This chain of thoughts reminded me of a story from the blog of Paul DePodesta, a gentleman who was instrumental in the use of sabermetrics in baseball, which is essentially analysis via statistics to objectively measure ball players; here is the story as told by Mr. DePodesta:
“Many years ago I was playing blackjack in Las Vegas on a Saturday night in a packed casino. I was sitting at third base, and the player who was at first base was playing horribly. He was definitely taking advantage of the free drinks, and it seemed as though every twenty minutes he was dipping into his pocket for more cash.
On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: 'Dealer, I want a hit!' She paused, almost feeling sorry for him, and said, 'Sir, are you sure?' He said yes, and the dealer dealt the card. Sure enough, it was a four.
The place went crazy, high fives all around, everybody hootin' and hollerin', and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: 'Nice hit.' I thought, 'Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn't justified just because it worked.'
Well, I spent the rest of that weekend wandering around the casino, largely because I had lost all of my money playing blackjack, thinking about all of these different games and how they work. The fact of the matter is that all casino games have a winning process - the odds are stacked in the favor of the house. That doesn't mean they win every single hand or every roll of the dice, but they do win more often than not. Don't misunderstand me - the casino is absolutely concerned about outcomes. However, their approach to securing a good outcome is a laser-like focus on process... right down to the ruthless pit boss.
We can view baseball through the same lens. Baseball is certainly an outcome-driven business, as we get charged with a win or a loss 162 times a year (or 163 times every once in a while). Furthermore, we know we cannot possibly win every single time. In fact, winning just 60% of the time is a great season, a percentage that far exceeds house odds in most games. Like a casino, it appears as though baseball is all about outcomes, but just think about all of the processes that are in play during the course of just one game or even just one at-bat.
In having this discussion years ago with Michael Mauboussin, who wrote "More Than You Know," he showed me a very simple matrix by Russo and Schoemaker in "Winning Decisions" that explains this concept:
|Good Outcome||Bad Outcome|
|Good Process||Deserved Success||Bad Break|
|Bad Process||Dumb Luck||Poetic Justice|
We all want to be in the upper left box - deserved success resulting from a good process. This is generally where the casino lives. I'd like to think that this is where the Oakland A's and San Diego Padres have been during the regular seasons. The box in the upper right, however, is the tough reality we all face in industries that are dominated by uncertainty. A good process can lead to a bad outcome in the real world. In fact, it happens all the time. This is what happened to the casino when a player hit on 17 and won…
As tough as a good process/bad outcome combination is, nothing compares to the bottom left: bad process/good outcome. This is the wolf in sheep's clothing that allows for one-time success but almost always cripples any chance of sustained success - the player hitting on 17 and getting a four. Here's the rub: It's incredibly difficult to look in the mirror after a victory, any victory, and admit that you were lucky. If you fail to make that admission, however, the bad process will continue and the good outcome that occurred once will elude you in the future…
At the Padres, we want to win every game we play at every level and we want to be right on every single player decision we make. We know it's not going to happen, because there is too much uncertainty... too much we cannot control. That said, we can control the process.
Championship teams will occasionally have a bad process and a good outcome. Championship organizations, however, reside exclusively in the upper half of the matrix. Some years it may be on the right-hand side, most years should be on the left. The upper left is where the Atlanta Braves lived for 14 years - possibly the most underappreciated accomplishment by a professional sports organization in our lifetimes. In short, we want to be a Championship organization that results in many Championship teams.
I'll touch on our draft in greater detail in the next day or so, but I will say that we are proud of our process and it was carried out with discipline. Will it lead to a good outcome? We don't know for sure, but we have confidence in the group of picks that were made. I do know, however, that our process gets better every single year, and we expect it to be better again next year.”
The similarities between blackjack, baseball, and investing in this story is apparent: just like with the gentleman who hit with 17, an investor could blindly waddle into an investment and walk away with attractive returns; and just like the audience who was there to congratulate the blackjack player, the investor will likely give himself a pat on the back for his shrewd ability to pick stocks.
Unfortunately, as Mr. DePodesta notes, noting that your success was due to blind luck is always difficult to do, particularly while you’re still in the process of counting your profits; however, if you fail to make that admission, you are doomed to repeat the bad process, and will eventually be dealt the poetic justice that you deserve.
Process is critical in investing: to begin with, one should find a methodology that has stood the test of time, and is rooted in logic; luckily for the readers of this blog, this step is already complete: value investing is the real deal, and you are privy to that reality that alludes so many.
In addition, you must have a process for addressing investment analysis; it doesn’t have to be a rigid approach, but it should likely take the form of a checklist to address that no stone is left unturned.
Finally, you must have a process for assessing investments post-mortem, in order to refine your process and learn from your mistakes. Many investors skip this last step, and simply assume that their gain or loss on the trade is the telling number; these people, much like the “skilled” blackjack player, are setting themselves for a long-term result that is commensurate with their process.
About the author:I'm a value investor, with a focus on patience; I look to buy great companies that are suffering from short term issues, and hope to load up when these opportunities present themselves. As this would suggest, I run a fairly concentrated portfolio by most standards, usually with 8-10 names; from the perspective of a businessman rather than a market participant / stock trader, I believe this is more than sufficient diversification.
I hope to own a collection of great businesses; to ever sell one, I would demand a substantial premium to the average market valuation due to what I believe are the understated benefits to the long term investor of superior fundamentals and time on intrinsic value. I don't have a target when I purchase a stock; my goal is to replicate the underlying returns of the business in question - which if I've done my job properly, should be very attractive over a period of many years.