Who are all the "dumb" investors/analysts?

Being in B School I get to hear from lots of successful investors, guest speakers, and current/former professionals teaching classes. There is a common refrain that gets repeated in different formats by lots of people. Its often talking disparagingly about sell-side analysts but also referring to other investors and buyside firms. The statement usually takes some form of, "We've been successful because we do the hard work. Lots of investors don't even [fill in the blank]." I've heard a number of different things like, only model the income statement and don't look at the balance sheet, don't bother reading the 10-k, don't think about Cap Ex and only look at EBITDA, etc.

A good example of this was in this week's Baron's talking the PM's at Lucerne Capital "His experience in valuing small and midsize takeover targets had given him a healthy skepticism for equity analysis. "People don't do a lot of in-depth work, particularly in Europe,""

My question is how much of this is just trying to explain success ex-post and how much of this is true? Ignoring algorithmic trading, are there really people out there doing long/short equities (or even sell-side research) that don't even crack the 10-k? And if so how are these people getting hired? Maybe the "dumb" funds just aren't hiring but everywhere I've had interviews the process is grueling and very detailed. I can't imagine pitching a stock and saying, yeah I didn't read the 10-K but the last investor day presentation looked good and the stock is cheap, let's buy!

It would be great if there really are that many dumb people out there because it means that many more opportunities to make money by being smart. I guess I'm just skeptical that it is really that easy and there really are that many lazy people out there.

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Comments (29)

Apr 3, 2015

You are absolutely right to be skeptical. Every time you buy, you're buying from someone who is selling. It's sort of obvious, but that person selling likely has a very different view than you do. Anybody who thinks their competition is lazy or dumb is not someone I would want to put my money with.

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Apr 3, 2015

expanding on what DF says, investors have different motivations & philosophies. for example, my tendency is value, div growth, and I tend to be early to the party. most of my buys will be during the downturn of price (stealing a page from klarman's book, doing half of a position at first, then inevitably it will drop further, then I'll buy more), so if I'm buying from a momentum guy who has a stop loss, he could be cashing in on profits while I'm just getting in.

there are very few dumb people who handle money as measured by IQ, but depending on your philosophy, you may think they are foolish. I'm a value guy, so I think anyone who's top down is foolish, I also think technical analysis and indexing is foolish, but the Gene Famas of the world (who are intellectually brilliant) think I'm foolish as well.

it's not a question of smart money vs. dumb money (though some people in the markets, namely retail people buying SHAK at >800x earnings), it's differences in philosophies.

also, I'll play devil's advocate with the 10k bit. it is important depending on the type of investing you're doing. there are quant strategies (screen based) that have outperformed, namely low PE strategies, graham checklist stocks, or the magic formula by joel greenblatt. of course all of that could be construed fundamental bottoms up investing, but you technically don't have to read the 10k to do that, just sayin.

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Apr 3, 2015

A "dumb investor" is anyone who disagrees with the person doing the talking. EVERY TRADE has someone on the other side of it. It's almost like politics or war: the person on the other side is the enemy, regardless of the actual truth.

Your own personal truth, your P&L, is the only thing that matters...

Apr 3, 2015

It astounds me how many long/short funds can't even describe the x different drivers of contracts for its positions, i.e. having no understanding of how a company collects revenue.

Lots of non-concentrated non-deep dive focused funds are out there and they simply do not put in the work necessary to really understand a company.

We just had an investor day with a company around here and out of 50 investors they invited, we were leagues ahead of everyone else. Of course everyone thinks they're the best and brightest but you would be surprised how many things are missed by even the top fund PMs (lowering reserves to earnings, escheatments, off balance sheet issues, etc.).

Apr 3, 2015

a bit of that is people talking their book... of course each person thinks they are the smartest, brightest and most hardworking. Every sell-side analyst has read a 10k on each of their companies, that statement is absurd. If you are simply counting on making money by reading a 10k and a balance sheet which you think will give you an edge because you think everyone else is "dumb" then you are in for a surprise. The market is a lot more efficient than you think.

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Apr 3, 2015

I still wonder where investing might really stand on the zero-sum scale between the "winner vs loser" theory and "everyone plays paper shuffle theater to make a little dough" realpolitik (potentially facilitated by the creators of the Plunge Protection Team). Mostly because it means the difference between whether I'd be butchered as a new trader or not :)

Apr 4, 2015

People need reasons why their performance is repeatable (I.e. to effectively raise capital). One way is to talk up your own process, another is to bash everyone else.

