Prior Letters Archive

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June 9, 2001

Is the Stock Market a Horse Race?

Back in my younger days, when (I vaguely recall) I occasionally had spare time. I used to go to the race track with some friends once in a while. These guys were very up on horse racing, and I wasn't. I'd probably gone less than 1 time for every 20 or 30 times they had. But I used to give them fits because I'd almost always win more money than they did, despite the fact that I could hardly tell the front end of a horse from the back.

How did I do that?

The same way I pick stocks. I study the numbers real hard; then, I make rational judgements about the probabilities of winning; then, I only bet when I get a probability I like. Most of the time when I would bet, I would bet on the third or fourth best-looking horse in the race. I'd look for horses that were likely to go unnoticed because they had had a few bad prior races, where they may have gotten "boxed in" and couldn't break clear, but that had shown winning characteristics at some earlier time.

The upshot of my strategy was that I would win 2 or 3 races a night, but they'd each have big payoffs, and I'd either break-even or win a lot of money. This would drive my friends crazy because they'd study hard to find the best horse every race, and they'd win 5 or 6 races in a night and either end up losing money or winning only a little. They were betting on better horses, but they weren't winning often enough to make up for the low pari-mutuel payoffs because they were betting the same favorites as everyone else.

Once my friend Neil, in utter frustration said to me, "How could you think that horse would win?" I told him, to his utter astonishment, that I didn't think it would win. Then he said, even more incredulous and agitated, "How could you bet on a horse you didn't think would win?" To this I replied, "Well, does the fact that you think your horse is going to win, make him win?"

It was a beautiful moment. His face went blank. It was a strange epiphany for him. After a moment he said, very sheepishly, that no, it didn't. Then I explained to him that it wasn't important to me to win races. I wasn't even a racing fan. (In fact, I seldom even watched the races because I was busy reading the stats for the next race.) My only interest was in winning money. And I correctly gauged that you could win more money by getting 2 or 3 well-chosen long-shot winners out of 10 than you could by hitting "chalk" all night.


Now, I'm much choosier about picking stocks, but there is a certain similarity of attitude that I have which I believe holds us in good stead. You've heard me say over and over again that the most volatile component of a stock's price is market sentiment. A company's actual prospects change very slowly and can be reasonably assessed, but the over-reactions of alleged investors to a company's good fortunes or problems make stock prices swing way out of line (in both directions) from its intrinsic value. When a good company is having problems, no one wants to look at it; they want to go with the latest winner. They want to put that next race under their belt and brag to their friends at the cocktail party that they own XYZ Corporation, and boy is that baby flying! We saw how those babies flew last year -- like the Hindenburg.

Me, I prefer the unloved companies with low market expectations. The ones that have problems the JCPenneys, the Cendants, the Celgenes. When, after a few months, Chicken Little discovers that the sky isn't falling after all, we cash in. Just like at the race track, no one wants the third best-looking horse, even though you get a much better risk-adjusted reward.

Three weeks ago, I recommended Celgene when it was $23. Our official recommended price (the closing price on the first full day of trading after I recommended it) is $23.95. Today, with the stock at almost $33, we are already up 37%. We are also up 141% in JCPenney in just 6 months, 55% in Cendant in just 5 months, and up between 28% and 44% in 5 others. We have nasty losses in two stocks of 22% each. All in all, we have 9 winners and 3 losers. Our portfolio is up 27% in 6 months. Our average holding period for our stocks is 4.4 months.

Not that I expect our results to continue to be this good, but theoretically speaking, our performance works out to be a 73% return, annualized.

That's not a bad day at the races.

Copyright 2001 by Jack Adamo. All rights reserved.