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This weekend witnessed the 139th running of the Kentucky Derby, a storied tradition of American sports in which a field of horses compete but only one winner will emerge. Watching the event caused me to think about some comparisons between the stock market and sports betting that are an instructive framework for conceptualizing why the market acts the way that it does.

Figure 1: The Thrill of the Kentucky Derby
(Click to enlarge)

First, a bit of background on the role of a bookmaker: the general role of a bookmaker is to act as a market maker for sports wagers. The goal of a bookmaker should be to give a good spread that will attract gamblers to bet for equal corresponding payouts for each possible outcome of the race. For example, if twenty horses compete, a bookmaker should set odds that will attract bets on each horse such that he will profit regardless of the outcome. For a simpler comparison, consider the outcome of a binary sporting event, such as a football game. The bookmaker will offer points causing gamblers to be willing to bet on the underdog. If he has set the line correctly, an equal number of bets will be placed on either team, such that the bookmaker has zero net exposure to the outcome of the sporting event. The same is true for a more complex betting arena such as the Kentucky Derby. Adding the odds or probability of winning for all the horses will result in a total of 100%. If spectators believe the odds for an individual horse are greater they bet on that horse, pushing its probability up and payout down. Then before paying out the bookkeeper subtracts a commission, usually about 10%.

The following chart illustrates this movement. Odds in a race are very dynamic and move up or down based on the perceived chances of a particular horse winning the race. Orb was the favorite both in the morning odds and when the race began, but his odds slipped slightly from 7:2 in the morning odds to 5.4:1 when the race began. The table shows the morning odds and the implied probability of each horse winning the race and then the final odds. The delta factor is the percentage change during this time frame, while the final column shows the difference between the odds implied finish and the actual result. The true outperformer in the 2013 Kentucky Derby was not Orb, but rather Golden Soul who was tied for last in odds of winning, but finished second in the final result. If each horse was a stock, Golden Soul would have netted the best return. Because it is possible to bet not only on the winner, but also for second place or the top three, betting on Golden Soul to place or to show would have netted a higher payout than betting on Orb to win.

Table 1: Changes to the Kentucky Derby Odds on Race Day
(Click to enlarge)

Similarly, the market discounts the future performance of companies. The stocks that net the greatest total return are not necessarily those with the best corporate performance. Instead the greatest capital appreciation comes from the companies that most outperform their expected performance. Because the market is a discounter of widely known information one cannot simply consider the same factors that other investors are mulling over in order to know whether to buy/sell or hold a stock. For example, the economy may presently be weak, however, if other investors already know that the economy is weak then the question becomes whether the economy will outperform or underperform lowered expectations. How else can Friday's stock market surge after a report of 165,000 new jobs be explained? Investors were simply expecting worse and a fair jobs report resulted in a buying frenzy.

In the stock market, the role of a market maker is not exactly analogous to that of a bookkeeper in a sporting event. In this case, there will be bids of buyers willing to own stocks for a certain price and asking prices for sellers willing to part with stocks they own. If you put in a buy order for a stock, you can pay the asking price, or set a limit order for a price that you are willing to pay. Alternatively, a sell order will either take the best price available at the time or you can specify a price at which you would be willing to part with your stock via a limit order. The market maker will take your asking price if he can align a buyer and profit from the transaction. If buyers outnumber sellers eventually the bid will rise along with the price. In contrast, when sellers outnumber buyers the reverse will take place and the price will fall. It is interesting to note that overall the market is setting odds that seem appropriate for a given company at that time. If these odds insufficiently discount a company's performance, more buyers will emerge and the price will rise. If not the price will fall.

A value investor will analyze a company and judge that its worth is greater than the market is discounting. However, a value investor will not profit until other investors also realize that a stock should be purchased and bid up the price accordingly. Thus an essential component of any successful investment thesis must be to anticipate how other investors will judge the value of a company before they do so. Before purchasing a stock, always consider what you know that others do not and how that will cause your purchase to become more attractive at a future date. Perhaps you understand the fundamentals of a business and realize that they should be improving, but the price of the stock in question has not yet risen in order to account for that. Alternatively, you may appreciate that a company is unfairly undervalued, but always consider what will cause other investors to come around to your point of view. At its core, value investing presumes that stocks for which the price is low are too harshly discounted and eventually a reversion to the mean must occur. However, the value investor must ask himself or herself: what catalyst will cause other investors to realize that the price is too low?

