until they finish the trip to the bottom.

A close study of the Elliott Wave Principle took me out of stocks at the end of 1999. The same studies indicate that the bottom will not come until around 2016, but that is not certain. What is certain is that the bottom will feature massive public liquidation, which will show up in the mutual fund statistics. I last saw this type of event in 1974. It was an unbelievable financial hemorrage.

Today the yield on the blue chip averages ranges from 2.5 to 4%. After the next liquidation, the yields are likely to be north of 20%. My only obstacle then will be my own fear. The blood will probably be running in the streets this time.

Hedgehogs play great defense. That’s what is called for now. Over the next few years, how much we don’t lose is sure to be more important than how much we make.

Cheers,

Rod

The author makes no representation as to the accuracy of the quoted material, but believes the sources to be reliable. No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.

 

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