15
May
2009

The horse race: Betting on individual companies

The Horse Race

Individual Stocks: Just a horse race?

We consider buying shares in a single company to be gambling. In order for us to explain our investment philosophy, let us use the analogy of a horse race.

In short, buying individual shares is the equivalent to taking a bet on one horse in a race. We might attempt to identify the winner based on some measure of “form” and naturally we are drawn to a healthy contender with a good track record. When buying shares, investors often work in the same way, many investors are drawn to buying healthy companies with good prospects and in just the same way as race goers backing a favourite, the odds shorten. In investment terms, the compensation that investors demand for the risks they take in buying healthy companies is lower than that for distressed companies or smaller companies – they get worse odds.

The outcome of each horse race is a largely random event influenced by many factors such as the condition of the course, how many horses are running etc. In much the same way, stock prices are said to follow a “random walk” with the price of any one stock rising with good news and falling on bad news. Since future news events are random in nature, the future movement in prices is also random and impossible to predict.

Therefore investors seeking to back a single company are disproportionately affected by the good and bad luck that happens to that one company relative to the opportunities presented by all the companies in the market. If their share “falls at the first”, they are taken out of the race and cannot profit.

Our investment philosophy:

So to continue with the horse racing analogy, we do not bet on one horse winning the race – what we do is we set out to own the racetrack, we own the studs, the jockeys, the trainers, the bookmakers, we own the catering company that feeds the race goers and the transport company that brought them to the meet and the utility companies providing light and heat. We own the brewery that makes the beer they drink.

In short we bet on the fact that racing will take place every week or every month, rather than on the outcome of any individual horse race.

That is not to say that we don’t back the horses either, we do, but we lay off bets on all of them. Now in a real race, the bookies would ensure that the odds were set in such a way that it would be impossible to profit. However, when we bet on global capitalism, backing all the companies means we have a positive expected return of around 4%pa more than cash on average.

Furthermore, if we slightly increase our bets on those companies with longer odds, by tilting our portfolio towards value companies or smaller companies, then we find that our “odds” are better. Sure, we want to hold the healthy companies in proportion, but we have a higher expected return, better odds if you will, from backing companies that are more risky. In the global capital markets, the “long-shots” tend to come in more regularly than you might imagine.

Mark OByrne