Zero-Sum Games

While sports is not a subject that's covered much on this blog, I'll use the upcoming Super Bowl -- with consideration for the amount of betting on the event that will occur in mind -- as a convenient excuse to revisit some of the differences between gambling, speculation, and investment.

Naturally, a variety of bets will be placed on that big game. Also, plenty of bets were made on game outcomes and individual player performance (through, for example, various forms of fantasy football) during the regular football season. On occasion, I'll hear someone suggest that owning stocks is just another form of gambling. Well, it certainly can be turned into gambling -- or a gambling-like activity -- but it need not be. It all comes down to behavior. Those who trade rather frequently are doing what, at least to me, is effectively gambling. There's nothing inherently wrong with that approach other than too often it tends to be not all that lucrative.

In fact, what happens to a stock over short amounts of time is essentially a coin flip. The price action of a stock is moved in the near-term by the voting machine. The price level in the long run is set, within a range, by the weighing machine. In the short run it's a popularity contest; in the long run it mostly comes down to what something is intrinsically worth.

Now let's say, for example, someone participated in fantasy football league and ended up winning 7-8 times their money that was put at risk.
(Over the course of the regular football season.)

That's a nice rate of return by any standard, right?

It would be tough to match that by owning common stocks -- other than , maybe, the most speculative variety -- even with some leverage involved (e.g. via margin or equity options).

Yet such an impressive return can't viewed in a vacuum.

First, the fact is it's likely that all or a good chunk of that money put at risk in the sports bet could be permanently lost. In contrast, that can be a much lower probability outcome with, for example, a quality common stock that's bought well (i.e. plain discount to a conservative estimate of value) and owned for a very long time.

A sports bet -- or any bet -- is generally a zero-sum outcome. The reward comes at the expense of at least one other person.*

A good investment is -- or should be  -- very different. Capital certainly can and does get permanently lost with equity investments but, with a sound overall approach, the probability of it happening can be much reduced (over the long haul relative to typical pure zero-sum bets).

The value of a dollar bill will not increase in purchasing power over time. Well, at least that's the case if history is any guide. The fact is, especially over the very long run, most currencies tend to decline in purchasing power rather substantially. For a business -- whether owned outright or via common stock -- this need not be the case. Good businesses, unlike dollar bills, can intrinsically increase in value especially over the longer haul. They do so because, through their competitive advantages, quality businesses can profitably produce something of value year after year at an attractive rate of return on capital.** A business that is financially sound with a strong at least sustainable (though ideally improving) competitive position has the potential to generate attractive returns for quite some time.

So a key difference is investment can provide an outcome that is not zero-sum:

"...stocks grow in value over time because they retain earnings and they expand basically the companies underneath you." - Warren Buffett on CNBC

Those retained earnings may or may not be put to good use but, at least with capable management in place, it's unlikely the cash that's generated is being thrown into a furnace (though sometimes dumb capital expenditures and acquisitions act as a functional equivalent to this behavior). The earnings from a business with durable advantages should directly benefit long-term owners (via dividends and buybacks) or be of indirect benefit as the retained earnings are put to work (on hopefully what are high return investments) with an eye toward the longer term.

If two people put $ 100 each into a bet with each other then the winner walks away with $ 200 and the other walks away with, well, nothing.

Zero sum.

One winner.

One loser.

Much like the big football game this weekend.

If the same two people put $ 100 each into an investment that doubles in value both end up with $ 200. Both win.

Of course, it's also possible, unlike the bet, that they could have both ended up with a loss.

Now, an investment generally require much longer time horizons than a bet. Think decades. So they mostly will just not produce lottery ticket like outcomes. For those stocks that do happen to produce quick and spectacular returns, the risk of permanent loss was likely very high.

A big part of the challenge is minimizing the possibility of capital being permanently lost while still generating an attractive return. Risk and reward need not be positively correlated. Temporary paper losses are acceptable; permanent losses are not. Mistakes will inevitably be made but, when you can minimize the big losers then the winning decisions usually take care of things.

So returns need to be viewed in the context of the possibility of permanent capital loss. Most forms of gambling fail miserably in this regard. Gambling might provide some entertainment but, otherwise, it has little in common with investment.

