In most casino games, one plays against the house; the house writes the rules, enforces the rules, and ensures that the odds are always stacked in their favor. This activity has a negative expected value, and I would classify it as gambling. Value investing is not gambling. When properly understood and implemented, value investing has a positive expected value. In other words, value investors can find situations where they have an advantage and the odds are stacked in their favor. They may not always win, but they are not gambling.
I am playing in a poker tournament this week, so I have been thinking about the overlap of my job as a value investor with my strategy as a poker player. Poker, unlike most casino games, is played against other individuals, not the house. So in poker, it's possible to be an advantage player and have a positive expected value.
Like many people, my education on the topic of poker tells started with the great Caro's Book of Poker Tells: The Psychology and Body Language of Poker, which teaches you how to read your opponent in order to get an edge. Does anything like that exist in the investing world? Yes, it does. Tactical behavior assessment services are used by certain investors to detect whether corporate executives are exaggerating accomplishments, avoiding discussing a topic, or are flat out lying.
People are not naturally good at lying. Holding the truth and a lie in one's head at the same time is difficult, uncomfortable, and causes cognitive dissonance that shows up in both verbal and non-verbal signs. There is scientific evidence regarding how to observe and how to exacerbate these signals. In both poker and investing, it can be lucrative to know how to detect deception.
"If you think the math isn't important, you don't know the right math."
- Chris "Jesus" Ferguson, 2000 World Series of Poker champion
Poker and investing are both about decisions amidst risk and uncertainty, played out in real time. The core of both poker and investing is the maximization of average profit based upon probability. In both activities, intuition is a dangerous guide. Quantitative reasoning, instead, is key to exploiting counterparties. Both rely on the branch of economics known as utility theory. Utility theorists quantify preference orders such that a utility maximizer can determine how to make rational decisions. Making the most money requires that participants maximize the expected value (EV) of decisions. To the end of maximizing EV, we use probability distributions in which we study and quantify all possible outcomes as well as their probabilities. The EV of a probability distribution is based upon the numerical value of every possible outcome.
What is my takeaway from poker math? My major concern is this: if I could see everyone's cards, what would I do? I judge myself based upon my proximity to that behavior. There will still be losses and there certainly will always be bad cards. Who cares? The key is to have one's decisions approximate expectancy maximization as closely as possible. One should aim for perfect optimization minus only unavoidable constraints. For the investor, the analogous question is this: if you had perfect information, what would you do? Stocks will go up and down and subsequent events will hurt business, but what should your decision be today, assuming perfect information? Make those decisions as best as you can with the information available.
If you want to read more about poker math, I would start with The Theory of Gambling and Statistical Logic. For further reading, two other superb poker books are The Mathematics of Poker and The Theory of Poker.
Liquidity-constrained counterparties make the best opponents. It is much easier to play an advantaged game with more chips. The Professor, the Banker, and the Suicide King: Inside the Richest Poker Game of All Time is a wonderful book about Andy Beal's triumphs at the poker table. Beal is a good poker player, but not one of the greats by professional standards. That being said, he could play a winning game of poker simply by being rich enough, and willing enough to gamble that he threw everyone else off of their games. He turned -EV to +EV by playing well enough with a very strong stack.
In the financial markets, large investors have specific advantages based on their size, access, trading cost, timing, etc. Outside passive minority investors (OPMIs) often lose because larger players or insiders can influence a situation. DELL and OTC:AUTO are examples of buyouts where management and private equity firms receive a much better deal than outside passive minority shareholders.
What does this teach me about investing? It tells me that I always want more liquidity than my counterparties in the capital markets. I always want relatively larger, influential stakes in the companies in which we invest. I look at the ideas that we are considering and, even before picking individual ones for the portfolio, ask myself if we are taking every advantage. Specifically, within the individual security, are we able to position ourselves relative to scale, concentration and liquidity to have an advantage. Anyone who shows up for a fair fight is unprepared, and we never show up unless we have an advantage.
Unsurprisingly, given these overlaps, many of today's top investors are also serious poker players; (the list includes Cliff Asness, Ken Griffin, Jim Simons, Boaz Weinstein, who once won a Maserati playing poker, Steve Cohen, who once quit his job so that he could focus on poker, Peter Muller, David Einhorn, Marc Lasry and of course Andy Beal). And Carl Icahn? He got his start by winning $4,000 playing poker in the army.