Michael Steinhardt: How Successful Investors Perceive Things Differently

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You can be a successful long-term investor in one of two modes: passive or active.

Passive investors tend to look at the research related to investment transaction costs and the challenges of beating the market over the long-term and put their investments on “autopilot” by selecting solid index funds over the long-term with a reasonable asset allocation and doing some simple rebalancing no more than annually. Being a passive investor is great if you never want to watch CNBC or pick your own stocks and are generally happy with the idea of matching what the market gives you while paying very low costs to do so.

However, as a BroStocks reader, you’re probably at least somewhat interested in a more active approach.

Active investors look to tilt their portfolios and make bets based on their set of beliefs about the future. An active investor may not want to own all 500 stocks in the S&P 500 (as a passive index investor is happy to do) if he or she has a strong conviction that sectors such as airlines, retailers and restaurants may struggle in the near future or even go bankrupt as a result of the coronavirus bear market.

A key part to adding alpha (excess return above the benchmark) to your portfolio as an active investor is recognizing where the market is complacent or crowding into a trade that may not play out as the majority expect. Developing your own view, or variant perception, is crucial to to active investing success. This is because the price you pay to enter an investment is one of the most important aspects to ultimate success and total return. When an investment is not in demand by the broader market, the price will naturally be lower than when that investment is widely accepted as a promising one.

The concept of variant perception is described by Michael Steinhardt, one of the original Market Wizards profiled in the eponymous book that offers lessons from the world’s best traders, thus:

“Concept number one is variant perception. I try to develop perceptions that I believe are at variance with the general market view. I will play those variant perceptions until I feel they are no longer so.”

Michael Steinhardt interview from Market Wizards

You might want to listen to Steinhardt is you are an aspiring active investor. At the time this interview was conducted, his firm, Steinhardt Partners, had put together a 21 year track record of 30% annual compounded returns, compared to 8.9% annually for the S&P 500 over the same period.

Steinhardt goes on to note that variant perception can be applied to individual stock ideas, such as when in 1988 he was short Genentech from $65 and rode it down to under $15, or can be applied thematically to broader market concerns such as sectors or styles that are in or out of favor.

Examples of Variant Perception That Paid Off From the Last Financial Crisis

• Perceiving the onset of the 2008 Global Financial Crisis: Looking back now with the aid of a best-selling book and Hollywood movie called The Big Short, it seems oh so obvious that mortgage backed securities would eventually trigger a major financial market meltdown. However, to most of the world’s notable money managers, investment banks and world leaders, this was not so. Only a few professionals saw the crisis coming and acted on it in a way that generated profits—huge profits, by taking major short positions in mortgage backed securities, bank stocks and the market more broadly. We profiled Steve Eisman, one of the most notable managers who saw it coming based on his own set of perceptions about the health of the housing market.

• Calling the 2009 market bottom: Likewise, once the financial crisis hit, it was almost impossible to believe things would ever return to normalcy again. Yet Jeremy Grantham from GMO issued a now famous market commentary titled “Reinvesting While Terrified” which marked the bottom of the market to the exact day—those few who listened and began buying securities consistently from 2009 profited significantly over those who remained shell-shocked and were concerned by issues ranging from runaway inflation after the Fed took extraordinary actions or slow growth rates that dogged the early days of the recovery. The key perception that the early investors got right was that the Fed would aggressively prop up the financial system and with it all risk assets.

As you can see, the Global Financial Crisis provided two major pivot points for investors to use their perceptions, both of which had major consequences for both the investors who got these calls right and wrong. Major turning points like these come along relatively rarely, until now…

Coronavirus Crisis Provides Ultimate Variant Perception Test

Just like the previous Global Financial Crisis in 2008-9, the current coronavirus financial crisis we find ourselves in today offers investors perhaps the best chance of developing a perception that is markedly different from the market which could have major investing implications for years. Entire industries, major companies and consumer habits are all in flux. Being on the right side of these trades before everyone else should be a priority for active investors.

