The moment you invest in the stockmarket, you sign up to participate in what is known as a ‘zero-sum game’ – in essence, for you to make a gain, somebody else has to suffer a loss.

That simple idea has some profound implications. It means, if you want to outperform the wider market, it is not enough simply to be a nice person or to try your hardest or even to be, as the leader of the Free World might put it, ‘like really smart’.

As all your gains are funded by somebody else’s losses, you are operating in an extraordinarily competitive marketplace and so, if you want to outperform over time, you need an advantage over your competition.

You need an edge.

An edge can come in many different forms or flavours but, at its heart, an edge boils down to the difference between skill and luck.

 

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We would suggest there are four broad categories across which investors can enjoy an edge, if they are prepared to put in the work:

    – Informational

    – Analytical

    – Behavioural

    – Organisational.

The very best investment processes will have a number of each type embedded throughout the strategy.

#1 – Informational edge

Let’s start at the very beginning then – the sourcing of ideas – an area in which today’s investors suffer from an embarrassment of riches.

Thanks to the internet, all that separates you from the sum of all human knowledge is a few keystrokes into your search engine of choice. What that means, of course, is that any informational edge to be enjoyed nowadays relates not to the data you can find but how you use it.

If you were to ask most professional investors how they make use of all the information potentially at their fingertips, they will tell you they will scour The Economist or the Financial Times, say, or they will read the research reports produced by company analysts or they will go to meet the management teams that run the businesses they are thinking of buying into.

The trouble is, if that is what most people are doing, it cannot be an edge.

For any aspect of an investment process to count as an edge, it must have two distinct qualities

    – It should be different to what everyone else is doing and;

    – It needs to work.

Rather than taking the comparatively scattergun approach of seeking investment ideas in the media or in broker reports or wherever, we simply focus our attention on the cheapest stocks in the marketplace – whether that be the FTSE All-Share index in the UK or the appropriate European or global indices – and we believe you will gain a significant edge if you do too.

This is the starting point of a value investment strategy – the art of buying stocks which trade at a significant discount to their intrinsic value.

And as we often point out, here on The Value Perspective, there is now more than a century of data showing that, if you buy into the cheapest companies in the market, you should outperform (although past performance is not a guide to future performance).

Focus on the cheap stocks

Of course, if it really were that simple, everybody would be doing it – but just look at the sorts of businesses a valuation filter currently identifies as the cheapest 20% of the market.

Banks, mining companies, retailers … yes, we can picture you recoiling from your screen as you read those words.

But that is the point – these are sectors very few are willing to look at these days – and that is why most people do not use a valuation filter.

The fact they do not, however – twinned with the fact a valuation filter works – means, for the few who do use one, it certainly constitutes an investment edge.

In Value investing skills #1, we highlighted the ‘informational edge’ to be had through a value approach to investing – that is, buying stocks that trade at a significant discount to their intrinsic value.

Rather than seeking investment ideas in, say, the media or broker reports, value investors focus their attention on the cheapest stocks in the marketplace – something, incidentally, that is easier said than done.

Having done the work to identify the investment pool you want to fish in, then, the next step is to assess the quality of what you find there.

#2 – Analytical edge

Once again, this is easier said than done because, at this company-analysis stage of the process, what value investors are trying to do is to separate those businesses that are cheap temporarily from those that are cheap permanently – and for a good reason.

If you can tell those so-called ‘value traps’ (companies that are cheap for good reason) from the real deal, you will have a significant edge over everyone else who are filtering companies by valuation. But how can you set about effectively differentiating between the two?

Lots of angles to consider

When you start analysing businesses, you will find there are all sorts of different angles to consider – balance sheets, company strategy, competitors and suppliers, to name just a few.

And with any cheap company, there will always be upsides and downsides to the investment case. For example, at the most basic level, the money you could make versus the money you could lose after buying in.

Human nature being what it is, investors will tend to focus on the more interesting ‘headline’ part of that equation – the potential reward – while skimming over the ‘small print’ – the associated risks.

As human beings themselves, value investors are well aware of the allure of a good headline but they also know reading the small print can make all the difference in the world.

Process…check!

In other walks of life, where the stgil is in the detail, people build checklists into their process. For example, pilots like to make sure they have enough fuel to complete their journey, surgeons that they are operating on the right part of the body and so on.

As professional investors entrusted with other people’s money, we feel we should be similarly disciplined and so, here on The Value Perspective, we have built ourselves our own checklist.

This takes the form of seven questions we ask in relation to every single cheap company we analyse and which help us distinguish those likely to remain permanently cheap from those whose share prices have the potential to bounce back.

Addressing these questions helps flag up the companies to avoid. These relate to:

    – The quality of a business

    – The strength of its finances

    – The degree of ‘structural change’ it is facing in the area in which it operates.

To take one highly topical example, over the last 18 months, Carillion (the failed facilities management and construction services company) kept on cropping up as one of the cheapest companies in the UK – and kept on falling foul of our checklist.

Carillion failed our questions in relation to its financial strength, the quality of its business and whether it turned its profits into cash and so, despite its undoubted cheapness, we did not own it in any of our portfolios, here on The Value Perspective.

And if you have a process that can – on a consistent basis – help you to weed out such companies that deserve to be cheap and only pick the ones that are temporarily so – that rebound – then, once again, you have an edge over your competition.

Nick Kirrage, Fund Manager, Schroders

 

Opinions, estimates and projections in this article constitute the current judgement of the author as of the date of this article. They do not necessarily reflect the opinions of Schroder Investment Management Australia Limited, ABN 22 000 443 274, AFS Licence 226473 (“Schroders”) or any member of the Schroders Group and are subject to change without notice. In preparing this document, we have relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources or which was otherwise reviewed by us. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this article. Except insofar as liability under any statute cannot be excluded, Schroders and its directors, employees, consultants or any company in the Schroders Group do not accept any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this article or for any resulting loss or damage (whether direct, indirect, consequential or otherwise) suffered by the recipient of this article or any other person. This document does not contain, and should not be relied on as containing any investment, accounting, legal or tax advice. Schroders may record and monitor telephone calls for security, training and compliance purposes.