In the The Art of War, Sun Tzu wrote that those who excel in warfare do so because they seek out battles that are easy to win. Similarly, Warren Buffett wrote that he likes to look for one foot hurdles to step over, rather than trying to jump over seven  hurdles.  Of course actually finding  easy battles, and one foot hurdles is itself quite challenging.   If it was easy market forces would ensure that it quickly becomes hard. With so much brain and computer power dedicated to financial markets, there are few areas of opportunity left worth exploiting.     However,  by developing a behavioral and structural edge,  one can act on the rare opportunities, and  perform better than those that theoretically have an analytical and informational edge.

How can one develop a behavioral edge? Cultivating the right habits in order to be physically and mentally healthy goes a long way.  Considering carefully what media to read is important to avoid being overwhelmed by noise. Finding time to think requires excellent resource management. It requires discipline to be willing to work on a name for months, only to pass on it, or to wait for months or even years for the right business to become cheap enough.  Some might not enjoy spending hours reading about obscure nanocaps or corporate transactions, while ignoring popular stocks in the news.  Some people seem naturally more willing to be contrarian, but I doubt anyone finds it easy all the time, especially during drawdowns.  Being fearful when others are greedy, and greedy when others are fearful is harder than it sounds.  Checking oneself for cognitive biases before any major financial decision is important.  This is not an easy process, since cognitive biases have biological roots.  I like to take a “red cell” approach, and try to understand potential short arguments for any stock I own.      The connection between action and consequence is usually delayed in markets.     It requires a lot of discipline, double checking and introspection to  make your way through the vicissitudes of investing.

The cultivation of a structural edge is also nuanced.  If you have developed a behavioral edge, then you can probably manage your personal finances in a way that allows your personal accounts to be invested for the long term. This requires maintaining excess liquidity at most times.  If you manage money for other people, you have to be really careful who you take on as a client. If a client has a shorter time horizon than you, or are likely to need to pull money suddenly, the impact can be devastating.  This is a difficult tradeoff, especially for small funds, since more AUM means more fees right away. With the right clients a capital markets disruption is a major opportunity, with the wrong clients it is a disaster.  Whether in a personal account or a fund, simply having a long time horizon  and a liquidity cushion can be a major source of long term alpha.

If one chooses to look at what other’s don’t  one may actually end up with an analytical and informational edge in areas with less competition. I like to invest in things that are uninvestable for most investors with better resources, whether due to “headline” risk, illiquidity, or other institutional constraints.   For example liquidations, delistings, and anything nanocap  are fertile grounds  for bargains. There are also interesting opportunities in distressed debt, and bankruptcies.  I also  like to look for situations where statistical services(Bloomberg, YCharts, Yahoo Finance, etc) are likely to have misleading or incomplete data, and companies that don’t  fit in a comfortable category.   Sometimes consolidated financials can be deceptive because of accounting rules, especially if a company has made acquisitions, holds real estate and/or holds a portfolio of securities.  I also always make sure to adjust for material events that occurred after the 10-Q or 10-K date in determining a valuation.   Judging by occasional market behavior I don’t think everyone does this.  In any case there is always a gap between accounting reality and economic reality.   The financial statements are just a starting point.

An ideal long term holding is a business that has a major competitive advantage and can easily earn a high return on capital over the long term, even if management screws up.   These businesses are hard to find, and they’re sometimes hidden in a group of weak businesses that screened poorly, or attached to an old business that didn’t work.    Thrift conversions are ignored by many, and easy to understand.  Although the upside for thrift conversions is rarely large, the risk/reward tradeoff is phenomenal.  Key information is often found on the OCC and FDIC websites, rather than in Edgar.   Most OTC securities are ignored by sophisticated and large investors(plus the messiness of sorting through hundreds means  you aren’t competing as much against computers). Sometimes I can get an informational edge by actually bothering to go to the company’s website and/or  buying a token share and calling the company to ask for financials, which one has a legal right to access as a shareholder.

Whatever the investment, I’m only interested in buying if a lot can go wrong before I lose, and just a little going right provides a nice gain.  Finding the right security is hard, but it should be easy to win once its in the portfolio.   “Sifting through the debris of financial wreckage, out-of-favor securities and asset classes in which there is limited competition”,  as Seth Klarman has called it does requires intense discipline and dedication, but provides ample rewards.

The extraordinary delusions and madness of crowds also serves up huge bargains from time to time, but the analysis is much harder.      In all transactions, one must ask,  why is someone willing to take the other side?   I suspect there is more benefit to carefully analyzing my own psychology than to trying to outsmart others.  I’d rather buy from a “non-economic” seller, when possible.   Funds with industry or market cap mandates sell spinoffs indiscriminately.  Funds that manage to an index dump companies kicked out indiscriminately.  Delistings and liquidations are also sometimes forbidden by investment mandates regardless of the actual condition of the business or quality of the assets. I like to look at the portfolios of large concentrated funds that are facing massive redemption or shutting down, or from investors otherwise desperate for liquidity(oops did I say that out loud?).   Sometimes people sell securities for reasons that make sense from the perspective of their job security, but are actually unrelated to the merits of the security being sold.   Of course it takes a lot of searching to find where the right sellers are.

Charlie Munger told Howard Marks: “its not supposed to be easy, anyone who thinks its easy is stupid.”  Indeed, finding easy things is hard.