I spend a lot of time reading the research produced by my colleagues in the equity research department here at Morningstar. I read these reports not only through the lens of my job, which includes showcasing some of this research, but as part of my own investing efforts.

In either case, I am clear on my favourite phrase to see in one of these reports. While the wording may vary, the meaning is usually the same: “things might be bad for a while, but we think the long-term picture looks an awful lot better”.

Why is this my favourite thing to see? Well, I think that situations like this – if the underlying analysis is correct – are one of the few situations in which an individual investor can hope to exploit a so-called edge against the professionals.

Why seek an edge in the first place?

An investment edge is something that gives you an advantage when it comes to achieving your financial goals through investing.

It is often discussed through the lens of whether an investor should pick their own investments or accept a ‘market’ return or thereabouts through index tracking ETFs. Either way, we think that weighing up your potential edge (or lack of one) is an important step in forming your broader investing strategy.

It may even dictate the execution of your strategy. If you don’t think you have an edge, for example, you may choose a passive approach. If you do think there is an edge to pursue, thinking about the source of that edge might inform where you look for investments that lean into it.

The four potential sources of investment edge

Let’s quickly skim through the four potential sources of investment edge.

Informational edge is having access to better information. In the age of multi-million dollar data collection efforts and stringent insider trading laws, having a genuine informational edge is unrealistic at best and illegal at worst.

An analytical edge is better use of the same information. This isn’t impossible, but it is hard to claim on a consistent basis for most investors. Especially in bigger stocks that are widely covered by dozens if not hundreds of very smart, highly incentivised professionals worldwide.

This leaves us with behavioural and structural sources of edge, which aren’t strictly the same thing but have some overlap.

A behavioural edge is self-explanatory: you commit fewer errors than other investors and therefore end up with better returns. Easier said than done, perhaps? Structural edge is where you attempt to turn the professional money management industry’s shortfalls to your advantage.

These shortfalls vary in nature but revolve around the same issue: a need for most funds – except those with the very best track records and most gravitas – to perform favorably against the benchmark and their peers over stupidly short time periods. Among other things, this perpetuates fear.

  • Fear of not owning the current winners
  • Fear of not picking the bottom in current losers
  • Fear of not picking the top in stocks you own and have risen

There’s also the fear of dead money – of owning something that has clear underlying value but doesn’t have an obvious catalyst and could therefore go nowhere for years.

The fears I have listed above are not exhaustive. And they are by no means exclusive to professional investors. But I’d argue that the added element of career risk and regular requirement to justify your holdings to clients and higher-ups increases their intensity.

Flip these fears on their head, then, and we might arrive at some ways to pursue an edge over professionals:

  • Indifference to owning current winners
  • Focus on long-term value over trying to pick the bottom
  • Focus on long-term value over trying to pick the top
  • Focus on long-term value over timing of return

An example of exploiting the fear?

Most industries have some elements of cyclicality to them, and I'd posit that stocks in cyclical industries are especially prone to being caught up in two of the three fears: fear of not owning current winners (which might mean overpaying at a cyclical high), and fear of not picking the bottom in downturns.

Where is the opportunity here? Well, if a company’s industry is cyclical but the company also has strong long-term secular trends in its favour and a moat, you might find situations where fear about the current downcycle presents an attractive long-term opportunity.

Melexis NV (BRU:MELE), which is listed in Europe, could prove to be a good example of this. For a description of what Melexis does, I defer to our analyst Javier Correonero:

“Melexis designs sensor integrated circuits, which are a type of analog/mixed-signal chip, for the automobile industry. Its chips measure variables like positioning, temperature, electrical current, and pressure and convert real-world signals into digital signals to control car functionalities like the powertrain, rotation, safety systems, and pumps and fans, among many others.”

For many years, the number of chips per car has been on the up and up. Modern safety, performance and user experience features rely on them. At the same time, however, there is no getting away from the cyclicality of Melexis’ end market.

Melexis is currently experiencing one such down cycle. This is visible both in Melexis’s recent fiscal 2024 results (revenues and profits were down 3.5% and 18% respectively versus 2023) and in its popularity with investors.

Zoom out, though, and the picture looks a whole lot better. Since 2005, Melexis’ revenue has increased to over EUR 900 million from under EUR 175 million. Operating profits in 2024 were almost EUR 220 million, compared to under EUR 35 million in 2005. Great long-term growth, despite many down cycles.

The future also looks promising. Javier Correonero can’t be sure when the current downcycle will end, but he forecasts that more growth in chip content per car can drive average revenue growth of at least “high single-digits” per year for the next decade.

His confidence here is boosted by his assertion that Melexis enjoys sustainable competitive advantages in the markets that it serves.

For one, Melexis’ portfolio is increasingly IP-heavy and is focused on smaller niches that might not move the needle enough for larger players. Customers also have little incentive to switch supplier once a component is included in a vehicle’s design.

“Every chip has its own IP and is designed and tested to work with other chips and the system’s microcontroller in a certain way” says Javier. “If a chip is replaced, the whole system would need reprogramming and new testing, something that makes no sense from a cost/benefit perspective”.

When it comes to competing for inclusion in new models, Melexis has another thing in its favour: at under EUR 0.50, the cost of your average Melexis chip is trivial compared to 1) the value of the vehicle being built and 2) the crucial role played by the chip in a car’s performance and safety.

“As the failure of a single chip could compromise production and safety, OEMs choose providers based on performance and not on price” Javier says. “Chip providers like Melexis must have almost zero-defect rates to be considered reliable.”

As I spoke about in this article on companies with Warren Buffett’s favourite quality, the act of providing mission-critical products at a trivial cost can entail excellent pricing power and juicy profit margins over time. In Melexis’ case, this is reflected by operating profit margins averaging north of 20%.

This combination of an attractive and growing market, a strong niche position and near-term uncertainty (AKA fear of not picking the bottom) could present an opportunity. As Javier’s recent research report put it, “we see upside for investors who can stomach a few quarters of volatility”.

A life less comfortable

I think the idea of exploiting the short-sightedness of many investors for better investment returns holds some promise. And I think it holds promise because the fears we talked about earlier in this article are all 100% rational.

Who wants to pick a stock, only to see it fall further? Who wants to make paper gains in a stock, only to see them evaporate? Who wants to stand by while your competition (and your benchmark) are benefitting from this year’s hot stock? And who would want to own a sleepy stock with underlying value but no catalyst? Nvidia’s up another 10%, we needed those returns yesterday!

Hunting out this fear – and potentially even buying it – is going to involve discomfort. So if you are going to try and do this, you need to accept that up front. Or you need to think about ways to manage it.

One obvious route is diversification and taking a portfolio view of things. Who cares if an investment that meets your criteria continues to go down for a bit after you have bought it? There is every chance that something else in your portfolio is making up for it.

More important is to remain conscious of what you are trying to do. You are not trying to be right every time, nor can you be. No investor on Earth has a 100% hit rate. You are trying to exploit an edge that, on average, provides the chance to invest in good companies at better prices that lead to better returns.

And most important of all…

Try not to forget why you are investing in the first place. Achieving your goals is a lot more important than taking the smartest or most complicated route there. In other words, you may be best served by not seeking to exploit an edge at all.

Considering your edge is one of five steps we recommend you take when it comes to setting your investment strategy. To see the other four and learn more about defining your approach to investing, see this article by my colleague Mark LaMonica.

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