Sunday, June 7, 2009

Investment Lessons from the Belmont Stakes

Readers of my book, MONEY WISE, (which was published last September) will recall that the race track is one of my two great educational experiences. Thus, I look with great interest at the handicapping, (if you will, the analysis) of picking winners in the Belmont Stakes. This race is like no other race in the country. For most horses, the Belmont is the only time they will be asked to run a mile and a half on dirt. The horse that wins this extreme challenge is often viewed as the three year old horse of the year. Fewer horses enter this race than either of the first two legs of the Triple Crown, the Kentucky Derby and the Preakness. Because of the fewer contestants and the longest race, there is less chance that racing luck will be the determinant of the winner. The whole concept of well-known classic races with large purses is a showcase for the future breeding fees that young stallions can demand before their progeny start to race.

The plan to win the Belmont begins with selecting the correct stallion with the right mare to breed an eventual starter. Usually the selection process is driven by the racing record of the parents and grandparents. Our lesson plan for today is going to focus only on the first three horses to finish in a fairly tight bunch, under 3 (horse) lengths. The third placed horse was the mathematical and sentimental favorite, Mine That Bird. This rather small gelding finished first in the Derby and second in the Preakness under different jockeys, but was ridden by the jockey who won the Derby with him, and was also on the winner of the Preakness. His sire was Birdstone, who won the 2004 Belmont. His pattern of running last and closing very fast seemed ideal for this race. However, both his jockey and a number of handicappers (or if you will, analysts) recognized that if the early pace was too slow, Mine That Bird would not be passing tired horse in his late running charge. The second place winner was Dunkirk who has lots of champions in his pedigree and was bought for $3.7 million compared to the $600,000 purse awarded to the winner of the Belmont. Dunkirk ran a poor race in the Derby and was not raced in the Preakness, but trained very well coming up to Belmont. (These two horses were my picks.) The winner was Summer Bird, who was also sired by Birdstone, and did not have a good race in the Derby but was being trained for longer races.

For the purposes of our investment lessons, I want pull out a couple of facts about the race:

  1. Dunkirk was the lead horse for most of the race and was able to regain the lead after he lost it briefly, but not a second time at the end.

  2. Mine That Bird moved a little prematurely and was not passing tired horses as easily as expected.

  3. Summer Bird not only showed the benefit of his extended distance training, but also could charge up the middle of the track well wide of the leading horses.

  4. Dunkirk paid $5.40 for a $2.00 bet to Place (second).

What are the investment lessons that I draw from this race of all 2 minutes and 27 seconds?

First, as with markets, the defined future is somewhat unpredictable. The earlier than expected move by Mine That Bird changed the expected race pattern. Competitors have a way of doing that by learning new tricks. Think of Apple and the iPhone/AT&T. Second this small gelding, whose only earnings will be from racing, was the sentimental and mathematical favorite of both the bettors and the crowd. The race tracks normally publish the percent of winning favorites; rarely is the number 50% or higher. (In my novice period of handicapping at New York tracks the percentage of winning favorites was more like a third.) Most importantly, when one surrenders a winning ticket to the cashier, he/she pays out in real dollars not sentimental dollars. The lesson here is: generally stay away from where the crowds have gathered for two reasons. The first is that the greater the number of backers for a horse, by definition the odds are smaller. The second reason is that the chances of success are less. The hottest stock at some point peaks out, having sucked in all the bettors that it can and with no other buyers in sight a rapid decline is likely as owners scramble for liquidity. The phenomenon works clearly and often rapidly with individual securities. Much to my chagrin it also works with large mutual funds that become the dominant buy of a small class of securities e.g. “dot-com” stocks.

The owners of Dunkirk (or if you prefer the Damon Runyon term the horse's “connections”) appear to know what they were doing when they paid $3.7 million for this colt. After the running of the Belmont, Dunkirk has proven at equal weights that he can lead at most distances. If after this race they retire the horse to take up stallion duties, the aggregate breeding fees will more than recoup the owners’ initial cost plus operating expenses for at least the first three or four years. If the connections are more ambitious and are willing to assume the inherent risks, there are a number of classic races for three year olds that could add luster to his “Horse of the Year” crown. The title would almost be assured if he won various handicap races in his fourth year where he will be carrying more weight than others. The investment lessons with Dunkirk begin with the fact that there are some smart people with money and vision. This suggests that when looking for investment managers, one should determine whether these managers were trained in successful shops which can handle most of the different investment environments. Further, Dunkirk’s “connections” were willing to pay up for the long term benefit of owning a potential big winner. The attraction of investing in very well paid managers could be, but not completely, parallel here. In this light both winning jockeys and trainers participate in the winnings. The key to these successes is not just spending large sums of money on horses and investment managers. The execution of the day to day process of selection and training along with a clear vision of the future are also vital criteria. The vision should be based on desired competitive strengths, not extrapolations of present conditions.

The winner of the Belmont was Summer Bird. The casual reader of past performance data would have clearly missed this one, who carried 11 to 1 odds. This colt had only won one out of his prior four races. While he was sired by Birdsong, an upset winner of the 2004 Belmont, the other Birdsong sired entry; Mine That Bird had won the Kentucky Derby and a second place in the Preakness. Summer Bird did not run a good race in the Derby in the company of undistinguished rivals. Like others, I missed looking at this colt carefully. What I failed to do was what I require when looking for good managers of mutual funds and hedge funds: get a focus on them as individuals. What I missed was that Summer Bird often keeps running well beyond the finish line. When his trainer recognized this trait, and started to lengthen the distance for his training sessions, the value of the past performance data diminished. Further, I did not contemplate that this colt, in his race with two track turns, would be strong enough to race in the middle of the track and thus in effect sneak up on the then leaders.

All of these lessons are less instructive for portfolio investors than the final factoid. Dunkirk, who was clearly the second best horse in the race both before and after the race, paid $ 5.40 for a $2.00 place bet. (The pay off would have been smaller if the favorite and Dunkirk had finished in the first two.) The lesson here is that one could have a bet on any horse in the race and a place bet on Dunkirk for the same amount of money and come out a $1.40 winner. ($5.40-2.00 -2.00=$1.40) Being a $1.40 winner is not only better than being a loser, but you paid for an opportunity cost which did not work out. The lesson for portfolio investors is that in an appropriately diversified portfolio one can afford some losers and still come out ahead.

As they say at the track, “whaddya think?”

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