Insights that can generate investment outperformance
A component of generating investment outperformance, known as alpha in industry parlance, is to uncover insights that the market has overlooked. As Peter Lynch famously said of investing: “The person that turns over the most rocks wins the game”.
The harder one works, the greater the chances of them finding insights about a company that can contribute to investment gains. But what specifically qualifies as insights?
It’s possible to group insights into two broad categories: (i) information that others don’t possess; and (ii) information that others have, but analysing it differently and drawing different conclusions. Having information that others don’t have is probably less common, given that many stocks (particularly large cap stocks) are well-covered. Notably, I am not referring to insider information, which is illegal, but rather instances where you might have a seemingly unrelated data point and are able to foresee that it could have implications for a particular stock.
For example, in 2018 we saw enormous freight inflation in the U.S. due to a trucker shortage. Spot rates for hauling goods across the country increased dramatically. At MGIM, we follow a generalist approach, whereby analysts are free to look at investment opportunities across different industries, rather than being restricted to looking at just one sector (an approach followed by other investment firms).
What this means is that we were able to observe this data point of U.S. transportation inflation, and reflect on the implications of cost inflation for say food companies, or retailers. These are firms which as a part of doing business must transport goods to stores, and are thus negatively exposed to freight inflation. This trend was an insight we were able to identify before others who focus just on the food industry were fully aware of.
The second type of insight is where the same information is analysed, but different conclusions are drawn. For example, earlier in the life of the global funds, we were invested in Take-Two Interactive Software (Nasdaq: TTWO), the maker of the Grand Theft Auto and Red Dead Redemption franchises, among other video games. Market participants and sell-side analysts could see that recurring consumer spending (RCS) was growing very strongly. This revenue stream refers to in-game purchases such as skins, virtual currency, weapons, etc.
We observed the same trend, but we also made some broad assumptions as to what the incremental gross margins could be on these burgeoning revenue streams. We concluded that the incremental margins of selling virtual currency is close to 100 per cent, and that this new revenue stream had very positive implications on the overall margins for TTWO that were not being reflected in the current share price.
On any investment you own, it’s important to ask what is the insight I possess, and is it one that is likely to translate into investment gains? While it might sound like a simple question, it is enormously difficult to answer, and represents the crux of what investing is about. A failure to identify stock insights, yet still persisting with an investment, is putting the fate of your capital in the hands of chance.