One very interesting point regarding sports betting is the severe underperformance associated with betting for the Kentucky Derby favorite. Let us consider two possible bets. First, a gambler could have wagered $100 at each Kentucky Derby since 1981 on the favorite to win the event. Alternatively, assume that another gambler bet $5 on each of the twenty horses competing in the race. Since the bookmaker has an 11 to 10 advantage over his customer as his commission, spreading your money over each available horse would be a losing bet, meaning a gambler would on average win $91 for each $100 bet. However, even with the losing proposition of the second contestant, betting on the winner has been an inferior strategy historically. If you had bet $100 on the favorite to win the Kentucky Derby each year since 1981 you would have collected winnings five times or 15.1% of the time. Usually twenty horses compete, but sometimes less. Since 1981 590 horses have competed or 17.9 on average per year. Thus, placing a random bet you would have a 5.6% chance of picking the winning horse. However, betting on the favorite for $100 each year since 1981 would have only returned $2310, or 70 cents on each dollar wagered. Assuming 11-10 odds in favor of the bookkeeper, spreading $100 equally across the field would have returned $3000 or 91 cents on each dollar wagered.

Table 2: Results from Betting the Favorite Since 1981
(Click to enlarge)

-An asterisk (*) and yellow highlighting indicates that the winning horse was the favorite. The payout is the odds times the bet plus the initial bet. So a $100 bet on Orb at 5.4:1 odds would receive $640.

Similarly, in the stock market betting on the favorite often results in a capital loss even if a favorite stock appears to be modestly valued. For example, Apple (NASDAQ:AAPL) at its peak had a TTM P/E ratio of 16x, seemingly a reasonable valuation relative to the performance of the company. However, betting on the winning horse has thus far resulted in abysmal returns as the share price has collapsed from a high of over 700 dollars per share to sub 400 dollars per share more recently. In stocks and in horse betting, there is often a severe penalty for betting on the favorite. Once everyone has already realized a company is a fantastic investment it becomes difficult for buyers to outnumber sellers and the share price moves down as a result. Thus, the curse of Icarus comes into play and the stock price falls once further buyers cannot be found. As a result, finding unappreciated or unknown companies is a superior strategy as the herd effect causes favorites to be overpriced and underdogs to be underpriced.

Consider the record of Warren Buffett, probably the greatest value investor of all time. Think about the great investments that he has made over the course of his career. He purchased American Express (NYSE:AXP) when it had fallen out of favor. There was not only long-term value and brand recognition in the name, but also a sense among the investing community at the time that the company had permanently fallen out of favor. However, American Express was a huge long-term success story, due to the increasing prevalence of credit cards for financial transactions. Thus, the pick was not only a value investment, but had a terrific long-term investment thesis that would over time cause other investors to realize that Buffett was correct and bid the share price up accordingly. Coca-Cola (NYSE:KO) followed much the same script. After the disastrous performance of "New Coke" in the mid-1980s, Buffett recognized the tremendous long-term potential of the Coca-Cola brand due to increasing consumption of sugary beverages. The resulting returns were spectacular. More recent investments in International Business Machines (NYSE:IBM) and Deere & Company (NYSE:DE) also seem to fit the bill, although the companies are not presently as down on their luck as some of Buffett's most successful purchases. The lesson here is that undervaluation alone is not a sufficient investment thesis, the future prospects of the company are at least as important. Or in Buffett's own words: "It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

Another observation that can be drawn from the Kentucky Derby is that the crowd is often wrong. An investor can take advantage of this dynamic by buying an equal weight exchange traded fund, such as the Guggenheim S&P Equal Weight ETF (NYSEARCA:RSP) in preference to the market capitalization weighted S&P 500 Index ETF (NYSEARCA:SPY). Buying this fund is analogous to betting an equal dollar amount on each horse instead of betting more on horses that are deemed more likely to win. Because the crowd systematically overvalues popular companies and undervalues less well-known companies, betting equally on each company has historically resulted in outperformance. Thus an equal weighted fund is an intelligent way to avoid following the crowd, particularly if you do not have the time or inclination to pick individual stocks.

Finally, horse racing very well illustrates the effect of frictional costs. When you place a bet in a sporting event approximately 10% goes to the bookkeeper as a fee. In the market each time you make a trade you pay your broker a commission and you pay the market maker's bid/ask spread. In addition, any profit you have made will be taxed upon the sale of a winning position. In gambling frictional costs are required every time you want to participate, however, in the market, you are able to either buy a low cost ETF or individual stocks and then hold them so long as you choose. The investor's ability to limit frictional costs is another key advantage and readers should be encouraged to limit these frictional costs as much as they can.

Successful investing bears much more resemblance to gambling than most would care to admit. In fact, viewing the purchase of stocks in the same conceptual framework as betting on horses should lead to greater profit. Ask yourself: is this stock an underdog for no good reason? Is it an unknown company that I have discovered before all the big money managers catch on and bid up the price accordingly? What is it about the company that the rest of the investing community does not yet understand, but will in due course? Then place your bets accordingly, at least in the stock market the payout for each dollar invested leads to a positive return as companies grow and increase their profitability. At the end of the day, this is the main reason to prefer investing in stocks to gambling on horses.

Source: What Can The Kentucky Derby Teach Us About The Stock Market?