Luck can be misperceived as skill. In this article, our expert explains how to apply skill to investing versus depending on luck.

By Brian J. Regan, CFA

Part of my job is to keep people from gambling under the guise of investing. The challenge in that job is that sometimes people get lucky gambling. When people get lucky gambling, it becomes very dangerous for them in the long term. Luck can be misperceived as skill. In this article I want to break down how we can recognize skill versus when luck is involved.

© Provided by Retirement Daily on The Street Brian Regan

I think there are investing lessons to be learned by studying gamblers. Recently, I listened to an interview with Daniel Negreanu. Negreanu is a world class poker player. He has made a great living by playing a game where the odds are stacked against him. He breaks down his approach into two ways of thinking. There is a concept called “Game Theory Optimization” (GTO) which is the idea that there is a mathematical optimal play given the hand that is dealt. The second way of thinking considers playing the person or making an intelligent guess as to how a particular person will play a hand.

Value investing has many definitions, and in my experience, it is often mislabeled by the Morningstar style box default. To me, value investing could also be called Investing Theory Optimization (ITO). Value investing is the mathematical optimal investment decisions given the prices of the assets available. GTO is optimizing for a game where the likelihood of a positive outcome is below 50%. ITO is optimizing for a game where the likelihood of success is far greater than 50%. Basically, that is why we encourage people to invest rather than gamble unless, of course, you are a world class poker player.

ITO (my term) looks at the business model, the competition, and the financials to determine an investing strategy. GTO looks at the cards dealt, the number of players at the table, and the value of the pot to determine a betting strategy. The process is similar except a business can have a bad quarter or year without bankruptcy but only one player can win a poker pot. To me, ITO is a winnable game especially since you can choose which cards you want to play. You may choose that you only want to play businesses that are metaphorically pocket aces, or you may assess that it would be advantageous to see more flops, so you broaden out the hands you’d hold. After all, pocket aces likely won’t lead to a flush.

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Now the second way of playing – guessing how another player will act – is easier at a poker table albeit still extremely hard. There are likely only to be, at most, seven other players at the table with 52 cards the deck. A dwindling range of possible hands held. Finally, everyone at the table has the same goal and motivation. In the investing arena, nothing is consistent. There is not a finite number of possible players, investments, or motivations. You cannot even look the other investors in the eye or have casual conversations. Guessing how a player will act is not a winnable game unless one happens to get lucky.

So, how can we use ITO to determine if something is a good investment? Let’s use an example my younger brother has been asking me about –  (TSLA) - Get Free Report (Tesla, Inc.) – as share price has recently been crumbling. He wants to know if it is a good buy. First, I emphasize that I have no idea what will happen in the short term because I cannot guess how other investors will act and I am not sure if I ever feel that lucky. I emphasize that the tool I can utilize is ITO.

There is a lot to look at when analyzing a company, but I’ll jump to what I think is most important: cash flow (EBITDA [Earnings Before Interest, Taxes, Depreciation, Amortization] as a proxy), interest rates, and market capitalization (price).

Here are the Cards Dealt:

As of this writing, TSLA is trading around $400 billion. It is expected to grow EBITDA 32% in 2023. It has grown EBITDA 120% in the last 12 months. The current EBITDA is approximately $16 billion. If EBITDA grows at the expected 32% to $21 billion then I would have a cash flow yield of about 5.25% in year one. A standard deviation of estimates is about $3 billion so I can reasonably say that cash flow yield can be anywhere between 4.5% ($18 billion) and 6% ($24 billion). The S&P 500 has a forward earnings yield of about 6%.

What Needs to Happen to Make the Pot Valuable:

Assuming the investor wants to at least match the return of the S&P 500 (earnings yield: 6%) we can deduce a few things. The average range of investors in this stock seems to believe that (A) TSLA will reach the upper range of the EBITDA target, which would lead to a cash flow yield consistent with the market and/or (B) that the outsized growth of the stock will continue making up for the difference beyond 2023. (A) seems unlikely to happen if the range of estimates is reasonable. (B) looks likely considering 2023 expected growth is more than 3 times the market long term average, but possibly may be more unlikely than meets the eye given the big slowdown from 2022 to 2023, a massively competitive industry, and a part time CEO. In fact, the lower end of estimates for 2024 would reflect zero growth.

Given the numbers today, to match the earnings yield of the S&P 500, the estimated one standard deviation downside of cash flows would bring the stock down 25%, and a one standard deviation upside of cash flows would increase the stock 0% in 2023. You do not need a statistics degree to see these numbers are negatively skewed. I am holding a 10/7 off suit. I could win the hand, but I would need to get very lucky. If TSLA falls to $300 billion, all else equal, I have a much better hand. My downside at one standard deviation becomes 6% and my upside becomes 8%. My variability of returns narrows with a positive skew in year one. This would be an Ace/King and I’ll raise the pot.

Data and estimates sourced from YCharts.

About the author: Brian J. Regan

Brian J. Regan, CFA®, MBA, is the chief investment officer for Asset Management Resources, LLC. His responsibilities within the firm relate to investment research, portfolio design and implementation. He has education and experience in portfolio risk management, asset allocation, fixed income security selection, equity security selection, and macro-economic analysis.

This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax, or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice.

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