In The Theory of Poker, David Sklansky defines the objective of poker as winning money, not winning pots. He also says the sucker at the table is usually the person who plays every hand, no matter what the cost.
I want to make money in the stock market (and not be the sucker), and you probably do, too. So how can we do it? By following some simple rules great poker players use to maximize their winnings:
1. Play more hands when the odds are in your favor and less when the odds are not.
2. Bet big when the odds are in your favor.
Wired for action
As humans, we are wired to act. We want to participate and be a part of the action. Wall Street understands and exploits this, because more action from us means more revenue for them.
Think about it. Prices and research reports and financial magazine headlines tempt us to make lots of investment decisions just as growing pots can entice poker players to play too many mediocre hands. Don't be lured into that trap. Too much action is expensive (antes and calls in poker, commissions and taxes in investing) and can even cloud our judgment.
Follow the money
I know what you're thinking -- laying down hands is tough. So is waiting for bargains in the stock market. We want to make money now. Doing so means we need to be in the game. But hear me out: Following a "do less, earn more" strategy can prove to be very successful.
In his article "Investing: Profession or Business?" (link launches a PDF file), Legg Mason's chief investment strategist Michael Mauboussin shows some interesting data about fund managers who have beaten the market on average over a 10-year period.
They play fewer hands
Twenty-seven of the 31 managers on the list held their stocks for two years or more. Eighteen of the managers held their stocks for four years or more.
They bet big on their best ideas
Those 27 managers that held their stocks for at least two years had 37.4% of their assets in their top 10 holdings. Those 18 managers that held theirs for at least four years had 46.1% of their assets in their top 10 holdings.
They beat the market over time
Those 27 managers who invested with patience and made big bets on their best ideas beat the market by an average of 2.3 percentage points after taxes. Based on my analysis, those 2.3 points over 10 years on a $100,000 investment earns an extra $55,000. Not exactly chump change!
Some hands to play
Today, many of the best value investors are saying that even though small caps continue to be hot, large caps offer some attractive possibilities for good returns. Some names that come to mind are Wal-Mart (NYSE:WMT) and eBay (NASDAQ:EBAY).
Wal-Mart is a great business that generates good returns and lots of cash. However, the stock is down from its all-time, wildly inflated price of $69.12 back in December 1999, when it was trading for more than 50 times earnings.
Today, Wal-Mart is a stronger business with a much better valuation. Will it average 25% annual returns for the next 10 years? No way. But at these prices, the odds are much better that it will outperform the market over the next 10 years (and it should do it with less risk, as Wal-Mart is probably not going out of business anytime soon). So Wal-Mart could be an interesting way to steal some antes from the market.
eBay is a fascinating yet misunderstood company. Most people see eBay as an online flea market. I don't think that's quite right. I believe eBay is in the business of creating and monetizing markets, and performs its job very well. I calculate its return on invested capital as being 20% last year, excluding its investment in Skype at the end of the year.
Today, worry surrounds the company. Analysts are worried about slowing growth and the lack of a catalyst, investors are worried that eBay forked out too much money for Skype, and everyone is worried that Google (NASDAQ:GOOG) has eBay in its crosshairs.
I don't see it that way. I see an incredibly strong business model with a moat full of spikes and alligators and boiling oil. That's because eBay's interactive networks (auction site and PayPal) create strong bonds between buyers and sellers, making switching costs very high and generating a significant competitive advantage. And Skype should reinforce those bonds and help facilitate the growth of its fixed-price business by efficiently bringing together buyers and sellers to share information. eBay's stock is not cheap today, but I think this is a situation where calling at today's prices to play for a flush draw after flopping two hearts could take a very large pot.
Some tough hands to fold
Not investing in stocks that are going up fast is just as tough as folding a good poker hand (pocket jacks) because the odds of winning are not in your favor (the flop comes down ace, king, 4). Take, for instance, energy drink maker Hansen Natural (NASDAQ:HANS). It's a great business that's growing fast. But why would I pay a price-to-free cash flow ratio (P/FCF) of 52 for Hansen Natural when Motley Fool Inside Value selection Coca-Cola (NYSE:KO), with its lasting franchises and huge cash flows, sells for a P/FCF of 25?
Fast-food restaurant Chipotle (NYSE:CMG) is another example. I love its made-to-order business model, I love its food, and I love its growth opportunities. However, I didn't like the frenzied following who drove up the price post-IPO. It's tough to pass up a story like that, but you can't always play over-priced stocks -- the ace or the king on the board could very easily get paired up and beat our pocket jacks.
The Foolish bottom line
Great poker players and great investors have patience and discipline. Neither makes money over the long run chasing pots or hot stocks. Instead, they pick their battles very carefully and have the courage to place big bets when the odds of winning are in their favor. And as the data shows us, those types of investors make considerably more money over time.
At Motley Fool Inside Value, we try to exhibit that same patience and discipline. Our service wants to find the market's dream stocks -- not be the sucker at the table. If you want two stock picks a month and free access to our entire lineup of recommendations, click here for a free 30-day trial to Inside Value. There's no obligation to subscribe.
This article was originally published on June 9, 2006.
Retail editor and Inside Value team member David Meier does not own shares in any of the companies mentioned. He is currently ranked 619 out of 20,943 investors in the Motley Fool CAPS rating service. You can view his TMF profile here. Wal-Mart, Legg Mason, and Coca-Cola are Motley Fool Inside Value recommendations. eBay is a Motley Fool Stock Advisor pick. The Fool takes its disclosure policy very seriously.
