Value Spotlight

🎓 Letters to Investors: What Are The Odds Again?

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In part 1 of this series examining probabilities of the stock market, entitled What Are the Odds, we saw a few sobering statistics about individual stocks.

Maybe the most disappointing fact, quote:

Looking at the track record of Warren Buffett, his heavy concentration into his best ideas makes all the more sense from a probabilistic mindset.

But that's not the only way to skin a cat.

I hope to shine some imagination into how stock pickers can deal with the hard truths of the odds of the stock market— by diving into probabilities once again.

Odds/Probabilities

Odds are useful for sports betters, poker players, and Yahtzee enthusiasts because they describe your average chances of winning.

Take a six-sided die, for example.

Your odds of rolling a "4" are 1/6, because there are 6 possibilities.

If you were to roll a die (with no defects) something like 100,000 times, the number of times you roll a "4" would be around 1/6, or 16,667 times.

The probability of rolling a "4" again is 1/6, or a 16.7% chance.

Knowing this probability can also tell you, as a decent approximation, what odds are good or bad to make a bet.

If you had 6 dice rolls, your odds are pretty good that you'll roll a "4" at least once.

Of course, nothing with odds and probabilities are a guarantee, which can make these games dangerous to play, especially with hard earned money.

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The Odds of Stocks: Part 2

Remember that in part 1, I ran a backtest using today's S&P 500 constituents to look at average 10 year stock returns. A stock had to have 10y+ of data, so our sample size was around 450.

Taking that same list, and running a similar backtest but using Free Cash Flow per Share, I find the following distribution:

The higher that a bar reaches on the chart, the more companies there were with a particular range of growth rates. In this case, our sample size was 394, because a company had to have positive FCF in both 10y periods examined.

As we can see, similar to the chart in part 1, we have a normal distribution of outcomes, with fat tail outliers especially on the upside.

Most stocks, or about 100 of them, had 10 year FCF/share growth of 7% to 12% annualized.

Throwing a dart at random, our best chances (or highest probabilities) are picking a stock with a 10y FCF/share growth of 7% to 12% annualized.

Our second best chances, with almost 100 occurrences, would be to pick a stock at random with a 10y FCF/share growth of 2% to 7% annualized.

Again, with a small sample size in a single point in time, I found the median CAGR to be 7.9%, while the average CAGR of all was 8.4%.

The Odds of 5 Star Businesses

Another way we can think of the data is by grouping stocks into 5 approximate buckets:

• 5% or less growers/decliners
• 5%+ growers
• 10%+ growers
• 15%+ growers
• 20%+ growers

Or to make it simple, classes of 1 star through 5 star businesses.

In this description, a "5 star" business counts in stars 2-5, because a 20%+ grower is also a 15%+ grower, a 10%+ grower, etc. This works enough to tell us some approximate "odds."

The odds become discouraging again; our chances of picking a "5 star" business was around 7%. A stock picker might get lucky to pick a 5 star business once every 14 times, and probably has to take higher risks (especially with valuation) trying to do so.

Imagining Success

Average investors have an advantage with the ability to pick their spots. You don't have to swing at every pitch, and you can keep a truly long-term mindset.

My circle of competence, personally, has been the 2 star to 3 star range— businesses expected to grow at 5% - 10% per year with the possible upside for more. I find the odds to be greatly in my favor through careful selection in this specific sweet spot.

But every once in a while, extreme pessimism can put a 4 star or 5 star business into potential reach, enabling tactical risk-taking in the right context.

Consider the odds of a 4+ star business again, a 15%+ grower over 10 years. With odds of success of 16%, if you take 6 swings at a stock like this, you have a decent shot of hitting at least one.

The compounding effect of one winner could, in theory, pay for more losers.

For example, say we bought 6 stocks that were 4 star businesses with 4 star valuations that we thought would grow 15% for 10 years. Say 5 of those reverted to 3 star businesses, now with a growth rate of only 10% and a lower valuation multiple because of it. Our 1 superstar business maintained its growth rate of 15% and did not see its valuation multiple compress.

We'd see the following results:

Using our backtest dataset, we'd underperform the sample size by about 0.6% annually.

Now let's say our 4 star business with a 4 star valuation turned into a 5 star business. The compounding works better in our favor in this case:

In this case, we'd outperform the sample size by about 1.1% annually. The upside could be even greater if the 4 star valuation turns into a 5 star valuation too.

What to Do About It

There are a wider range of outcomes when you fish for 5 star businesses, which can make it a thrilling endeavor.

In this case, you only need the proverbial "one" that Akre and others talk about to make your investing career. Benjamin Graham had his "one" with GEICO, Ron Baron had Tesla and Bill Miller had Amazon.

But this can be much more complicated than it sounds.

1. In our examples above, we assume less mean reversion

For our hypotheticals, we took 4 star businesses with 4 star valuations and assumed these stocks regressed into 3 star businesses with 3 star valuations. Reality could bite much harder than that; stocks (and especially growth stocks) can degrade to much worse than that.

That said, picking the right 4-to-5 star businesses might help a stock picker to stay closer to these hypothetical outcomes.

Like Bill Brewster astutely said on an episode of Value After Hours, not all stocks have the same risk of reverting to the mean. In the same way Chicago real estate is not average, some stocks are simply not average and will not carry average valuations for a long time through their life cycle.

2. Concentration is VERY dangerous in these stocks

Remember the low odds with the 4-to-5 star businesses, and what putting high conviction capital into these ideas means.

If you make a 25% position size concentration bet on a 4-to-5 star business, you are really only giving yourself 4 dice rolls. (We all only have 100% of capital, you can only make a 25% bet 4 times).

In effect, you are rolling the die only 4 times for a game with only 16% or 7% odds.

In that scenario, according to the probabilities, you are NOT likely to have a successful outcome because your large position size isn't allowing you to take enough swings.

There's taking additional risks, and then there's being reckless.

Seasoned stock pickers have all likely been there at one time or another— be grateful if you happened to be fortunate if you make a mistake like this.

3. Start with the end in mind

If you want to be the next Chuck Akre, building a portfolio of above-average stocks while maintaining below-average risk, the caution against concentration should be considered again.

Take our winning example above, in this example you bought a 5 star business and turned $100 into $600.

If you start with a 10% position size at time of purchase, you will have a position that's now close to 60% of your portfolio!

Your risk profile shifts from average to enormous.

Key Takeaways

To me, Tom Gayner epitomizes the ultimate low risk, high margin of safety kind of portfolio for the equities portion of the insurance company Markel. Gayner's portfolio has 128 positions; he is very selective with his position sizes.

Yet even Gayner likes to share the story of Benjamin Graham's GEICO investment; this single investment outpaced all the other lifetime gains of Graham's portfolio combined.

As Tom Gayner said in his Talk at Google:

So, if we're to take the data around stock market returns and historical FCF growth, we should remember that if we're searching for 5 star businesses:

1. Be humble.

2. It's simple, but it's also hard.

3. Paying up for a potential 5 star business might feel risky, but in the right context it might make a ton of sense if you have the risk appetite.

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