On Track

“A friend is nothing but a known enemy.” - Kurt Cobain

Last week marked the end of the JetBlue-Spirit saga with the court ruling against the merger. I had no particular interest or view on this case and, therefore, no exposure, but I have found the subsequent public discussion surrounding the situation a bit disjointed. However, tucked neatly into the discourse is one perspective I appreciate. Andrew Walker, a portfolio manager at Rangeley Capital and the host of Yet Another Value Podcast, wrote a compelling post-mortem. A particular excerpt stands out:

The market was always saying SAVE was more likely than not to be blocked; I simply always disagreed. I thought JBLU had a better case and was ~70% to win; if you gave me the same odds tomorrow (30-40%) on a similar case, would I take the bet?

Absolutely. Losing sucks. But I would bet on a “better” case at underdog odds every time, and I’d just hope over a long period of time I’m right enough in my assessment to make money. Remember: if the market is offering you 5% odds of something and you think the true odds are 35%, you can make an awful lot of money taking that bet even though the naysayers will be right more often than not!

Andrew’s piece is a holistic reflection—most investors would be better served by taking this kind of care in analyzing their own work. But rather than focusing on the specifics of the JetBlue-Spirit case, what I am interested in are several critical points raised that are widely applicable throughout finance. To explore further, there is no better way than by pointing to the work of Steven Crist.

Steven Crist, now retired, is a legendary figure in the world of handicapping and horse betting and pioneered several of the statistical measures that are still widely used today. He has also been far from shy in sharing his views, having been both columnist and editor-in-chief for publications covering the sport. He also provided a critical contribution to the 2001 book Bet With the Best: Strategies from America’s Leading Handicappers, Chapter 3: Crist on Value. It is exceptional—you can access the chapter here (if this link ever finds itself a dead end, please email me, and I will be happy to forward you a copy). If you read only one other piece today, make it Chapter 3. You will not regret it.

I would like to touch on several of Crist’s points, quoted below:

Probability and Odds

…even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds. A horseplayer cannot remind himself of this simple truth too often, and it can be reduced to the following equation:

value = probability x price

This equation applies to every type of horse and bet you will ever make.

It is simple and hard to argue against, and yet, so many people ignore the equation above. Why? Beyond the idea that many approach the horse track and global financial markets the same—viewing both as entertainment, casinos, or believing themselves clairvoyant—Crist highlights that many horse bettors like to pick favorites, sticking with them regardless. Assuredly, we see countless market participants fixated on specific companies. These people see ‘winners’, though they can not detail how they themselves will win, and no further exploration occurs. Conversely, there are those strictly focused on price—drawn to what appears cheap without defining on an absolute or relative basis what cheap is. In both instances, allegiance has been pledged against sensibility.

In contrast to the horse track, financial markets also present interesting complications. The number of horses and races is far more immense. More daunting, unlike with the traditional horse track, is that there is no set start time or declared distance to be run. Many watchers quickly bounce between races, focusing on inches and feet. They look for fast breaks. Few are looking ahead to the Mongolian Derby years out. Further, with numerous ways to structure exposure, horses in financial markets are running more than one race at a time, and many are essentially running in innumerable every second, minute, day, week, month, and year. Keeping this in mind, I find it useful to look at an equivalent expression of the equation Crist provided:

price = value / probability

For many assets, our best-calculated probabilities likely don’t reflect true odds. Likewise, the anticipated value we prescribe is rarely going to match the true underlying value. Even working to account for a spectrum of scenarios to reach a reasonable expected value, there are always lingering unknowns. But unlike these uncertainties, public markets ensure that price is never a question—we are presented with updated prices at rapid intervals. This is terribly convenient when you consider who you are actually competing against. Just as handicappers aren’t working against the race track, investors are not playing against the exchanges—it all comes down to other participants.

The Competition

If every horseplayer but you were a certifiable idiot, betting at random on names and colors, you would win every day. Conversely, if the only people betting into the pool were the small number of professionals who make a living this way, your chances for long-term victory would be slim.

Either way, what would make you a loser or a winner would not be a change in the number of winners you bet, but solely the odds that these horses would return. To put this another way: Your opportunity for profit at the racetrack consists entirely of mistakes that your competition makes in assessing each horse's probability of winning.

Despite all other variables, this source of opportunity does not change. But this does not mean that significant opportunities are frequent:

There are also plenty of races in which your competition will make no actionable mistakes. Everyone seems to be at about the right price, and there is no compelling reason to jump into the pool. It is worth remembering that the whole is better than the sum of its parts: The betting public's post-time favorite wins more often than any individual public handicapper, and over time first choices win more than second choices, which win more than third choices, and so on down the line. There is no shame in passing a race because you just don't see any value in it.

A significant advantage is your ability to decide when to buy and at what price. The markets show us time and time again that certain assets periodically receive inappropriate levels of attention, acting as black holes for capital, which further distorts prices across the board. With this occurring, even with considerable uncertainty, you have a striking amount of leeway to be imprecise so long as collective expectations sit opposite and are far further off base. I often see people considering their competition as enemies. But the competition is most certainly your best friend as they add extra weight to one side of the scale and tip it in your favor. This, in essence, is a margin of safety.

It's not an easy game, but you're not playing against "the game." You're betting against the other bettors. It doesn't matter if they pick as many winners as you do, or even more, if you are betting only when the price is right.

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Disclaimer

This publication’s content is for entertainment and educational purposes only. I am not a licensed investment professional. Nothing produced under the Invariant brand should be thought of as investment advice. Do your own research. All content is subject to interpretation.