Investors often spend enormous amounts of time studying charts, economic forecasts, interest rates, political events, and market sentiment. Yet when we examine the greatest investors, hedge funds, family offices, and institutional investors over long periods of time, most excess returns can usually be traced back to only a handful of fundamental approaches.
In simple terms, there are only three major ways to generate investment returns that exceed broad stock market index funds such as the Vanguard Total World Stock ETF or the S&P 500 Index over long periods for hardworking investors who are ordinary white-collar professionals.
Path A
Buying Exceptional Companies at Attractive Valuations
Path B
Buying Good Companies at Extremely Cheap Valuations
Path C
Buying Companies Benefiting From Special Events or Catalysts
Almost every successful long-term investment strategy is usually a variation, combination, or specialisation of one of these three approaches.
A) Exceptional Companies at Attractive Valuations
This is the approach made famous by investors such as Charlie Munger and, more recently, Terry Smith.
The idea is straightforward. Instead of searching for cheap companies, investors search for outstanding businesses. These companies often possess characteristics such as:
Examples throughout history have included companies such as:
These businesses often earn superior returns because they can reinvest capital at attractive rates for many years or even decades.
Suppose a company earns 20% returns on capital and can continue reinvesting for a long time. Even if investors pay a reasonable price today, the growth in earnings and free cash flow can create tremendous shareholder wealth over time.
The challenge is valuation. Even the best company can become a poor investment if purchased at an excessively high price. For example, paying 100 times earnings for a wonderful business may still lead to disappointing future returns if growth eventually slows.
Therefore, successful investors following this approach seek a combination of:
- Exceptional business quality
- Attractive or reasonable valuation
- Long investment horizon
This strategy generally requires patience because exceptional companies rarely become very cheap. When opportunities appear, they are often during market corrections, economic recessions, industry-specific downturns, or temporary company-specific concerns.
Historically, many of the world’s greatest fortunes have been built through this approach because business quality and compounding can work together for decades.
B) Good Companies at Extremely Cheap Valuations
The second path focuses less on business excellence and more on valuation. This approach is often associated with Benjamin Graham and many deep-value investors.
The core principle is simple: a company does not need to be exceptional to generate excellent investment returns. It merely needs to be extremely undervalued.
Imagine a company worth $100 per share that is trading at $40. Even if the business grows very little, investors may still achieve strong returns if the market eventually recognises the true value of the company.
These opportunities often emerge when investors become overly pessimistic, entire industries fall out of favour, temporary problems create fear, or economic crises cause indiscriminate selling.
Examples can include:
Unlike the first strategy, these businesses may not possess strong economic moats or outstanding growth prospects. They may simply be reasonably profitable, financially stable, or temporarily misunderstood.
The investment thesis often relies on what value investors call “mean reversion.” This means that a company’s valuation eventually moves back toward a more normal level.
Mean reversion, illustrated
In such situations, investors can generate substantial returns even if business performance remains merely average.
The advantage of this strategy is that opportunities appear more frequently. The disadvantage is that many cheap companies deserve to be cheap.
Therefore, successful deep-value investing requires rigorous analysis to distinguish temporary problems from permanent impairment.
C) Event-Driven Company Stocks
The third major source of alpha comes from corporate events. Unlike the first two approaches, which focus mainly on business quality and valuation, event-driven investing focuses on specific situations that can unlock value.
Examples include:
In these situations, investors attempt to identify opportunities where future outcomes are not fully reflected in the current share price.
For example, a company may announce that it intends to sell a valuable division. The market may underestimate the proceeds from the sale. An investor who correctly assesses the situation may profit when the transaction is completed.
Similarly, a company may spin off a subsidiary. The newly independent business may attract investors who previously ignored it, resulting in a higher valuation after separation.
Many professional hedge funds specialise exclusively in these situations because they often require detailed legal, financial, and transaction analysis.
Unlike traditional investing, event-driven opportunities are usually time-limited. Once the event occurs, the opportunity often disappears.
The key advantage is that returns may be less dependent on overall market direction. A merger can succeed during both bull markets and bear markets.
The main risks involve:
• Transaction failure
• Regulatory obstacles
• Unexpected delays
• Deterioration in business conditions
Because of these uncertainties, event-driven investing often requires specialised expertise.
Why These Three Paths Explain Most Alpha / Excess Returns
Although many investment strategies are often given different names, many ultimately fit into one of these categories.
How familiar strategy names map onto the three paths
Quality investing, compounders, and growth-at-a-reasonable-price strategies generally belong here.
Deep value, contrarian investing, net-net investing, and asset-based investing generally belong here.
Merger arbitrage, spin-off investing, activist investing, and special situations investing generally belong here.
The terminology changes, but the underlying economic logic remains remarkably similar. Investors outperform because they either:
- Own businesses that become much more valuable over time.
- Purchase assets at a very low level below their intrinsic value.
- Exploit specific events that unlock hidden value.
Conclusion
The search for alpha often appears complicated, but the foundations are surprisingly simple. Over long periods, excess investment returns generally come from one of three sources.
First
Buying exceptional companies at attractive valuations and allowing long-term compounding to work.
Second
Buying good companies at extremely cheap valuations and benefiting from valuation normalisation.
Third
Investing in event-driven situations where corporate actions create opportunities that the market has not fully recognised.
Most successful investors spend their careers specialising in one of these approaches rather than attempting to master all three simultaneously.
The greatest investment results usually occur when an investor develops deep expertise in a single approach, applies it consistently over many years, and maintains the discipline to act when genuine opportunities appear. The specific method may differ, but nearly all sustainable alpha generation can be traced back to one of these three enduring paths.