Common stock picking shall be touched on, we’ll not be going into emerging markets, bond arbitrage, or any other “sophisticated” financial instruments.
The first question to ask is, “What’s the nature of the stock market?” And that gets you directly to this efficient market theory that got to be the rage taught at all business schools. It states that at any point, at any time, the market is always efficient, that is to say the price always adjust very quickly to reflect all the news of a business. Simply, it means that no one can beat or perform better than the average of the market. Those who do are plain lucky.
So the next question is to ask, “Is the stock market so efficient that people can’t beat it?” Well, the efficient market theory is only roughly right – meaning that markets are quite efficient and it’s quite hard for anybody to beat the market by significant margins as a stock picker by just being intelligent and working in a disciplined way.
Surely, the average result has to be the average result. By definition, everybody can’t beat the market as it is an average. But the iron rule in life is that only 20% of the people can be in the top fifth. That’s just the way it is. So the answer is that it’s partly efficient and partly inefficient.
Then there are people who went to the extreme efficient market theory by doing extreme research. It was just an intellectually consistent theory that enabled them to do pretty mathematics. So obviously when things get complicated, it gets a little more seductive to people with large mathematical gifts. The problem is they have a difficulty in that the fundamental assumption does not tie properly to reality. Again, to the man with a hammer, everything seems like a nail. If you’re good at manipulating higher mathematics in a consistent way, why not make an assumption which enables you to use your tool?
If you think about the pari-mutuel system of the racetrack, pari-mutuel system is essentially a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in a stock market.
Any fool can see that a horse carrying a light weight with a wonderful win rate and a good post position and etc. is way more likely to win than a horse with a terrible record and extra weight and so on. But if you look at the odds, the bad horse pays 100 to 1 while the good horse pays 3 to 2. Then it’s not clear which is statistically the best bet using mathematic. 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 the rest of the betters, but you have to outwit them by such a huge margin that on average you can afford to pay the 17% of your gross bets off the top to the house before the rest of the money can be put to work.
Given those constraints, is it possible to beat the horses only using one’s intelligence? Intelligence should give some edge because a lot 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 incline could have a very considerable edge, in the absence of the frictional cost caused by the house take.
Unfortunately, what a shrewd horseplayer’s edge does in most cases is to reduce is average loss over a season of betting from the 17% that he would lose if he got the average result to maybe 10%. However, there are actually a few people who can beat the game after paying the 17% house take. Then perhaps these people would bet only occasionally when he saw some mispriced bet available. And by doing so, after paying the full take by the house, he made a substantial living.
You have to say that’s rare. But the market was not perfectly efficient. And if it weren’t for that big 17% take, lots of people would regularly be beating lots of other people at the horse races. It’s efficient but not perfectly. And with enough shrewdness and dedication, some people will get better results than the others.
The stock market works about the same way except that the house take is a lot much lesser though I would say it is still very substantial. If take transaction costs – the spread between the bid and the ask plus the commissions – and if you do not trade too actively, you are talking about fairly low transaction costs. So that together with enough dedication and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things. Of course, like the nature of things, 50% will end up in the bottom half and 70% will end up in the bottom 70%, you can’t change the nature. But some people will have an advantage and they ends up in the upper tier of the class. And in a fairly low transaction cost operation, they will get better than average results in stock picking.
How do you get to be one of those who is a winner – in a relative sense – instead of a loser?
Again, look at the pari-mutuel system. In the whole history of people who’ve beaten the pari-mutuel system is quite simple – they bet very seldom.
It’s not given to mankind to have such talents that they can know just everything about everything all the time. But it is given to humans who work hard at it – who took and sift the world for a mispriced bet – that they can occasionally find one. And the wise ones bet heavily when the world offers them the opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.
It’s such a simple concept but yet, in investment management, practically no one operates that way. A large majority of the investment community have some crazy ideas in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, they’ll come to know everything about everything all the time. That’s insane. The way to win is to work, work, work, work and hope to have a few insights.
So how many insights do you need? Well, you don’t need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated millions, the top ten insights account for most of it. That doesn’t means the man operating Berkshire has got only ten insights. It is just that most of the money came from ten insights.
So you can get very remarkable investment results if you think more like a winning pari-mutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced bet or something. And you’re probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. It’s just that simple.
Warren Buffett preaches that “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches – each representing all the investments that you got to make in a lifetime. And once you’ve punched through the card, you couldn’t make any more investments at all.”
He says, “Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”
This is a concept which is pretty straightforward and obvious but yet, this one of the few idea which very few business schools will teach – simply because it isn’t a conventional wisdom. It is obvious because the winner has to bet very selectively.
Why then it isn’t obvious to the rest? The reason could be like in this story about what someone told a guy who sold fishing tackle. Someone ask the seller, “My god, they’re in purple and green. Do fish really take these lures?” and the sell said, “Mister, I don’t sell fish.” Investment managers are in the position of that fishing tackle salesman. They’re like the guy who was selling salt to the guy who already has too much salt. And as long as the guy will buy salt, they’ll sell salt. But that isn’t what ordinarily works for the buyer of investment advice. On Wall Street, they will sell anything that you will buy – quality control is never prized.