The retail investor does have an advantage in the capital markets — but it isn’t agility and it isn’t localized expertise
One of the most frequently asked questions I get in providing research and consulting to retail capital market participants [i.e. “retail investors” or “mom and pop” investors] is, “what is our advantage — does the little guy have any advantage in playing this game?”. The answer is “yes”; but it isn’t what most expect it to be. Most expect it to be agility — the ability to buy and sell quickly because of a lack of scale; or localized expertise — that because of lack of scale the retail investor can take concentrated positions in market sectors or specific companies in which they have an “expertise”-advantage [e.g. a medtech salesman investing in medtech, etc.]. Neither are really the case of the retail investor’s advantage.
First, despite the trading prowess of some retail investors [and some do in fact have the gift of “reading the charts”] most fail to outperform “the market” by trying to time the market [without listing any specific statistics or sources — a simple Google search and 15 minutes time will prove this out]. This is, at this point, just a well accepted “fact” of capital markets. So, without spending much more time on it, agility has effectively zero benefit on the performance of retail investors. Again, I encourage those reading this to vet this out via third-party data [as I’m confident you’ll find that this is an accepted fact in the capital markets].
But what of localized expertise? Well, being an expert in a field or market vertical can be helpful or even advantageous to a certain degree — no doubt; but often this operational-level expertise doesn’t translate to the capital structure level or to the capital market level.
For instance, being an expert rig hand [on an oil or natural gas rig] might provide an expertise into the operations of an oil or natural gas company; but, as we’ve seen over the last few years in the Energy Complex, operations can and often are well-overwhelmed by the capital structure. Plenty of excellent oil and natural gas operations have been forced to restructure via Chapter 11 bankruptcy because of capital structure flaws. This is despite having fine [or even superb] operations.
The dislocation, in this example, of believing that the operations of a company are perfectly correlated with the financial health of a company can lead to catastrophic outcomes for investors [especially those with localized expertise]. Thinking, because of localized expertise, “we can’t go into bankruptcy because we’re an excellent operation” can lead to catastrophe. In some cases, cases where an investor doesn’t realize what they “don’t know”, localized expertise can be a net-negative. [A quick backward-look at most Social Finance platforms and/or message boards will show examples of this “net-negative being described].
But if the retail investor isn’t advantaged in agility or localized expertise, what exactly is the retail investor’s advantage?
Pain tolerance. Really, that’s it; or, put a bit more softly, leveraging structural constraints that are in place for larger entities that are NOT in place for smaller entities [e.g. the retail investor]. Really, this is it folks. Without writing a full dissertation, I’ll give an example that recently made a lot of sense as a research and consulting breakout via the ATLAS platform. [To be clear, we’re not the only shop providing research and consulting services to retail investors and we’re not the only shop leveraging the retail advantage to the max utility].
We recently provided research and consulting on an energy debt issue [a bond] that had fallen from being priced at over 100 cents on the dollar to being priced at 7 cents on the dollar. The bond had fallen in pricing because of  commodity volatility and  a lack of visibility at the underlying company into forward looking viability. Put simply, the underlying company [obligated to pay the interest on the bond and obligated to repay the initial investment into the bond at the bonds maturity] was sick; very, very sick. But, we didn’t think the company [and by way of that the bond] was 7 cents on the dollar sick [for many reasons that we can’t outline here nor would you want to read that dissertation in its entirety].
How or why would this bond, if it wasn’t as destined for doom as the price was implying, trade to this level? Wouldn’t other investors step in and buy the bond as it reached “fair pricing”? Why would the investors holding the bond in the first place sell at “unfair” or “inefficient pricing”? The answer to all of the above [among other things] is structural constraints.
Most of the holders of this particular bond were midsize to larger size mutual funds, broker-directed accounts, etc. All of these, in this particular instance, had risk-management policies in place that forced selling of debt at certain price points. All of these, in this particular instance, also had risk-management policies in place that prohibited buying of debt trading at or below a certain price point [which limited the buyside activity and embellished the sellside activity].
Why are these risk-management structural constraints in place if they’re so inefficient? Because usually they aren’t; usually a bonds trading price is reliably indicative of the underlying firms viability [READ: the company responsible for maintaining the obligation]. Usually these structural constraints work as intended. Usually.
But, not always.
That’s where the retail investor has its advantage. In being able to pick through certain stocks and bonds which have overshot the “efficient” price landing because of accelerated/exacerbated selloffs driven primarily [or at least secondarily] by structural constraints. Leveraging this “domino effect” inefficiency [in pricing] to max utility is a huge advantage of the retail investor.
Remember, the retail investor is responsible for all of his or her own investing successes and failures. There is zero risk-management governance on the retail investor. Put another way, the retail investor has full optionality as to how to invest, when to invest, and at what allocation; and that’s hugely powerful. For me, this is the one quantifiable, uniform advantage of the retail investor. The single advantage that translates across the entire investor base as a class. Again, I think it’s hugely powerful as well.
Now, the retail investor is still tasked with either individually assessing each opportunities inefficiency OR paying somebody/something to assess each opportunity for it — but, again, this is at least an option; picking through the “bin” of investments that the larger entities [in successive fashion] can’t pick through. Regarding the bond used in our example, we ended up dialing in a cost basis below 10 cents on the dollar [an average pricing]; and the bond now trades into the mid-$90s [not inclusive of the well over 100% annual yield we’re owed on the bond — just for holding the paper].
The facts are that the retail investor is largely disadvantaged in the capital markets; these are just the facts. We can all try to “just make it up” that we aren’t, but we are. I think more retail investors should consider [risk-adjusted for their own personal use cases] leveraging in-market structural constraints in trying to maximize the utility of each dollar and of each risk unit assigned to their wealth. The hope is that this note leads to much deeper research by the reader and, maybe, ultimately experimentation with some degree of leveraging the advantage.
Good luck everybody.