Why Sklansky's idea should not work

[DesertCat]

David's original recommendation was that you value both the company, and estimate what the market will price the company at. Using the discrepancy between actual price, your guess at the market price and your estimated value gives you the tools to determine if your price is "good".

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If, on the other hand your evaluation of a stock's worth is significantly different from your guess as to what the market price is, you have a play if you are about right about the market price. My gut feeling is that the best situation occurs when the actual price is shaded slightly toward you own valuation. In other words if you think a stock is worth 20 and you think the public will price it at 29, I would feel best about shorting it if it is about 27. Its an indication that some rich, smart people might be agreeing with me.

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Now this application is easy for me to dismiss. I feel I have no idea how to predict how the public markets arrive at prices each day, and am skeptical anyone has any predictive ability at that "game". But that's not a counter-proof, TA adherents and David would just disagree with me and we are back to ground zero.

This is where I think David makes his mistake.

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

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Now I think my counter-proof was already touched on in the thread by several people, including myself. But I believe it's worth re-stating for clarity.

David bases his idea on the logical certainty that two good, but imperfect predictors can improve the accuracy of their predictions by taking the other's prediction into account. And I agree with this.

To demonstrate it with an example for those who haven't read that thread, assume David and I have coin flip ESP. We both can predict whether a flipped coin will land on heads or tails with greater than 50% accuracy. I can do it 51% of the time, and David, possibly because of his greater intellect, can do it 90% of the time. Unfortunately David's skill is so well known he can only get action at 1:9, essentially an EV neutral bet. But I am unknown to the world of coin flip betting. If David incorporates my independent guess, even though it is much less accurate than his own, he knows if we disagree his accuracy is less than 90% and if we agree his accuracy is more than 90%. Hence as long as he's able to not bet flips we disagree on, he will be profitable betting at 1:9.

So David's idea is that an investor who can rationally value a company, should also incorporate the level of the market's disagreement with him, into his resulting valuation. If he values a company at $100, and the market prices it at $60, he must know the real value is less than $100, even if it's only slightly less, simply because the "market's opinion is better than random" and even the greatest stock valuator can improve their own valuations by factoring in the market price.

But the problem is the assumption is wrong. Efficient Market Theory tells us that market prices are essentially neutral, they are efficient because every price offers the prospect of the same returns going forward, essentially "the market return". And any price deviations from market returns are random, and cannot be predicted/explained by mortal man.

If my coin flip accuracy is 50%, EV neutral, logically I add no value to David's coin flip ESP and he'd be foolish to incorporate my opinions. But market prices are essentially 50% accurate at predicting market returns for individual stocks, hence they can add no value to a trained valuator's judgments.

Now of course value investors only believe in a weak form of the Efficient Market Theory, where market prices are usually efficient, but not always. Value investing (FA) involves searching for the "not always". When a value investor finds what they believe to be an inefficiently priced stock, by definition the current market price must be substantially -EV at predicting this particular stock's future returns. So a value investor would actually reduce their returns by incorporating prices they regard as incorrect.

This does not lead to disagreement with the Sklansky fundamental theorem of investing, i.e. that an investor should understand the other side, and have a good idea why the market is pricing a stock so attractively before buying it. But understanding the other side must be used only to ensure that your analysis is complete, and that you have included all potential risks. But it doesn't extend to using market prices in valuing those risks. Valuations can only be done through your own intellect and research.

David, I believe you got to this point because of the similarities between sports betting and investing, and the apparent value of incorporating market lines in handicapping. But again, there is one huge difference between sports betting and stock market investing, the importance of non-public information. It can often be important in sports betting, and is rarely important in investing. If Bellagio has tremendous skill at sports handicapping, but the public line is substantially different than theirs, it implies the existence of important non-public information on that contest.

But for a value investor, most investments, esp. the ones they will be most drawn to, have little non-public information risk. So worrying about what "smart money" is doing isn't important, the only thing that is important is doing your own research and estimates.

Let me know what you think. If you still disagree I'm still willing to write that letter to Buffett, and you can edit the important parts before I send it.