A few months ago, I read Malcolm Gladwell's Outliers and Geoff Colvin's Talent is Overrated. Both books explore what it takes to become an expert, or even the best at something. Examples such as Tiger Woods, Grandmaster Chess Players, Steve Balmer and Bill Gates, fill the pages of the books. Did you know when Tiger Woods was an infant, like 6 months old, his father would sit Tiger in his highchair and then proceed to hit hundred of golf balls in front of Tiger - Tiger would be fixated on his father and somehow, maybe that exercise, helped begin to wire the fundamentals of a golf swing into Tiger's head.
Both books draw heavily from the research of K. Anders Ericsson of Florida State University. He is the thought to be the world's expert on expertise. Most of what Ericsson postulates (there is a enormous body of his research on the web via Google Search) comes back to the fact that expertise comes from something he refers to as dedicated practice. This is a very specific type of work that is repeatable, offers quick feedback, and adjustments can be made. Again drawing on Tiger woods, when he was 15 years old, his father would pick a target for Tiger to swing at. Maybe this target was 150 yards out. Tiger then had to meticulously hit each of his clubs ranging from driver to pitching wedge that exact distance. Then, he had to do the same exercise, but this time each time he swung he had to hit the ball with a low fade, then a high fade, then a low draw, and finally a high draw. He did this for hours on end. Constant repition, with measurable results, and quick feedback.
I began to think, how can this exercise of dedicated practice be applied to investing. I began to try devising techniques to improve my investment instincts and feel. And you know what? I came up short. I then read a quote somewhere that Warren Buffett generally reads the financials of a company, and then tries to guess its stock price. I wondered if this could be turned into some repetitive exercise and again I fell up short.
I then came across a very specific piece of research that Ericsson penned. It is entitled: The Enigma of Financial Expertise: Superior and Reproducible Investment Performance in Efficient Markets. You can read the article yourself (I very much enjoyed it). One of the big take-aways comes from the abstract: "...data suggests that financial expertise is highly specialized (e.g. by sector) rather than general." Of course, this flies in the face of Warren Buffett's The Superinvestors of Graham-and-Doddsville. Actually, maybe it doesn't.
Now for the record, I think the efficient market hypothesis is just something that keeps economists busy between their 6 hour a week class load, golf, flirting with undergrads, and summer vacations on Martha's Vineyard. It's like CAPM: Assume not taxes, transaction costs, etc. What world are we living in? So, I for one think that markets are wholly inefficient due to the random variable that is human emotions (loosely behavioral finance).
In the paper, Ericcson point out that: "Expertise is the final reslt of the gradual improvement of performance by additions of new patterns acquired during extended experience in a domain, and thus is attainable by highly motivated, normal and healthy individuals without any requirement for innate talents. These finding have lead to the "10-year" rule sggesting that winning at an international level in many if not most domains occurs only after at least 10 years or 10,000 hours of deliberate practice." Further, Ericcson throughtout a lot of his research, refers back to an expert identifiying patterns and making decisions based on them. If you throw a bunch of random chess pieces on a board, a Grandmaster will see his skill diminish greatly versus having an actual game piece positioning, where his performance will skyrocket.
Maybe this is why Warren Buffett and Seth Klarman are so good at what they do? They have seen the patterns and playbooks before. It is said that Warren Buffett reads multiple annual reports a day - maybe after reading so many, his brain has somehow made the connection that this combination of factors, combined with this valuation, leads to superior investment performance. Maybe Seth Klarman has seen so many bankruptcies and reorganization, he can accurately predict the probability of XYZ occurence, its payoff, and therefore his potential gain vs downside risk.
Further down the paper, Ericcson postulates some other reasons how investors can get superior market beating returns. Fund managers have abnormal returns for stocks that they are geographically near (attributed to better contacts and information). Maybe this is why the Burkenroad Reports seem to always outperform (fantastic reading there by the way). And the one that I find most fascinating, managers who concentrate on stocks in a few industries exhibit superior investment performance (vs. diversified managers). In depth (insider) knowledge about specific companies also produces superior investment performance.
What do the three of these all have in common: They share the link of better, more specific information about a certain company. When Warren Buffett was younger, he focused a lot of his attention on companies that were near Omaha. In addition, and I may be reaching here, but WEB has seen the most success out of three industries: Insurance/Financial Institutions, Consumer Products, and Utilities.
Over the past year, I have taken on one industry in particular, and focused on it greatly. This has been outside my duties at my job where I cover a number of industries (including this aforementioned one which I have covered loosely for over 5 years now). I have focused on the domestic companies only which number somewhere nearly 100 companies with market caps over $5M. In addition, many companies in this industry tap the debt markets across the rating spectrum, allowing me to bring my experience in high yield and distressed investing to the forefront.
And to what end? Many people that have spoken with me in the past, know I want to eventually get seeded and run my own show. While I sometime have thought in the past that limiting your investment universe in any one way can hinder long term performance, I believe a long/short, up and down the capital structure, industry (assuming its broad enough) focused fund could produce outsized returns for investors with low volatility. If you need any examples, look at Healthcor or any of the niche specific Tiger Cubs.
If you have any thoughts on methods of dedicated practice as it relates to investing, leave a comment or send me an email.