The Two Big Advantages For The Individual Investor

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During his recent interview with Tobias, Mark Simpson, author of Excellent Investing: How to Build a Winning Portfolio, and manager of Danger Capital, discussed the two big advantages for the individual investor. Here’s an excerpt from the interview:

Mark Simpson:
And I think there’s probably two advantages or probably only two advantages that individual investors like myself can have. They are smaller companies, the stuff that your average fund can’t invest in due to size and thinking longer term than the market and that doesn’t mean investor has to hold for the long-term, but they’ve got to be willing to do that. And I think there’s some structural reasons usually to do with bonus incentive and not being fired why fund managers can’t truly think long-term with their portfolios. And finally, I think there’s an advantage that all investors can have and that’s this so-called special situations. So you look for places where people are selling that are unrelated to the underlying value of the asset or the business. So spinoffs are the classic example of that.

Tobias Carlisle:
So individual investors short a little bit sometimes, everybody does. If you can value a company that’s just mis-priced in the market, whatever the reason is, I don’t think you’d have to worry too much about why you’re the one who found it, you just know that over the course of a year, if you find a company trading at say, $100 over the course of the year at trade, this is pretty common, they trade as low as $50 and as high as $150 and if you think it’s worth somewhere between 80 and 120, then you can buy it at 50 and maybe sell it at 150 or hold onto whatever the case may be.

Tobias Carlisle:
So I do think that individual investors can do this stuff for sure, but there’s no question at all that there are going to be some places where that’s easier and it’s certainly going to be in small and special situations as you point out. So that’s one of the bits of advice that you give, think small and then I interpret from that or you discuss shortly after that, think about value to why focus in those two areas beyond the returns that you can find there?

Mark Simpson:
Yeah. Well, I guess just the historic out-performance that value is shown as well as small caps. So both are a little bit controversial. The small cap effect as being widely criticized, but there’s a good paper from Cliff Asness called… Let me get this right, Size Matters If You Control Your Junk, that you’re probably aware of it. And his thing is you do have the size effect as long as you ignore the really scummy companies that promotes the bankrupt, some of the IPOs where there’re just the founders’ cashing in. If you just avoid those worst quality companies, the size effect comes back in and it’s more pronounced in value stocks as well or maybe the value of… That’s probably the wrong way around it. The value effect is more pronounced in smaller stocks as well. So if you do have the mindset to be a value investor, I think that small is the place to be. You still need to be able to analyze a company, but you’re still swimming with the flow rather than against it, in my opinion.

Tobias Carlisle:
Small caps is one of those places where really does pay to be a stock picker rather than an index hugger for the reasons that you point out. I also think even though value has had a horror run and size has had a horror run to the point that I think now there’s a question whether the size effect actually exists or not, which the contrarian in me says, “Well, that’s probably a good place to be hunting right now.” You say that folks who think differently, what do you mean by that?

Mark Simpson:
Yeah. So what I said in instruction is that the process of thinking or finding opportunities where somebody else is selling and they don’t really care about the price they get. So that’s when you’re going to find your biggest inefficiencies. Joel Greenblatt’s spinoffs are the classic one where you get a small business unit that spun off from a larger company and then everybody says, “Oh, what’s this small amount of stock I’ve never heard of in my portfolio?” They treat it like a free bit of money. They’re like, “Oh, hey, I can, well, depending on the size guide for me or go on holiday, I’ll sell it.” And they view it as something that they’ve got for free and therefore doesn’t really have any value. Other examples I think you sometimes see this year-end, you get companies that nobody wants to hold the loser at the year-end and [crosstalk 00:11:15] yes. Within the UK it’s different.

Tobias Carlisle:
You got a fiscal year-end and a tax year-end are not the same.

Mark Simpson:
Yeah, so you get it.

Tobias Carlisle:
So this is a hoarding phenomenon. They just don’t want to show that they were holding it over the course of the year. Right.

Mark Simpson:
Yeah. And if you’re going to buy something you think is undervalued, you’ve just got an incentive to wait a couple of weeks and put it in your portfolio when it’s got a full year or a full quarter to recover and show that you’re the genius that picked the recovery stock and with low liquidity at Christmas time, new year as well, I think that the whole combination of the three, the tax, the liquidity and the reporting means you often get price insensitive sellers, which you can take advantage of.

