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  #1  
Old 11-24-2007, 08:33 PM
DesertCat DesertCat is offline
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Default Why Sklansky\'s idea should not work

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.
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  #2  
Old 11-24-2007, 09:52 PM
etizzle etizzle is offline
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Default Re: Why Sklansky\'s idea should not work

not saying i agree with sklansky, but i think the crux of his argument is this.

Your FA analysis determines the price at which you think the purchase of the stock is neutral EV (vs avg market returns).

The market price thinks its 'value' for the stock will also be EV neutral. The market price is almost def better than a random price, regardless of how far it is from the true value.

For example, if your FA says it should be 140, and the market says its 100, would you say the true value is more likely to be 100 or 180? Independent of the market price it should be neutral (maybe not exactly because the diff between 140 and 180 is less then 140 and 100 % wise), but with the market price known it is almost certainly more likely to be closer to $100.

Thus the market price is a better predictor then a random selected price, even if that price is likely to be off given your FA. Your coinflip ESP analysis would then apply, regardless of how badly mispriced the stock is relative to your FA value.
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  #3  
Old 11-25-2007, 12:24 AM
DesertCat DesertCat is offline
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Default Re: Why Sklansky\'s idea should not work

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Thus the market price is a better predictor then a random selected price, even if that price is likely to be off given your FA. Your coinflip ESP analysis would then apply, regardless of how badly mispriced the stock is relative to your FA value.

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A random price does not offer a neutral EV, it's clearly offering -EV. Pick a random price in the range of 0-$134,000 (Berkshire Hathaway's current stock price), which corresponds to the range of prices currently available on the exchanges. 99.99% of the randomly chosen prices would be dramatically higher than the value of a randomly chosen stock.

So while market prices are clearly better (offer more EV) than random prices, that fact does not make market prices +EV. As I've explained, EMT is based on the idea that market prices are neutral EV.
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  #4  
Old 11-25-2007, 02:46 AM
Mark1808 Mark1808 is offline
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Default Re: Why Sklansky\'s idea should not work

Here is the problem with David's theory as I see it. Some small percentage of stocks in the market are priced too low. Lets say maybe 5 out of 100 are for example. Lets say you had a barrell with 95 red marbles and 5 blue, the market for marbles. The market is very good at making red marbles. If you were color blind and picked one you'd have to bet it would be red, because the market makes mostly all red marbles and you can't tell the differance. Buffett is not color blind like most investors when he picks a blue one, he knows its blue even if the market is 95% red.

But Buffett isn't always right. Well lets say that one of the red marbles is painted blue so that Buffett thinks its blue, but its actually red. Is their any advantage in Buffett disagreeing with his blue choices just because he knows some will be wrong and the market is very good at making red marbles. The answer is clearly no.

Another thing to add is the market is believd to be mostly effeciently priced. If Buffett is wrong in the stock being undervalued the next logical choice is that it is in fact fairly valued and should expect a market return. Even if he is only half right in picking undervalued stocks he should be reasonably certain the half he is wrong on are actually fairly priced. In fact if you find just one stock out of ten that outperform the market and the rest equal the market performance you will do better than most mutual funds and professional money managers.
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  #5  
Old 11-25-2007, 04:56 AM
David Sklansky David Sklansky is offline
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Default Re: Why Sklansky\'s idea should not work

You haven't changed my stance. But I thought of a different way to explain what my stance is (one aspect of it anyway) to those who may still not be following me.

Also the following is true regardless whether there is non public information or not.

Imagine an astute stock handicapper/bookie, living on a colony on Mars, that doesn't get stock quotes but does get all the public information about some twenty companies. With this information he allows his co colonists to "buy" or "short" any of these twenty stocks at the price he puts up. And he takes a 5% commission. When they get back to Earth, years later, they settle up based on that future price after discounting interest rates and whatever.

Now this guy is really good. His prices are close to perfect. Meaning that both buying and selling at his price will usually have a break even EV on the settlement date and cost you 5%. But he is not perfect. If he was, he would be unbeatable. But since he isn't, the colonists try to figure out a way to take his money. So what they do is establish contact with an earthling who DOES see stock quotes. Most of which, by the way, are quite similar to the Martian bookie's. But a few are not and when this happens the other Martians take the side that the quotes would indicate to. Either "buying" when the quote is higher or "shorting" when the quote is lower. If the bookie is indeed not perfect (and we bar super weird graphs regarding his skill) then this method will rate to beat him. That's my basic contention.

BUT. Just to make things clear. Suppose the Martian bookie was a different guy who knew nothing about the market. Except unbeknownst to the other colonists, he had tapped in to someone who knew the market prices. And that was his "line". He would rate to beat his typical co colonists out of the 5% commission on average. And this time those colonists who could find out market quotes would be among those losers. BUT WAIT. Suppose that first bookie went home with his tail between his legs and the colonists now, ironically, instead of beating him with their knowledge of market prices, solicit him to help beat this second bookie who knows the market prices. When he agrees, the colonists now buy or short in the direction of the disgraced bookie and away from the market price of the second bookie. And they beat this second bookie EVEN WORSE.

