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Is Investing a Game of Luck or Skill?

Over a period of time, a certain School of Investing has dominated all investment thought.

And that is the Warren Buffett School of Investing.

What exactly is that school of investing about?

That school of investing in essence comes down to this:

Buy a small group of high quality branded consumer companies which have supposed pricing power (the ability to raise prices without affecting demand much) and therefore 'predictable' cashflows - companies which have strong "moats", that is, companies whose business fortresses are protected by strong fortifications so that competition cannot enter their kingdoms.

This story has been told over 35 years by none other than Buffett himself. And it has been told and sold beautifully by him. 

It has pervaded investment thinking deeply, so deep that it is considered heretical to even question any part of it, let alone question it in its entirety.

About the only person who has managed to get away by questioning Buffett, has been the legendary Chicago Business School professor, Nobel Laureate Eugene Fama. When asked about Buffett, he has always shaken his head, saying "Ah, that man Buffett..."

Fama's view has been that Buffett is a purely statistical phenomenon, an outlier, and nothing more than that.

Let me explain what that phenomenon would look like: if you get 1 million people to play the stock market, using any method that they want, there is a certainty that a very small number of these original 1 million people, will get fabulously wealthy through the stock market. That is nothing but a simple probabilistic outcome. 

Probability theory dictates that when a large number of people play a game, a very small number of people will emerge as the statistical outliers, or the winners.

It is these statistical outliers that are then played up in the popular imagination to be representative of the merits of the game which draws the next 1 million into it.

The story then repeats with a handful of fresh millionaires getting born out of the second 1 million players.

According to Fama, Buffett represents that "handful" of people out of the millions, who become fabulously wealthy through the stock market.

Therefore if only a very small percentage of people become truly wealthy through the stock market, what is indeed this game of investing?

Is it a game of luck as the statistical probabilities above show, or is it a game of skill?

This is a question we pose ourselves every day as fund managers, and it has some very interesting aspects to it.

We bought Amazon in 2001 at the depths of its crisis. The price then was around $15. 

The stock is now around $3,000 and we sold the last of our holdings in the last few months.

Was this fabulous, 300- bagger trade, a trade of luck or a trade of skill?

Let us analyze the rationale for the investment first. We turned bullish on Amazon for two major reasons back then.

Reason number one: the company had turned free cash positive in that period after bleeding cash for its entire history. 

The second reason was equally important: uniform negative opinion on Amazon on Wall Street. Lehman Brothers' lead credit analyst, Ravi Suria, had downgraded Amazon bonds stating that they were going to default.

Mary Meeker, the High priestess of Internet 1.0, then with Morgan Stanley, wrote a piece on Amazon, titled "Throwing in the towel on Amazon".

Business Week had a cover around the same time, with the title "Can Amazon survive?"

A great trade was born. And the rest is history.

But back to the question: was it luck or skill? 

In hindsight when we look back, out of the total gains of around $2980 on the stock, we would attribute around $50 to skill. 

By this what we mean is: it was fairly easy to predict a doubling or even tripling if not quadrupling of the stock from the depths of despair, because when a debt laden company given up for dead, turns around by positive cash generation, it is almost a certainty that the stock which has been crushed, will rally massively.

History is replete with several such examples of beaten down stocks which when they get even a glimmer of hope, stage magnificent rallies.

So the journey from 15 to 60 can be attributed to skill.

But the remainder of the journey from $60 to $3,000?

Come on, that is pure luck! Nobody in their right mind could have predicted that the Amazon stock would be $3,000 and the company would one of the most valuable companies in the world. Not even Jeff Bezos could have done that.

Therefore if one were to dissect the element of luck and skill in this Investment, one can see that 98% of the profits made came from luck and only 2% came from skill!

The other way to look at this whole debate of luck and skill is to dissect the returns of any fund manager over a period of time.

If the returns are concentrated in a handful of stocks, while most of the stocks have not contributed much or have actually detracted from the overall returns, one can safely say that this fund manager or investor's returns are largely a product of luck and less a product of skill, because when Returns come from a tiny handful of somebody's holdings, that is nothing more than a very generous dose of luck at work.

That investor or fund manager can be called the "Survivor". In other words, he is the guy who has won the lottery as opposed to the millions who are destined to lose money in the lotteries.

As Charlie Munger candidly admits, "If you take out Berkshire's tiny set of companies that have delivered most of our returns, we are left with very mediocre returns on the majority of the portfolio." 

It is hard for a major fund manager to be as honest as this.

Without saying it in so many words, what this amounts to is that Buffett, and a few others, are the "lucky" survivors of a game in which the majority will lose. 

All because the way the majority plays the game is all wrong.

A game of skill by necessity, means that you are hitting at least an average of 55 to 60% winners in your portfolio. 

Almost every storied Investor, runs a strike rate of anything between 1% to 10%! Yes, that's it.

A US study of 20,000 venture Capital deals over several years revealed that only 0.5% of the deals, ended up being 50 baggers! Now if that is not luck at play, then what is?!

For us to call investing a game of skill, we must by necessity, establish that any fund manager or investor's returns are coming from a minimum of 55% of their holdings instead of the usual hit rates of 1 to 10%.

Remember, 50/50 is a given outcome of a series of coin tosses of a fair coin. 

This analysis leads to some very interesting conclusions on how most mutual fund managers as well as other money managers and individual investors, will randomly have periods of great runs, when they seemingly have a Midas touch, a "hot hand". 

And this period of pure luck is marketed, masqueraded, as skill.

It is like consistency in cricket: a batsman who gets to an average of 50 by making 0s in 4 innings, a 250 in the 5th,  will be largely a product largely of luck or randomness, while a player who gets 50 each in 5 innings, will be called a player with skill. 

Always analyze this aspect of any fund manager or investors' return profile and you will understand what is at work in terms of driving their returns.

(A version of this article first appeared in Outlook Business)

From the desk of 

Devina Mehra & Shankar Sharma

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