Tobias Carlisle:
The spinoffs is interesting because everybody read that Greenblatt’s Yellow Book when that came out, whenever that was, but it’s been around for 20 years or something like that, maybe longer than that. Is that right? Something like that.

Mark Simpson:
99, I think.

Tobias Carlisle:
Is it 99? Well, almost a little bit over 20 years and then had a great decade for spins and everybody made a lot of money and value guys get to look really smart, buying the uglier part of the spin and holding that or watching where the managers go as Joel recommends. But then the last decade it’s been really rough for spinoffs, so they just haven’t worked very well. So I don’t know whether it’s just the book got too popular or there’s something junky about spins, I’m not really sure. What do you think about them?

Mark Simpson:
Yeah, I think there’s probably a couple of facts. One is just everybody knows about it, so I would certainly expect the speed that people adapt to this would change. So I think in Greenblatt’s book he said you wait six to nine months before buying in, you’re waiting for the smaller investors to get bored, see their brokerage statement and sell off. And these days most people are checking their portfolios daily or, yeah.

Tobias Carlisle:
That would be a little restraint. I check it about 100 times a day.

Mark Simpson:
Yes. I would definitely think that the effect you’re seeing is going to happen quicker just because information flows. People are used to the idea that spinoffs are there, I think as well, what Greenblatt says is you still have to do the valuation work, whereas maybe in the past spinoffs definitely, you could just buy every single one and you get some excess return by doing so I think, but he never really said that was the way to do it. He said, “Well, if you do good valuation work, this is the place to be.” And that’s maybe what people forget and some of the valuation stuff of the general market could be considered excessive in certain areas. So again, if they’re spinning off popular companies at high multiples, do you really know better than those managements or better than those teams? Probably not.

Tobias Carlisle:
And you talk about merge-arb or as I like to call it risk-arb because it sounds a lot sexier, you can be Danger Capital and get a little thing on your card that says that you’re a risk arbitrager, that’d be great to get into a pub and hand those out. That’s super sexy. Merge-arb, what are your thoughts there?

Mark Simpson:
So I think these things work, but they’re not very good places for your individual investor to be searching in. The same with things like convertible-arb or capital structure-arb, where you buy one structure of share and you short the convertible and the bonds or something like that. Usually they have the wrong type of exposure you’re looking for an investor. So if you win, you win small and you lose, you lose big. If that merger doesn’t go through, you lose 30 or 40%, whereas if it goes through, you make 5%. And hedge funds really like this because it’s uncorrelated to the rest of the market.

Mark Simpson:
So if you call them right, you get this small return every time and no correlation. And if you invest in 100 of them and you have the resources to do your research well, you’ll do quite well out of it. And also if you prepare to use leverage, but for the average investor or individual investor, you’re going to not have the time to do the right level of research to gauge whether it’s going to go through ahead or not and the risk reward just doesn’t look like the thing you want as a independent investor, which is, “Heads, I win several hundred percent and tails I lose 5%.”

Tobias Carlisle:
I don’t merge-arb as a strategy for home gamers. I think you just need to combine it with a value mindset where you think about what happens if this busts, I hold whatever I hold, I’m short one and long the other one, not even worried about the short, just hold the target long. But I also like to do it when, if the merger gets busted or there’s some problem with it and it trades really wide and you think the under-lying’s undervalued, which often they are, so you can buy them.

Tobias Carlisle:
Well, I’ve got an undervalued stock, which is probably going to work. And then there’s a chance that those returns get pulled forward and the deal goes through and you get a pretty material. That’s worked a few times for me where the professionals have picked them over pretty heavily and don’t think it’s going to work at all and because I don’t know what I’m doing, I’m going to put in one or two or 3% in something that I think is undervalued and then it went through. I’m getting paid for something that I didn’t really know how it was going to work.

Mark Simpson:
Yeah, I think if you’re willing to hold the underlying for the long-term, there’s chances you get competing bidders and more people come in as well. So it’s probably the going longer and also shorting the acquirer and taking on significant leverage to make a 5% return into a 50% return that’s going to hurt most individual investors so yeah. I’m not aversed to it, again, if I spot something that I think is under-priced, but it’s definitely on the riskier end.

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