With Michael Batnick, CFA, Director or Research at Ritholtz Wealth Management, Writer at The Irrelevant Investor blog
Michael Batnick, CFA, is the Director of Research at Ritholtz Wealth Management and a writer for theirrrelevantinvestor.com blog where he posted the article “Ten Things Investors Can Learn from the Horse Track.”
In the article, he parallels the process of investing with that of gambling and, more specifically, with horseracing. Undoubtedly, there are risks and rewards with both, and before placing a bet or buying a stock, one must do a well thought out analysis and, to use a racing term, one must handicap properly. “If you handicap well, but bet poorly,” says Michael, “you’ve failed. 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”.
When investing, typically someone will be doing an analysis to calculate risk and reward and once that’s understood, you either take the leap or you drop it and move on. But often when picking stocks, people pay too much attention to a company they like or a product they like and way too little attention to value or the terms of probability. As Michael says, “They pay too much attention, again, to the story and not enough attention to actually what’s going on beneath the surface.”
Michael also writes that “investors pay too much attention to glamour and too little attention to value.” For example, people tend to look at companies such as Amazon or Microsoft in terms of their success and their gigantic returns, but don’t focus on “how insanely difficult it was to obtain those gigantic returns. The price of gigantic returns is gigantic draw-downs.” Generally, growth stocks underperform value stocks because a lot of the future growth is already priced in. He further states that “every single stock and strategy and theme and asset class goes through periods of underperformance. Whatever stock you’re buying or the strategy you’re employing—particularly on the value side—is going to be painful at times, and that is the price for high-end returns.”
As Charlie Munger, Warren Buffet’s partner has so famously said, “We look for a horse with a one in two chance of winning, but that pays you three to one.”
In horseracing or investing, you have to calculate the odds before placing your bet.
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Steve Pomeranz: I spend a lot of time reading and, in that process, I continually discover new thinkers and writers who enhance my knowledge and make me a better person and investor. I think I just found one of those individuals and, fortunately, because of this show I often get them to join me to so I can talk to them in more depth. Michael Batnick is Director of Research at Ritholtz Wealth Management, he’s a member of their investment committee and heads up the company’s internal research efforts, and I’ve asked him to the show to talk about a wonderful new essay he just wrote called, “Ten Things Investors Can Learn from the Horse Track.” Hey, Michael, welcome to the show.
Michael Batnick: Thanks for having me, Steve. Good to be here.
Steve Pomeranz: So, needless to say, that title, “Ten Things Investors Can Learn from the Horse Track,” caught my attention because I have discussed numerous times on this show the parallels between investing and poker playing, but I never thought about it in terms of other forms of gambling. I guess before we begin, let’s get this straight. I’m sure you think investing has risks, but would you put investing in the category of gambling?
Michael Batnick: It certainly can be if you’re not careful. I would say that traditionally the way an investment is thought of is not gambling. Ostensibly, somebody’s doing some sort of analysis while that’s being done by a company they’re investing in or something as simple as an asset allocation plan. And, hopefully, they understand the risks and the rewards and do not gamble by jumping in and out or trying to time the market or picking stocks and abandoning them a week later, and those sort of things.
Steve Pomeranz: Yeah, I wanted to make that separation clear because I know people who’ve been unsuccessful in investing on their own often say, “Well, you know it’s just a big lottery. It’s just a big casino,” I should say. And I often say, “No, it’s not really, when you understand how this stuff works, but if you treat it like a casino it can become a casino.” Okay, so let’s get to it. So here’s number one of these ten things—I don’t know if we’ll get to all of them—Analysis is only half the battle, investors don’t pay enough attention to execution, and so we’re talking about horses now. Remember I think in a lot of these cases, you said we can just substitute the word “stock” for “horses,” so it’s about handicapping properly. Tell us a little bit about that.