Honestly though I have never heard a great investor bash others. Most have a tremendous respect for their competition. This is necessary to keep yourself down to earth - otherwise you have trouble second guessing your opinions / changing up your process when it doesn't work.

Apr 4, 2015

Having said that I do think a large part of the market is overly short term focused / lacking in cyclical perspective sometimes - a lot of stocks putting mid cycle multiples on above mid cycle earnings power today.

Apr 4, 2015

You would be surprised how much mediocrity there is on the buyside. Like seriously basic shit. No joke have had to explain how to calculate interest cost to an analyst who was top B-school, GS, now incredible fund. (left GS too early ie, go told they were the bottom 10%)

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Apr 4, 2015

The key points IMO are (a) "dumb" is the wrong word, because intelligence in the IQ sense doesn't get you anywhere on its own, (b) most people in the market are forced to be short-term focused.

(A): The key here is that extremely intelligent people can be "dumb" investors. For one, I think most of investing success comes down to more qualitative factors than quantitative ones, so the most important thing is "judgment" which probably correlates weakly with increasing intelligence. I also think that a number of the people who go into the buyside, especially at the junior level, are doing it for reasons other than a passion and genuine interest for investing. The result is a bunch of very smart number crunches who went Top College -> Top IBD -> HF, but when it comes down to it they aren't the type who love it enough to immerse themselves in investing and to spend significant time out of the office learning. In banking at the analyst level, any smart guy with basic finance/accounting knowledge can be a rockstar; in investing I think it takes a true passion.

A good example of (A) is really sell-side research. These are generally bright guys and they have generally spent tons of time researching a given company, know a ton about a given industry, plus have unparalleled access to management in many cases. But most of them have zero perspective and confine their thinking process to a very small box. As an example, a point somebody made on another forum I follow:

"[1] For anyone interested in an aside, I think reviewing the recent call for the HNZ-KRFT deal (@37:00 in the recording) should be interesting in illustrating the dichotomy between running a business on a cash basis and a GAAP EPS basis. The JPM analyst questioned whether it made sense to refinance the BRK preferred because the preferred dividends didn't flow through the income statement."

(B): This is probably the #1 reason. Most of the HF or AM world has to be short-term focused, almost regardless of the natural inclination of the people running it. Fact is, most clients are looking at and demanding performance on a quarterly or even quicker time frame. Of course, this is insane, because the very reason that it may be possible to outperform the market is *because* the market does crazy things in the short-run, so hopefully those who can find discrepancies in price vs value can outperform. But then, even those who realize this still somehow end up following and caring about short-term performance. For a hedge fund to truly think long-term, you need the extremely rare combination of (a) PMs who themselves think long-term, and (b) clients who believe strongly enough in the managers to allow them to think long-term.

Apr 5, 2015

I am convinced that at least 90% of all retail investors don't read any 10ks.

Apr 16, 2015
hon2:

I am convinced that at least 90% of all retail investors don't read any 10ks.

I think it may be even higher than 90% because I think most retail investors rely on the buy, sell, and hold ratings that the firms give them. Even brokers at firms like EDJ (Edward Jones) rely on the firms research department to make investment decisions some which are good and other that end of being extremely bad. I am not trying to bash EDJ, but walk in to one of their 13,000 offices and ask a broker a simple question 99% will answer wrong.

Then again I don't think you can trust many 10ks because there is a bit of a flaw of auditing and creating the 10ks. They are all financial off to a degree which are deemed allowable by auditors, but this is another argument all together.

Dumb may not be the correct word, but un-rational.

Apr 5, 2015

In response to the "winner vs. loser" point, the reason why the market isn't zero-sum is due to the differences in time horizons among investors. If all market participants were to theoretically remain in their positions for the exact same amount of time (for a given stock, etc.), then the market would in fact function as a casino where one person's winnings would be another person's losses. Because it doesn't operate like that, there exists the *potential* for investors using different strategies across different time horizons to mutually profit off of each other in a potentially positive-sum game.

