27 OCTOBER 2020

You don’t need to work on Wall Street to beat the market.

“Smart money” has advantages:

  • Large amounts of capital
  • Access to large amounts of capital
  • Ability to take activist roles
  • Political influence
  • Influence through B2B connections
  • A lot of data and proprietary mathematical models (quants)
  • The best computers and closest vicinity to trading floors for fastest trading executions (quant)

How can normal people like us compete with that?

Wall Street Trading Dilbert Cartoon

Despite the advantages the Wall Street guys possess, there are fundamental disadvantages that come with running a large hedge fund. The disadvantages give average investors an “opportunity gap” to take advantage of.

In my opinion, playing to the advantages we have is the best way to beat the market and Wall Street.

We (should) love volatility. Funds hate it.

We invest for ourselves while hedge funds invest with other people’s money. The fact that most large hedge funds invest on behalf of their clients gives them less freedom with how they can invest.

It’s really hard for a hedge fund to invest in volatile stocks. For one, “professional” analysts all went to college or university and were taught higher volatility equals higher risk. Two, their clients, who often know little about the market will be weary of their money being invested in charts that look like roller coasters.

If you subscribe to the value investing philosophy, volatility isn’t risk; it’s opportunity. Since hedge funds are unwilling to invest in stocks that go through volatile dips, we should be scooping up the shares when they go on sale.

And we won’t have any clients to nag us for our decision (yay).

Funds can’t invest in the “uninvestable”

Imagine yourself as a Wall Street broker or fund manager having to explain to a client why this is a good investment:

99% of clients would freak out and remain unconvinced when they see a chart continuously fall.

Most brokers wouldn’t even try to sell their clients such a stock; it’s just a waste of time. They would rather pitch them a well-known stock like Apple (AAPL) and collect their commission.

Stocks with many bad years behind them and/or negative social stigma become “uninvestable”.

Since independent investors are not beholden to any clients, we are able to buy the “uninvestable”. We have the freedom to be contrarians and cut through the mainstream narrative to invest in businesses that big-money won’t.

Funds can’t have a long-term view

Sometimes, businesses will continue trading down or sideways for a while before the world realizes their value.

This isn’t much of a problem for retail investors like us because we can simply average down or hold. Even if we don’t outperform in the short-term, we will in the long-term.

But for Wall Street, the simple act of “not outperforming” is unacceptable for a few reasons:

  • Some clients will start to get antsy and wonder why they aren’t making any money.
  • Fund managers, analysts and brokers are often incentivised with “performance bonuses” – extra digits on their paycheque for short-term unrealized outperformance. (Bonuses are often awarded quarterly or yearly).
Wall Street Bonuses Cartoon

Because Wall Street must “continuously outperform”, they cannot have a long-term view.

Funds also have clients that may want to pull their money out at any time for whatever reason – an emergency, buy a house, kid’s college, etc. This means there is constant selling at random times, which makes it really hard to focus long-term.

Thus, they can’t realize the multibagger returns that usually take some years to materialize.

But we can!

We don’t have clients and we don’t have bonuses. Our bonus comes when our investment pays for itself.

We simply need to buy great businesses, average down and hold them until their value is realized (even if it takes a few years).

Small investors can invest in small-cap stocks

Hedge funds with billions of dollars under management can’t invest in small-cap and micro-cap stocks. These stocks are simply too small for them to invest in.

As of this article’s publication, Warren Buffett has around USD 140 billion in cash and another USD 500 billion in investments at least. The total market cap of all public uranium stocks is around USD 12 billion.

So investing in uranium is almost pointless for Buffett since even if he bought out the entire market, it would only make up 1.5% of his portfolio.

Many large hedge funds and sovereign wealth funds face the same issue; they are too large.

But we don’t have billions to spend, so small-cap stocks are easily accessible to us. Average investors have the advantage of getting into markets while they are small whereas large funds have to wait for the market to rise before they can put in a bid.

We are the most mobile and the first in line for small markets (if we can find them). Then the small funds. Then medium. And finally the large funds.

Each step bids stock prices higher.

Being able to invest before Wall Street is one of the best advantages average investors have. When large funds eventually invest in what we’re already in, it’ll be like drinking from a fire hose. The market must grow to receive their capital.

Being early when stocks/markets are small is a recipe for multibaggers. This, along with the other advantages is only available to average investors.

Take advantage of them while you’re still small!

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