Stock Selection Part 2 4 comments

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Often I find it useful in the stock selection process to view it as analogous to picking my bets in football betting.

Lest pure investors baulk at my comparison of their treasured art to such a common pastime as gambling, I am talking about the use of probabilities in both these activities.

When I go to a Singapore Pools outlet, I will look at the odds for each soccer match being played later that day. My attention will focus on those matches whose quoted odds disagree in a big way with my opinions. There are the "low-probability high-return" bets in which one typically picks the underdog because he believes the probability of the underdog winning are much bigger than the quoted odds suggest; hence if the underdog really wins the punter makes big money. An example is betting on the away team in any Real Madrid home match, which I've seen being quoted at as high as 10-1. Then there are the "high-probability low-return" bets which work the other way, where one picks the favourite because he believes the probability of the favourite winning outweighs that suggested by the quoted odds. That would perhaps be like Real Madrid vs Barcelona where both sides are quoted even odds even though Real Madrid has home advantage. However, if the favourite wins as expected, naturally the return isn't as much.

Both these techniques are clearly valid and similar in the sense that the punter buys where his perceived probability outweighs the quoted odds, the difference being in the type of team selected (underdog or favourite) and consequently the possible returns achievable. In fact the investor can adopt this kind of thinking when considering what stocks to buy. He could buy underdog stocks which have disproportionately "loser" valuations, hoping for low-probability high returns. Or he could buy market favourites with "winner" valuations, hoping for high-probability average returns. The first would typically be called contrarian, the second the conservative investor.

I feel both methods have their value, and I myself have done both. The important thing is to be aware of such qualitative considerations of probabilities when picking stocks, because then one is aware of what he expects from the stock. A possible step one might take is to set generous targeted returns for the underdog stock with "loser" valuations, similar to the generous odds being quoted for an underdog team; while setting less generous targeted returns for the high-probability buys.

Of course, this is not saying that the second type of "bet" is inferior. As a matter of fact, I prefer the second although I practise both. For, what is the point of securing better odds than the probability suggests, when at the end of the day you're more than likely to lose the money anyway? Of course, that's just me.

And of course, there is one other category which is rare, but which I will grab straightaway if I find them. It is the game where the team I perceive to be more likely to win, being priced as if it is the underdog. Which means, quoted odds are more than even, while (my perceived) winning probability is also more than half.
Translated to investment terms, it is a potential "winner" stock being priced at "loser" valuations. Everyone tries to find this but it is rare; my belief is that the Efficient Market Hypothesis is generally applicable.