Michael Batnick: Yeah, so the direct quote was, “If you handicap well, but bet poorly, you’ve failed.” You could do fantastic analysis; find the stock that’s selling for nine that you think is worth twenty; it could eventually get to twenty, but that doesn’t mean you’ll be there when it does. So execution is really underrated and probably not enough attention is paid to it especially when you see things like back tests. So I would say that the gap between what would’ve worked in the past and actually implementing it is probably much bigger than it looks.
Steve Pomeranz: Well, you say, “It’s as useless as crushing your tee shots and three-putting every green.” So you can do all this wonderful analysis, but I guess you can pay too much for a company, even though it could be the greatest company you’ve ever seen, or, like you said, it could take too long for it to achieve the goals that you’ve sought and you would bail, you could bail earlier. Is that what you’re talking about?
Michael Batnick: There are countless ways of not doing it right and you’ve just hit on a few of them, but, yeah, that’s exactly what I’m talking about.
Steve Pomeranz: So fundamentals are how fast a horse runs and the expectation are basically the odds. Discuss where odds come in. Now I know, you know with horse racing if you’ve ever been to the track you can see what the odds are, but discuss that in terms of investing in companies.
Michael Batnick: That was from Michael Mauboussin, who actually put me onto this article, I think I found in one of his brilliant pieces, “The Success Equation.” The direct quote was, “Horses that everyone perceives as having a 70% chance of winning pay substantially less than $4 because the odds are determined by the amount of money actually bet on each horse.” This goes right to the matter that people just pay too much attention to the company they like or the products that they like, and way too little attention to value. They don’t think in terms of probability or in terms of what’s potentially priced in, and, of course, it’s very difficult to know, but they pay too much attention, again, to the story and not enough attention to actually what’s going on beneath the surface.
Steve Pomeranz: You quote Charlie Munger, who you know is Warren Buffet’s partner, and he says, “We look for a horse with a one in two chance of winning,” or let’s say 50% chance of winning, “but that pays you three to one.” I think that kind of encapsulates it, doesn’t it?
Michael Batnick: Yeah, yeah, yeah. I can’t put it any better than Charlie Munger did it. As a matter of fact, Warren Buffet when he was a kid sold a newsletter at the track called “Stable Boy Selections.” So they both think very similarly in terms of horse betting and when Buffet’s father took the family to Washington when he became part of Congress, one of the first things that Buffet asked him to do was to go to the Library of Congress and ask for every book on horse handicapping. So he learned a lot of lessons early on and the similarities to betting on horses and finding the best odds, and maybe this horse will win, but everybody thinks this horse is going to win. Therefore, the risk-reward is not favorable on this horse that has a 10% chance of winning but is being paid out like it has a 3% chance of winning, that’s where you want to focus.
Steve Pomeranz: Well, I mean you know it’s fun to say that with, you know when you’re talking about horses at the track, but actually kind of figuring out that probability, I think it’s a little more difficult or at least it’s another set of challenges when you’re talking about a particular stock to buy. You know years ago, Peter Lynch, who was famous for writing One Up on Wall Street and these great books that were written for public consumption; he was also a very successful head of Fidelity Magellan Funds years ago. He would basically say if you walk into a store and you see something that you really like, and you find out that the company that makes it, they’re a public company, you just go ahead and buy it. But how do you kind of figure out this probability aspect of it with stocks that you were talking about figuring out the odds at the horse track?
Michael Batnick: Yeah, that’s a great question. I think that a lot of people toss around the term or the phrase “something is priced in” way too frequently without really necessarily understanding what it means. But how do you handicap what’s priced into the market or what’s priced into a company? I don’t know the answer to that; it’s extremely difficult. Measuring investors expectations is a pretty difficult thing to do.
Steve Pomeranz: You also say or write that “Investors pay too much attention to glamour and too little attention to value.” So even a horse with a very high likelihood of winning can be a very good or a very bad bet because it all depends on the odds once again. I often—and I’m going to restate this because it’s important—you can have the most perfect company, the greatest level of earnings growth foreseeable into the future as best you can, and you can pay too much, and you can lose an awful lot of money. And also the market gets very caught up in glamor, doesn’t it?
