Sunday, May 7, 2017

We are All Odds Players


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 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:

  • Learning is the key to their success. They have learned from their numerous past mistakes. Warren is a learning machine. Proof of his learning is the Apple purchase.

  • Charlie would be willing to put $150 Billion to work if they had the right opportunity.

  • China will do very well in the future due to the character of the people.

  • As a business, BYD is building well in terms of people and products. Looks for big returns with favorable odds.

  • 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:

  • They look for competitive advantages. Often they are the only choice for an entrepreneur who wants to sell a private firm, that wants to take good care of loyal employees.

  • Medical costs are the tapeworm that is growing in corporate expenses.

  • In 2017 there is a slight bias in favor of recognizing losses.

  • Trying to be a genius is dangerous.

  • Opportunities are more difficult to find.

  • The five largest operating companies within the S&P500 generate enough capital that they do not need any new equity capital.

  • Very, Very IMPORTANT: In some cases Intellectual Capital may be more important that Financial Capital. I also suggest customer capital in terms of relationships(at least in the financial services businesses) should be valued more the cash capital.

  • 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
    $ 5.80 



    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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