Improving On Buffett And Desert Cat

[David Sklansky]

Plenty. I am 99% sure.

Billy Walters and his team make their line befor they see the real line. They are supposedly the best in the world. How do you think I would do if I could bet into their line, laying 11-10 armed ONLY with the information as to what the actual line is.

I'm not talking about hedging. Just betting one side. Furthermore I won't force them to put up a line on every game. Just the two or three every week where they are most sure of their opinion. If they let me do that (my strategy would be to bet the public side when they disagreed by four points or more, getting HIS LINE don't forget) I would be the one owning golf courses pretty quickly.

[Jimbo]

[ QUOTE ]
Plenty. I am 99% sure.

Billy Walters and his team make their line befor they see the real line. They are supposedly the best in the world. How do you think I would do if I could bet into their line, laying 11-10 armed ONLY with the information as to what the actual line is.

I'm not talking about hedging. Just betting one side. Furthermore I won't force them to put up a line on every game. Just the two or three every week where they are most sure of their opinion. If they let me do that (my strategy would be to bet the public side when they disagreed by four points or more, getting HIS LINE don't forget) I would be the one owning golf courses pretty quickly.

[/ QUOTE ]

If only determining the value of a corporation were as easy as this.

Jimbo

[DesertCat]

[ QUOTE ]
"Buffett never lets the market price influence his estimate of value"

I'm sure you are wrong. You are misreading his words. He is only saying that he makes an estimate of value without letting the price (which he would prefer to be unknown to him while he is making this estimate) influence him.

But if the price is signifantly different than his estimate he would be an idiot not to revise it. No expert in any field would do otherwise. In other words lets say he thought a stock was worth 100 and the market made it 60. a He has to bet whether or not it will over or below 90 in three years. Disregarding interest rate considerations, I'm sure he would bet under. He might bet over 70, or even 80. But he would have to believe that his estimate is probably too high once he saw the price. You basically admitted this yourself. Otherwise why give yourself this large margin of error?

[/ QUOTE ]

I guess you didn't read the "Mr. Market Parable" I linked to. Read it and decide whether it is I or you who are misreading his words.

And a large margin of "safety" is because IV is an estimate. But it's an estimate that doesn't become more accurate by taking a vote from a disparate group of people with different investment philosophies, goals, and abilities, i.e. "the market". In the short run the market is a voting machine, in the long run it's a weighing machine (Ben Graham).

When Buffett was done reading PetroChina's annual report for the first time in 2003, and before he knew their stock price, he said anyone could who read that report could see that PetroChina was worth more than $100B. When he found out it's market cap was $37B, he didn't revise his estimate, he bought with both hands as fast as he could. In fact, he didn't sell until PTR reached a $200B market cap, demonstrating what he feels PetroChina is really worth.

[David Sklansky]

Note: I added a second post immediately after this that explains my stance in greater detail. Please read both posts before replying

"When Buffett was done reading PetroChina's annual report for the first time in 2003, and before he knew their stock price, he said anyone could who read that report could see that PetroChina was worth more than $100B. When he found out it's market cap was $37B, he didn't revise his estimate, he bought with both hands as fast as he could."

He did revise his estimate. Or perhaps this was an very rare exception and he didn't. But the fact that "he bought with both hands" says nothing about whether he revised his estimate. And I would be extremely shocked if Buffet wouldn't fully agree with my stance. The logic is almost irrefutable. It works like this:

Mr Market may be a manic depressive and you are not. But your estimates are admittedly far from perfect. And sometimes Mr. Market is feeling both sane and more expert about a stock (for legal or illegal reasons) than you are.
When that happens you are taking the worst of it when you invest. One way to insure an overall profit is to restrict yourself to trades where it APPEARS your edge is huge. Your edge won't be as huge as it appears because you will occasionally run into a sane, smarter (or more dishonest) than you Mr. Market. But that won't happen often enough to make up for the times you are up against crazy Mr. Market.

So the above method will work, though not to the degree it would appear. But it is leaving money on the table. Because it forces you to eschew what appears to be smaller edges, since you are not sure you are fighting smart Mr. Market. To get some of that money on the table requires an ability to know which Mr. Market has shown up today. If you are reasonably accurate you can start betting more of what appears to be 20% edges and sometimes pass on what looks like bigger edges.

