Since more things can happen than will happen, if we can identify where our expectations differ materially from those embedded in market prices, we can construct portfolios that we believe will earn higher risk-adjusted rates of return over time than could be earned by a passive investment program.
This involves always keeping in mind a basic business principle:only compete where you have a competitive advantage. WarrenBuffett refers to staying within your circle of competence. Social psychologists tell us, though, that we are prone to overconfidence when it comes to assessing our abilities, so even when we think we have an advantage, we may well be mistaken.
In markets, competitive advantages are three: informational, analytical, or behavioral. Informational advantage is when you know something material that someone else doesn’t. It is the easiest to exploit and the hardest to find. The securities regulators make it their business to see to that by mandating public release of all material information, by regulations like FD, andstiff penalties for acting on inside information.
Analytical advantages come from taking publicly available information and processing or weighting it differently from the others. The market appears to be pricing Amazon.com as though its current operating margins in the low single digits are a permanent feature of its business model, as they are of bookseller Barnes & Noble. We think that is wrong and that Amazon’s margins will soon begin a steady climb toward and perhaps into double digits. If our analysis is right, we stand to make an excess return from our holdings in Amazon.com.
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