Stop picking winners, start finding value
How horse racing reveals the secret to real estate investing.
Let’s say you are a real estate investor who knows your markets inside out. You understand the tenant base and what drives their decisions. You have a firm grasp of the current balance of supply and demand and are confident in your predictions of how that will change. You can combine these data points to build a solid view of which markets are likely to have the strongest growth prospects.
Do these capabilities give you everything you need to select assets and markets successfully? Definitely not. If that sounds obvious to you, read no further. If not, let’s go racing.
The best investment writing isn’t about investing
“Crist on Value” is a seminal piece of writing. It has been described as one of the best texts on investing, even though it is about horse racing. It is routinely distributed to students at leading business schools. Many of them find it a revelation.
Crist focuses on those racegoers who handicap well. In other words, people who put the time in and build up the expertise to predict racing outcomes effectively. For gamblers, handicapping is an essential skill.
But, as Crist says, “if you handicap well and bet poorly, you’ve failed”. Too often, a skilled handicapper is “unable to convert his knowledge into something useful,” he writes.
Crist argues that we have been conditioned to “find the winner, then bet”. But if that is how you approach betting (or, I would add, investing), you need to adopt a new way of thinking.
It’s all about the odds
Success isn’t about picking winners. It is about finding mispriced odds.
“Even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds,” states Crist. He adds that “a horseplayer cannot remind himself of this simple truth too often.”
Crist writes that, “there is no such thing as ‘liking’ a horse to win a race, only an attractive discrepancy between his chances and his price.” A 10-1 shot offers excellent value if you judge the horse to have a 15% chance of winning, but very poor value if you assess its chances closer to 5%.
You bet against other bettors
What determines the odds? The bets made by other gamblers.
So, Crist writes, “your opportunity for profit at the racetrack consists entirely of mistakes that your competition makes in assessing each horse’s probability of winning.” If your competition does not make any errors in assigning probabilities to outcomes, there are no attractive bets to be had. Hence, it is essential to know if you are betting against “nitwits” or “sharpies”.
There is unlikely to be much opportunity to find value if you are up against sharpies, as every horse would be bet in accordance with its true chances.
Fortunately, Crist believes that sufficient nitwits are betting to generate value from time to time. It’s not that nitwits don’t have racing knowledge; they just haven’t learned what to do with it. They are not sufficiently focused on the odds.
Human nature generates persistent inefficiencies
How can we be confident that mispricing will continue? Because not all racegoers have the emotional characteristics required to bet like a sharpie. As Crist writes, “the horseplayer who wants to show a profit must adopt a cold-blooded and unsentimental approach to the game that is at variance with both the ‘sporting’ impulse to be loyal to your favourite horses.”
Furthermore, while “Crist on Value” is enlightening to many, it leaves others cold. Some people struggle to accept that the world is an uncertain and unpredictable place. They find being unsure uncomfortable, so they choose not to adopt a probabilistic mindset.
That is not to say finding winning bets is easy. You are competing against all the other bettors. You need to develop and hone an edge in your ability to assess likely outcomes and assign probabilities to them appropriately. And often, your best course of action may be to sit out a bet.
It’s exactly the same in investing
Consistent profit doesn’t come from picking winners but from exploiting discrepancies between the actual likelihood of an outcome and the odds being offered. Those odds reflect the collective wisdom of all other bettors, so you will need a rigorous approach to have conviction in your edge.
In his memo, “You Bet!”, Howard Marks argues, “it’s exactly the same in investing.” Knowing that a company has a bright future and strong growth prospects doesn’t make it an attractive investment proposition. When betting on horses, you need to know the odds to assess the attractiveness of a bet. When considering buying stock in a company, you need to know the price. Excessively optimistic assumptions may be reflected in the price of a company with a bright future, making the stock expensive.
Marks writes, “Success in investing doesn’t come from buying good things, but from buying things well, and it’s essential to know the difference.”
Read across to real estate
Just as racegoers are prone to asking who you like in a race, property professionals often ask what you like in the market today. In both cases, the questions tempt you to pick winners rather than identify value.
Understanding real estate fundamentals, the balance of supply and demand, and income growth prospects is essential. Crist says, “the world’s savviest bettor cannot win with bad opinions.” Similarly, real estate investors cannot outperform without a deep knowledge of the tenant base, vacancy levels, and development prospects.
But developing that knowledge is a necessary, yet insufficient, condition for making sound investment decisions. Your assessment of growth prospects must be compared with the expectations of growth prospects implied by the price to derive an assessment of value.
Finding value
Market and asset selection is not just about finding opportunities with strong growth prospects. It is about finding markets and assets that offer deep value. Why may a particular asset or market offer deep value?
Perhaps there is excessive risk aversion. Market participants, prone to over-extrapolation, may fail to see that future market prospects differ from the recent past. You might have an information advantage or leverage unique relationships, which means you look at an opportunity differently. Or assets in a market are operationally complex so that you can capitalise on specific expertise.
Whatever it may be, an investor will need a source of edge to assess opportunities differently and more accurately than others in the market. That edge may be an information advantage or superior analytical skill. Or it could be behavioural – an ability to ensure greed, fear, short memories, and FOMO don’t misdirect investment decisions.
Finding value is not easy. It can be much more complicated than picking winners. But it is essential to sustained investment success. So, know and hone your edge before heading off to the races.
A version of this article originally appeared in The Property Chronicle. To read other articles I have written for The Property Chronicle, please click here.