[David Sklansky]

"And a large margin of "safety" is because IV is an estimate. But it's an estimate that doesn't become more accurate by taking a vote from a disparate group of people with different investment philosophies, goals, and abilities, i.e. "the market"."

Here I can say with 100% certainty that you are wrong. But before going any further I want to say to you what I say to my private poker students who get upset when they realize that were wrong about a long cherished belief. "Don't be upset. Be happy. Because you are now going to get richer."

Forgetting interest rates and the inherent upward bias of stocks a randomly picked stock will show a break even EV if you buy or short it. Known fact.

If there exists a perfect stock evaluator then buying or selling a stock at the price HE quotes will show break even EV.

If the perfect stock evaluator thinks the right price is ten dollars less than the market price, then shorting the stock will give you an EV of ten dollars. And you will average 17 cents profit if there is a 17 cent discrepancy.

If the expert stock evaluator is less than perfect, buying or selling at HIS price will STILL show a break even EV but only if you buy or sell RANDOMLY. But if you buy or sell into HIS prices with INFORMATION you will beat him. As long as that information isn't totally random. One example of non random information is Jimbo's opinion of a stock. If you invest at Desert Cat's price opinions randomly, except when Jimbo disagree's, you MUST show an eventual profit.

YOU MUST. DO YOU UNDERSTAND? Because you would break even even if Jimbo merely threw darts.

If instead you used the Market's opinion rathe than Jimbo's you would also show a profit. Since the market's opinion of a stock is also obviously better than random.

If the last paragraph is true, which it is, that means that the "true" expected value of a stock must be somewhere between the non perfect expert's opinion and the market price. In other words if you are an expert who has estimated a price before seeing the market price, you MUST, on average, revise your estimate TOWARD the market price after you see it. Period.

[Jimbo]

[ QUOTE ]
If instead you used the Market's opinion rathe than Jimbo's you would also show a profit. Since the market's opinion of a stock is also obviously better than random.


[/ QUOTE ]

I found this portion of your post very interesting. How do you reconcile the fact that one second in time the market says a stock is worth say, $109.10 per share and one second later the market says the value of the stock is $109.45? What changed in the underlying value of that stock from one second to the next?

Keep in mind there may be 100 million shares outstanding at that moment in time. Did the company's checking account balance just increase by 35 million dollars?

Jimbo

[David Sklansky]

The non randomness may not apply to pennies. In fact I speculated in a different thread that this may be part of DE Shaws strategies. But I am not sure you are getting the concept. The market's opinion is obviously closer to correct than a random opinion. Any non random opinion shows a profit against Desert cat's line if there is no juice. I used Jimbo's in my example but I could have just as easily used Aunt Hattie's. I probably should have.

[DesertCat]

[ QUOTE ]
"And a large margin of "safety" is because IV is an estimate. But it's an estimate that doesn't become more accurate by taking a vote from a disparate group of people with different investment philosophies, goals, and abilities, i.e. "the market"."

Here I can say with 100% certainty that you are wrong. But before going any further I want to say to you what I say to my private poker students who get upset when they realize that were wrong about a long cherished belief. "Don't be upset. Be happy. Because you are now going to get richer."

[/ QUOTE ]

You know David, I'm not offended by this. But I probably should be. I'm a professional investor with annualized returns north of 30% per year. You are an amateur investor who has a fraction of my investing experience. Don't get me wrong. I am always open to learning more. I study my craft intensely and don't feel I know everything. But it's a little disconcerting to hear that you are going to make me better at something I'm already great at, when you don't even have a track record in this area.

[ QUOTE ]

Forgetting interest rates and the inherent upward bias of stocks a randomly picked stock will show a break even EV if you buy or short it. Known fact.

[/ QUOTE ]

A specific randomly selected stock will show an EV based on it's IV vs. the price you paid for it. I think you mean that a group of randomly selected stocks will likely approximate the markets average return, with variance that depends on the size of the group in relation to the size of the market group. That's because the mispricing that occasionally occurs is "evened out" in big groups. But for individual stocks it can be egregious.

[ QUOTE ]

If there exists a perfect stock evaluator then buying or selling a stock at the price HE quotes will show break even EV.

If the perfect stock evaluator thinks the right price is ten dollars less than the market price, then shorting the stock will give you an EV of ten dollars. And you will average 17 cents profit if there is a 17 cent discrepancy.

