A $1 Billion Opportunity: NCAA Brackets Thought Out Like Stock Picks

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:

(11) Providence

(11) Iowa/Tennessee

(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:

1 Arizona
2 Louisville
3 Florida
4 Virginia
5 Wichita St.
6 Villanova
7 Duke
8 Creighton
9 Kansas
10 Michigan State

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

Risks For This Bracket Strategy Include:

  1. There are no risks its free!

OK, well if you want some risks (because we have to always ask ourselves “what’s the downside”)…

  1. 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
  2. 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)
  3. 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!

Conclusion

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)

Broyhill Investor Letter Quote.

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.

The Illusion of Control

The genesis of this post is couple of documents that I rediscovered on the ValueWalk Scribd page. The first is a speech given in 1981 by Dean Williams of Batterymarch Financial Management entitled, “Trying Too Hard”.  The second is a research publication written by James Montier called, “Seven Sins of Fund Management”.  Ironically, one of the main points made in both pieces is that investors (me included) spend too much time exposing themselves to all the informational noise that is distributed over the internet in the hope of boosting confidence enough to be comfortable with our investment decisions. As my co-founder Gregg constantly points out, over the long-run you will probably do better building a portfolio of companies that makes you uncomfortable than building one that makes you comfortableIn this article I am going to discuss why your investment process should be focused simply on understanding and valuing businesses, and being better at it than other investors. Trying to increase your confidence by gathering information that is supposedly unknown to most others really only makes you more comfortable with your investment decisions, not better at them, and is generally an unproductive use of your limited time.

 There are no answers in this business. There’s just a hell of a lot of questions.”-George Russell Jr. of Frank Russell Co.

Relative to the last ten to fifteen years, there has been a significant increase in the amount of investment-oriented information available to investors. In trying to provide investors with information that “is not in the current stock price” and therefore giving them an “edge”, many Wall Street, and independent investment research providers have begun focusing on such areas as “forensic” accounting, “channel checking”, public policy analysis, “lie detection” on conference calls, data mining and “expert” networking. Investors can find a diversity of opinion on a company because professionals and non-professionals alike publish and share their investment ideas on sites such as Seeking Alpha, Motley Fool, GuruFocus, Value Investors Club and SumZero. There are numerous investor conferences where attendees can hear ideas from “gurus”, portfolio managers, activist investors and contest winners. There are bloggers who aggregate news stories and analysis.  Investors can set up RSS feeds and use websites like Reddit to keep abreast of all the investment news they deem important. But do we really need to be doing all of this? How much information is enough and how much is too much? Let’s just say that the signal-to-noise ratio for investors has degraded substantially over the yearsIn spite of the large increase in investment information relative to the past, there is little evidence that active managers in aggregate have improved their performance relative to passive strategies. In addition, assets in passive investing strategies continue to increase as a percentage of total invested assets. Instead of lengthening investing horizons because investors have more information to make supposedly better long-term decisions, the obsession with trying to utilize all of this information has actually shortened them. Average holding periods of stock in mutual funds is under 11 months and the SPY turns over its assets once a week (investment periods which are too short for fundamental oriented investment returns to manifest themselves). It appears as though trading a stock on “the new news” has replaced investing in a real business for the long-term as an acceptable investment strategy.

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Incorporating Right-Brain Thinking into your Investment Process

The following article is the first part of a series designed to help investors develop their own investment process and increase the efficiency of dealing with the daily deluge of investment ideas that are now available to investors, thanks to the internet. 

