We had the pleasure to be interviewed by Marc Lichtenfeld, the Chief Income Strategist at the Oxford Club. We talked about short selling strategies (Hint most investors should just avoid it) and about contrarian thinking.
“The stock market is filled with individuals who know the price of everything, but the value of nothing.” – Phillip Fisher
“Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to…the operating results of his companies.”
–Ben Graham, The Intelligent Investor,
At Investing 501, Gregg and I try to help others improve their investment process by sharing our experiences on Seeking Alpha. One of our more popular articles was entitled, The Illusion of Control, which discussed how investors could improve their investment process by focusing on understanding businesses and how to value them and by not constantly trying to find that “new” piece of information that would bring more clarity to an investment idea. The stark reality is that we have significantly less control over our investment outcomes than we want to believe. We also posted an article on our blog entitled, “What are you hoping to gain by checking that stock price right now?” We consider the act of frequently checking stock quotes and looking at price charts to be part of the pursuit of trying to find “new” information and doing so can be detrimental to the performance of a long-term investor. In this article I will expand on the previous articles.
Next time you feel compelled to look up a stock quote, write down why you want to know what the stock is doing. After you know the quote, write down what you think you gained by doing so. How does that revelation help you in your long-term investment thesis on the company? If you truly believe that you are going to hold a stock for a few years, how does knowing what the stock is doing today add value to that thesis? There might even be some proximate news item (earnings perhaps) that is apparently driving the change in the stock price. If you are buying stocks with low valuations, the company is usually struggling from an operational standpoint. Turnaround results are not linear. The chances you bought the stock right before turnaround happens and therefore all stock price reactions to “new news” is positive is very low. My guess is there will be more negative stock price reactions to “new news” initially. Stop looking for validation of your long-term investment premise in the daily, mostly random, movements in stock prices.
The hardest thing about investing is isolating the elusive, always-different, information from the noise.
We love reading commentaries from a wide variety of investment firms. We read them to find potential new ideas or just to learn something new about analysis or investing. We thought this passage from the Frank Fund’s Q2 2013 commentary was spot on. The entire commentary is worth a few minutes of your time.
“With every investment case there are mountains of potential information available. To paraphrase Kathryn Staley from The Art of Short Selling, where creativity and experience come into play are boiling down the mass of numbers to “the most important thing.” Every buy or sell decision, long or short, should come down to a “most important” set of data, and the hardest thing about investing is isolating this elusive, always-different, information from the noise. As with Mr. Sabella’s problem of the day, it has nothing to do with the textbook, so you must draw on experience and creativity.”
This is a guest post from our friend Shaun Currie. Thought it was timely. And we do like sports betting!!!!!
It’s that time of the year – March Madness, the time of year in which brackets are in full bloom. But this year, there is a little more incentive to participating: Quicken Loans (with the help of Warren Buffett and Berkshire Hathaway (BRK.A) (BRK.B)) will award $1B to a participant that can get a perfect bracket. Though it’s unlikely that anyone will actually win the grand prize, top finalists will win $100,000 each (not a bad pay day for a free bet!). So the question is: How can I improve my chances of winning?
Well, since we talk about stocks and investing so much, let’s use some of this knowledge to try and give ourselves an edge in bracket-picking. I wrote this article because the skills we use to pick stocks and create portfolios are directly applicable to picking brackets. Plus, it’s just fun to talk brackets.
Where Is There Value?
We all know that there is a big difference between perception and reality. What a stock (or team) trades for (what its seeded) can vary drastically from its true value. For this portion of your analysis, I suggest that you take a look at some of the leading websites, like sagarin.com or kenpom.com, to get a ranked listing of the teams based on their statistical value (it’s the closest thing we can get to “valuation” for this practice).
If you see a 4 seed ranked 41st in the country, then maybe you shouldn’t think of them as a “4 seed” in your brackets. There’s a chance that this type of team might only be in the tournament for a “short” amount of time. Likewise, if you see Louisville as a 4 seed, yet they are ranked in the top 5 overall, it could be time to take them “long” into the final four.
What Is The Market Pricing In?
One fact to note for you brackets: In the first round, its typical for 8-12 upsets to occur. This is defined as a higher seed beating a lower seed. So how do you pick an upset? First, I suggest that you don’t take Weber State or Coastal Carolina. I know how bad you want to swing for the fences and be the person to call it, but it’s not happening – A 16 seed has never beat a 1 seed, and it won’t happen this year either.
In order to properly find upsets, I suggest that you put your “trader hats” on and ask: What is the Market pricing in?
For this, we will look at what market participants (bettors) are pricing in (through betting lines, or what investors would call “quotes”) for the individual games:
|8 seed vs 9 seed|
|Team (SEED)||Spread (Team on Left Favored)||Team|
|Pittsburgh (9)||-6.5||Colorado (8)|
|Oklahoma State (9)||-1||Gonzaga (8)|
|Memphis (8)||-2.5||George Washington (9)|
|Kentucky (8)||-4||Kansas State (9)|
|7 seed vs 10 seed|
|Team||Spread (Team on Left Favored)||Team|
|Texas (7)||-2.5||Arizona State (10)|
|UConn (7)||-4||St. Joseph’s (10)|
|New Mexico (7)||-2||Stanford (10)|
|Oregon (7)||-2||BYU (10)|
As you can see, “the market” is pricing in that two 9 seeds will win their games. Additionally, the market is also pricing in that it is less likely Kentucky loses its first round game than it is that Oregon does in a 7 vs 10 game. I like to look at this analysis to get a feel for “market participant perception” just as I would if I were trading.
