Nov 26

Portfolio Manager Commentary — Skill vs. Luck

In Michael Lewis’ Moneyball, the Oakland A’s took a critical look at the role of the statistics generated by the baseball players they evaluated. By questioning convention, A’s management noted that some statistics better represented an individual player’s skill. For example, On-Base-Percentage was a far better indicator of a batter’s ability than Batting Average, which incorporated greater elements of luck. Further, ERA over a season was far superior representation of skill than a pitcher’s Win-Loss record, which was often heavily reliant on elements of the game beyond a pitcher’s control. By successfully segregating the elements of skill and luck in the game of baseball, A’s management was able to build a competitive team cheaply. Michael J. Mauboussin of Legg Mason spends a lot of time studying the relationship between skill and luck, and the relationship between the two in a host of activities……sports, business….and investing.

To download a PDF of this report, click here.

In Untangling Skill vs. Luck, Mauboussin highlights that definitions are important:

Skill – “The ability to use one’s knowledge effectively and readily in execution or performance. Essentially a process or series of actions to achieve a specific goal.”

Luck – “The events or circumstances that operate for or against an individual.”

Of course, the mix of skill and luck differs among activities. Playing the lottery requires no skill, while a game of chess leaves little to chance. Further, the frequency of events tends to impact the relationship between the two. The results of one baseball game could be luck – but 162 games are more likely to represent the skill of the players.

In investing, an investor competes with a collective of other investors – the “crowd”. As the name implies, the crowd represents the group think that contributes to the pricing of stocks or other investments that many times will depart from fundamentals. Although the behavior of the crowd can distort stock prices from underlying fundamentals for significant periods of time, the fundamentals ultimately win out and stock prices will revert to the mean. In fact, this reversion to the mean against the decision making of the crowd ensnares a lot of decision makers per Mauboussin:

“The sad fact is that there is significant evidence that investors – both individual and institutional – fail to recognize and reflect reversion to the mean in their decisions. To illustrate, the S&P 500 Index generated returns of 8.2% in the twenty years ended 2009. The average mutual fund saw returns of about 7%….the average investor earned a return less than 6%, about two-thirds of the market’s return. The reason investors did worse than the average fund is bad timing: they put money in when markets (or funds) were doing well and pulled money out when money (or funds) were doing poorly. This is the opposite of the behavior you would expect from investor who understand reversion to the mean.”

So how does the skill of an investor manifest itself? As in baseball, outcomes over short period of times can be random – subject to luck. In fact, given different strategies tend to work in varying economic climates; an investor can be in favor or out of favor for several quarters or years. However, identifying and acting on mispriced opportunities generated by the crowd is the primary source of market inefficiency the skilled investor exploits. According to Mauboussin’s work, skill in the investment process is comprised of three key ingredients, all of which are critical:

1. An Analytical Edge: “At the core of an analytical edge is an ability to systematically distinguish between fundamentals and expectations. Fundamentals are a well thought out distribution of outcomes, and expectations are what is priced into an asset.”

2. Behavioral Discipline: “A large source of mispricing is when the {crowd} becomes uniformly bullish or bearish, opening large gaps between expectations (price) and fundamentals (value).” As academic research confirms that it is easier and more comfortable to be part of the crowd, have the courage to act contrarian when your knowledge and experience conclude it is appropriate to do so.

3. Organizational Constraints: “The profession is about managing portfolios so as to maximize long-term returns, while the business is about generating earnings as an investment firm. Ensure you have investment professionals focused intently on the profession.”

Michael Mouboussin has authored four books and published voluminous research in support in of the contentions summarized above.

At St. James, we have high regard for Mouboussin’s work. However, the information isn’t necessarily new – in our mind it serves to reinforce the principles of value investing Benjamin Graham outlined in The Intelligent Investor, which was first published in 1949. And, as Graham’s work is the foundation of our approach to investing, Mouboussin’s key ingredients serve as simple guideposts to adhere to:

1. An Analytical Edge: We believe our edge resides in our long-term outlook, as we contend there is very little competition for patient capital. As a result, we lock out the outside influences which tend to be short-term focused (such as sell-side research and the pundits on CNBC), and continually ask ourselves what an investment might look like in five years. Proven and enduring business models, which are responsibility managed, attract our attention.

2. Behavioral Discipline: Investing with a margin of safety typically means moving against the crowd. In fact, great opportunities manifest themselves when pessimism for a company is high, yet the business model is sound. Short-term headwinds often create opportunities to buy great companies well below our conservative belief of fair value. It seemingly occurs to few that “price is what you pay – value is what you get.”

3. Organizational Constraints: We contend that the very best way for us to guard against “career risk” is to own the firm, invest in the strategy, and caution that our approach is not for everyone. Suffice to say we believe that to try and keep up with benchmarks in all environments is a recipe for long-term failure.

Since 2000 the market has moved violently yet gone nowhere, as market participants continue to engage in the same short-term behaviors that have proven so futile. Everyone knows that frequent visits to a casino are a fool’s errand, but the vast majority of market participants can’t help but speculate on stocks – seemingly ignoring the work of Graham and Mouboussin. And yet we can’t help but think that those who forget the past are likely to repeat it.

The opinions expressed are those of the Fund’s portfolio manager and are not a recommendation for the purchase or sale of any security.

The Castle Focus Fund’s prospectus contains important information about the Fund’s investment objectives, potential risks, management fees, charges and expenses, and other information and should be read and considered carefully before investing. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. You may obtain a current copy of the Fund’s prospectus by calling 1-877-743-7820. Distributed by Rafferty Capital Markets, LLC-Garden City, NY 11530, Member FINRA.

The risks associated with the Fund, detailed in the Prospectus, include the risks of investing in small and medium sized companies and foreign securities which may result in additional risks such as the possibility of greater price volatility and reduced liquidity, fluctuations in currency exchange rates, and political, diplomatic and economic conditions as well as regulatory requirements in foreign countries. There also may be risks associated with the Fund’s investments in exchange traded funds, real estate investment trusts (“REITs”), significant investment in a specific sector, and non-diversification.

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