Opportunity Cost, Limitations And Differentiation

Opportunity cost and investing

Consider a situation where you choose between three meals. One is a high-end Japanese menu with fermented vegetable appetizers, raw fish, tempura and miso soup paired with whole grain rice and a finished by a green tea cake. The second is a western dish consisting of grilled meat, potatoes and salad. The third is a fast food menu.

Assume the first option costs $65, the second costs $20 and the third $8.

Let us assume that the flavor and nutritional value of each dish have been evaluated to yield an aggregate score. On a scale from 0 to 100, the scores assigned to each dish are 90, 60 and 30 respectively. We label this score ‘quality’ or score ‘Q’.

Between these three options, which should you choose?

To answer this question, you must first set some parameters. Assume that you have no preference to any world cuisine or style of food. Assume that you have no food allergies. Now, if you also assume an unlimited budget, it becomes clear that you should choose option number one as you would derive the most eating pleasure and long-term health effects from the most expensive option. However, assuming a linear trade-off between quality and cost, you should choose meal number 3 based on a ‘bang for the buck’ score derived from dividing the ‘Q’ score by the price. Resulting values are:

Dish one: 90/65 = 1.38
Dish two: 60/20 = 3
Dish three: 30/8 = 3.75

In a variation of this experiment, one may weigh the two values, assigning 1/3 weighting to price and 2/3 weighting to quality. It follows:

Dish one: (90*2/3)/(65/3) = 60/21.6 = 2.8
Dish two: (60*2/3)/(20/3) = 40/6.7 = 6
Dish three: (30*2/3)/(8/3) = 20/2.7 = 7.4

Dish three, the cheapest and least healthy, still emerges victorious. This tells us that the overall ‘value’ profile of dish number three is very robust despite its sub-optimal nutritious properties. In reality, people’s choices are limited by their spending power and consumers continually make choices and trade-offs. Choosing option A over option B and the resulting foregoing, or ‘passing-up’, on whatever benefits option B may have conferred, is defined in economics as opportunity cost.

As investors, we face a similar conundrum.

Every time we allocate capital to a given investment, we forego an almost infinite number of alternatives. The question arises: how can we be sure that our choice of investments is superior to all other possible alternatives? In short, we can’t. To some, this must seem like a frustrating prospect: statistically speaking, there is an overwhelming likelihood that there is something better out there, at all times.

The popular saying “The grass is always greener on the other side” is grounded in an ever-persistent human sentiment, and that is not a bad thing in itself: being discontented with our present condition is one of the most profound distinctions between us humans and our animal cousins. If we were to all of a sudden become completely happy with our condition material and spiritual alike, all progress would come to a grinding halt or drag along very tediously purely by means of natural selection and evolution.

In an investing context, we need to strike a balance between striving for ever-greater returns and a sense of quietude, or satisfaction, with our investment choices. Unless you are managing money for a living or you are really enjoying equity research, there is no good reason to spend disproportionate amounts of time frantically looking for the next best thing. You are bound to lose out on precious time with your loved ones and any other activities you could have conducted away from your screen, including running your own business. Just as importantly, it has been all but proven that shifting money around frantically is a recipe for sub-par investment returns. Many admire a steady hand like Warren Buffett yet few manage to emulate him for reasons that are in part linked to human psychology and in part due to the fact that Buffett is just a very smart and competent investor. The exceptionalism of Buffet and other great investors should not demotivate the rest of us – there is a lot to be learned and the vast choice of potential investments and portfolio configurations, which makes opportunity cost such a persistent challenge, is also an opportunity for differentiation: you can have it your own way and be successful, too.

From limitation to opportunity

The name of my service is derived from the notion of “second-level thinking” advanced by another great investor, Howard Marks of Oaktree Capital. If you haven’t already, I would urge you to read his book The Most Important Thing. If you are only going to read one book on investing in your lifetime, this should be the one: it’s as practical and insightful as they come. Second-level thinking, in a nutshell, means thinking at least one step ahead of most other market participants. For instance, rather than being content with the statement “Company A is a great business”, consider the following: “Company A is a great business but it trades at a hefty premium. This implies that little further upside is likely. By contrast, company B is only half as good a business but it’s also trading at ¼ the valuation of company A. Let’s give company B a shot!”. Another example of second-level thinking could be: “A majority of market participants expect company Y’s PhIII trial to be successful (=meet at least its primary endpoints). While we agree, we think that Y’s drug will not show sufficient differentiation from approved treatments to drive substantial sales in the future. As a result, Y is overvalued and we should avoid or short the stock”.

What I call macro news comes in many forms and is often completely unpredictable. Consider last Friday’s across-the-board sell-off on a report that General Mike Flynn had been directed by President Trump “to contact the Russians”. That news report was later amended and watered down. Taking the news at face value however, the markets initially reacted with a sharp selloff. Such corrections are often buying opportunities insofar the causative news item often has no material effect on our holdings.

Doing what others won’t (or can’t)

Many large investment funds are seriously constrained in their capital allocation due to 1) their mandates 2) their size. Managers of large funds, such as pension funds, need to keep risk minimization in mind at all times. When running a large ship, it’s more important to avoid icebergs than it is to rush across the ocean at warp-speed. Additionally, the larger the fund, the more it needs to spread its bets and favor blue chip stocks with plenty of liquidity.

As a result, there is a genuine opportunity for small funds and private investors to outperform their massive peers and the market at large by making smart bets on small- and medium-cap stocks. By narrowing down on a small group of portfolio companies as I am doing with Second-Level Investing, we ensure that we are not losing touch with our investments, which is paramount to this approach of “buying and caring”. We all have limited amounts of time at our disposal and my preference is to keep the size of my portfolio such that I can closely follow each stock.

A cautionary tale from a friend who is currently working for a small fund (around $220m assets under management): unfortunately, a lot of ‘investment professionals’ with their CFA and MBA degrees are more keen on stories than on underlying value. My friend recently complained that one of the portfolio managers at his fund oversees a whopping 60+ investments – with very little due diligence. Apparently, him and others pick up on stories promoted by brokers, which in turn are shared by the portfolio managers. This builds up a certain dynamic in the short term, which when applied to small and medium cap stocks can be sufficient to produce attractive returns – in the short term. The sin committed by these money managers is that they go straight from idea generation to execution while omitting due diligence. To readers inclined to frequent trading, I recommend allocating at most a small portion (10-20%) of their overall portfolio to purely speculative bets while keeping the bulk of their capital invested in long-term (6 months +) holdings. That way, you can shift a little money between your ‘long term investments’ and your ‘trading account’ when you feel like it, without putting your livelihood on the line.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.