Introduction
Sam Zell, Charlie
Munger, Warren Buffett, The Kentucky Derby betting, and the laws of economics were this week's input to
my investment thinking. The common theme of my reactions to each of these
inputs is that an understanding of odds leads to better investment decisions.
Odds
Odds are the generally
expected returns on successful execution of an action. Every single thing we do
is premised on the conscious or unconscious expectation starting with our
getting out of bed in the morning. Either we accept the odds set by others or
we believe that there will be a higher payoff than generally expected.
Sam Zell
I had the pleasure of
attending "A Conversation between Lee Cooperman and Sam Zell" at The
New Jersey Performing Arts Center last Thursday night. Sam is a very much a
self made billionaire through many entrepreneurial ventures largely built
around real estate. Similar to our friends at Marathon in London, he is a believer
in the capital cycle. They are attracted to investment opportunities when
capital has been removed and are sellers when there is a rush of new capital
entrants. They like unique assets where there is limited competition. This is
not real estate today. As a singular buyer, he has improved his odds. (He is
the chair and a large shareholder of a non-real estate public company with
limited competition in which I happen to own a few shares.)
Charlie Munger
Charlie Munger's family
hold a large family dinner the Friday night before the Berkshire Hathaway
annual meeting. He has been a major educational input to his senior partner,
Warren Buffett which Warren states is one of the reasons for many of the
successes of the company. I am combining Charlie's comments at the dinner and
at the meeting which can be summarized below:
Warren
Buffett
One of my sons and I go
to the Berkshire Hathaway annual meeting with perhaps 40,000 others. We view
this as a learning experience as to investing principles and a review of
business conditions at the entrepreneurial level. While it is difficult to
summarize five and half hours of questions with some answers, there were a
number of points made that were useful to us as portfolio managers shown below:
Betting
on The Kentucky Derby
I was asked who to bet
on in the historic Run for the Roses race. I had not the time or the
inclination to spend time on handicapping or analyzing these immature three
year old horses in the spring. However, I did say that the horses that had odds
of around 5 to 1 made sense and that at least one of the three top finishers
would be a long shot. The table below shows the payoffs on a two dollar bet in
each of the winning pools-to win, place, or show:
The
Winner
|
$11.40
|
$7.20
|
$
5.80
|
Second
|
$26.60
|
$18.20
|
|
Third
|
$20.80
|
For investors the
importance of this table is not that I was conceptually correct, but it
illustrates the importance of odds to making money. Often one can make twice as
much on betting on long shots to do almost as well as the winners. (For those
track aficionados my analytical bet for the 2018 race without knowing who is
running is that the favorite will not win. After five straight years of the
horse with the lowest odds winning, I am guessing that a horse with greater
odds than the most popular horse will win.
This is similar to the exercise of looking for attractive stocks to buy for
the next year by studying the new low list rather than the new high list.)
However not every long
shot has the same chance of doing well. The third best horse was never worse than
fourth out of twenty throughout the race. While the second best got up to
second best by the beginning of the final stretch drive. In picking horses and
stocks the odds is not the primary filter to make money but a reasonable
analysis that the horse or company behind the stock can be successfully
positioned to do well. In both cases picking unpopular horses or stocks is
based on a somewhat courageous view to bet against general perceptions, being a
contrarian by nature I am willing to explore such a bet. However, it is
important to understand that just like in The Kentucky Derby, favorites do
occasionally win.
Are There Any
Laws and Constants in Economics?
A Brief Comparison to the Sciences:
One of the advantages I
have is to be a member of an informal investment group of retired and semi
retired analysts, portfolio managers, and institutional sales people who
regularly share ideas and research. The above titled article from the Journal
of Contemporary Management by Harold Vogel was recently circulated. What does
this erudite article have to do with the concept of odds? The connection is
that the author does a good job showing the various "laws" and
"constants" that various economics proclaim don't hold to the same
level of rigor we expect from scientific laws. In essence these so-called laws
and constants work some of the time, maybe even most of the time. Further, it
is reasonable to expect that there will be some conditions in the future when they
may not work. Thus, it would be wise to view these inputs through some lens of
probability or under my construct, odds. This is particularly important as
various central banks and government officials treat these as immutable laws
that will always work. This has not been the case in the results of either our
fiscal or monetary policies.
As bad as the
"dark science" of economics has been, the impact of its errors when
applied to investments is much worse. Conceptually, the error rates of the
economists are multiplied by professional investors. To protect us poor
investors I suggest that we should develop a mechanism of putting some odds
around the different proclamations of well known economists and investment
pundits. These proclamations should not be totally ignored because we have just
shown that popular views as measured by favorites at racetracks do occasionally
win. Nevertheless, my approach is to construct odds or if you prefer, discounts,
to various public statements.
Putting Odds
on Where There is No Experience
The current editions of
one of my favorite magazines, Barron’s has a cover story
entitled "Income: The Best ETFs for Yield.” I have no problem using a
collective vehicle as a way to invest in fixed income. This is becoming very
popular. According to my old firm, iBoxx $ 1 G Corp Bond ETF had the highest
net inflows of the week of all ETFs, totaling $412 million.
My concerns are first
that the ETF trades many times a day, some of the underlying bonds trade
rarely. While the popular press thinks most of the flows around ETFs is from
individual investors, I suspect most of the trading is done by institutional
investors, often hedge funds and other professional traders. Often these trades
are done in combination with other trades combining long and short positions.
This is a cheaper way to do these trades than through their prior habit of
using futures. Except in the special case of Vanguard who has been able to
create an ETF class in their low cost open end funds, most of the other funds
can't absorb a large amount internally, they will have to find a buyer for the
ETF's selling specific bonds.
In addition, most ETF
transactions pass through "Authorized Participants" who act as did the
old specialists did on the floor of the stock exchanges. There are often a
small number of "APs" for each ETF. These dealers often make markets
in other securities as well. The old specialists used to have known levels of
capital which was closely supervised by the various exchanges. These artifacts
don't seem to be in place in today's world.
My concern is that at
some unknown point in the future the major hedge funds and other traders will feel
compelled to quickly liquidate their fixed income and perhaps other thinly
traded security ETFs. Some of the thinly capitalized ETFs can not absorb the
sudden waves of selling at the same time
the sponsors of the ETFs can not absorb the continuous waves of selling.
It is important to
declare this has not happened....yet. But it did to the old single stock
specialists on the floor of the exchange. My concern, just like various
economic laws and constants not working, there could be a liquidity crisis in
the ETF world.
My suggestion is that
wise investors assign some chance of this event and monitor the relevant
conditions.
My
Investment Conclusions
As every single thing
we do involves some chance of favorable and unfavorable results to develop an
awareness of chance or odds, I recommend building investment portfolios with
different odds of positives and negatives. This approach may generate uneven
statistical results, but its most important characteristic is focused on the
need to survive under numerous difficult conditions.
What
do you think?
__________
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A. Michael Lipper, CFA
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