If the expert stock evaluator is less than perfect, buying or selling at HIS price will STILL show a break even EV but only if you buy or sell RANDOMLY. But if you buy or sell into HIS prices with INFORMATION you will beat him. As long as that information isn't totally random. One example of non random information is Jimbo's opinion of a stock. If you invest at Desert Cat's price opinions randomly, except when Jimbo disagree's, you MUST show an eventual profit.

YOU MUST. DO YOU UNDERSTAND? Because you would break even even if Jimbo merely threw darts.

[/ QUOTE ]

Are you trying to say the market price is the sum of all skilled participants opinions? Because if you are, you are only correct most of the time. Because the market itself, is only efficient most of the time. And I'm not a market participant when the market is efficient. I think you might believe in the efficient market theory a little too strongly.

Do you realize that many market participants are unaware of earnings of a company they buy, that most participants never do any sort of valuation estimates at all? That many practise TA concepts with no FA at all? That a large participant with an urgent need for cash can quickly drive a stock's valuation down to unreasonable levels? I.e. a single participant may have a long lasting influence on price far greater than thousands of other participants, even if they are more rational and better evaluators than he.

[ QUOTE ]

If instead you used the Market's opinion rathe than Jimbo's you would also show a profit. Since the market's opinion of a stock is also obviously better than random.

If the last paragraph is true, which it is, that means that the "true" expected value of a stock must be somewhere between the non perfect expert's opinion and the market price. In other words if you are an expert who has estimated a price before seeing the market price, you MUST, on average, revise your estimate TOWARD the market price after you see it. Period.

[/ QUOTE ]

The value of the stock is the value of the stock. It's not affected by a participants opinion, my opinion, or the stock price. If you come across an obviously mispriced stock, you should adjust your opinion based on others who are clearly wrong?

I'll give you credit in one way. The reason to have a margin of safety is to overcome uncertainty. Part of that uncertainty is that you misunderstand, or mis-estimate company risks. By having a large margin of safety, if it turns out that your risk estimates were too low, and the markets were too high, and the real valuation is in between, you can still make a profitable investment. But that doesn't imply that the real value is always between your IV estimate and the market's. My experience is that is seldom true.

So I don't adjust my estimates for market opinions. I adjust them for facts. I use my interpretation and my judgment to make the best estimates, and I stick with them until new facts require me to change.

Real World Example: Preview Systems is a microcap with over $3.50 per share in net cash, easily ascertainable from their financial filings. They have sold their business and have few remaining liabilities and employees. They announce that they will liquidate and distribute $3.25 to shareholders immediately upon completion of a shareholder vote at a meeting to be held in one month. Afterwards they expect to pay out another 25-50 cents over the next year as they complete the liquidation process. I know that management in these cases is highly incented to be conservative in their estimates for some obvious reasons. So I estimate PRVW's value to be around $3.50 per share, given the likelihood of a $3.75+ payout, discounted a little for time. For the week after the release of this information the stock price trades at $2.93.

Should I adjust my estimate because of this low price? No, think about who is setting the price. The existing shareholders don't know anything about liquidations. They bought PRVW thinking it was going to be the leader in internet ecommerce and be a $400 stock someday. Now they are just going to get a tiny fraction of that in cash. Some want out of their "dead" internet company so they can trade into a live one so they can make "high returns"? Some are frightened this means bankruptcy, or hate mgmt for failing and don't trust a word they say and just want out before they lose it all. And a 20-30% return seems small to those who were waiting for a big payday, they don't realize that over one month makes it equivalent to an annualized 1600% return. No one from Wall Street is covering them anymore, it's a sub $50M market cap. So why should I adjust a clearly rational IV estimate for a bunch of irrational actors who are selling for differing reasons?

I'll give you the river card on this one. I stuck to my estimate, bought with both fists, and the eventual payout was $3.90 total, so I made about a 30% return for one months use of my money.

[DesertCat]

[ QUOTE ]

"When Buffett was done reading PetroChina's annual report for the first time in 2003, and before he knew their stock price, he said anyone could who read that report could see that PetroChina was worth more than $100B. When he found out it's market cap was $37B, he didn't revise his estimate, he bought with both hands as fast as he could."

He did revise his estimate. Or perhaps this was an very rare exception and he didn't. But the fact that "he bought with both hands" says nothing about whether he revised his estimate. And I would be extremely shocked if Buffet wouldn't fully agree with my stance.