Apr 5, 2015

think part of this might be quite anecdotal on whatever sectors happen to be generating a lot of activity. our energy analyst (20+ years of experience) is always talking about this but there were so many people chasing energy names last year that i'm sure a lot ventured out of their depth. i'm sure if all other sector coverage at a firm was like this they wouldn't be in business

Apr 5, 2015

I've certainly seen sell-side analysts take massive shortcuts. For example, I've seen a handful use a plugged interest expense forecast, rather than taking the time to calculate what the company's expected interest should be based on their debt schedule.

But I think the issue here is this: when making an investment decision, how much incremental insights do you obtain by taking the extra 15 hours to calculate, down to a dollar, what a company's interest expense will be? The answer: not a whole lot.

In other words, "taking shortcuts" isn't necessarily a problem, as long as the area in which you're taking the shortcut is not a huge driver of valuation or risk. The higher level business/industry themes will, over the long run, be the true determinants of a good vs. bad investment decision. And these themes cannot be found in a 10k.

Apr 6, 2015
Bizzidy:

I've certainly seen sell-side analysts take massive shortcuts. For example, I've seen a handful use a plugged interest expense forecast, rather than taking the time to calculate what the company's expected interest should be based on their debt schedule.

But I think the issue here is this: when making an investment decision, how much incremental insights do you obtain by taking the extra 15 hours to calculate, down to a dollar, what a company's interest expense will be? The answer: not a whole lot.

In other words, "taking shortcuts" isn't necessarily a problem, as long as the area in which you're taking the shortcut is not a huge driver of valuation or risk. The higher level business/industry themes will, over the long run, be the true determinants of a good vs. bad investment decision. And these themes cannot be found in a 10k.

For the most part I agree with this. There is a lot of wisdom in the 80/20 rule. Klarman talks about this in MoS: http://www.valueinvestingworld.com/2013/06/seth-kl...

That said, there are definitely exceptions. I think the key skill is to recognize, depending on the nature of the situation, (a) what kind of information is needed to make a decision, and (b) what level of detail of information is needed. In making an investment in distressed debt, specific language in one line of the credit doc can completely change the situation, so it is hard to say the 80/20 rule really applies there. But if I am thinking of buying Mastercard, maybe the three key things that matter are overall growth in electronic payments, effect of competition, and effect of regulation. And maybe the last 20% of my analysis could be a detailed modeling of FX effects on Q1 2015 numbers, but getting that right will have very little impact on my long-term investment.

The other point Klarman makes which is crucial I think is tying the level of information you require to make a decision to the price you are paying. I think this is actually where a lot of guys who have studied value investing trip up. Notably, in saying this Klarman differs quite a bit from, say, Buffett. The idea that you can and should invest in situations that are highly uncertain, versus Buffett where he says that he needs to understand where the business will be in 10 years. You just have to be getting paid for the uncertainty.

Apr 6, 2015

As many others have said, I don't think its about being smart or lazy. I think there are a lot of smart and diligent people who are investing, but many investors are constrained by factors outside of their control. Some investors are investing to make money in the short-term and need to generate a positive return every quarter. Other investors have much longer-term horizons and don't care about short-term performance for a stock. Many large money managers can only buy large-cap stocks and don't look at certain companies, Equity Research Analysts have a bias toward publishing "buy" recommendations and so on. Other investors might be holding on to a stock that is sure to be a winner, but need to sell to pay for their children's education. The key is to realize that every investor has different goals and circumstances and that is what leads to inefficiency in the market. If you are able to stay disciplined and stick to your strategy, the odds are that you can make money in the long-run if you are thorough and are investing based on a reasonable strategy.

Apr 6, 2015

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Best Response
Apr 6, 2015

Its not necessarily about being smarter than your opposition, so much as its about exploiting the edge that is inherently built into your strategy at a hedge fund. The fact of the matter is, there is only so much time in a day, and not everyone can possibly know everything about every investment. As a result, a great deal of the world leans on heuristics to streamline their investment process and harvest excess returns - the most common being momentum (both of earnings and price), value and for FI, carry. The vast majority of the investment universe, as measured in AUM, is benchmarked to a degree and has an extremely diverse portfolio they cannot possibly understand all the nuances of. By doing a deeper dive than the majority of the market on a smaller subset of investments, you can (sometimes) generate a divergent view than the consensus and express that via a trade. Most of the time your work will probably take you to the consensus, but becuase, as a l/s hedge fund your mandate is absolute return, you can afford to be selective, whereas benchmarked investors really can't. People feel really smart when their investments are working and tend to get lazy and add at the wrong times b/c of the positive feedback associated with PNL - witness the rise of passive investing, 7yrs into a bull market.

