I used to play poker when I was young with a guy who made a substantial living doing nothing but bet harness racesâŚ. Now, harness racing is a relatively inefficient market. You donât have the depth of intelligence betting on harness races that you do on regular races. What my poker pal would do was to think about harness races as his main profession. And he would bet only occasionally when he saw some mispriced bet available. And by doing that, after paying the full handle to the houseâwhich I presume was around 17%âhe made a substantial living.
You have to say thatâs rare. However, the market was not perfectly efficient. And if it werenât for that big 17% handle, lots of people would regularly be beating lots of other people at the horse races. Itâs efficient, yes. But itâs not perfectly efficient. And with enough shrewdness and fanaticism, some people will get better results than others.
The stock market is the same wayâexcept that the house handle is so much lower. If you take transaction costsâthe spread between the bid and the ask plus the commissionsâand if you donât trade too actively, youâre talking about fairly low transaction costs. So that with enough fanaticism and enough discipline, some of the shrewd people are going to get way better results than average in the nature of things.
It is not a bit easy. And, of course, 50% will end up in the bottom half and 70% will end up in the bottom 70%. But some people will have an advantage. And in a fairly low transaction cost operation, they will get better than average results in stock picking.
How do you get to be one of those who is a winnerâin a relative senseâinstead of a loser?
Here again, look at the pari-mutuel system. I had dinner last night by absolute accident with the president of Santa Anita. He says that there are two or three betters who have a credit arrangement with them, now that they have off-track betting, who are actually beating the house. Theyâre sending money out net after the full handleâa lot of it to Las Vegas, by the wayâto people who are actually winning slightly, net, after paying the full handle. Theyâre that shrewd about something with as much unpredictability as horse racing.
And the one thing that all those winning betters in the whole history of people whoâve beaten the pari-mutuel system have is quite simple. They bet very seldom.
Itâs not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at itâwho look and sift the world for a mispriced beâthat they can occasionally find one.
And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they donât. Itâs just that simple.
That is a very simple concept. And to me itâs obviously rightâbased on experience not only from the pari-mutuel system, but everywhere else.
And yet, in investment management, practically nobody operates that way. We operate that wayâIâm talking about Buffett and Munger. And weâre not alone in the world. But a huge majority of people have some other crazy construct in their heads. And instead of waiting for a near cinch and loading up, they apparently ascribe to the theory that if they work a little harder or hire more business school students, theyâll come to know everything about everything all the time.
To me, thatâs totally insane. The way to win is to work, work, work, work and hope to have a few insights.
How many insights do you need? Well, Iâd argue: that you donât need many in a lifetime. If you look at Berkshire Hathaway and all of its accumulated billions, the top ten insights account for most of it. And thatâs with a very brilliant manâWarrenâs a lot more able than I am and very disciplinedâdevoting his lifetime to it. I donât mean to say that heâs only had ten insights. Iâm just saying, that most of the money came from ten insights.
So you can get very remarkable investment results if you think more like a winning parimutuel player. Just think of it as a heavy odds against game full of craziness with an occasional mispriced something or other. And youâre probably not going to be smart enough to find thousands in a lifetime. And when you get a few, you really load up. Itâs just that simple.
When Warren lectures at business schools, he says, âI could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punchesârepresenting all the investments that you got to make in a lifetime. And once youâd punched through the card, you couldnât make any more investments at all.â
He says, âUnder those rules, youâd really think carefully about what you did and youâd be forced to load up on what youâd really thought about. So youâd do so much better.â
Again, this is a concept that seems perfectly obvious to me. And to Warren it seems perfectly obvious. But this is one of the very few business classes in the U.S. where anybody will be saying so. It just isnât the conventional wisdom.
To me, itâs obvious that the winner has to bet very selectively. Itâs been obvious to me since very early in life. I donât know why itâs not obvious to very many other people.
I think the reason why we got into such idiocy in investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, âMy God, theyâre purple and green. Do fish really take these lures?â And he said, âMister, I donât sell to fish.â
Investment managers are in the position of that fishing tackle salesman. Theyâre like the guy who was selling salt to the guy who already had too much salt. And as long as the guy will buy salt, why theyâll sell salt. But that isnât what ordinarily works for the buyer of investment advice.
