Weekend thoughts: Underwriting Overconfidence and "None of the experts own it"

There’s a famous anecdote (I think it’s from One Up on Wall Street, but I could be mistaken) about an analyst who knows everything there is to know about a company (I believe the company is Clorox, but again I could be wrong). This analyst knows the economics of his company down cold, and I don’t mean in a “their EBITDA margins are 10.4%” type of way. The analyst has spent so much time on the company that they can accurately estimate profit margins that the company doesn’t come close to disclosing. So, for example, the analyst could tell you the margin difference between two different products in the same line (assuming it’s Clorox, they can tell the difference between, say, Clorox fragrance free versus regular Clorox), or they could tell you the margins of different plants (“the Mexican plant is top tier! It has 50% gross margins, while the Kansas plant is bottom of the barrel with only 25% margins”).

So the analyst knows the company better than anyone does…. but the analyst’s position in the company inevitably ends up underperforming the rest of the market. The underperformance can come from a variety of places, but I generally think it comes from “underwriting overconfidence.” Underwriting overconfidence is a term I made up, but I’ve generally used it to describe two situations:

1. When an “expert” on a name makes a position way bigger than they otherwise would because they feel so confident in a name. For example, they might take a huge position in a levered oil and gas stock, and when you ask them about the risk of combining all three forms of leverage (operational, commodity, and financial) in one stock, they just say “I know this company better than anyone; they’re the low cost provider and commodity prices can never drop low enough to turn them unprofitable because everyone else would be bankrupt!”

   1. Just absolute famous last words, and generally uttered right at the top of a commodity cycle!

2. The “expert” builds a model that shows the company is moderately undervalued and they use that to take a huge position….. but the model assumes that everything goes exactly right and the analyst feels comfortable with that assumption because they know the company so well. When something inevitably goes wrong (either an operational hiccup or something like a hurricane disrupting their business), it turns out there was absolutely no margin of safety in their underwriting.

   1. I find this happens most with good businesses trading at lofty prices. No one doubts Costco is a great business, but it trades for 40x P/E. Maybe COST’s undervalued, maybe it’s not…. but if you have a basket of 20 COST-like stocks that are relatively mature and trading for 40x P/E, I’d near guarantee that basket will underperform going forward. There are a few funds who run concentrated funds investing in things like COST at 40x P/E and saying they’re underwriting to >20% IRRs; color me skeptical!

Maybe those descriptions of underwriting overconfidence feel silly…. but I can promise you example #2 happens a lot. In 2021, there were tons of people who had two or four or even ten baggers in stocks they bought during 2020. I can guarantee you those massive moves had pushed the stock prices way higher than those investor’s most optimistic bull case when they first purchased the stock…. and yet many held on to the stocks as they raced higher. Why? Plenty of reasons, but I suspect one is the investors felt like they were “experts” on the company and could confidently underwrite lots of growth optionality. Maybe not exactly the same thing as the expert who “knows” the margin of every Clorox plant, but very similar principles. And lest you think I’m throwing stones from a glass house, I will absolutely admit that this exact thing happened to me with a stock or three.

So it sounds strange to say “knowing less is better”, but I generally find going into that type of “I know the margin of every line at every plant” detail is counterproductive for investing. The best investments are generally made alongside some type of parreto principle; you’ve done enough work that you can confidentially and knowledgably discuss all aspects of the business, but not so much that you find yourself overwhelmed by the details.

Anyway, I mention all of this because I had a few discussions this week that stuck out to me. In one, I mentioned a healthcare stock that might be interesting and the person said, “O, none of the healthcare specialists I know own that.” In another, I mentioned a bank that looked expensive and my friend said, “O, I have three banking expert friends and they all own it; they think it’s a great franchise.”

Which got me wondering: how do companies / stocks that “sector experts” own / don’t own perform?

It’s a tough question to answer. I’m not sure there’s a list of companies that are widely owned by “sector experts”. I guess you could argue a stock with high hedge fund ownership is the closest thing to a “sector owned” stock, but I’m a little skeptical.

And I’m not even sure you can measure “sector expert ownership”. Most of the stocks I know that are owned by “sector experts” tend to be based on anecdata: you know a two or three people who really focus on an industry, and the “sector expert” stocks tend to be the handful the those that you know they overlap in. Obviously that’s not a huge statistical sample!

Maybe a “sector owned” stock is a stock where one of the largest owners is a sector specialist. For example, Baker Brothers are well known in the pharma world; a stock with them (or someone similar) as a big owner could be a “sector owned” stock.

Speaking of Baker Brothers, I also wonder if “sector expertise” matters more in different sectors. They’re pharma specialists; pharma is a very technical sector where you can make very binary bets (and likely generate tons of alpha) by reading different studies and having different views on approval likelihood, market share, etc. Retail, in contrast, is certainly not an easy sector to invest in, but I’d guess the knowledge gap between a generalist ramping on the sector and an expert are much smaller than a generalist trying to read a clinical study versus a trained researcher!

Sector experts also have another drawback. If you’re a sector expert, you probably spend most of your time talking to other sector experts or management teams in the field. That makes it easy to get caught up in the crisis du jour. For example, in March and April, if you were a banking expert, you were probably spending most of your time talking to banking management teams who were terrified that all of their deposit base was going to evaporate and planning how to stave off a bank run. It’s tough (not impossible, but tough) to get bullish or stay rational when every one you’re talking to is panicking!

There’s one other sector that’s worth calling out here: real estate. Real estate is unique among public stocks because there are so many transactions that happen off market. There might only be one or two public sector deals involving Austin warehouses every year, but I can promise you there’s dozens of private deals that happen every month. You’ll often hear real estate investors pitching that they have an advantage in public markets because they see both public and private market deals and they can use that to find inefficiencies.

There certainly could be something to that line of thinking (particularly when the private investors are involved in development and can bring private knowledge of replacement costs to the equation), but I am somewhat skeptical. It’s not like it’s particularly hard to track down private market comps for real estate assets, and I think most REITs that trade at a discount to their private market value do so not because investors don’t understand the private market value but more because the investors are applying a capital allocation / corporate governance discount to the companies (yes, a single warehouse in Austin is worth a 5 cap, but it’s worth that because the owner directly controls the cash flow, capex timing, and exit decisions. In contrast, 20 Austin warehouse inside a publicly traded REIT are worth a 6 cap because investors are assigning a discount to the management team’s capital allocation and assume the management team will practice a bit of empire building). So the investors think they’re buying at a discount to public market value, and while technically true what they’re actually making a bet on is rational capital allocation (and perhaps the investors might be better served to make that bet than an average investor! as a private real estate person, perhaps they’ve interacted with the head of the company and have a view they’re way better than the market thinks!).

Anyway, I don’t know the answer to any of these questions. It’s tough for me to look at my personal history and makes any conclusion: I’ve invested in stocks that none of the “experts” would touch that have done incredibly, I’ve invested in stocks that all of the experts loved that have bombed, etc.

But it’s a question that’s been tickling my mind, so I figured I’d share (and, of course, if you have thoughts on the topic, my DMs are always open!).