I'd rather do something that's not such a zero-sum game. If I invest in equities – the businesses are growing; for example, Wrigley's will make more gum. It's automatically working for me, even if I do nothing. But if I invest in currencies, it's not working for me. - Charlie Munger at the 2005 Wesco Annual Meeting

Speculation and gambling are similar in many ways yet they are not the same:

"...I would distinguish between speculative and gambling. Gambling involves, in my view, the creation of a risk where no risk need be created." - Warren Buffett at the FCIC

Buffett contrasts pure gambling -- the taking on of risk that need not be taken on -- with someone who plants a crop early in the year, now has locked in expenses, and needs to speculate on what commodity prices will be late in the year.

The possible price fluctuation represents a real risk that already exists and needs to be managed. That kind of speculation is necessary and very important.

Lions, leopards, and house cats have some similarities but the differences matter.

Gambling, speculation, and investment might also have some similarities but the differences matter.

Investing well requires, among other things, figuring out what something is conservatively worth then buying when the discount becomes meaningful. A margin of safety is what protects against the unexpected and mistakes.

Buying a dollar bill for 50 cents makes permanent capital loss rather a lot less likely. The same goes for buying all or part of a good business at a 50% discount to intrinsic value (again, conservatively estimated) especially since there's the potential for increases to value.

Along the way market prices may fluctuate quite a bit but that, in itself, doesn't necessarily make the asset risky.

Adam

Related posts:
On Speculation and Investment
Bogle on the Financial System
Graham on Investment: "Most Intelligent When It Is Most Businesslike"
John Bogle on Speculation & Capitalism's "Pathological Mutation"
Bogle: Back to the Basics - Speculation Dwarfing Investment
Buffett on Gambling and Speculation
Buffett on Speculation and Investment - Part II
Buffett on Speculation and Investment - Part I

* For simplicity, I'm ignoring frictional costs here though many forms of gambling have huge frictional costs. So it's actually a negative-sum game for the participants putting money at risk (though not for the croupier).
** High returns on capital beats growth for its own sake. Businesses with exciting growth prospects understandably get plenty of attention. The question is (or should be) whether that growth can be achieved in a way that is beneficial to owners. Durable high returns on capital -- whether growing quickly or not -- is what matters. Growth can certainly be a good thing; it's just not inevitably a good thing.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

Shaq Still Dominates around Basket (of fries)

From an article in The Onion:

Celtics coach Doc Rivers said the 7-foot-1 center showed remarkable passion, screaming at opponents and throwing elbows in order to clear out the area in front of the basket of fries.

According to Rivers...

"Some people say that he's slowed down over the years, but he showed some real lateral quickness when he was defending his basket. He must have snagged about a dozen fries that I thought were out of his reach."

"He sent a clear message to the league tonight," Rivers added. "If you get close to that basket of fries, Shaq can still make you pay."

Check out the entire article.

Adam

Soccer's Scoring Problem

With Spain winning the World Cup yesterday after a 1-0 extra time victory (minutes from it instead ending with penalty kicks) in mind, here's an additional Wall Street Journal article with the title:

The Scoring Problem

Soccer's low scores may be leading to random outcomes. 

Richard Bookstaber argues that the game of soccer's current system and rules needs to change to produce more meaningful outcomes. Some excerpts:

There is an analytical basis for determining the amount of scoring a sport should have, and soccer is well below that point.

More Scoring = Less Lucky Wins
The greater the number of scores in a sport, the lower the chance for a lucky win by a team that is inferior.

Addressing Design Flaws
Most sports have conceded flaws in their design, and are better off for having addressed them. Tennis added the tiebreaker, football penalties for pass interference, basketball the three-point shot. So why not soccer? Oh, there was one attempt: the penalty shootout. It's like someone said, "For really important games, let's make the outcome even more random."

Makes some sense.

Check out the entire article.

Adam

O'Rourke: Make Soccer Less Boring

Some thoughts on soccer from P.J. O'Rourke in a new Wall Street Journal article with the title: A Modest Proposal for Improving a Dull Game.

Excerpts:

Scoreless Sports Ties Are Boring
...let's talk about soccer scores. There are a few things that people all around the world need to admit to themselves. Trade restraints slow economic growth, the euro is not a reserve currency and scoreless sports ties are boring. What if there were a World Series where no team got a run? What if, during March Madness, Indiana were able to advance to the Final Four without making a basket?

Boredom Easily Obtained
The purpose of sports—even foreign sports—is not to bore people. Boredom can be so easily obtained. Hunger, exhaustion from making a living and authoritarian governments that ban the fun parts of the Internet provide it free in most of the world. 

