Equity Analysis Strategy: Uncertainty Improves Performance

This article about improving your investment performance with an equity analysis strategy was written by Jack Lyons. Jack has worked as an equity analyst and auditor in Dublin, Ireland. He focuses on applying a quantitative net net and Acquirer's Multiple strategy in his personal account. Article image (Creative Commons) by Tero Vesalainn, edited by Broken Leg Investing.

Less is more! — it’s a phrase that people often use incorrectly, inappropriately, or, to appear wiser than they really are.

However, as annoying and ill-advised as these clichés often appear, they do have their place in the English language. And for the sake of this article, this is great news, because I’m about to use one again.

When it comes to (Seth) Klarman stock-picking and an equity analysis strategy, less really might be more. How could this be? Have a read for yourself!

The Role of the Equity Research Analyst

To many budding finance and economics students, becoming an equity analyst is the ultimate career goal. After all, what is cooler than taking everything you’ve learned while studying investment and economic analysis modules, reading the Financial Times, and watching CNBC every day — and then applying it to your actual job! What a dream!

Equity analysts, once they begin, usually get placed in charge of a particular industry or group of companies and earn their trade by knowing everything there is to know about those companies.

As a result, the analyst’s role provides for far less diverse exposure to a broad equity analysis strategy than one might think – and many investors believe what works for the equity analyst will work for them. In his book Margin of Safety, Klarman alludes to this very point:

“Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer.”

The work that these investors carry out is both admirable and intuitive. After all, doesn’t it make sense that the better you know a company, the more likely you are to be able to make a well-informed decision about it? The answer, of course, is yes. However, the motives of the equity analyst are no doubt different to yours when it comes to the topic of investing.

Value Investors ≠ Equity Analysts

While the analyst is paid to have an in-depth opinion on a handful of companies, you are probably not. What this means is that you also have the entire population of global stocks with which to form your own equity analysis strategy. Anyway, as it turns out, it may not be that beneficial to know a lot about just a handful of stocks.

Klarman explains.

“First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit… The value of in-depth fundamental analysis is subject to diminishing marginal returns.”

Klarman’s point here regarding one’s equity analysis strategy is that after a small amount of time, the additional benefit of doing further research on any single company begins to fall off a cliff. In other words, an investor who has every stock in the world to choose from is far better off knowing a small-to-medium amount about many companies than knowing a large amount about a few companies. This is simple math – and it is difficult to argue with math.

Another key point that Klarman makes is that even if an investor could know everything there is to know about a company – even if they knew every single piece of both publicly and privately (this would likely be as a result of insider trading) available information – they could still not see into the future and the uncertainties that it can bring. As a result of this, it is not possible for anyone to know what will happen to a company’s stock with 100% certainty.

Klarman highlights this point with an excellent example:

“David Dreman recounts the story of an analyst so knowledgeable about Clorox that he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox's line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs.... The stock fell from a high of 53 to 11."

When it comes to your equity analysis strategy, less really is more – by having a decent knowledge of a basket of stocks, you can maximize your chances of success while managing your risk through diversification. However, by pursuing complete knowledge of just one or two stocks, you are both exposing yourself to a lack of diversification and making the assumption that you aren’t wrong and have not missed any aspect of the company. This is a dangerous assumption to make – we all make mistakes.

The Importance of Diversification

In addition to the fact that equity analysts are paid to do a specific job, there are other reasons why following the lead of such a focused investment strategy is not a viable option for most investors. One of these reasons is that by following a highly focused strategy, you most likely ignore some big-picture fundamentals.

According to Klarman:

“Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. Merrill Lynch's pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds.”

Essentially, by adopting an equity analysis strategy that resembles the role of an equity analyst, you are limiting your ability to see broader industry trends. Ultimately, your desire to know it all will cause you to miss out on countless wonderful investments.

Therefore, a wiser strategy for the majority of investors is to choose a basket of stocks of which you have a decent understanding.

Good Equity Analysis Strategy? Embrace Uncertainty

What this entire issue ultimately comes down to, and what actually separates the greatest value investors from those who fall by the wayside, is one’s ability to accept uncertainty in their equity analysis strategy. The need to solve problems drives us, humans. Big or little, it is the solving of problems that allow us to move on to the next problem, and thus progress with our life. When we are unable to solve a problem, we often become anxious. This also happens when it comes to our equity analysis strategy.

“Most investors strive fruitlessly for certainty and precision avoiding situations in which information is difficult to obtain. Yet high uncertainty is frequently accompanied by low prices. By the time the uncertainty is resolved, prices are likely to have risen. Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.”

As we see, by learning to embrace our uncertainties, we can actually benefit from an investing perspective. By allowing ourselves to accept that it is extremely difficult – if not impossible – to achieve 100% certainty with our equity analysis strategy, we will become more open to making the more difficult choices. After all, the hallmark of the best value investors has always been to make the unfavourable and unpopular decisions. Unless we too can learn to accept our investing uncertainties, the ability to make truly value-oriented investment choices will elude us.

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