The Arrogant Investor

I was reading through fund letters from The Baupost Group, managed by value investor Seth Klarman, and came across an interesting topic in the firm��s year-end 1996 shareholder letter:

��We regard investing as an arrogant act; an investor who buys is effectively saying that he or she knows more than the seller and the same or more than other prospective buyers. We counter this necessary arrogance (for indeed, a good investor must pull confidently on the trigger) with an offsetting dose of humility, always asking whether we have an apparent advantage over other market participants in any potential investment. If the answer is negative, we do not invest.��

This is an interesting concept, and one that many people don��t fully consider when purchasing a stock: When you��re buying, somebody is simultaneously selling, and vice versa. While many people understand that concept (the definition of a ��market��), the implications of that action should lead one to ask two important questions before completing the transaction:

1. What��s the flip side of this transaction and why would another investor want to be on that side of the table?

While this question should be a part of one��s analysis to begin with, it can often get swept aside when emotions (��I��ve got to get in now before it��s too late��) and biases (such as confirmation bias, where one spins any bit of information to agree with their ex ante position) get involved. Stopping to ask this question can avoid serious errors of judgment; in other situations, it may lead to a dead end (a good thing) that can only be answered by the second inquiry:

2. What is my advantage in this situation? Am I dealing with an unwilling, forced or illogical counter party?

Sometimes, there might not be a logical reason for being on the other side of the transaction; for example, when a bond falls below investment grade, many funds are forced to sell for the simple fact that their! mandate says they cannot hold ��junk��; as a result, the prudent investor may have an advantage to pick up a security with a serious trade-off imbalance between risk and reward due to the forced hand of the counter party.

In today��s market, investors are given a significant competitive advantage due to the short term nature of traders, which constitute a significant portion of the daily trading volume. A great example of this is Berkshire Hathaway stock (BRK.B); with a market cap of nearly $200 billion and a diverse mix of businesses, one would safe to assume that Berkshire��s intrinsic value is relatively steady from year to year. However, if one looks at the stock chart over just the past year, you can see price has peaked around $87 and bottomed around $66, a difference of more than 30%. This isn��t a handpicked example, and can be found in multiple large caps (the stocks that should be the most efficient of them all based on their analyst/institutional following) over the past year; having a long term perspective and being patience is a huge competitive advantage that the investor holds over traders.

As Mr. Klarman notes, investing involves a bit of arrogance; for the intelligent investor, this adds the burden of rational and well-tested analysis, not just emotional conviction, before committing capital.