How to Beat the Efficient Market

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The stock market is like a pari-mutuel system of horse racing. Everybody goes there to make a bet and the odds change based on what?s being bet. Everyone can tell a quality company has better profitability, higher return on capital than a company with a terrible record. But when you look at the odds, the terrible record company has a 7 P/E and the quality company selling at 25 P/E, it becomes hard to determine which one is cheap. The odds make it hard to beat the market. The market is efficiently priced to a point.

If you follow the market or have a consensus view, you only earn a market average return for being right. But that's not the outcome you want as a stock picker. It is better to invest in index funds or passive ETF if achieving market returns is the financial goal. What you're after is outperformance-above-average market returns. To do that, you've to be a contrarian.

Contrarian means having a different view of the market. It doesn't have to be the opposite; you don't have to think the market has to go down. If the market is going up yet you think it is going to move in the other 99 directions, that makes you a contrarian. The essence of a contrarian is to think differently.

So how does one think differently to achieve long-term outperformance? There's no universal formula. If there's one, the consensus would adopt it until the odds ensure an average return over time. But here is something to think about. To beat the market, pay attention to the input. This can be expressed in an equation.

Input = Output
Process -> Results

Output, the results, is determined by what goes into the input. To change the output-from an average return to outperformance-you have to change the input. That is, what goes into the investment process.
Take stock screening tool as an example of input. Screeners are popular because it saves time. It's efficient. But here's the problem. Do you know anyone who doesn't use a screening tool? Not many. Google stock screening, and there are 161 million results. Anyone armed with a screening tool sees what you see. What metrics do you use to screen stocks? Low P/E? High ROE? Price-to-FCF? Magic formula? Ben Graham Net-Net? The bad news is that hundreds of thousands of investors have culled through those criteria so many times that whatever is left are unlikely to be bargain anymore. Efficiency is a disadvantage when everyone wants to be efficient.

This concept applies to more than the screening tool. If your input is the same as everyone else, your output is not going to be that different from the rest. If you follow the market, read the same mainstream news, think in a similar fashion and use the same process as everyone else, it is hard to outperform in the long-term.

Imagine buying a house. You determine your budget (the price), the location, number of rooms, and so on down the priority list. But everyone else is using the same criteria to buy a house. Which means you’re competing against the majority in a competitive market to look for value. How do you find value if you are looking at the same place as everybody is?

What if instead of an efficient tool like a screener, you do something inefficient? Like, go through every company starting from alphabet A to Z? That's time-consuming. Who does that? That's the point. No one is doing it. And that’s where the potential outperformance comes from. There is no guarantee your time will be worthwhile. But there's a higher chance of outperformance from an unconventional method than a conventional method like a screener. What about instead of using those popular metrics, you look for companies as measured by durability? Strong capital allocation skills? Companies that promote failure? Companies that have the highest employee satisfaction? That's hard because there’s no way to quantify these things. What about companies that no one would touch with a ten-foot pole? Again, it's hard for psychological reasons. Not many people do it. But that's how you beat the market. Outperformance comes from doing what others aren’t willing to do.

If you ever look at the stocks owned by some famous investors, you'll notice none of their portfolios look alike. Some have concentrated positions, others have a diverse portfolio; some hunt for special situations, deep value while others focused on franchise business or small caps. However, what?s interesting is not how different their portfolios are. Rather, it is the similarity that they all managed to beat the market over the long-term. These investors build their edge through originality-unconventional ways to find ideas and an investment process that can?t be easily replicated. They're all contrarian in their own way.

Being original free you from all kinds of rules. You have the freedom to develop your own rules as long as they're grounded on sound principles. How do you develop original ideas? For one, learn what surprises you. Read widely. Most of what makes you a better investor lies outside of investing books. Cultivate second-level thinking. The more you read and think, the more ideas you gather. And the more ideas you have, the higher chance of connecting them in creative ways. Originality starts with making connections. Occasionally, some of these connections will turn into valuable insights that lead to outperformance.

In William Thorndike's The Outsiders, he profiled eight unconventional CEOs on how they generated an extraordinary return by doing things that confound Wall Street. While the book is written more for CEOs and hedge fund managers than individual investors, it hits home an important message: To achieve exceptional performance, you have to play your own game, not rules of the game set by others. What’s more, he discovered that while these CEOs all have their own unique, different approaches to their businesses, they all share a common trait - They're independent thinkers.
This topic about beating market efficiency is very interesting, especially for value investing, whose purveyors have often claimed to be able to do just that.

