With Smarty Jones nearly claiming the Triple Crown at Belmont earlier this month, horseracing has recaptured America's attention. We were also reminded that there is no such thing as a sure thing.
Clearly, there's universal applicability to that lesson, but there are plenty more for investors to learn from the racetrack. There is, in fact, a great similarity between the two. As Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) Vice Chairman Charlie Munger pointed out in a speech at University of Southern California in 1994. "[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."
So off to the races we go. Or at least to an outstanding essay about horseracing. Appearing in Bet With the Best, Steven Crist's "Crist on Value" is a terrific read for investors and horse players alike. Crist, the publisher of Daily Racing Form (a statistical bible of sorts for the racing business), writes with the horseplayer in mind. But the seven lessons below that I gleaned from the essay are just as helpful for turning good handicappers into good bettors as it is for turning good business analysts into better investors.
7 Lessons from the Racetrack
1. "At the racetrack ... every bettor is playing only against the other bettors.... Your opportunity for profit at the racetrack consists entirely of mistakes that your competition makes in assessing each horse's probability in winning."
It's both important and sobering to remember that on the other side of every transaction is another person. "Whenever a purchase is made," fellow Fool Bill Mann writes, "the buyer is essentially saying, 'There is no better place in the world for my money than right here,' while the seller is coming to the exact opposite conclusion. This is what makes a market."
Achieving above-average returns (on a risk-adjusted basis) requires seeing value where others currently don't ("variant perception," as legendary hedge fund manager Michael Steinhardt calls it). Basic economics proves this: If everyone saw the same value, demand for the stock would rise, increasing the price, and decreasing the above-average return to something near average. The successful investor, therefore, takes advantage of "other persons' mistakes of judgment," as Ben Graham called it.
2. "This is the way we all have been conditioned to think: Find the winner, then bet. Know your horses, and the money will take care of itself. Stare at the past performances long enough, and the winner will jump off the page.... The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory."
A good company is easy to spot, a good value is not. eBay (Nasdaq: EBAY ) is an unusually good business; Fresh Del Monte Produce (NYSE: FDP ) , frankly, isn't. But when taking into account the valuations of the two companies, it's hard to tell which is the better investment. Is it Fresh Del Monte, trading at 7 times earnings, or eBay, at 105 times earnings? "If you look at the odds," Munger said in his speech, "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.... The prices have changed in such a way that it's very hard to beat the system." (For what it's worth, Tom Gardner thinks Fresh Del Monte is a likely solid long-term investment, as it is his February pick for his Hidden Gems newsletter.)
Many people spend all of their time searching for the next Microsoft (Nasdaq: MSFT ) or Wal-Mart (NYSE: WMT ) , yet wouldn't have a clue about what's already priced into the stock of whatever company they find. They naively, and wrongly, assume that since the business is good, the stock must be, too. Knowing how to value a business is key.
3. "...Handicap[ing] horses is work that you do before the betting opens. As soon as those first prices go up on the board, you are looking for discrepancies between your odds and those set by your opponents.... You must have a clear sense of what price every horse should be, and be prepared to discard your plans and cease new opportunities depending solely on the tote board."
One tool used by most great investors is the watch list. Whether tracked electronically or mentally, good investors follow dozens, even hundreds, of stocks that they have determined a rough estimate of value. (By the way, a great ready-to-go watch list of potentially good companies is provided in every issue of Hidden Gems.)
Most of the time, the stocks on one's watch list trade at or above fair value, because the market, like the race track, is mostly efficient. But not totally efficient. By keeping track of so many stocks, the day occasionally comes when one or more will fall to a price low enough to make it a great investment, moving it from the watch list to the buy list.
The key is that good investors, like good horseplayers, do their homework ahead of time to become familiar with what they're looking at. If I see a Coca-Cola (NYSE: KO ) on sale for a nickel, I know that's a great deal. But, being more of a connoisseur of cola than cabernet, were I to find a bottle of Australian shiraz on sale for $50, I wouldn't know if I was getting a good, bad, or fair deal. Good investors put themselves in the position to act quickly when bargains emerge because, as every shopper knows, a good bargain doesn't last long.
4. "It might not be a great deal of fun, but you could sit around and wait for mismatches, races in which one horse is so clearly superior to the competition that anyone could fairly agree that he has a better than 50 percent chance of winning the race.... There is no shame in passing a race because you just don't see any value in it."
"Sitting around and waiting for mismatches" is exactly what Warren Buffett has done for the past half-century. "We're not going to buy anything just to buy it," he said at Berkshire's annual general meeting in 1998. "We will only buy something if we think we're getting something attractive." As evidenced by the $35 billion of cash he's holding onto, as well as his comments over the years, Buffett will hold cash indefinitely until a "mismatch" comes along. He is well aware that "shame" comes not from shrewdly "passing a race," but recklessly entering one. "You don't get paid for activity," Buffett instructed, "You get paid for being right."
5. "What defines sucker money is not the horse selected, but the acceptance of odds on that horse that are substantially out of line with its chances of winning."
Even a horse with a broken leg can be a good bet if the odds the track is offering are right (trillion-to-one seems about right). Same goes for investing. A bad company can be a good investment at the right price, because unless a company's equity is really of no value -- and there are cases of that -- then there is some value. So it's entirely possible that the stock of a bad business can offer attractive returns. But watch out. While there are certainly true bargains out there, "Cheap crap is still crap," as former Fool analyst Randy Befumo wrote.
Just as a bad company can make for a good investment (though "bet" is probably a more appropriate term in this case), a good company can be a bad investment. As with horses, the sure thing is never a sure thing (ahem, Smarty Jones), and can be a sucker's bet if the reward of winning isn't enough to compensate for the risk, while small, of losing. As Buffett says, "You can, of course, pay too much for even the best of businesses. The overpayment risk surfaces periodically.... Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid."
A bad (or good) investment has as much to do with what price was paid as it does with what business was bought.
6. "...The world's savviest bettor cannot win with bad opinions"
It's not just that Warren Buffett can do discounted cash flow valuations in his head -- which he can! -- it's that he understands the underlying businesses better than anyone.
There are plenty of "investors" who come up with very precise valuations for companies (down to the penny in some cases), yet their knowledge of the companies is scant, and therefore, their valuations worthless. Truly understanding the business is a prerequisite for valuation.
7. Finally, as Crist says, "If all of this seems too calculating and joyless, by all means feel free to forget about it and enjoy yourself at the races betting horses you fancy regardless of their price. You'll have plenty of company, and the rest of us could use your money."
Daily Racing Form Press kindly granted this author permission to reprint passages fromBet With the Best, Copyright 2001 © by Daily Racing Form LLC.