The Stock Market as a Parimutuel System

I read an article some years ago in which Charlie Munger (the Vice Chairman of Berkshire Hathaway) likened the stock market to a parimutuel betting system (referred to in some countries as a totalizer betting system).

This aroused my interest and the more I thought about it, the more I thought that Munger was absolutely correct.

A parimutuel or totalizer betting system is where people wishing to bet on a particular event (let’s say a horse race or a sporting event) place their bet with an organisation that pools all the money wagered and then sets the odds for each outcome based on the amount of money bet (after taking a set percentage off the top, I believe the percentage is around 17% in the US).

For example, Team A is playing Team B in some sporting event. Those betting on the outcome of this event have bet $800,000 in total. Of this $800,000, $600,000 has been bet on Team A and $200,000 has been bet on Team B.

The organisation running the parimutuel system will take off the top a certain amount, let’s say 17%. Therefore, $136,000 of the amount wagered goes straight to the betting organisation. So $664,000 is left to distribute in winnings.

Because $600,000 was wagered on Team A and those making that bet can only be paid $664,000, the payment for a $1 bet is close to $1.11 ($664,000/$600,000). The payout for Team B is $3.32 ($664,000/$200,000). We are assuming that a draw cannot happen in this example (and yes, I have simplified the calculations).

The organisation running the parimutuel system doesn’t care who actually wins or loses – they take their cut right up front. In the parimutuel system, bets on opposite sides of a wager are competing against each other and the odds are set based on how much each side is prepared to bet on a particular outcome. The winners share the entire pool of money and the losers get nothing.

In the betting world, all of the really large horse racing syndicates operate in Hong Kong because it has the largest betting market in the world.

These syndicates use extremely sophisticated software to calculate odds. This software usually cost upwards of $1 million to develop and many of the people involved in these syndicates come from an actuarial background.

It can be highly lucrative. The late Alan Woods (an Australian) died in 2008 with an estimated fortune of $670 million, all of which was derived from gambling.

Now, as Charlie Munger observed, the stock market is very similar to the parimutuel system. Individuals in the stock market submit buy and sell orders (rather than bets) and market prices (like the odds) are determined by the number of buyers and sellers on each side.

In the stock market, the buyer of company XYZ’s shares is in effect “betting” against the seller of company XYZ’s shares that company XYZ’s share price will rise.

A really good horse will have low odds in a race and a really good company will generally sell at a high price in the market.

As Munger has stated, the two huge advantages that the stock market has over the parimutuel system are:

1. The stock broker takes far less off the top than the betting organisation;

2. Prices of shares can occasionally completely disengage from the fundamentals. This is far less likely to happen when setting the odds in a parimutuel system.

Obviously the share market is not a zero sum game like the parimutuel system (that’s if we exclude derivatives). It’s highly unlikely that you will lose all your money in the stock market if you have a sufficiently diversified portfolio. But just like the parimutuel system, if you don’t really know what you are doing, you will lose some money overtime, it’s just a slower process in the share market.

So what implications do Munger’s observations have?

1. It’s extremely important to keep brokers’ costs as low as possible to maximise the potential gain. This is one of the reasons why sophisticated share market investors rarely use full service brokers;

2. Research pays off. Just like those syndicates in Hong Kong, use of statistics and research can aid in finding an incorrectly priced “bet”. But remember, this research is not always the kind of thing that you can just find out from a broker or read in a newspaper;

3. Professional gamblers only bet when the odds are incorrectly set in their favour (based on significant research). Most of the time the odds will in fact be accurate, just like the prices of shares in the stock market will be and when this is the case the professional will not “bet”. Fortunately however, this is not always the case – bear markets and bull markets offer real rewards to the patient investor;

4. Most novices would not seriously think that they could make money betting on horses but many share market novices think they can beat the market (I’m sure that 2008 probably changed that attitude for many of these people).

Just to pick up on that last point - you may be an average investor with a small portfolio and limited knowledge, the person on the other side of your buy or sell order may have vast knowledge and may have made millions in the market. You are unlikely to outsmart such people, just as novices won’t outsmart professional gamblers or bookmakers.