Generally if your thesis rests on outsmarting other managers you respect, your odds are probably not great (unless you understand exactly why those investors are missing and when this is likely to come to fruition). For me, ususally I find edge from investors who are missing the forest for the trees or being greedy and falling prey to short-termism (for example, the glut in oil last year was pretty clear ~6mo out for anyone who understood production dynamics around shale - which could have been derived from bottoms-up reading of EOG and the like's reports, and then political game theory made it clear that it was counter to saudi interests to continue to support the market and cut. Geopolitical lossess could only offset US production gains for so long - but the market did not discount this risk at all). Another great example of this dichotomy in a single-stock is Warren Buffet vs Stan Druckenmiller on IBM ("its cheap, they will buy back shares" vs. "their business model is dying" - in this case Warren is actually being short-termist and backwards-looking whereas Stan is investing based on his assesment of the future not the past).

Two great books to give you a better framework for thinking about this are "Behavioral Investing" by Montier, and "Thinking Fast and Slow" by Kahnman. The subtext of both of these books is that smart people fall into behavioral traps all the time (as do entire societies). The key is identifying these ex ante, and the harder part is identifying when you think it'll become apparent. Its not easy, but you only need a few of these "aha" moments to make your year. This is basically what Soros explains as his strategy in Alchemy too. Finally, you only need to be right 60% of the time to have a fantastic track record.

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Apr 7, 2015

So, the call on oil is obvious to you? Did you make that call 6-12 months ago or is it just obvious to you in hindsight?

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Apr 8, 2015

No I made the call in April, and the fund I work for made money on the trade through the end of the year. We had been waiting almost 2yrs for the shift in balances to occur and wrote about it pretty extenstively to our investors. To me, the surprise was it took the market so long to price-in - there was almost zero forward-looking by the mkt despite production guidance implying a large north american surplus building starting in Q4, which would only be able to be solved via price.

There have been similar structural shifts over the past 3yrs in coal, iron ore, aluminum as you moved from demand-balanced markets to supply-balanced ones. Its really not that different from those playbooks.

Apr 8, 2015

Good job. I assume your fund must have been up at least 50% last year then, right?

Apr 8, 2015
DickFuld:

Good job. I assume your fund must have been up at least 50% last year then, right?

I just sent in my resume

Apr 8, 2015

it was not, we had a good year though

Apr 8, 2015

Would also just add that Zach Schreiber at Pointstate laid out the pillars of the thesis pretty clearly in June at Ira Sohn. And plenty of funds got it right (just like subprime). It only seemed out of left-field if you were not focused on it as an issue. The timing was a btch though, as it always is with these things. But it was not a mystery that was unforeseeable, you just had to be a little flexible in your thinking and have seen a few of these transitions play out in other markets to understand the path. It just felt impossible to people because it hadn't happened in oil in 30yrs. But it had happened to plenty of other commodities in recent history.

Apr 10, 2015

What's your call on the next 6-12 months then big shot?

Apr 15, 2015

Most active mutual or hedge funds will turn in long-term numbers net of fees that suggest they are the "dumb" investors. You become the "dumb" sheep when you listen to the majority of them exude confidence over their investment "skills" and pay 1%+ per year in fees, believing their story. Most funds are not concentrated and have little clue as to what is really driving performance any given year. Leverage, size, and other factor bets are generally at work much more than any company-specific story / divergent thesis in the portfolio.

"The actively managed funds came out on top as recently as 2013 and lost to the broad index in 2014. Based on the recent calendar-year returns alone, you might conclude that the actively managed funds have been holding their own.

But the longer-term results are telling: Over the three years through December, the index beat 76.8 percent of the actively managed domestic stock funds. Over five years, it outdid 80.8 percent of them. Over 10 years, it beat 76.5 percent. Put simply, at least three-quarters of those actively managed mutual funds regularly failed to beat the broad market index over three, five and 10 years. This underperformance has persisted year after year."
http://www.nytimes.com/2015/04/05/your-money/measu...

If there is one thing you should take away from this post, dig into the fees you are paying. Whether you believe in active, passive or some combination of the two, making sure your fees are low and not capitulating near market inflection points (e.g. freaking out and selling in 2009 after your account drops) will save you thousands in the long run.

Apr 18, 2015
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