You don't think Buffett would agree with all that?
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  #6  
Old 11-25-2007, 10:21 AM
stephenNUTS stephenNUTS is offline
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Default Re: Why Sklansky\'s idea should not work

I arrived in LV yesterday afternoon,and after finally getting my laptop online at the hotel.....the first thread/post I perused through was this:

Imagine an astute stock handicapper/bookie, living on a colony on Mars, that doesn't get stock quotes but does get all the public information about some twenty companies.

David,I know you love to use hypothetical examples in your arguments,but I am really starting to LOVE your 'realistic' examples more and more [img]/images/graemlins/smirk.gif[/img]

TTYL,
Stephen [img]/images/graemlins/cool.gif[/img]
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  #7  
Old 11-25-2007, 10:41 AM
adios adios is offline
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Default Re: Why Sklansky\'s idea should not work

You wrote in part:

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Now this guy is really good. His prices are close to perfect. Meaning that both buying and selling at his price will usually have a break even EV on the settlement date and cost you 5%. But he is not perfect. If he was, he would be unbeatable. But since he isn't, the colonists try to figure out a way to take his money. So what they do is establish contact with an earthling who DOES see stock quotes. Most of which, by the way, are quite similar to the Martian bookie's. But a few are not and when this happens the other Martians take the side that the quotes would indicate to. Either "buying" when the quote is higher or "shorting" when the quote is lower. If the bookie is indeed not perfect (and we bar super weird graphs regarding his skill) then this method will rate to beat him. That's my basic contention.

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seems to be the similar as what DesetCat wrote in his OP when he wrote:

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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.

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You continue with:

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BUT. Just to make things clear. Suppose the Martian bookie was a different guy who knew nothing about the market. Except unbeknownst to the other colonists, he had tapped in to someone who knew the market prices. And that was his "line". He would rate to beat his typical co colonists out of the 5% commission on average. And this time those colonists who could find out market quotes would be among those losers. BUT WAIT. Suppose that first bookie went home with his tail between his legs and the colonists now, ironically, instead of beating him with their knowledge of market prices, solicit him to help beat this second bookie who knows the market prices. When he agrees, the colonists now buy or short in the direction of the disgraced bookie and away from the market price of the second bookie. And they beat this second bookie EVEN WORSE.


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Hmmnm.... Interesting.

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You don't think Buffett would agree with all that?

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Don't know about the second part but maybe.
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  #8  
Old 11-25-2007, 01:14 PM
Jcrew Jcrew is offline
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Default Re: Why Sklansky\'s idea should not work

So the compact version of the conjecture is that the few times a super investor errs on his valuation, the probability distribution of the valuation is biased towards the market valuation?

Edit: If my interpretation of your conjecture is correct, I think it fails in the case where he and the public consistently incorrectly estimate some factor, but he doesn't as badly.
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  #9  
Old 11-25-2007, 02:09 PM
Mark1808 Mark1808 is offline
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Default Re: Why Sklansky\'s idea should not work

Since the market is not static and in fact has shown a propensity to rise 10% a year on average those who bought a basket of stocks are going to come out ahead no matter which of the bookies they follow, although they would do better with the one who has a propensity to find stocks priced too low. There is no "settlment" at true value in stocks like there is with a sports bet.

There is no assurance that just because a stock is over priced today it won't be over priced tomorrow. Buffett said in the short run the market is a voting machine and some stocks can stay popular and over priced for years resulting in large losses on the stocks you choose to short even if those stocks are over priced by reasonsable measures. This explains why Buffett does not short stocks outside of arbitrage positions. If Buffett agreed with you why wouldn't he also take short positions in stock?

Your example works great where market prices are static and the true intrinsic value of a company will be determined and reflected in the market price shortly. In the market there is no gurantee stocks will gravitate towards intrinsic value and intrinsinc value is ever changing meaning its value may change drastically before the market price ever reacts to yesterdays value. Buffett's skill has been to find company's that are not just undervalued but increase in instrinsic value at a better than market rate due to a "competitive advantage". Even when he is off on the proper valuation this "competitive edge" more than makes up for it. In fact he said he made a big mistake buying Berkshire Hathaway, because although it represented quite a bargain based on assets and such it was in a lousy business. This is in fact one of Buffett's great quotes that directly relates to this issue, 'It is better to buy a great business at a fair price than a fair business at a great price'.
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  #10  
Old 11-25-2007, 09:23 PM
etizzle etizzle is offline
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Default Re: Why Sklansky\'s idea should not work

[ QUOTE ]
[ QUOTE ]

Thus the market price is a better predictor then a random selected price, even if that price is likely to be off given your FA. Your coinflip ESP analysis would then apply, regardless of how badly mispriced the stock is relative to your FA value.

[/ QUOTE ]


A random price does not offer a neutral EV, it's clearly offering -EV. Pick a random price in the range of 0-$134,000 (Berkshire Hathaway's current stock price), which corresponds to the range of prices currently available on the exchanges. 99.99% of the randomly chosen prices would be dramatically higher than the value of a randomly chosen stock.

So while market prices are clearly better (offer more EV) than random prices, that fact does not make market prices +EV. As I've explained, EMT is based on the idea that market prices are neutral EV.

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DC, they are neutral EV, yes. What I'm saying is that if you have to pick one side of your FA value or the other, would you rather choose the market side, or flip a coin?
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