I see a lot of people recommending “hidden gems” on value investing forums. They pour over financial reports of cigar butts and net-nets to try to uncover these gems that everyone else has somehow missed. I am here to tell you that it’s unlikely that hedge funds and other savvy investors missed anything. The odds that you are the smartest person in the market to come across this information is not great. You must be an unusual person indeed to see what no one else sees. There are hedge funds full of super smart people that are highly incentivized to find hidden gems wherever they can uncover them. They have armies of financial gurus and PhD physicists and mathematicians looking at the market. These people have intelligence that makes even the top 1% of the population look dull by comparison.
You are not outsmarting these guys on an academic, mathematical, or financial inquiry. Because of this, many of the “cigar butts” and net-nets that remain in value territory are likely to either a) be value traps because smart people saw something that you didn’t that is a problem, or b) have something that is undecidable about them that introduces a substantial risk, in which case the payoff comes down to the chance of a coin flip. In Benjamin Graham’s day, deals in bottom-of-the-barrel value stocks were more ubiquitous because: a) access to information was more limited without the internet and other resources, b) the general mood about stocks was still fearful after the recent great depression so people were slower to pounce on opportunities, and c) methods had not yet been refined for investing in these areas and were not yet widespread knowledge.
So, if you cannot outsmart the smartest people in the market, how can you hope to earn outsized returns? Glad you asked! There are actually some opportunities that you have going for you that not many hedge funds can seize upon.
One advantage that you have is that you can invest in far less liquid and much smaller market cap stocks than the typical hedge fund. There relatively fewer savvy investors in this space, so if you wanted to uncover hidden gems, cigar butts or net-nets, you might just have a chance if you focused your search in these stocks. In other words, you look where most of large, sophisticated investors are not even looking due to lack of ability to invest in that space.
Another advantage is when you have industry or company specific knowledge because you work in the industry or in the company. Other specialized forms of knowledge are also applicable here. Wisdom of applied knowledge can often outsmart raw intelligence without the benefit of that wisdom. For example, if you are a brain surgeon, and you start using a new tool that makes brain surgery so much better / more survivable / easier, you might figure out that the company making that tool is far better than a competitor making an inferior tool before a hedge fund manages to figure it out. Similarly, you might be able to figure out that a particular drug for brain cancers will fail before a hedge fund can because one of the assessments the FDA is requiring for approval is based on a measure of recovery that is hampered by Covid 19 lockdowns. The hedge fund members might be super-smart, but in this case, they don’t even know where to look for the right information, so it will take them longer to figure it out, giving you an edge. (Note that some funds even employ industry experts to uncover some of this stuff too.)
My issue isn’t so much that you can’t uncover a hidden gem with specialized knowledge or being willing to look where hedge funds can’t go, but rather, that I see so many armchair analysts who think they have found a secret that no one else sees or that they are somehow smarter than the rest. Do not assume this.
There is one area of advantage, however, that everyone, including the armchair analysts can exploit. The most important advantage you can have over hedge funds by far, is patience. Patience is rewarded in the market if you make reasonably intelligent investments. A hedge fund cannot afford patience usually, because their investors are impatient. These investors pay the hedge fund a lot of money in fees to get outperformance in the market. The hedge fund needs to outperform right now, this year, every year, or it will lose investors to the next hot hedge fund. You don’t have to worry about that. You don’t have to buy a stock and anticipate the timing of when it will pop and give you a quick return. You simply can invest in great companies at great prices and wait forever.
This is why the Star List investing approach works better, in my opinion, than buying cigar butts and net-net stocks. Cigar butts and net-nets are on borrowed time. You must get the value extracted out of them before they fail, or they must turn it around before they fail. If they fail, you must be able to extract the value from them quickly to earn a profit. Time is not on your side here. With Star List investing, you build a shopping list of the highest quality companies you can find with durable and sustainable returns on capital. You then buy the ones that give you the best value on a price to free cash flow basis. You are not worried if you have to hold for 1 year or 10 years to realize the value because these companies will still be here and doing well decades from now if you are selective about the companies you add to your list. You don’t care if the stock price ever comes up to full valuation, because you can reinvest and generate wealth even faster if the stock remains permanently undervalued.
The best part is that these great companies are not hidden gems that you need special knowledge to uncover – you just need to do a bit of work. They are companies that are often household names, and you can uncover them with just some basic financial skills and common sense that can be cultivated in a short time. The hedge funds, by the way, also know what these stocks are. And while they dabble in and out of these stocks to try to make quick gains, they don’t have the luxury of time to take advantage of them like you do. They cannot sit inactive in 20 great stocks for decades while the growth compounds, or their investors will question why they are charging high fees to “do nothing“, even if doing nothing is often the best thing that you can do.
So, in the end, you don’t have to be smarter than the hedge funds to beat them at their own game. You just need patience and a buy and hold attitude coupled with buying the highest quality companies at good to great prices. While you won’t outperform the hedge funds every year, over the very long run, you will probably leave them in the dust if you simply practice the right investing behaviors, buy-and-hold being key among them.
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