Charlie Munger’s Recipe for Beating the Pari-Mutuel Market
April 6th, 2009
Warren Buffett’s long-time business partner Charlie Munger compares in his excellent book,Poor Charlie’s Almanack
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 race track. 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 damn 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 seventeen percent off the top. So not only do you have to outwit all the other bettors, but you’ve got to outwit them by such a big margin that on average, you can affort to take seventeen percent 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 using only 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 absense of the frictional cost caused by the house take.
Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce his average loss over a season of betting from the seventeen percent that he would lose if he got the average results to maybe ten percent. However, there are actually few people who can beat the game after paying the full seventeen percent.
I used to play poker, when I was young, with a guy who made a substantial living doing nothing but bet harness races. Now, harness racing is a relatively inefficient market. You don’t have the debt of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness as his main profession. And he would bet only occationally when he saw some mispriced bet available. And by doing that, after paying the full handle to the house - which I presume was around seventeen percent - he made a substantial living.
You have to say that’s rare. However, the market was not perfectly efficient. And if it weren’t for that big seventeen percent handle, lots of people would regularly be beating lots of other people at the horse races. It’s efficient, yea. But it’s not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.
The stock market is the same - except the house handle is so much lower. If you take transaction costs - the spread between the bid and the ask plus the commissions - and if you don’t trade too actively, you’re talking about fairly low transaction costs. So that, with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.
It is not a bit easy. And, of course fifty percent will end up in the bottom half, and seventy percent will end up in the bottom seventy percent. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.
How do you get be one of those who is a winner - in a relative sense - instead of a loser?
Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three bettors who have a credit arrangement with the track, now that they have off-track betting, who are actually beating the house. The track is sending money out net after the full handle - a lot of it to Las Vegas, by the way - to people who are actually winning slightly, net, after paying the full handle. They are that shrewd about something with as much unpredictability as horse racing.
It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it’s given to human beings who work hard at it - who look and sift the world for a mispriced bet - that they can occasionally find one.
And the wice ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.
The one thing all those winning bettors in the whole history of people who’ve beaten the pari-mutuel system have is quite simple: they bet very seldom.
And yet in investment management, practically nobody operates that way. We operate that way - I’m talking about Buffett and Munger.
This also reminds me what Warren Buffett wrote in his 1993 letter to Berkshire shareholders:
Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions. That judgment became ever more compelling as Berkshire’s capital mushroomed and the universe of investments that could significantly affect our results shrank dramatically. Therefore, we adopted a strategy that required our being smart - and not too smart at that - only a very few times. Indeed, we’ll now settle for one good idea a year. (Charlie says it’s my turn.)
You often hear that patience is one of the keys to Buffett’s success in investing. Earlier I thought that the patient is required after you have purchased the stock, when you are waiting for the market to discover the value, but these quotes show that the patience before you purchase a stock is maybe even more important.
Book Value - a Real Contradiction
March 28th, 2009
Let me start this blog with a little quiz:
In the following table you have two companies that are both growing at constant rate of 5% per year. These are very Buffett style companies: stable and debt free. Everything else equal, in which one would you invest?
| Widget Inc. | Gadget Inc. | |
|---|---|---|
| P/E-ratio (price per earnings) | 10 | 10 |
| P/B-ratio (price per book value) | 5 | 0.5 |
| Growth | 5% | 5% |
If you are like most of the investors, you chose Gadget Inc.. Price per earnings is the same, but the other valuation metric, price per book, shows that Gadget Inc. is cheaper. This is what Ben Graham is teaching us in The Intelligent Investor and in Security Analysis. This is also what he taught to Warren Buffett. Basically you will get what the company owns for 50% of its value. In the case of Widget Inc. you would pay 5 times what the company owns.
Let’s assume that the stock price for both companies is $10 which means that the earnings are $1 per share. The book value for Widget Inc. is $2 per share (P/B = $10/2$ = 5) and for Gadget Inc. $20 per share (P/B = $10/20$ = 0.5).
Now we can calculate the return on equity for both of the companies:
- Widget Inc: ROE = Earnings/Book Value = $1/$2 = 50%
- Gadget Inc: ROE = $1/$20 = 5%
So for every dollar invested into the business (machines, working capital etc.) Widget Inc. can generate 50 cents of earnings (50% of one dollar). Gadget Inc. will generate only 5 cents for each dollar. To grow 5% a year, which means that the earnings will grow 5 cents next year, Gadget Inc. needs to invest $1 into the business. Widget Inc. has much higher returns, so it needs to invest only 10 cents.
What this means, is that Gadget Inc. needs to invest 100% of its earnings to grow 5% a year. Widget Inc. can grow 5% a year by investing only 10% of its earnings and it can pay the remaining 90c as a dividend (9% dividend yield at the price of $10). If Gadget Inc. will keep growing and does not change its strategy, they can never pay a dividend.
Gadget Inc. works basically like a bank account with 5% interest rate with one very important difference: you can never withdraw you funds because those are needed to growth the company. The stock investors in average expect about 10% annual return, so when Gadget Inc. reinvests it’s earnings at 5% rate, they are actually destroying value.
When you are comparing different investments in general, you are naturally thinking in terms of returns you will earn. Your thinking regarding the book value of the company (i.e. the assets the company owns minus its liabilities) should not be any different; the more the assets are earning, the more you should be willing to pay. You don’t want to pay the same amount for an asset that earns 5% than for an asset that earns 50%.
Based on the information above, Widget Inc. with its higher P/B-ratio and ROE is clearly a better investment. So why would have Ben Graham - and early Buffett for that matter – chosen Gadget Inc.? Why did Graham consider the premium paid over the book value to be speculation? I think there is couple of reasons:
- Graham thought estimations of future earnings to be very uncertain
- Unlike earnings, the book value could be estimated with some certainty
- The thinking was that the company could liquidate itself and distribute the proceeds to the shareholders if its price is much below its book value. So there was margin of safety in that kind of situations.
Later on, Buffett changed his strategy and wrote, “Ben Graham wanted everything to be a quantitative bargain. I want it to be a quantitative bargain in terms of future streams of cash.” So Graham did not want to rely on the future earnings, but preferred to base his valuation on what the company owned.
Buffett confirms this difference in his speech to Stanford Law School students in 1990:
The strange thing – it’s a real contradiction – is that if a business is earning a given amount of a money and everything else is equal, the less it has in assets, the more it’s worth. You won’t get that in any accounting book.
To be fair, Graham would have probably picked the right company, if he had been told that the future earnings are 100% secure.
This same example also illustrates how good of a valuation tool the P/E-ratio is; Widget and Gadget both had the same ratio. Please also note that they have also the same PEG-ratio.
Think about all the investing books and guides you have read where the valuation is based on the above mentioned ratios. Think about all the investing services that faithfully report these ratios year after year. Return on equity (or return on invested capital for companies with debt) seems to be the missing link in the popular investing literature. Maybe we should be happy about that, because that implies that there is some hope for intelligent investors after all!
Comments are welcome.