While it may be impossible to predict the course of events over the next few months or years as a result of the coronavirus and the economic crisis that has followed it, there are two basic frameworks that might be useful for generating active investment ideas as the market continues to lurch forward based on simplistic headlines of promising vaccine results and state governments’ vague reopening plans.

Again, you may not feel comfortable making a call here either way. If that’s the case, then passive investing through index funds and a reasonable asset allocation likely is the best call for you.

For those who do have a strong view, let’s see where those views might lead to investable ideas.

Potential Bearish Variant Perception: The market is significantly underestimating the long-term economic ramifications of the coronavirus and its economic impacts.

If you have a strong bearish view on either the progression of the coronavirus itself (emergence of a second wave, unrealistic vaccine timeline, etc.) or its ultimate economic impact, you already may have a credible starting point for variant perception as the broader market has made a major rebound from its crisis lows and seems to be highly positively reactive to even the smallest news related to vaccines and treatments.

However, it may be even more worthwhile to drill down on your bearish beliefs and identify specific areas where your perception differs from the market crowd.

Specific bearish variant perceptions might include:

• A significant percentage of people will not want to go out to eat at a sit down restaurant wearing a medical mask and gloves, as many states are requiring in order for their restaurants to reopen. This will impair profits for much longer at dine-in establishments.
• Disney World or major Las Vegas casinos will never be the same type of premier destination they were pre-coronavirus, considering how tactile and dependent on large volume of consumers the experiences are.
• Commercial real estate owners (REITs) will suffer as the remote work trend becomes permanent. REITs that have the most exposure to markets like NYC where this trend will likely be felt in the strongest degree due to expensive square footage and impact from the disease are most at risk.
• The long-term future of business travel may never fully recover to pre-crisis levels now that so many professionals have had forced exposure to remote work and video conferencing, and many may prefer it to the perception of riskier travel. If even 25% of business trips are conducted remotely instead of in-person over the long-term, how will this impact airlines and hotels business models?

As you can see, the more specific you are with your variant perceptions, the more naturally investable ideas will emerge (Restaurants, REITs, DIS, casinos, hotels, airlines).

Potential Bullish Variant Perception: The market has overreacted to coronavirus and as therapies, vaccines become available and herd immunity is achieved, pent-up demand will drive the economy and markets higher than expected.

Specific bullish variant perceptions might include:

• Lack of widespread testing early on, earlier cases than previous reported and increased antibody testing indicates that more people have been infected or exposed to COVID-19 and therefore the fatality rate is lower than currently reported; as these facts are more broadly appreciated, the fear and extreme measures such as lockdowns will become less prevalent and therefore less economically damaging and the global economy will come surging back.
• Lack of enthusiasm for crowded public transport will be bullish for automakers long-term as more people prioritize mobility and car ownership.
• The coronavirus economic crisis has established that the Fed will do anything to prop up markets; this is bullish for stocks and any bad news about the virus will actually be positive for stocks, much like the famous “Bernanke put” during the last bull market.
• Healthcare companies will experience massive inflows of both public and private investment as society focuses on never having a repeat experience of COVID-19 again.

Whether or not some or any of these bullish or bearish variant perceptions turn out to be true or not may be unknowable, and certainly not without a lot more research than we have done.

The point is that as an active investor, you are rewarded for successfully deploying your own variant perception when it leads you an under-appreciated investment idea that will eventually become recognized by the broader market.

It was much more useful and profitable to identify that stocks had bottomed in 2009 compared to 2012 or later, as many investors did. Those fully invested in stocks from 2009 have much fatter accounts today than those that waited three or four years later for the “all clear” sign. By the time the market appreciates that it’s safe, the trade also tends to be less profitable. This is why Steinhardt notes that he will play the views that differ from the market consensus until he feels they are no longer at variance.

If you want to be an active investor, then be active. Don’t follow along with the majority of the market—if you prefer to do that and don’t enjoy sticking your neck out with bold and contrarian views, then just buy an index fund.

Figuring out where your own perceptions vary with the market at large is a great step toward becoming an active investor.