May 18, 2022
Dear Investors and Friends,
For a few brief hours on the first Saturday in May, America becomes a country of gamblers. It is fascinating to watch not only for the spectacle of the event but also because, once the race is over, viewers from California to Maine suddenly become armchair experts on horses most people did not know existed the day before. This phenomenon was especially on display this year in the aftermath of an 80-1 longshot winning the race in a spectacular come from behind burst of speed. If you haven’t already done so, I urge you to click here to watch Rich Strike’s charge from the back of the pack. It is one of the most thrilling couple minutes in sports.
Another reason that I enjoy the Kentucky Derby, and a more relevant one as someone that spends his days investing other peoples’ hard-earned capital, is that it provides a tangible example of what it means to gamble versus to invest. The purpose of this month’s newsletter is to provide a very brief discussion on what Mike and I believe differentiates gambling from investing.
Horse Racing from an Investor’s Point of View
For most people, the fact that an 80-1 longshot won the Kentucky Derby is proof-positive that betting on horse races is an unpredictable and foolish endeavor. With some important caveats, we do not agree. There is no question that horse racing is unpredictable but so what? Nearly everything we do in life has an element of unpredictability. More on that later. As far as it being foolish, that accusation gets to the heart of the difference between gambling and investing.
Let us address the issue by first migrating from a discussion of odds to one of probabilities. Fortunately, odds can be easily converted to probabilities. In the case of Rich Strike, as an 80-1 longshot, the betting community was giving the horse a 1.2% chance of winning the race (Note: if you are not already familiar with the interchangeable nature of odds and probability feel free to reach out to one of us directly). Once you have that information, there are really only two questions to ask. First, is my expectation of Rich Strike’s actual probability of winning the race better than 1.2%? Second, how repeatable is what I am about to do?
We are not experts on the subject of horse racing but let’s assume there is someone out there that is, and that she has a process, proven and perfected over time, that gives Rich Strike a 5% chance of winning. This level of variance, 1.2% for the “market” and 5% for the better’s process, would represent a massive mismatch between what the “market” thinks and the better’s analysis. Translated back to odds, this puts the horse at 19 -1 rather than the market expectation of 80-1.
From a pure mathematical perspective then, should the person make that bet? In a real-world setting, the answer is that it depends mostly on the second issue of repeatability. Is the process “proven” and can it be applied to a large enough sample of races? Even with the much better probability predicted by the better’s process, the horse still has a 95% chance of losing this particular race. So, if the better’s process can only be applied once, the probability the better will lose her money is still very high, even if she is right that the market is undervaluing the probability the horse will win. On the other hand, if the better’s process could be applied to dozens or, even better, hundreds of races, she should absolutely make the bet. In absolute terms, she will still lose, on average, her entire bet in 19 out of every 20 races but because the bet is paying off at 80-1, she will be more than compensated for the losses when she does win. In fact, she will, on average, make a return on her investment more than 3X! She is an investor not a gambler.
The investor takes both questions into account. The gambler takes neither. Whether such a person exists in the world of horse racing, we do not know but will leave it to the reader to ponder. One thing is almost certain, if he or she does exist, that person is likely holed up in a small windowless room somewhere with a couple high powered computers, a fast internet connection and certainly not pontificating on TV about track conditions.
Lessons in Horse Racing for the Fixed Income Investor
So, how can these lessons be applied to investing in fixed income securities? Just like with our horse racing example, we believe there are really only two questions, albeit different ones, a person needs to answer. First, how will changes in interest rates affect the securities in the portfolio? Second, what is the probability of default on the bonds either already owned or in consideration? At Roosevelt Capital Management (RCM), we mostly avoid worrying about the first question by owning short duration bonds. The second question is where we spend nearly all our time.
Bond yields indicate the amount an investor will make by owning a bond. Like odds in horseracing, bond yields can be converted into a probability of success (the bond is paid on time) and the probability of default (you lose some or all your money). For instance, using bond conventions commonly in practice, a bond that pays a 10% yield implies a probability of default of ~ 14% (as with our conversion of odds into probabilities above, please reach out to us if you would like to understand the actual calculations involved in going from a 10% yield to maturity to a 14% implied probability of default). At RCM we use this probabilistic framework in an effort to deliver our clients the highest possible return with the lowest possible default risk.
How do we do find the bonds we ultimately buy? We use proprietary technology to scour the bond market for those opportunities where our view of probability of default is materially lower than the probability of default implied by the market. This process is identical to what our horse racing expert was doing, we are trying to find bonds where the market implied probability of default is high but we believe the probability of default is lower. Upon finding those opportunities we perform due diligence to confirm our analysis and then once in the portfolio, we audit our analysis on a daily basis with the latest information available to us.
Even with this strict framework, good decisions can and will likely result in negative outcomes. To counteract this reality, repeatability is critical. While we have strong conviction in every security we buy, we will occasionally be wrong and so appropriately size one’s investments to minimize any single loss. Over the past 12 years, we have invested in over 500 securities and have had material losses in four of them, well under the average for high yield corporate bonds.
Conclusion
At the end of the day, we would like to make the case that horse racing, under the right conditions, can be investing and buying bonds, under the wrong conditions, can be gambling. It is not the field of interest that determines whether one is gambling or investing, but rather the analytical rigor applied to the “process,” and the ability to apply the “process” repeatedly, that sets the investor apart from his gambling counterparts.
Please reach out to us with questions and comments. Thank you for trusting RCM with your capital. It is a privilege for us to serve you.
David and Mike
Disclaimer
Roosevelt Capital Management LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. No guarantees or assurances that the target returns will be achieved, or objectives will be met are implied. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal.
The performance and characteristics information contained herein is for accounts solely managed by David Roosevelt, Managing Member of Roosevelt Capital Management LLC. Investment performance and characteristics through September 2019 are for Roosevelt Investments accounts managed by David Roosevelt. Investment performance and characteristics for October 2019 and thereafter are for Roosevelt Capital Management accounts managed by David Roosevelt. The performance information has been certified by ACA Compliance through December 31, 2018 and is available upon request. The values and performance information contained herein do not reflect management fees. While all the values used in this report were obtained from sources believed to be reliable, all calculations that underly numbers shown in this report believed to be accurate, and all assumptions made in this report believed to be reasonable, Roosevelt Capital Management LLC neither represents nor warrants the reports, values, calculations or assumptions and encourages each prospective investor to conduct their own review of the reports, values, calculations and assumptions.