It worries me when I see people who know almost nothing about share market investing jumping into the market (sometimes with borrowed money). These people need to educate themselves before making any investments – read, read and then read more. If someone wants to invest in the market but doesn’t want to bother with research, they can always buy a good quality listed investment company (this will be the subject of an upcoming post).

Blackmores and Campbell Brothers: Why I like them

Two companies that I have admired for a long time are Blackmores (BKL) and Campbell Brothers (CPB). Both companies have been listed on the ASX for many years and have excellent track records.

Blackmores is a manufacturer of high quality dietary supplements and Campbell Brothers derives most of its profits from the provision of consulting and analytical laboratory services.

Let’s look at some financial statistics:

Statistic	Blackmores	Campbell Brothers
Average 10 year Return on Equity	31.7%	13.5%
Average 10 year Price-Earnings Ratio	16.8	15.1
Current Price-Earnings ratio*	11.7	10.0
Price-earnings ratio based on forecast 08-09 earnings	11.7	7.8
Average compound growth in earnings**	16.6%	17.2%
Debt-to-equity ratio (as at last reporting date)	75%	73%
Current dividend yield*	6.5%	6.02%
Current dividend payout ratio (07-08 year)	69%	76%
Current share price*	$13.85	$18.27
Approximate market capitalization*	$224m	$961m

* As at 9 January 2009.

** 30 June 1999 to 30 June 2008.

A number of interesting things are apparent from the above table:

1. Both companies have exceptional growth rates over the nine year period;

2. Both companies have maintained exceptional growth rates while also maintaining a high dividend payout ratio;

3. The current dividend yields are attractive compared to bank interest rates (note that CPB’s dividend is 50% franked);

4. The current price-earnings ratios are well below historical averages;

5. Debt is a bit on the high side for both companies (but appears manageable);

6. Blackmores has maintained an outstanding return on equity over the 10 year period (although that is likely to be because its equity is understated, i.e. it has not valued brand names etc that clearly have significant value).

Campbell Brothers has forecast huge earnings growth of 70% for 2008-09 (when so many other companies are forecasting earnings declines). Blackmores’ earnings are likely to be flat for 2008-09.

Neither of these companies were included in The Stock Scribe portfolio because they would not have passed one or two of the filters specified by Benjamin Graham. But this is ok. Investors do need to use a degree of judgment in what they do. I’m willing to be somewhat flexible with companies that have very long and successful track records.

While it would be imprudent to expect that the growth rates achieved for both companies over the last decade or so will be repeated over the next decade, it would be reasonable to assume that some level of growth will take place. The multiples that these companies are currently selling at imply that there will be little or no growth and this seems unlikely based on each company’s past record.

Whenever you are contemplating an investment always ask yourself: “What can go wrong?”

One thing that you should be aware of with companies that manufacture food products or drugs is that they always carry a special risk – the possibility that if there is a scare associated with a “bad” batch of a particular product it has the potential to destroy the business. I would definitely not expect that any such thing would happen with Blackmores, but it is something the investor needs to be cognisant of.

Something else to note is that Campbell Brothers has significant intangible assets on its balance sheet. If we were to calculate the debt-to-equity ratio using only tangible assets it would be 220% - very high. Given Campbell Brothers very long history and reputation, it is likely that those intangibles are valued appropriately (although we can’t say that for sure).

Both companies trade low volumes of shares - something which investors need to be mindful of.

So what are these two companies worth?

I will say that in my opinion (and it’s my opinion only), Blackmores is worth approximately $18 and Campbell Brothers is worth approximately $23. That makes for an interesting situation at prices prevailing in early January 2009.

Note: None of the above constitutes financial advice. You need to do your own research and consult appropriately qualified people for advice (where necessary).

Snowball: Things you never knew about Warren Buffett

There are 11 books sitting on my book shelves that are about Warren Buffett – some of them I bought, others were given to me.

Sometimes I have been asked what the best book ever written on Warren Buffett is and I have always said that it’s Roger Lowenstein’s 1995 book: Buffett: The Making of an American Capitalist. However this is no longer true.

