In a recent article, I looked at some of the reasons why Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) might favor loans and preferred stock transactions over equity investments when investing in companies in certain situations. Buffett has said before that loan deals provide an opportunity to achieve an attractive return on capital, in a situation where he may not be able to understand the company borrowing the money completely. Loans provide the opportunity to lock in a return without having to worry about equity market volatility if the company does not perform as expected.
For Buffett, the decision of whether or not to proceed with a large loan transaction all comes down to a mathematical equation. If there is a high chance the company is not going out of business, and he can achieve a high return on his money to compensate for the risk, then the probability of success is high, and he might be able to proceed.
This is a vitally important point all investors need to consider. No investor is ever going to have access to 100% of the information available for an investment opportunity. Not only does an individual investor not have the resources to interpret this amount of information, but in many cases, it's just not there. Even companies cannot tell what every employee is up to on a day-to-day basis. There is just too much information.
Therefore, probabilities play a crucial part in the investing process. We will never know 100% of the information available, but if there is a high probability that we know most of the information, we can swing the odds of success in our favor. In 2000, Buffett referred to this as having a "mathematical edge in every transaction."
A mathematical edge
Entering into a situation where one has a mathematical edge helps improve the odds of success. It does not guarantee one will not have to take a loss, but it does reduce the risk of loss. It also minimizes the risk of big losses over time.
Buffett explained this idea in 2000:
"We think that we'll do enough transactions over a lifetime so that, no matter what the result of any single one, that the group expectancy would — gets almost to certainty. When we look at businesses, we try to think of what can go wrong with them. We try to look [for] businesses that are good businesses now, and we think about what can go wrong with them. If we can think of very much that can go wrong with them, we just forget it. We are not in the business of assuming a lot of risk in businesses."
To put it another way, if an investor enters every transaction with a mathematical edge, they won't win 100% of the time. Still, even a 55/45 success ratio should produce a positive overall outcome in the long run.
This is assuming the investor earns more from the winning trades than from the losing trades. For long-term investors with a horizon spanning decades, that should be relatively straightforward. All investors need to do is hold the winners and sell the losers, which is the approach Buffett has been using for decades. Yes, he has had to take some losses on holdings, but overall, by focusing on maintaining that mathematical edge, his fortune has steadily expanded. The winners have grown and grown, and the losses have shrunk into non-existence.
Probabilities and having a mathematical edge are core tenants of investing success. By understanding this, investors can help improve their own probabilities of success by focusing on what they understand, letting winners run and cutting losers.
