For many people investing in the stock market is quite a lot like the casino. Whereas for me, it really is not. The truth is I have very little experience as a “gambler”, at the very most the typical EuroMillions with friends when there is a rollover, which mathematically is a very bad bet.
I suppose that for those that gamble, the big attraction is the emotion, the glamour “of breaking the bank”. Cue visions of James Bond in the casino… This clearly has certain pull to it. The thing is, in order to break the bank you need to choose the games where the bank does not have all the possibilities of winning, you need to turn it around. This is exactly what Edward Thorp did, a mathematics professor at MIT, New Mexico State University and the University of California. Thorp designed a system to win at Black Jack, based on the study of probabilities (using his University’s IBM supercomputer). His book, “Beat the Dealer”, published in 1962, is a classic in the world of investment (and gambling). Obviously they banned him from playing, as well as many who read his book and followed his example.
Maybe, if you are looking for excitement, you should leave everything down to luck. But if you want to win, it is clear that it is necessary to do some work to find situations where the probabilities are more favourable. That way, we can be right more often and wrong less, and when we make errors we will have enough of a safety margin in order to lose little. From my point of view, in the long run winning is much more exciting than taking part!
Investing, by definition, must be very different to gambling. It’s not about the emotions, but rather the results. Thorp wasn’t interested in the game but rather in the statistics of the game. He searched for the way of “placing a safe bet”. In games of chance, the probabilities are what they are, they cannot be changed, and that’s why the bank always wins in roulette, in baccarat, on the slot machines, etc. Thorp chose Black Jack which is more favourable, and only really gambled when he had the right hand.
So, when investing one should only choose situations with very favourable probabilities, which is what Thorp did. In my opinion there are four key points that we compare with the assessment in any investment, and three of them can offer high probabilities of success: The net assets of the company, the current business and the quality of the managers. The combination of the first three points is basically what interests “value” investors. A current example from our portfolio would be Teekay Corp.
The fourth point, which requires forecasts and on occasions leaps of faith, is the growth and the execution of the future vision of the company. The fourth point is particularly important to “growth” investors and certainly offers more emotion, but also involves much more uncertainty. A current (extreme) example would be Tesla. The future is uncertain, and I don’t consider myself to be a fortune-teller, therefore I try to limit dependency on the fourth point as much as possible.
Touching briefly on each one, the net assets of the company are everything that has value, and which are surely not necessary for the business to continue. Mostly we are talking about cash liquidity (the easiest to value), as well as interests in other listed companies, and even real estate and infrastructures.
It is necessary to evaluate who the managers are, and what they have done in the past at other companies.
Here the focus would be: How much would somebody be prepared to pay for these assets of the company if they were sold today, while the business of the company is independent and does not depend on such assets? The value of these assets should be a very solid support. If we bet on companies where the stock market value is lower than the value of these assets, then this will be a very favourable bet!
For example, Teekay Corp, one of our biggest investments at this time, has interests in several listed companies which only three months ago were worth $614 MM on the market, compared to their market capitalisation of $573 MM at the time. On the other hand, it’s fixed assets and other interests would practically cover its debt. In other words, the total was cheaper than the sum of the parts. We were also starting out at a point that was really depressed in terms of valuing said interests.
The second point – the current business –, refers to what profits a company generates at this moment in time, or how much can we consider “almost sure” without having to depend on the managers… from pure inertia. People will continue eating bread, drinking Coca-Cola, taking aspirin, turning on the lights at night…
The vast majority of companies do not enjoy such stability. In reality nothing is exempt from risk and perhaps it might be discovered that the whole world is gluten intolerant and stops eating bread or that Coca-Cola reduces the average life expectancy, or some other unexpected situation, and our work also means being on the lookout for something material to change. Until then, the present value of the conservative cash flows of these businesses must offer another solid support for our investment.
Going back to Teekay, from its subsidiary alone LNG, Teekay Corp should receive $100 MM a year thanks to its long-term contracts, and the world will continue to need gas as a cheap and relatively clean source of energy. The present value of this flow could be between $1,000 MM and $1,500 MM.
Finally there is the quality of the managers. It is necessary to know who are those responsible for the company in which we are thinking about investing. A bad or dishonest manager could be capable of squandering our valuable assets and could destroy the inertia of the profit flows. It is really necessary to evaluate who the managers are, what they have done well and poorly in the past and at other companies. Do you know anybody who would give their savings to somebody who is incapable and/or associates with bad company to set up a business, even if they were a childhood friend? Once again with Teekay, we have been able to confirm that their managers are very well respected by their customers and competitors.
If we manage to be satisfied with these three points, and we have found a company whose stock market value is clearly less than its net assets plus the present value of its conservative future profits, and managed by honourable, experienced and efficient managers, we have a high probability of success in our investment. So far, Teekay Corp has not performed badly at all (+ 35% since the beginning of June), and as the market begins to better understand the magnitude of its problems and the solidity of its solutions, the correct valuation will begin to materialise.
If we manage to find a few companies like this, year after year, we will doubtlessly break the bank. But, there is one other thing, the best thing about the stock market is that no casino can prevent us from entering. Perhaps this is why Thorp decided to stop experimenting and seriously dedicate himself to investment (with great success by the way).
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