Sunday, May 22, 2016

Investment Selection: “Horses for Courses”


Each tool has its best single application. Each investment strategy has its best single application. In a similar fashion horse racing professional handicappers have often stated that there are "horses for courses." Meaning certain horses run better at certain race tracks than others. The most productive implementations of these choices are often the function of changed conditions from the immediate past.

As fund performance analysts and investment managers we have been urged to proclaim that past performance does not guarantee future results. Nevertheless all too many institutional and individual investors use past performance and particularly recent past performance as their primary selection screen. Many have taken this to the ultimate decision by investing the bulk of their money in Index funds.

The source of much of my analytical thinking came from handicapping horses races which is what track aficionados call analysis. The daily Bible reading for handicappers is the Daily Racing Form, (in  my day it was the Morning Telegraph.) In these pages the racing record of each horse is shown. From an analytical standpoint what I find of greater value than number of winning races are the conditions of the race to include which track, distance, time of the winner, time of the particular horse, weight carried relative to others, training times and conditions,  plus the names of the sire, dam, and sire of the dam and finally the conditions of the track. Professional analysts and portfolio managers can translate these factors into various selection screens in picking stocks, managers, and funds.

Selecting Investment Strategies for Different Portfolios

When choosing a bet in a race it is wise to start looking at the most popular which is called the favorite. The favorite is based on the most money being bet, not necessarily the horse that has the highest probability of winning. At the track and around the Investment Committee table most decisions are based on avoiding embarrassing losses, not optimizing the chances of large winnings.

The way I handle this challenge is not to bet on each race or every stock that is currently performing well. This tends to produce fairly concentrated portfolios of stocks, managers, and funds. The long-term (but evolving) focus is on a high aggregate dollar win/loss ratio. If you will, I am describing a contrarian bettor. However, as a contrarian, I should not disregard the weight of money bet on the favorite. This is even more true in investing than at the track because by definition popular stocks attract cash flow. In the short-term some investors can make them appear to be right.

Understanding the Investment Favorites

According to Moody’s* “Globally 10% of all public companies account for 80% of all profits.” Therefore these companies have less credit risk for their bonds. Also, almost by definition, they are large capitalization equities. With the goal of reducing the chances of losses, most investors prefer large-cap stocks or funds. This is particularly true for endowments. 

Endowments are one of the four TIMESPAN L PORTFOLIOS®, and depending upon on the needs of the account can be aggressively or conservatively invested.  Many of the standard endowment portfolio managers are getting frustrated as it has been a year on Monday since the S&P500 has hit a new high, and for the last four weeks the DJIA has been declining. (Perhaps there is some validity to the pre-air conditioning ditty of “Sell in May and go away.”)

The frustrated investors, the media pundits, and the various sales forces have not been paying attention to Charlie Munger, Warren Buffett, and their two investment associates. As a group, Berkshire Hathaway* has been selective long-term buyers of stocks and companies. As the oracles of Omaha have often said, they like declining markets for their long-term holdings. Despite what they recommend for others, they are not buying an S&P 500 Index, they are selectively buying a small collection of Large, Mid, and Small-Cap stocks.

I believe that size does not define a stock as a good investment, but due to size many stocks have increasing difficulty making progress. (This does not mean that investors are blind to the attractiveness of some Large-Caps in their recent purchases of Apple*, IBM, and Wells Fargo*.) One of the reasons that they are more active now than when there is more enthusiasm in the market is Charlie Munger’s belief that is wise to buy a good company at a reasonable price rather than a less good company at a good price.

Applying Betting Principles to The Preakness

In a postscript to my blog that commented on The Kentucky Derby,  I urged bettors not to bet on its winner to Win the second race of the Triple Crown for 3 year-olds. I suggested to find a good Place bet. (A Place bet pays off if the horse comes in first or second, a Show bet pays off if the horse comes in first, second or  third. The pool  of money that is used to payoff winning bets is divided into three parts for a Show ticket, two parts for a Place ticket and one part for the Winning ticket.  Thus it is normal that winning tickets pay more than Place tickets and Place tickets pay more than Show tickets.) I felt the dollar odds would be larger if the Derby winner came in first. This was before I knew that the track would be muddy on Saturday, and based on past experience was an advantage to the eventual winner. Racing luck and jockey skill  produced the result. Regardless of the change in track conditions, my suggestion to make a Place bet on a non-favorite was valid.  On a money basis a $2 Place bet paid $3.20 whereas the favorite, which came in third, paid $2.20.

*Stock owned in a managed private financial services fund and/or personally.

Question of the Week: What methods do you use when investing in Large-Caps and Small-Caps?
Did you miss my blog last week?  Click here to read.

Did someone forward you this Blog?  To receive Mike Lipper’s Blog each Monday, please subscribe using the email or RSS feed buttons in the left column of 

Copyright © 2008 - 2016
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

No comments: