The First Mover Advantage

“Diversifying is easy; doing so early is difficult.” – William Bernstein

John Burr Williams wrote The Theory of Investment Value in 1938. It was based on his Ph.D. thesis that stated prices in the financial markets were a reflection of an asset’s intrinsic value.

He was among the first people to ever use Discounted Cash Flow analysis (DCF) to value stocks, which states that any investment is simply the present value of its net future cash flows. Before this theory was more broadly accepted, most investors were purely speculating on past prices.

One of the early benficiaries of the fact that valuation was such a new phenomenon was Benjamin Graham. He bought value stocks throughout the 1930s, 40s and 50s while the playing field was wide open. It was easy pickings because there wasn’t much competition.

Shortly before his death, Graham discussed how the changing investment landscape altered his views on discovering value:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity say, forty years ago when our textbook Graham and Dodd (Security Analysis, 1935) was first published. But the situation has changed a good deal since then. In the old days any well-trained analyst could do a good professional job of selecting undervalued issues through detailed studies. But in light of the enormous amount of research now being carried on, I doubt that in most cases such extensive efforts will generate sufficiently superior returns to justify their costs.

Fast forward to the early-1970s for another early adopter of market analysis, Michael Steinhardt.  Steinhardt’s hedge fund was one of the most successful funds of all-time, racking up annual returns of nearly 25% over a dozen years. The majority of this success can be traced to a three year period from 1973 to 1975.

Here’s one of the main reasons Steinhardt’s fund was so successful from the book More Money Than God about one of the researchers on his team:

Cilluffo had begun tracking monetary data, hoping it might anticipate shifts in the stock market. A decade or so later, this sort of exercise was common on Wall Street. […] But during the 1960s, Wall Street’s equity investors could not be bothered with this sort of analysis. Monetary conditions and the Federal Reserve’s response were marginal to their thinking.

This different line of thinking helped the firm anticipate and profit from both the 1973-74 stock market collapse as well as the eventual recovery that followed. The fund was up 43% in the 73-74 bear market when the S&P 500 was down almost 37% and up 54% in 1975 when the market recovered 37%.

Both of these instances show the first mover advantage that can be gleaned from non-traditional analysis. Stating the obvious, this is not an easy task, especially in today’s day and age where knowledgable investors are constantly seeking out mis-priced securities.

Something I’ve noticed since the financial crisis is a steady stream of investors touting back-tested models they’ve created in the past few years that make some variation on this claim:

The model we created would have gotten out right before the market peaks of 1929, 1973, 2000 and 2007 and got back in at the bottom so you’d miss the downside but participate in the upside.

Unfortunately, it would have been extremely difficult to pull this off in those earlier periods. You have to ask yourself: Could I have made these same decisions with the information that was available to me at that time?

While I don’t question the fact that you can create systems based on historical information to show just about anything you want, I am skeptical of any model or investor that thinks they can guess the future of investor emotions. Because that’s really what you’re saying when you make the claim that a model can call tops and bottoms.

Although market analysis will continue to evolve, the aspect of investing that will never change is our human nature. Emotions will always play a role in causing some investors to make the wrong move at the wrong time.

Regardless of the fire hose of information we try to digest it will still take second level thinking to truly separate yourself from the crowd. Emotional intelligence, discipline and patience will never go out of style. They will be tested, but that’s nothing new.

I guess the point here is that it’s never going to be easy. The low hanging fruit is gone. Unless you can be truly innovative in your approach, you’re never going to completely outsmart the market at all times. And the innovation life cycles are getting shorter and shorter, so one of the only ways to really differentiate yourself these days as an investor is to extend your time horizon.

There will always be a handful of standout market performers that earn seemingly easy profits, but that’s really a pipe dream for 99% of investors. For the rest of us, getting rich at a painstakingly slow pace is still the best option.

More Money Than God

And here’s the best stuff I’ve been reading this week:

  • 28 secrets of exceptionally productive people (Inc.)
  • Failure is not predictive of your future success in life (Reformed Broker)
  • A dozen lessons learned from Josh Brown (25iq)
  • Never delegate your understanding (Research Puzzle)
  • When’s the best time to invest? (Boomer & Echo)
  • The secret to investing success: Amnesia (Daily Finance)
  • Avoid extreme stances and give up on the either/or line of thinking when building a portfolio (Derek Hernquist)
  • Rick Ferri’s solution for the mutual fund industry (WSJ)
  • Things you should know the difference between (Morgan Housel)
  • Why we watch certain movies over and over again (Atlantic)
  • Watching the market all day is a bad idea (Abnormal Returns)
  • How to invest in active funds (Monevator)

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