July 2024 Parimutuel in Perpetuum
““We look for a horse with one chance in two of winning and which pays you three to one.” – Charlie Munger
July 2024 Parimutuel in Perpetuum Market Commentary
By John Goltermann, CFA, CGMA
This past May 4, I was lucky enough to be invited to attend the 150th running of the Kentucky Derby. The race was an exciting mix of fashion, cuisine, gaming and horses – one I would highly recommend for anyone to do at least once. The whole experience, and the way wagering is done in horse racing, got me thinking about investment markets and some of the conversations I have had with clients who have compared investing to gambling.
In my strong opinion, an investment is not a gamble, and a gamble is not an investment. While each involves a payoff or loss, they are not the same. Investments are owned claims on productive assets that have underlying value. Those claims are continuously re-priced by market participants in response to a variety of factors. By contrast, a gamble depends on a single, event-driven outcome – a win or a loss. One and done.There is nothing of value behind the money put down on a gamble – just the prospect of a favorable future outcome. Yes, you can opt to gamble again, but each outcome is generally independent of the previous outcome.
Serious long-term investors such as Charlie Munger would cringe at the idea of comparing investing to gambling because they take the process of valuing claims seriously. With investments there are a multitude of variables that factor into pricing and price changes. But if we had to compare investing to something, we can make a case that it is similar to a parimutuel activity. Like odds on horses, investments are priced by a consensus of others who put real money down. Those prices reflect expectations of future results. Results of what? The future operating results (free cash flow to shareholders) of the company. And since the price always reflects expectations for future performance, and because there is no finish line — it is a race in perpetuum.
Parimutuel betting involves many players who place money on a single event where the entrants are ranked in the order of their finish. It has a nearly 150-year history, going back to 1865 when a Paris perfume shop owner named Pierre Oller figured out a system of wagering on horse racing that circumvented the problems of notorious bookmakers and a lack of regulation. Pierre would sell interests in individual horses through an auction pool, with each horse’s price (the odds of a win) being the stated odds of winning. These odds are determined by the total money coming in on one race in proportion to the total bet on each horse. In parimutuel betting, the odds are not the actual probabilities of winning…just the crowd’s consensus perception, as reflected by real money down.
In a parimutuel system, bettors wager against one another. In fact, parier mutuel means “to wager among ourselves”. The goal in a parimutuel system is not necessarily to pick the winner of the race – it is to pick the horse whose actual odds of winning are far better than the stated odds (the price). For example, rational bettors would always put their money on a horse whose stated odds (also the payoff) are 8:1, but whose actual odds are 5:1. In a rational world, these bettors would place such bets an infinite number of times even though they would lose 4 out of 5 times. The same principle holds true for investing.
In investment markets the race is being run every second of every day. There is no end — just prices(the odds) changing continually. Changing stock prices reflect changing expectations of future performance as the race continues in perpetuum. News releases and financial reports provide updates on the contestants performances and condition. When prices move up, other investors have expressed the view that the odds of “winning” have improved; when the prices move down investors have expressed an opinion that the odds of “winning” have declined. These price changes are independent of the actual results. And, as with horses, price movements generally do not reflect whether the actual odds have changed or not – they just reflect the amount of money people are willing to put down.
In parimutuel betting you are paid at the end of the event. Within investment markets you can cash in your investment at any time at the stated price and accept the payout.Or you can hold the investment if you believe that future results will exceed the results that are “priced in”.Think of the stated odds on a horse as its “price”. If you place your money on a 5:1 and the odds move to a 3:1, you will earn a gain. If the odds move to 8:1, you will suffer a loss. In investment markets, the odds (as expressed by price) can change for or against you at any time simply based on other people’s (or computer’s) perceptions. If this is the case, it follows that investors must determine what they believe an investment’s real odds are – and balance this against what expectations the current share price reflects. Since there is no end to the race (only changing prices), the goal is to look for mispricings (actual odds better than stated odds).
Occasionally, prices move to levels where accepting or avoiding certain investments becomes an easy decision: the payoffs are either too great or too insufficient. In horse racing, a heavily favored horse may carry a 1:5 odds (meaning a $5.00 bet earns you $1.00 if you win) may not be worth the risk. Cisco Systems Is a memorable illustration of this (but not the only one). In late 1999, everyone knew Cisco was a fantastic company, had great products, and was dominating an exploding market (the internet). High expectations of magnificent future performance were reflected in the price. But, if you purchased Cisco’s shares in 2000 when everyone else had already bet on them, it would be a bad bet because the stated odds of winning (the share price) would be high and the potential payoff would be low (such as a 1:5 odds on a horse). Indeed, Cisco today is still 40% below its 2000 high, even though earnings per share are up 5-fold since then,why?The payoff (the stated odds) was too low relative to the risk. Avoiding bad bets can be as important as making good ones.
To add a layer of complexity, investors also need to be cognizant of factors that can distort the system-wide price/value relationships. For example, when a central bank floods markets with liquidity, it may inflate prices (stated odds of winning) across the board. Or when a large number of investors (index investors) decide not to select individual investments, but rather to simply allocate capital pro ratato those with the highest prices (lowest payoffs) –price distortions can persist. Eventually these anomalies get reset.
In my opinion, much of investing is about understanding the expectations that are implied by prices. This is why time is well-spent, as Charlie Munger advises, analyzing the actual odds relative to the stated odds. Often, people (and computers) invest in what they view as the likeliest winner, but without regard to price and payoff. And because of this, the prices/odds of the perceived “best” investments can rise to levels that make them super-risky (because so many have placed the same bet). Likewise, prices/odds on perceived “risky” investments can decline to levels that make them safe (because so many investors avoid them) and they carry high payoffs. This is where so many investors get tripped up: it’s not only about just trying to own good things, but also about prices. Ultimately, it is better to allocate capital to high-quality assets where payoffs are high, and risk of loss is low.
To summarize, we do not consider investments to be gambles, but there are certain parallels between the activities of investing and parimutuel betting that are worth considering. As Charlie Munger has said, “You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.” We “wager among ourselves” because one person’s loss can be someone else’s gain (opportunity or otherwise), but distortions do occur from external factors that impact sentiment and prices.