If you invested Berkshire Hathaway-style, it would be hard to get paid as an investment manager as well as theyâre currently paidâbecause youâd be holding a block of Wal-Mart and a block of Coca-Cola and a block of something else. Youâd just sit there. And the client would be getting rich. And, after a while, the client would think, âWhy am I paying this guy half a percent a year on my wonderful passive holdings?â
So what makes sense for the investor is different from what makes sense for the manager. And, as usual in human affairs, what determines the behavior are incentives for the decision maker.
From all business, my favorite case on incentives is Federal Express. The heart and soul of their systemâwhich creates the integrity of the productâis having all their airplanes come to one place in the middle of the night and shift all the packages from plane to plane. If there are delays, the whole operation canât deliver a product full of integrity to Federal Express customers.
And it was always screwed up. They could never get it done on time. They tried everythingâmoral suasion, threats, you name it. And nothing worked.
Finally, somebody got the idea to pay all these people not so much an hour, but so much a shiftâand when itâs all done, they can all go home. Well, their problems cleared up overnight.
So getting the incentives right is a very, very important lesson. It was not obvious to Federal Express what the solution was. But maybe now, it will hereafter more often be obvious to you.
All right, weâve now recognized that the market is efficient as a pari-mutuel system is efficient with the favorite more likely than the long shot to do well in racing, but not necessarily give any betting advantage to those that bet on the favorite.
In the stock market, some railroad thatâs beset by better competitors and tough unions may be available at one-third of its book value. In contrast, IBM in its heyday might be selling at 6 times book value. So itâs just like the pari-mutuel system. Any damn fool could plainly see that IBM had better business prospects than the railroad. But once you put the price into the formula, it wasnât so clear anymore what was going to work best for a buyer choosing between the stocks. So itâs a lot like a pari-mutuel system. And, therefore, it gets very hard to beat.
What style should the investor use as a picker of common stocks in order to try to beat the marketâin other words, to get an above average long-term result? A standard technique that appeals to a lot of people is called âsector rotationâ. You simply figure out when oils are going to outperform retailers, etc., etc., etc. You just kind of flit around being in the hot sector of the market making better choices than other people. And presumably, over a long period of time, you get ahead.
However, I know of no really rich sector rotator. Maybe some people can do it. Iâm not saying they canât. All I know is that all the people I know who got richâand I know a lot of themâdid not do it that way.
The second basic approach is the one that Ben Graham usedâmuch admired by Warren and me. As one factor, Graham had this concept of value to a private ownerâwhat the whole enterprise would sell for if it were available. And that was calculable in many cases.
Then, if you could take the stock price and multiply it by the number of shares and get something that was one third or less of sellout value, he would say that youâve got a lot of edge going for you. Even with an elderly alcoholic running a stodgy business, this significant excess of real value per share working for you means that all kinds of good things can happen to you. You had a huge margin of safetyâas he put itâby having this big excess value going for you.
But he was, by and large, operating when the world was in shell shock from the 1930sâwhich was the worst contraction in the English-speaking world in about 600 years. Wheat in Liverpool, I believe, got down to something like a 600-year low, adjusted for inflation. People were so shell-shocked for a long time thereafter that Ben Graham could run his Geiger counter over this detritus from the collapse of the 1930s and find things selling below their working capital per share and so on.
And in those days, working capital actually belonged to the shareholders. If the employees were no longer useful, you just sacked them all, took the working capital and stuck it in the ownersâ pockets. That was the way capitalism then worked.
Nowadays, of course, the accounting is not realistic because the minute the business starts contracting, significant assets are not there. Under social norms and the new legal rules of the civilization, so much is owed to the employees that, the minute the enterprise goes into reverse, some of the assets on the balance sheet arenât there anymore. Now, that might not be true if you run a little auto dealership yourself. You may be able to run it in such a way that thereâs no health plan and this and that so that if the business gets lousy, you can take your working capital and go home. But IBM canât, or at least didnât. Just look at what disappeared from its balance sheet when it decided that it had to change size both because the world had changed technologically and because its market position had deteriorated.