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Value Investing: Luck vs Skill Part 2

October 25, 2013 | About:
Earlier this week I responded to a comment that centered around the role of luck in long-term outperformance. Feel free to read my response to the comment in Part 1 of this post where I list the No. 1 main reason why most people don't replicate the results of Walter Schloss. It's a very simple reason demonstrated by the results of Schloss himself.

Today, I'll discuss luck in Part 2 of this post.

Does Luck Play a Role in Great Results?

I do think there is a lot of luck that goes into short-term results. Luck is involved maybe even over two to three years. But over five years or 10 years, luck plays less of a role. I find it very amusing when luck is assigned as a reason for Buffett's or Schloss' results. I think it must be because it's the stock market as opposed to real estate, steel, technology, media, manufacturing, etc. I've never heard luck as the reason for a business mogul's success, but if you think about it, billionaires who made their fortune in industry by building or developing businesses outperformed others that were trying to do the same thing. I've never heard that pure chance was the reason that Murdoch, Trump, Gates, Walton, etc., were able to achieve their results.

I suppose we're all lucky to a certain degree from a general point of view. But I don't think luck (i.e. random chance) can be seriously assigned to investors who outperformed throughout the course of their careers. After all, Buffett is a business owner. And as stock investors, we are business owners. Some are simply better at valuing, buying and owning businesses than others. It's really that simple.

When Stocks Are Thought Of as Businesses, Your Mindset Changes

I think luck is given as a reason by those who think of the stock market in a completely different manner from the way I think of it. If you think of it as a casino, then you might assign luck to those who outperform. I simply think of the stock market as a place where I can find businesses (pieces of businesses) for sale at a wide variety of prices. Sometimes the prices as a whole are very attractive, other times they are not. But usually there are a few that are priced in such a way that my estimated future cash flows will be significant relative to the amount of money it takes to buy that business.

I think once a person really starts thinking about businesses as opposed to stocks, they will get to a different level of thinking. Buffett talked a lot about beating the market, but I don't think he necessarily gave it much thought when he was looking for investments. I think he was thinking about the business, and the assets it had and the cash flow it was producing. And he thought about how much cash flow it would give him relative to the investment he would have to put in.

Just like an apartment building. When Sam Zell was building his empire, I doubt he ever compared his results to some arbitrary economic metric or some multifamily index. He just looked at each individual building and determined what it was worth to him based on the long-term earning power of that building. Imagine if someone said he was lucky because his results outperformed GDP and said that his outperformance was due to pure chance. No one would take that seriously.

Is Business Outperformance Due to Luck?

Extending this example, the GDP is simply a number that measures the total value of all the goods produced and services provided in a country during the year. The change in GDP simply is the change in that overall amount of "sales." It's obvious that if GDP grows at 4%, there are plenty of businesses that grew their sales at much more than 4% that year and plenty that grew sales at much less than 4% that year. I've never heard someone say Google is lucky because they've managed to grow their sales at greater than 30% per year over the past decade and Alcoa is unlucky because their sales have declined at an average rate of 1% over the past decade. Most would say those results aren't due to luck, but due to the fact that one business is better than the other at generating sales and growing their business.

One might say that Google is in an easier industry. Internet search is a faster growing industry than aluminum. But what about two companies in the same department store? Kohl's has grown its revenues at around 9% annually over the past decade, well in excess of GDP growth. J.C. Penney, on the other hand, has seen its sales decline about 9% annually over the past 10 years. Is Kohl's simply luckier than JCP? I would say Kohl's is a better business than JCP.

And I would extend the argument that if some businesses are better than others (and not simply luckier), then it would make sense that the owners of those businesses made corresponding good/poor business decisions when they decided to own them.

Note: One of my favorite anecdotes surrounding the efficient market and "luck" discussion is how Paul Samuelson, who won a Nobel Prize and was one of the most vocal advocates of efficient market theory ended up investing a large amount of his own money with Warren Buffett and got rich in the process! So even Samuelson deep down must have thought that some business owners (i.e. stock pickers) are better than others (skill was more important than luck).

Stocks Are Just Pieces of Businesses Some Better Values Than Others

So I think it's possible to make reasonable conservative assumptions about the values of various businesses by reasonably approximating the quality of those businesses combined with the price that those businesses are being offered at. The stock market is really just that--it's a market place where you can go to buy pieces of businesses.

Investing in stocks is really the same thing the local entrepreneur does that owns the McDonald's or Subway franchise in town. How much do I have to pay to acquire the business and how much cash flow will I get in return over time? Some are better at business than others, and that's really the simplest way to explain it.

I really don't think luck has much to do with long term results of successful entrepreneurs, at least not relative to their competitors. (I've often heard the following argument: "Well, Buffett invested during the greatest period of prosperity in US history"... okay, well that's true, even though he's seen 3 different 50% bear markets. But in that case, everyone has been lucky to have participated in the same market. How come Buffett, Schloss, and others did so much better than everyone else if everyone else had the same tailwind?)

Anyhow, it's an interesting topic to debate. I'm obviously a firm believer that while luck plays an overall role in our lives in general, it's skill that separates some business owners from others. It's no different in the stock market, athletics, Hollywood, medicine, music or any other field where some are significantly better than average.

Feel free to share you own ideas. It's an interesting debate.

About the author:

John Huber
I am the Portfolio Manager at Saber Capital Management, LLC. Saber manages an investment partnership as well as separately managed accounts for clients interested in a focused value investing strategy. My investment style has been most influenced by Ben Graham, Walter Schloss, Warren Buffett, and Joel Greenblatt. I am also the author of www.BaseHitInvesting.com, a value investing blog.

Visit John Huber's Website


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