A long time ago when I was trying to learn how to draw and paint (note: unless childlike stick figures become immensely popular I failed, which is why I became a photographer), I read a book called Drawing on the Right Side of the Brain by Betty Edwards. The idea of the book was to help a person tap on the strengths of the right side of the brain and “deepen your artistic perception” when engaging in creative endeavors. Athletes and musicians often talk about “being in the zone” and from personal experience as an investment analyst, a drummer,  and a professional sports photographer, I can tell you that you can put your brain in either a “right brain” or “left brain” thinking mode. One of the first exercises in Edward’s book is to look at a picture and draw it.  More than likely it will look “ok” but the perspective and other things may not look just right. The author then tells the reader to turn the picture upside down and draw it again. You would be amazed at how much closer to the original the second drawing looks than the first attempt. Why is that? Edwards explains that since the brain doesn’t recognize the upside down drawing as an object, the brain switches to the right side and allows the artist to “see it”  more in the abstract and not a preconceived recognizable image, which makes it easier to “draw” the lines more accurately. Since successful analysts incorporate the ability to think in non-linear, non-analytic ways; being able to tap into those aspects of the right side of the brain is very important. This idea can be thought of as “inversion.”

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An example of the mentoring process

Gregg and I have always enjoyed helping promising and ambitious young analysts improve their analytic skills. Many have gone on to have successful careers in the industry. One promising young analyst is Shaun Currie. I helped hire Shaun at Manalapan Oracle and had the pleasure to work with him for several years.  He has been accepted to several very prestigious  MBA programs including MIT, Duke, Dartmouth and University of Chicago. Before beginning his schooling in the fall, Shaun is writing research articles for Seeking Alpha.

As part of our educational section of the website, I thought it would be of interest to other young analysts to see how some input from “experienced” investors such as ourselves can help improve the analytic process.  I have posted the first and second draft of his analysis of Finish Line (FINL). I think that there is a noticeable improvement in the thought process and the presentation.

FINL-Write-up-attempt-1

FINL-Write-up-attempt-2

Here is a link to the final version of his article that was posted on Seeking Alpha. I would like to point out that my first attempt to post an article on Seeking Alpha required at least four revisions and a couple of days of work before it was posted. Shaun’s FINL report was posted within just an hour or so of its submission. Congratulations to Shaun for the publication of his first research article. We look forward to working with him in the future and wish him good luck on his pursuit of his MBA.

The Defense Industry: A First Glance – L-3 Communications Is The Leader In The Clubhouse

This is the first of several reports on the aerospace/defense industry.  Our goal is to find the stock with the most attractive risk/return characteristics. We have begun our review of 5 of the 25 companies in this industry.  There is quite a bit more work to be done, but so far the “leader in the clubhouse”, is L-3 Communications.

The aerospace/defense industry is an ideal place for a value investor to begin searching for inexpensive stocks.  As two wars grind to a conclusion, and the threat of a budget sequester has materialized, it is hard to imagine an industry where expectations could be any lower.  Many of the stocks are selling at low multiples of cash flow and book value.  It is exactly this type of “negative environment” that value investors must relish examining if they want to find real values.

Let’s get started by taking the first steps on a long journey. [Read more…]

Why Price To Book Value Is A Good Starting Point

The use of price to book value is one of the most important and controversial subjects in all of security analysis.  Let’s begin the discussion of why we consider P/B an important variable.

  1. The academic studies have concluded it is among the most powerful predictors of future returns   Please see What Has Worked In Investing.  I was always suspicious of the studies that showed low P/E was a good predictor. Many of these stocks were cyclicals at the peak of their cycle.  A footnote in one low P/E study showed the curious result that companies with negative earnings did even better than low P/E stocks.  I was not surprised when the Fama/French work in the mid-1990’s show that P/B was a better measure.
  2. P/B works best with companies with negative or volatile earnings.  A good value investor should relish working with these types of companies. They are often widely misunderstood.  Here P/B must be used in conjunction with other metrics.  But as a starting point P/B is best.
  3. We have found there is a strong negative correlation between low P/B and Wall Street’s opinion on a stock. Pick any list of low P/B stocks and see how many you find on Wall Street recommended lists. It will not be many.
  4. With all the new rules about writing down goodwill to its economic value, P/B is even a more accurate measure that it has been in the past.

Of course, P/B is often misused.

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