Check out the entire article.

Adam

Tiger Woods and Bill Gates

Very different skills, similar advice.

Tiger Woods: Best advice (from his Dad)? Keep it simple.

"My dad's advice to me was to simplify. He knew that at my age I couldn't digest all of golf's intricacies. He kept it simple: If you want to hit the ball to a particular spot, figure out a way to do it. Even today, when I'm struggling with my game, I can still hear him say, "Pick a spot and just hit it." When I'm making adjustments during a round, I know some of the television commentators theorize that I'm changing this or moving that, but really what I'm doing is listening to Pop."

Bill Gates: Best advice (from Warren)? Keep it simple.

"Well, I've gotten a lot of great advice from Warren. I'd say one of the most interesting is how he keeps things simple. You look at his calendar, it's pretty simple. You talk to him about a case where he thinks a business is attractive, and he knows a few basic numbers and facts about it. And [if] it gets less complicated, he feels like then it's something he'll choose to invest in. He picks the things that he's got a model of, a model that really is predictive and that's going to continue to work over a long-term period. And so his ability to boil things down, to just work on the things that really count, to think through the basics -- it's so amazing that he can do that. It's a special form of genius."

I don't know much about golf...but the reasons to invest in a business should be pretty simple:

Something like this is a great investment because the company...

• owns dominant brands with broad distribution creating a wide economic moat and durable high returns on capital.
• is selling at a fair price relative to its long-term prospects.
• has competent management with a solid track record.
• is built around a conservative capital structure.

I noted in previous posts that Buffett believes there should be little need for tricky calculations* but you need to have the patience to wait for that fair price.

Having that patience is easier said.

Coca-Cola (KO) is a good example. If someone started investing in the mid-1990's and decided KO was a good business back then...that person would not have been able to buy it at a fair price until 2006. Patience is more important than IQ. Seeing that KO was overvalued back then required 4th grade math. It was selling at over $ 80/share in 1998, was earning less than $ 1.00/share yet informed market participants were still buying. Efficient markets? Today KO is selling in the mid to high $ 40's/share and will earn $ 3.00/share this year. So it can be bought at a fair price.

By the way, that's a rock solid $ 3.00/share of earnings that will grow over time. Earnings will not always be smooth but the general direction is up. So KO tripled its earning power per share in slightly more than a decade. Some cyclical businesses** can appear to triple earnings rapidly in an economic upturn but those profits usually get crushed during a downturn. These highly variable, not necessarily durable earnings need to be normalized across a business cycle to get a true picture. Not so for the KO's of the world...that triple in earnings power is the real deal.

With its growth in earnings KO intrinsically has become much more valuable over the last ten years. It's just that the stock price has been a very poor proxy for this increase in intrinsic value.

"I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There's no penalty except opportunity lost." - Warren Buffett in Forbes

One challenge in investing is the pressure from taking a swing now, but not getting meaningful feedback for many years. Some may say that quarterly earning reports, or the stock price itself provide a scorecard, but I mostly disagree. Quarterly earnings do not tell you whether a competitor will emerge (or a substitute technology) that alters the economics of a business a decade from now. You may see some cracks emerging but that's about it. Being able to see that the moat will be there ten years out or more is what matters. The rest is distraction. At the very least, this differentiates investing from things like golf, other sports and stock speculation where the performance feedback loop is more immediate.

So investing is easier if you can figure out the long-term strength of an economic moat. Things like quarterly earnings and recessions become just noise.

I know the businesses I like. I'm buying those businesses now. If it turns out my judgment is poor on the strength of the moat, it'll be tough without a time machine to make a meaningful adjustment that improves the result.

Traders and speculators live in a different world than this. They swing at many pitches and seem to accept a lot of mistakes as long as the gains are greater than the losses. In contrast, Buffett's approach is to take less swings...make few mistakes...but do your homework until you feel confident of the outcome.

Adam

* Not much complex math is required but as Charlie says: "Anyone with an engineering frame of mind will look at [accounting standards] and want to throw up in the aisle." The deconstruction of income statements, balance sheets, and cash flow statements into something meaningful economically is a bit of an art unto itself. So you need to not only have the ability to read financial statements in your "toolbox", but develop good judgment on what the numbers actually mean.
** There are plenty of good cyclical businesses you just have to take care to normalize the earnings.
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This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.

MLB's New Policy

Excellent.