Just to note, I think the best way to use this strategy is relative to others games on the same line (like comparing all 7 vs 10 games against each other, just like we do when comparing metrics on similar companies).
When In Doubt, Pick Teams That Have Done A Good Job Lowering Transportation Costs
After you have done all of your analysis, if it’s still too close to call, I suggest you take the team that is closer to home. There’s a better chance your fans show up, you don’t have to worry about time zone changes (like being an west coast team that has to play at noon on the east coast), and it just makes it easier to focus on the game, which could result in a better performance. Good luck to any team that has to play Syracuse in Buffalo, NY or Duke in Raleigh, NC.
Don’t Fall In Love With A Stock (Or A Team)
Do you have that one stock in your portfolio that has never really made you money, but you don’t want to sell it because you have convinced yourself that you’re in it for the long-haul? Chances are picking your bracket in the same manner will result in equal dissatisfaction. Maybe it’s your Alma Mater, or maybe you watched them as kid, or maybe “Pounce the Panther” out of Milwaukee is just the coolest thing you have ever seen; BUT I’M TELLING YOU NOW, DON’T PICK THEM!
Come’on, this is $1B we’re talking about here, straight from the Oracle’s pocket himself! Look at the data, form a thesis, and make the right selections. I promise that Pounce the Panther will forgive you.
It’s OK To Hold Onto One Flyer (But Only For A While)
Now I know this sounds like somewhat of a contradiction with the section above, but it is OK to hold onto one long shot into the sweet 16. Usually, at least one double digit seed makes the second weekend. Again, it’s not Pounce the Panther, but a team in the 10 to 13 seed range making the sweet sixteen is realistic. Some names I think have a higher likelihood include:
(12) North Dakota St or (13) New Mexico State
I will note though, odds say that the second weekend is the last weekend for these teams, so let’s take our gains in the sweet sixteen and not advance them any further.
So overall, we’ll let one speculative pick slide because the odds say it makes sense. Plus, it’s fun to root for the underdog; we’ll just call it our own personal Plug Power (PLUG)!
Trust In Good Management Teams
Just like investing in companies, teams should be given a premium valuation if they have strong management teams, or in this case very successful coaches. Teams like Michigan State, Louisville, Duke, Syracuse, Florida, and Kansas should be given a little extra value when filling out your bracket because they have experienced coaches that have won championships before. When it comes down to the final minutes of the game, wouldn’t you want to make sure that your picks are in trusted hands of coaches that have a history of strong execution? I know I would.
Make Sure “Blue Chip” Teams Are Weighted More Heavily In Your Bracket
Just like when you construct a good portfolio in order to minimize risks, make sure that your final four is weighted more towards the top teams. It’s fine to have a bunch of small positions (early round wins) in some of the speculative teams, but make sure that your core portfolio (the big games) holds top 10 teams. I have provided the top 10 list from Kenpom.com, a leader in statistical analysis on college basketball, below:
As tempting as it is to include the Ivy League in all the fun, I plan to have all of my final four picks come from the list above.
Risks For This Bracket Strategy Include:
- There are no risks its free!
OK, well if you want some risks (because we have to always ask ourselves “what’s the downside”)…
- You could lose your job because you spend the next 8 hours working on your bracket, and maybe your boss isn’t a basketball fan
- You could be reading this article, thus missing out on another article that could be making you money in the markets (but I’ll note: 1. This is a lot of fun so I don’t really think you’ll mind, and 2. I have you covered – just check out my Top Ideas for 2014 Article)
- I could be totally wrong and Pounce the Panther could be hoisting the trophy on April 6. That’s the fun part about March Madness: Anything can happen!
I hope that you enjoyed this article. I considering it a fun exercise on how to use your investing skills in other areas, and I hope that some of the information above helps you fill out your brackets better. I wish you the best of luck in March Madness! (well, best of luck to everyone except Warren Buffett.)
(My apologies to Mr. Buffet in advance – I’m a big fan)
Experience has taught us that the management of return is impossible – outcomes are extremely unpredictable in investing and timing is uncertain at best. Consequently, we focus on what we can control – process.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson
I will be the first to admit that over my 30 years in the investment field, I have wasted a significant amount of time checking stock quotes. I am also convinced that my investment returns would have been higher if I had used that time reading SEC filings and annual reports or listening to presenations or talking to other investors about ideas. Frankly, unless an investor is looking to buy or sell a stock right then or use it to calculate an enterprise value while doing research, there is little need to look up the current stock price of a company. If you are really intending on holding an investment for years, does it really matter that the stock is up or down 1% or even 5% on any given day?