Michael Batnick: Absolutely because everybody looks at Amazon or Microsoft or whatever the company might be in the rear-view mirror, and they don’t think about how insanely difficult it was to obtain those gigantic returns. The price of gigantic returns is gigantic draw-downs. So it’s extremely difficult to get, and no company wants to be a value stock, right? That is the market saying, “I’m sorry, your business stinks or your fund, or whatever the case may be,” and then they, you know it just perpetuates. So it’s the exact opposite thing with glamours [sic] that people think that this is going to continue indefinitely, and, of course there are exceptions, but by and large growth stocks—there’s an over-generalization—but growth stocks underperform value stocks because, and I’m using the phrase that I just said was used way too often, but because a lot of the future growth is already priced in. Markets do a pretty good job of discounting what’s going to happen and is Uber going to grow 30% in a year for the next ten years, or whatever the expectations are, maybe not.
Steve Pomeranz: Well, I think Apple is a great example of that. I mean Apple was the quintessential glamour stock a few years ago. Books were being written, movies were being made, and the stock was just going up and up and up, but a lot of that growth had already happened, but now because everybody can relate to a story like Apple where you can see the iPhone and the iPad, it became very popular and it became very very expensive relative to that. Now today the company is going through the typical iterations of a normal company’s cycle: hot product becomes stale, they look for new ways to improve the product, and I don’t think people working at Apple got stupid all of a sudden. It’s just going to take time for them to figure out their new direction and now I think Apple’s a value stock. What do you think?
Michael Batnick: I would agree. It’s certainly making the transition to value. It’s been a while since they made a new high and this is sort of shocking. I think that for the last four years, or just about that, it has not beaten the S & P 500, and that’s what Howard Marks refers to a lot as “first-level thinking” and that’s what people get caught up in. Well, the average investor thinks is, “What a great company! I want to buy Apple.” And, of course, they only come to the realization after several thousand percent increase, but then second-level thinking says, “Well, yeah, it is a good company, but everybody knows that and perhaps it’s not as great as everybody thinks. So maybe it’s a sell or an avoid.”
Steve Pomeranz: Here’s one—and this will be the last one we’ll get to talk about—but there’s always a temptation to abandon your strategy when it’s out of favor. So let me read to you from your writing here, “If you begin espousing this approach, you’re sure to suffer abuse from your fellow horseplayers when one of them asks you who you like in a race, and you say, ‘Well, I think number four is a bigger price than he should be.’ The likely response is, ‘So what? Who do you like?’ Your cronies are apt to tell you that you should always be betting on horses, not on prices, and after an inevitable stretch of watching some of theirs win, you’ll begin to doubt yourself.” That’s a big part of investing, isn’t it?
Michael Batnick: Yeah, and just to be clear, of course, that’s Stephen Crist who wrote that. I was just pulling from it. If I had written that, I would be much more famous than the recognition I have.
Steve Pomeranz: Well, maybe you know you’re on your way to being famous.
Michael Batnick: Yeah, so that’s exactly right. Every single stock and strategy and theme and asset class go through periods of underperformance. I guess staying on the horse and Buffet and Munger thought, Buffet obviously got killed in the late 90s and Barron’s famously wrote on the cover, “What’s Wrong, Warren?” Over a one-year period Berkshire underperformed the NASDAQ by 140% at the worst, and over a three-year period, they underperformed by 230%. Everybody knows that value investing works and that Buffet is really smart, but even he had to go through a period of scorn and mocking and contempt and all these sorts of things, and that’s just the way the markets work. Whatever you’re doing, whatever stock you’re buying, the strategy you’re employing—particularly on the value side—is going to be painful at times, and that is the price for high-end returns.
Steve Pomeranz: Very good. My guest is Michael Batnick, Director of Research at Ritholtz Wealth Management. He’s also a member of the investment committee, heads up the company’s internal research efforts. Michael, we’re going to have you back on for other articles that you’ve penned, and I thank you for spending your time with us today.
Michael Batnick: Pleasure, Steve. Thanks for having me.