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John Emerson
John Emerson
Articles (106) 

The Similarities Between Poker and Value Investing

May 02, 2011

"Different people approach poker different ways. Loose aggressive types play lots of hands – virtually any two cards – and try to win lots of small pots. They are the day traders of the poker tables."--David Einhorn from his 2006 speech at the Value Investing Congress

Anybody who watches the World Series of Poker is familiar with Scotty Nguyen, he is one the past champions which ESPN likes to feature when they cover the various World Series of Poker events. Several years ago he was a virtual lock to make the final table of ten players in the Main Event, poker's version of the Breeders Cup Classic. Suddenly and inexplicable he suffered a huge meltdown after being among the chip leaders with less than 20 players left in the tournament, many of which were short-stacked (low on chips).

Nguyen began entering numerous all-in, head to head duals with other players and he kept ending up on the short end of the duals. With stunning speed, he ended up squandering his entire quarry of chips and eliminating himself from competition to the amazement of the crowd. A shocking development considering his poker acumen; such a meltdown would not be expected of seasoned veteran and former champion. If he had merely sat "chilly" he would have entered the final table as one of the chip leaders and the likely favorite, instead he never accorded himself the chance. In essence, Nugyen unwittingly switched from a "value player" to a day trader as a direct result of an uncontrolled emotional reaction.

What happened to Nugyen happenings on a reoccurring basis to investor/traders from Wall Street to Main Street, America. When investing, a sudden surge of emotion coupled with a temporary lack of composure can destroy years of good work in a matter of months or even days. This is only one of the many analogies between tournament poker and value investing.

The world of poker is a microcosm for the world of investing although hours in poker represent months or even years in terms of investing. The subject of today's discussion is an in depth analysis of the similarities between poker and the world of value investing.

Poker and the Dynamic Nature of Value

All successful poker players understand the concept of underlying value and how it relates to their particular hand. Every single decision is based upon a sense of risk vs. reward which is determined by multiple factors. It is not merely the cards which one holds that determine the entire risk vs. reward scenario; subtle factors such as table position or the skill levels and psychological makeup of the competition directly influence the value of one's hole cards in any particular hand. It is pokers version of qualitative vs. quantitative analysis.

Investors are faced with the same type of questions. Stock screens and fundamental analysis provide quantitative data for value investors but frequently such data provides a false read about the underlying value of a company. Trailing data is just that, it tells us what has happened in the past. Just as every disclaimer begins, past results are no indication of future performance, past quality does not ensure future quality. Similar to the poker table where every new card which is flopped, and every new player who enters the game, changes the odds of success, so does the evolutionary nature of business.

The calculation of intrinsic value is constantly evolving, it only remains static for a limited period of time. Once upon a time, Polaroid made millions selling a camera called the "Swinger" which provided "instant" pictures at an extremely low cost for the average American. http://en.wikipedia.org/wiki/Polaroid_Swinger

When the Swinger was introduced it not only affected the profits of Polaroid it as affected the profits of virtually every other camera and film producer, as well as the behavior of many average Americans. Although its effect and ultimate profitability proved to be fleeting, the introduction of the Swinger introduced a new player to the table, demonstrating the dynamic nature of product innovation and its effect upon profit and loss statements of multiple companies.

The Eclectic Styles of Poker Players and Value Investors

If you watch the top professional poker players you will find that they exhibit various styles, with slightly different skill sets. Some are more analytical or statistically-based, while others excel at reading nonverbal cues and anticipating the hands of other players. Daniel Negreanu plays a slightly different brand of poker than Phil Helmuth or Phil Ivy. Gus Hansen and Scottie Nguyen are much different than the aforementioned players; they are involved in many more hands during an average tournament. No specific formula defines the success of a professional player.

Exactly the same point holds for successful value investors. Peter Lynch beat the markets by focusing on growth, as well as value. Walter Schloss frequently focused on the underlying value of a companies assets rather than the earnings of a company. Bob Olstein analyzes the business as an auditor would and then focuses upon free cash flow. Warren Buffett looks for companies with a durable competitive advantage which he can purchase at a fair price. Successful value investors tend to develop their own niche which generally reflects their personal strengths; very few rely on a "value formulas."