I was lucky enough to have been given a copy of The Snowball: Warren Buffett and the Business of Life (by Alice Schroeder). This book is that much better than Lowenstein’s book simply because Buffett, his family and his friends cooperated with Schroeder on the writing of the book.

Schroeder interviewed Buffett over the course of five years for this book and this brings many insights to the reader that are absent from all the other books written about Buffett.

As Buffett is never going to write an autobiography, this book is as close as we are going to get to an autobiography.

Schroeder clearly (but gently) exposes the flaws and genius in Buffett.

Buffett’s family have had their fair share of problems. For example, all of Buffett’s children have had failed marriages and all of them are college drop-outs, some members of his extended family have suffered from mental illness and there has even been the odd suicide in the family. Buffett himself engaged in shoplifting as a teenager.

This is no Brady Bunch family - as many other authors have portrayed it to be. Every family has its problems and the Buffetts are no different to anyone else.

Buffett does come out looking like a rather one dimensional character – obsessed with making money, with his only other interest seemingly being the card game Bridge. This is not really surprising – the vast majority of people who have achieved excellence in their chosen field are fanatical about it, you don’t get excellence any other way.

Buffett’s diet consists of coke, hamburgers, steaks, hash browns, peanuts, ice cream and popcorn (this of course has been well documented elsewhere). Most of these foods (if eaten continuously) are not exactly conducive to longevity and it’s even more surprising when one considers that Buffett has always been obsessed by his own mortality.

In 1989 Buffett was invited to dinner by Akio Morita, the chairman of Sony. Morita had his chefs serve sushi (many courses of it) and Buffett sent every course back without even having tried it. Buffett felt embarrassed about this but even then he could not bring himself to try some of it – this simple example shows an inflexibility that extends far beyond food.

When his sister Doris ended up owing a few million dollars in the wake of the 1987 stock market crash (she had been playing around with derivatives), Buffett refused to clear her debts. He did eventually help her out in a roundabout way, but in his position, I would have helped my sister – most people would have. Whether it was sushi or his sister, he was not prepared to bend his own rules.

He is a person who easily and quickly develops strong emotional attachments to certain people – the late Katherine Graham (no relation to Benjamin Graham), Charlie Munger, Bill Gates, Carol Loomis and Sharon Osberg to name a few. In fact, Buffett is more attached to some of these people than to certain members of his own family.

The whole Salomon debacle (Buffett invested $700m in the 1980s in this now long gone investment bank) occurred primarily because he liked Salomon’s John Gutfreund (they later fell out). Had Buffett known what he was getting into, he would never have touched Salomon.

Many other books do not mention (or gloss over) the failed investments that Buffett has made (there are not too many of them, but they do exist). Dexter Shoe is the most unfortunate investment Buffett has made (up to now).

The book has all sorts of little revelations in it, for example, who knew that Berkshire Hathaway shareholders have been known to steal from some of the stalls set up to promote Berkshire’s businesses at the annual meeting? Who knew that Bono (from U2) was a good friend of Buffett’s daughter Susan and was one of the few non-family members to attend Buffett’s (first) wife’s funeral?

As is normal for this type of book, lots of Buffett wannabes will scour it for some blinding investing insight that they can take away and use to great effect. For me, the best paragraph in the book concerning investing relates to Buffett’s purchase of more than $1 billion of Coca-Cola stock in the late 1980s:

“Buffett applied a margin of safety to his estimates. He did this simply by taking a whack at the number, rather than using some complicated model or formula. He used no computers or spreadsheets in doing any of these calculations; if the answer didn’t hit him over the head like a caveman’s club, in his view, the investment wasn’t worth making.”

No spreadsheets, no computers, no models, no secret formulas – just some basic arithmetic, some historical information and some good judgment – that’s it. It’s as close as you will get (or need to get) to what Buffett does.

Schroeder’s book is 969 pages long (with the index and notes) - it’s one of the largest books I have ever seen. However, it didn’t feel long because Schroeder held my attention all the way through – she has done a superb job. I highly recommend it to you.