This Is More Important Than Investment Profits
January 11, 2011
"It's all about making money that's the facts and talk is worthless."
That's the comment one reader left on an article I recently wrote about casino giant Las Vegas Sands (NYSE: LVS). Based on the available information, I argued that there wasn't a compelling case for buying Sands at today's price (just more than $50 as of this writing). The commenter in question disagreed with me, saying that we'd know who was right based on where the stock price finishes the year. After all, the comment implies, if you can't judge investing prowess based on profits, then how can you judge it?
The argument is compelling on the face. Certainly, every investor aims to make money with her or his investments. However, when it comes any particular investment, is the profit or loss that's banked really the best way to judge success or failure?
A lap around the track
Let's take the discussion to the horse track for a moment. One bettor at the track lays his money on SmartyBet, whose odds are listed on the tote board as 30-to-1, but who we know (with our hypothetical preternatural insight) has a 20-to-1 chance of actually winning. Meanwhile, another bettor puts money down on WayOverbet, a horse paying 3-to-1 whose actual odds of winning are 5-to-1.
Let's take the discussion to the horse track for a moment. One bettor at the track lays his money on SmartyBet, whose odds are listed on the tote board as 30-to-1, but who we know (with our hypothetical preternatural insight) has a 20-to-1 chance of actually winning. Meanwhile, another bettor puts money down on WayOverbet, a horse paying 3-to-1 whose actual odds of winning are 5-to-1.
The race is run, and WayOverbet ends up winning by a nose, paying our second bettor $3. Was that a good bet?
If all we care about is profit, then we'd say yes -- after all, that bettor has $3 instead of $1 in his pocket, while the other has a lonely spot in his wallet where a dollar used to be. But if both of these bettors make these same bets over the course of 100 races, it becomes quite clear who the smarter player is. Our first bettor will end up winning five of those 100 races, each paying $30, for a total of $150. The second better will win much more often, showing a "profit" 20 times out of the 100 races, but each will only pay $3, leaving him with just $60 for his $100 worth of bets.
Obviously, the most important thing here wasn't to show a "profit" on a given bet, but rather to make sure that each bet was smart -- that is, one that had better actual odds than what the tote board showed.
Process versus outcome
Probably the best discussion that I've seen about this issue comes from Michael Mauboussin's book More Than You Know. Tellingly, it's the very first chapter of the book, and it opens with this quote from Robert Rubin:
Probably the best discussion that I've seen about this issue comes from Michael Mauboussin's book More Than You Know. Tellingly, it's the very first chapter of the book, and it opens with this quote from Robert Rubin:
Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.
Mauboussin emphasizes the point, writing:
... investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field -- such as investing, sports-team management, and parimutuel betting -- all emphasize process over outcome.
Winning the process game
Mauboussin very clearly lays out what the ideal goal of any investment process should be:
Mauboussin very clearly lays out what the ideal goal of any investment process should be:
The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value. Expected value, in turn, is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes.
What does this mean in practical terms? I often begin my investment research using a screen that identifies stocks with certain attributes. For our purposes here, let's say I'm looking for stocks that are currently out of favor with investors, so I set a screen looking for any stock that has declined by 20% or more over the past year and is currently trading at less than its tangible book value. Here are a few of the companies that pop up:
Company | Year-Over-Year Price Change | Price-to-Tangible Book Value |
|---|---|---|
| Banner Corp (Nasdaq: BANR) | (23.7%) | 0.6 |
| K-SEA Transportation Partners(NYSE: KSP) | (61.4%) | 0.4 |
| Oilsands Quest (NYSE: BQI) | (59.0%) | 0.4 |
| Hercules Offshore (Nasdaq:HERO) | (38.1%) | 0.4 |
| American National Insurance(Nasdaq: ANAT) | (26.5%) | 0.6 |
Source: Capital IQ, a Standard & Poor's company.
To follow good process in evaluating these stocks, I'd first try to identify possible outcomes for them, and what those outcomes would mean for the stock price. Washington-state-based Banner, for instance, traded at more than twice its tangible book value prior to the financial crisis, so we could probably envision a case where shares recover to three or four times their current value. American National Insurance, meanwhile, has had cyclical valuation swings that have typically put its tangible book value multiple in a range of 0.5 to just above 1.0. In a scenario where toxic assets don't eat away at the balance sheet and investment returns start to increase, investors could see real upside here, too.
Of course, we also need to consider negative outcomes, as well. For example, investors would want to note that Oilsands Quest has never reported an annual profit. There may be a huge upside if the company finds a way to profitability, but its assets may not be worth all that much if it can only produce losses. Similarly, driller Hercules Offshore has been trying to find its footing again, but the need for a balance-sheet-strengthening capital raise may impact the value of currently outstanding shares.
Once you have a list of the potential outcomes for the stock in question, you can then weigh the potential for each of those outcomes to come to fruition, and end up with a good sense of whether the stock is a worthwhile investment.
The year-end review
Any one of these stocks -- Las Vegas Sands included -- may end the year with a higher or lower price than what the ticker tape shows right now. But the best investors won't spend all of their time focusing on whether there was a profit or loss -- but rather on evaluating whether the decision-making that led to the investment was sound.
Any one of these stocks -- Las Vegas Sands included -- may end the year with a higher or lower price than what the ticker tape shows right now. But the best investors won't spend all of their time focusing on whether there was a profit or loss -- but rather on evaluating whether the decision-making that led to the investment was sound.
The comment that I highlighted at the beginning concluded that "talk is worthless." Perhaps talk that focuses simply on the outcomes of investments is worthless. But I think few things are more valuable than talk that discusses potential investment outcomes and helps hone process.