Learning From Mistakes

Top level poker players tend to review the serious mistakes that they made during competition. They review over and over in their minds the hands that led to their downfall or otherwise seriously crippled their bankrolls. It is this internal review process which allows them to learn from mistakes and become better players in the long term.

Top value investors follow a similar thought process. Virtually every Buffett Annual Letter features at least one of his investing blunders or a serious failure in a thought process. Read virtually any annual letter from any investment or mutual fund for the year 2008 and you will find that most top money managers were explaining their mistakes in detail. Rising markets tend to disguise serious errors of judgment but market implosions expose the errors in spades. 2008 was the year that many managers found "religion" in their annual letters, however only the future will tell if they really learned from their indiscretions. It easy to report one successes but the best managers regularly report when they suffered from an error in judgment even when their returns were better than the average in that particular year.

Peter Lynch described the process of silently removing the losers from a fund as the process of "burying the evidence". Fund managers are apt to hold any position so long as it represents a gain from the point from when it was purchased even if the gain represents a dramatic underperformance of the overall market. The good managers report their "bombs" along side their masterpieces and ultimately learn as much from their losers as their winners.

Knowing the Correct Questions to Ask

"If you've been playing poker for half an hour and you still don't know who the patsy is, you're the patsy." Warren Buffett

Top poker players identify the "fish" at the table in a few moments and fillet them accordingly. Not only are the fish incapable of identifying the weaker links at a table, they do not possess a clue as to why their chip stack disappears as if it was sitting on top of quick sand. They lack the savvy to even ask the essential questions that continually run through the mind of the serious player.

Skilled Texas Hold 'em players can assess what hand represents the "nuts" (the best possible hand) almost instantly as new cards are flopped. A "fish" generally has no clue what constitutes the best possible hand, worse yet, the fish is frequently unfamiliar with the concept itself.

Durable competitive advantages, stocks which are trading at a huge discount to their liquidation value and companies which have materially understated book values are example of the "nuts" in investing patois.

Value investing requires that the practitioner be able to ask the right questions as well as find the answers to the question. Before Warren Buffett was able to find a company which possesses a durable competitive advantage, he had to be savvy enough to define why the concept was useful. Likewise, as Walter Schloss combed through the list of 52 week lows, he had to be able to separate the broken companies from the ones which were temporarily out of favor. If he lacked the cognitive structure which identified the proper questions to ask, he held no hope of differentiating between the potential winners and losers.

Don't Play Someone Else's Game

In poker as well as investing one has to develop his own style and circle of competency. Some professional poker players like to stay in more hands than others. It has to do with their level of patience and their ability to read the competition. If they deviate from their style and level of comfort they tend to underperform in tournaments.

In value investing, successful managers have to develop their own style as well. If one intimately understands the energy or technology sectors; they are well advised to play to their strengths. Some managers feel more comfortable holding positions in dozens of companies while others feel confident when holding a few concentrated positions. Some managers are apt to hold more cash than others. Success does not reside in copying the strategy of another investor, rather it develops gradually as one learns their own personal strengths and weaknesses.

Conclusion

1) An emotional outburst can destroy years of investment returns in a matter of months.

2) Poker playing and value investing are dynamic rather than static entities. A multitude of factors affect risk and reward scenarios and these scenarios continually change.

3) The concept of value is an eclectic notion. Success can be achieved in many different ways.

4) One needs to learn from their mistakes as well as their success stories. Acknowledging mistakes is a necessary process which must be performed on a regular basis.

5) One has to play their own game in regard to poker and investing. Attempting to copy another style generally leads to underperformance.

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

Rating: 2.8/5 (5 votes)

Comments

davidm1
Davidm1 - 7 years ago    Report SPAM
I find poker makes me a better investor- it helps you control your emotions, and learn that you don't have to play every hand (over trading).

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