There's a number of parallels between the twin worlds of investment and gambling. It's no surprise that many hedge fund managers also enjoy playing poker (Like David Einhorn) and both Buffett and Munger have used the analogy of the pari-mutuel system to describe investing. To quote Munger from this talk (italics are my emphasis):
The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market.
Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system.
And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work.
Given those mathematics, is it possible to beat the horses only using one's intelligence? Intelligence should give some edge, because lots of people who don't know anything go out and bet lucky numbers and so forth. Therefore, somebody who really thinks about nothing but horse performance and is shrewd and mathematical could have a very considerable edge, in the absence of the frictional cost caused by the house take.
Whilst many gamblers consciously try to find their edge through techniques like statistical analysis and informational advantage I find many investors have never really sat down to think about what their edge is. There's a famous saying in poker that if you sit down at the table and can't tell who the fish (the worst player) is, you're the fish. You don't want to be the fish at the investing table! Ray Dalio, the founder of Bridgewater, has similar thoughts on investing:
The bets are zero sum. In order for you to beat me in the game, it's like poker, it's a zero sum game. We have 1,500 people that work at Bridgewater, we spend hundreds of millions of dollars on research, and so on. We've been doing this for 37 years and we don't know that we're going to win. We have to have diversified bets. So it's very important for most people to know when not to make a bet. Because if you're going to come to the poker table, you're going to have to beat me, and you're going to have to beat those who take money. So the nature of investing is that a very small percentage of the people take money essentially in that poker game away from other people who don't know when prices go up whether that means it's a good investment or if it's a more expensive investment.
There's a number of ways to gain an edge in investing and beat the market. The most obvious is an analytical edge - you have the same information as everyone else, you're just able to process it better than others and see what the market doesn't see. If your valuations are consistently better than everyone else then over time you could beat the market. The problem with this approach is that it's very hard for stocks that have a large analytical following. For stocks in an index like the S&P500 or the FTSE100 you are up against thousands of analysts who pour over every result and are also looking for valuation discrepancies. Especially for the lone private investor, beating the large cap indexes consistently is very tough. The high degree of competition makes out-performance harder and harder. Michael Mauboussin addresses this concept in his book, The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing:
The key is this idea called the paradox of skill. As people become better at an activity, the difference between the best and the average and the best and the worst becomes much narrower. As people become more skillful, luck becomes more important. That’s precisely what happens in the world of investing.
This is the foundation of the 'Efficient Market Hypothesis', that stock prices reflect all information known about them and hence cannot be beaten. Whilst I don't believe that the EMH is perfect (and certainly some of the stricter forms of it seem completely barmy to me!) there is a degree of truth to the idea that having more and more analysts tracking a security will tend to make it more efficiently priced.
Another route to investing edge is an informational one - you know something about the company that no one else does and it's significant in determining a valuation. Again, for stocks that have a large analytical following we run in to the same problem - many people are doing all they can to talk to customers, suppliers and industry experts to glean further insight in to a company or an industry and profit from anomalies. For the private investor it's tough to compete against big research teams with huge budgets. It's also illegal to act on insider information, not that it always stops some hedge funds.
So what can the private investor do to find a source of edge? I think PIs have a number of ways they can gain an edge over the investment professionals - they just need to pick their bets carefully. Private investors aren't managing huge amounts of capital so they can explore smaller opportunities that bigger managers can't. It's worth the time for a PI to spend hours reading up on some small micro cap stock that only has the one house broker because the lack of research competition is likely to throw up big mis-pricings that can be taken advantage of by the good investor. Private investors can get both an analytical and informational edge over the market by focusing on the less-followed securities because the wider investment community is neglecting the opportunities. Howard Marks sums it up best:
People should engage in active investing only if they're convinced that (a) pricing mistakes occur in the market ... (b) they - or the managers they hire - are capable of identifying those mistakes and taking advantage of them.
The other big edge PIs can have is that of patience. Big institutional funds are often forced by redemptions to sell their assets even if they think them to be cheap and equally compelled to buy assets if they have inflows. This creates a buy high, sell low approach that means that investors as a whole under-perform the funds they invest in. The smart private investor can manage his affairs such that he never needs be a forced buyer or seller and can be patient in waiting for attractive opportunities. Institutional investors are compelled to do what their (frequently irrational) clients want them to do. To quote Buffett:
The stock market is a no-called-strike game. You don't have to swing at everything -- you can wait for your pitch. The problem when you're a money manager is that your fans keep yelling, "Swing, you bum!"
Obviously none of these edges come easily. The PI needs appropriate analytical skill, an understanding of the economics of the businesses (the 'circle of competence') and the emotional strength to act against the crowd when they spot big opportunities. None of these abilities come overnight but they can be learned with time, discipline and patience. However, if you want to outperform the market through active investing, having a reliable source of edge is the only way. You don't want to be the fish at the poker table
Filed Under: Value Investing,