[/ QUOTE ]

David, Buffett disagrees with you. It doesn't make you wrong, but clearly he doesn't think the same way you do. I've read almost everything he's written or said, and he's very clear about his philosophy. He doesn't incorporate market prices into his valuation estimates. He is looking for situations where the market is wrong, so why would he listen to it's opinion? He's actually said once he's established his positions he would not care if the market was open only once a year, or even every five years. He buys many private businesses, his approach has no need for public stock quotes.

In the PetroChina case he described clearly what he does. Never did he mention using the price to validate his estimate. For you to be right, you must assume that Buffett lies about his methods. The problems with that is

a) Buffett shares his methods freely, even though he isn't required to. If he were lying about his methods (to throw off the competition?) he could just tell people he uses astrology.
b) Even if Buffett was lying about his techniques, they've been documented by his teacher, Ben Graham, in several books that are taught in CFA courses as FA bibles much as TOP is a poker bible. They are responsible for dozens of other top value investors of outstanding accomplishments who credit those accomplishments to following the same rules and wisdom in interview after interview. Walter Schloss is a perfect example.
c) Buffett a life long reputation for directness and honesty.
d) If he used the market price to validate his IV estimate in the PetroChina example, wouldn't he be forced to dramatically lower it, say to $60B to better match the price? So why did he wait until $200B to sell his shares? He always sells before stocks reach IV. It's hard to imagine he nearly quadrupled his IV estimate when earnings only doubled during that span.

So while it's always possible someone is lying, all evidence suggests it's extremely unlikely for Buffett to be lying about using market prices to validate his opinions. The burden is on you to show some evidence he ever has.

[ QUOTE ]
The logic is almost irrefutable. It works like this:

Mr Market may be a manic depressive and you are not. But your estimates are admittedly far from perfect. And sometimes Mr. Market is feeling both sane and more expert about a stock (for legal or illegal reasons) than you are.
When that happens you are taking the worst of it when you invest. One way to insure an overall profit is to restrict yourself to trades where it APPEARS your edge is huge. Your edge won't be as huge as it appears because you will occasionally run into a sane, smarter (or more dishonest) than you Mr. Market. But that won't happen often enough to make up for the times you are up against crazy Mr. Market.

So the above method will work, though not to the degree it would appear. But it is leaving money on the table. Because it forces you to eschew what appears to be smaller edges, since you are not sure you are fighting smart Mr. Market. To get some of that money on the table requires an ability to know which Mr. Market has shown up today. If you are reasonably accurate you can start betting more of what appears to be 20% edges and sometimes pass on what looks like bigger edges.

[/ QUOTE ]

I think your error is that you think there is a huge amount of hidden information incorporated into most stock prices. Buffett and I would say not. Many business can be valued simply through audited financial statements. And that value usually doesn't change much depending upon the news from one quarter or who is running the company.

The market is generally not inefficient because of fraud or insider trading. It's because there are skills to valuing companies (FA) & making investing decisions (patience to wait for big margins of safety, rationality to focus on businesses where IV can be accurately estimated, resistance to Mr. Market and other negative influences,etc.) and there aren't that many skilled practitioners. And the smaller the market cap, the fewer skilled participants exist.

And missing small edges is probably +EV. If you can eventually expect to find big edges, pursuing smaller edges ties up time and capital on lower return investments just when it might be needed for the next PetroChina.

[David Sklansky]

One last try. The Bellagio makes a line on football games. They are the best linemakers in the world. Their line is almost always perfect. So even a professional bettor who beats his bookie 56% of the time only picks 50.1% when he faces the Bellagio.

Joe Schmo is barely break even in his opinions. But he is better than the dart board thrower. (This is an important point.)

The Bellagio says the Yankees will win 70% of the time today. Joe Schmo thinks they will win 60%. In other words the Bellagio says that anyone holding a $100 even money bet has an equity worth $40. Joe says it is worth $20. Its TRUE worth is a tad below $40. Maybe $39.50. Change Joe Schmo to Mr Market. (And I would still love to bet that Buffett both agrees with me and doesn't think his words dispute my words)

Meanwhile your comment about being a 30% a year winner and me being an amateur is not only flawed, but ironically in a similar way that your analysis is flawed. Because I don't claim to be able to top your 30%. I only claim that I could top it if I had a DesertCat clone working for me.