There are those (hedge funds) who do so through the 'quant' way, and there are those who do so through the 'bottom up' way. Some of them have been discussed in VB. Turns out, neither of such approach appear to be beating the market. There may be outperformance for a year or more. But stretch the years out, and the performance gets closer to the benchmark.

Why are these smart and experienced money managers not over-performing? Are they not 'contrarian' enough? Do they need to apply even more contrarian strategies? If so, what would those be? Or is it simply still too early to judge?
One can consider investing in value stocks in line with business cycles:

Quotes from Fidelity: Historical analysis of the cycles since 1962 shows that the relative performance of equity market sectors has tended to rotate as the overall economy shifts from one stage of the business cycle to the next, with different sectors assuming performance leadership in different economic phases.1 Due to structural shifts in the economy, technological innovation, varying regulatory backdrops, and other factors, no one sector has behaved uniformly for every business cycle. While it is important to note outperformance, it is also helpful to recognize sectors with consistent underperformance. Knowing which sectors of the market to reduce exposure to can be just as useful as knowing which tend to have the most robust outperformance.

In addition, there are other strategies that can be incorporated to complement the business cycle approach and potentially capture additional alpha in equity sectors.
My belief when it comes to beating the market through having an edge, it should follows Andy Benoit's quote that "Most geniuses—especially those who lead others—prosper not by deconstructing intricate complexities but by exploiting unrecognized simplicities.”.

Business cycle can be an investment strategy that create that edge if you're familiar with it but I would say it is probably not suitable for most layman investors. There are many whitepapers or investing methods that have been backtested and proven to work but might not work in the future for few reasons: 1) Becomes popular -adopted by mass 2) The factor that causes it to work has disappear 3) It is impossible to do it.

What Fidelity mention could be true and lead to long run outperformance but the question is how much resources would you need to execute it? What kind of cycle do you look at? What factors? How do you get those data? How will you analyse them? How do you separate signal from the noise? Those are tough questions. This is also a 'top-down' approach, you look at the kind of method that has worked in the past i.e momentum investing, business cycle etc and find a way to fit it into your investment strategy.

Or another way is a 'bottom up' approach which I considered as 'unrecognized simplicities'. That is you start with your lifestyle, habit, temperament and figure out where is your edge from there, or if you don't have any edge yet, build it from there. Some examples. If you love gaming i.e Fornite, PUBG etc, you already have an edge over others in the game industry. You've have a better learning curve than the rest when it comes to understand what makes Electronic Arts special? or what makes World of Warcraft great and how that contribute to Activision? etc; or maybe you realised you have an extreme temperament that allow you to buy dirt cheap stocks with full of legal issues, that is your edge, you have the passion to dig deep and turn over the rocks to look for gold, that's your edge. Maybe you have a outgoing personality that allow you to have a massive social circle, that is your edge, how can you leverage that in investing? Maybe it helps you to understand the power of network effect? Maybe you're faster to figure out some popular apps i.e Snapchat 10 years ago because of your big network before anyone does.

You get the point. So it is about leveraging what you're already doing in your daily life, and start extend that abit and think, what are the things that im doing everyday can help me in my investing? It can be activities i.e gaming; habit i.e enjoy people watching (observing trend/brands?); or maybe as simple as the way you think. You're naturally good at certain things in your life, it is about leveraging that further and extend that into investing. Which is what I wrote: Connecting ideas. I feel this is way easier because you don't have to change your investment strategy, it fits to your lifestyle like lego blocks fit together. And you'll enjoy what you do. And most important of all: it cannot be replicated by anyone else. No guarantee you will outperform. But I think that is an easy, not replicable, align with your lifestyle (minimal friction) strategy to invest.
but the market disagrees with my lifestyle choices haha.

i think being yourself, independent thinking, not going against your nature, is one of the better and less stressful ways to live. i just finished Principles (ray dalio) and if i may sum it up in a couple of words, it's about knowing who you are and what you are like (and also the people around you), be as sure about it thru tests and feedback, thereafter accepting it and face reality in the most effective manner.

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