Many investors think that there is a certain amount of informational content in the daily random price movements in stock. They tend to worry about what “they” know and “why” their trading is moving a particular stock price. It is my experience that rarely do “they” really “know” more than anyone else and if they are acting on information you do not know, it is almost always very short-term in nature (whisper number on earnings) or illegal (merger news) and rarely is it something fundamentally significant in the long-term. I would argue that almost every negative “surprise” that drives a stock down is actually listed as a risk in the risk section of the 10K. Good analysts and investors attempt to weigh those risks against the financial strength of the company and current and potential future valuation under “normalized” operations before they even invest. Therefore, much of the “new news” investors are reacting to should have been incorporated in the long-term investor’s analysis (both macro and company specific, good or bad).
We have pointed out numerous times about how most successful investors think like owners of businesses rather than owners of stocks. Business owners understand that wealth is created by the accumulation of cash flows over a long period of time. How much of a distraction would it be for a business owner for someone to call him up several times a day and offer to buy his business or sell a similar one at a price that was driven in by the price quote of a public “peer”? The business owner would find the process extremely distracting and an unproductive use of his time. Yet, isn’t that what investors are doing when they check the price of their stocks multiple times a day, or even just once a week?
Next time you feel compelled to look up a quote on a stock you own, ask yourself, “why” you are doing so?
- How much does it matter to your investment thesis how others are reacting to news of the day in general or company specific news? Most successful investor letters we read often speak about a position that was acquired after a large drop in the share price due to bad earnings or other announcements. They are being proactive based on their own analysis and not reactive to “new news” which they have considered in that analysis.
- If the stock is up X percent in a day, do you feel some sort of satisfaction or vindication? If the stock is down Y percent, does it make you feel uncomfortable or anxious? Does it matter that there is a news story that supposedly explains the proximate cause of that reaction?
- Many times when a stock price has changed more than 1% or so during the trading day, there is usually a news story associated with it that is attempting to explain the proximate cause of the change. How often do you find the explanation additive to your investment thesis?
In a previous post, I talked about using the right side of your brain to improve your investment process. The post also talked about Charlie Munger’s idea of “invert, always invert” when analyzing a company. I am going to suggest another way investors can “invert” to help their investment process. Oscar Wilde has been quoted as saying, “A cynic knows the price of everything and the value of nothing”. I think many investors fall into the same trap. Ask an investor or an analyst the price of a stock, they might be able to tell you off the top of their head what it is. But ask them what market cap that represents or what enterprise value to EBITDA ratio or free cash flow yield and you will most likely get a puzzled look. If you really do have to look at stock prices frequently, I would suggest setting up your quote page in a totally different way than the traditional, Open, High, Low Close format.
Instead of setting up your stock quote page to show stock quotes, set it up using valuation metrics. Pick a couple of metrics that you use in your investment process. A few metrics that we find useful are price to book value, EV/EBITDA, free cash flow yield, dividend yield and EV/revenue. I believe you will find that your emotional reaction to big changes in stock prices will start to change. Let’s use a very simple example of a stock trading at $10 a share and at that price the stock is also trading at 10X EV/EBITDA. If the stock were to drop 10%, on a typical quote set up the stock would show $9 -$1.00 (-10%). However, if we set up the quote page so that the number we see is the EV/EBITDA and set up the color code as lower is better, we would see that the stock is now trading for 9X EV/EBTIDA and the 1X decline is GREEN or positive. Investors have been so conditioned by looking at stock prices that green is good and red is bad, we can use this set up to trick our mind into understanding that lower stock prices (generally speaking) are GOOD for long-term investment returns. It has been said that there are no bad assets, just bad prices. Assuming no significant permanent impairment to long-term cash flows, as the valuation of an asset declines, its expected return increases.
Another thing you will start to see that a 1% or 2% or even 5% change in the price of a stock has little impact on the valuation of the company. Using the example above, a 2% change in the price of the stock would mean that the EV/EBITDA changed from 10X to 9.8X. I would hardly call that material, even though seeing a 2% decline in a stock in a day may feel bad. Need another reason to try this? Studies have shown that equity valuations change 19 times the underlying fundamentals. So even rather large relative changes in stock prices, which feel like they represent an adequate re-pricing of “new news” usually overstate the true change in the long-term fundamental valuation of the company. Yes this is overly simplistic. Stocks do not decline 10% in value in a day for “no reason”. Earnings estimates are most likely to be lower after such a decline, but the company’s book value probably won’t change much and neither will the long-term earnings power. This is not so say that our original thesis is not wrong and cannot change based on current events. But as a business owner, we are spending our time thinking about the long-term competitive strengths and weaknesses of the company and should understand when the near-term results may in fact be signaling a change in our thesis.
If you set up your quote screen in the way I suggest, I think you will find yourself looking at it less often because valuations don’t change as much day to day, reducing the “entertainment value” of looking up stock price movements. I think you will find your investment returns will improve over time and you will spend more of your investment process time reading annual reports, SEC filings, transcripts of conference calls and presentations and searching the internet for relevant information on the company or its products.