Tuesday, April 7, 2009

Investing as a Zero Sum Game - Alpha

"Investors operate within what is for the most part a zero-sum game. While it is true that the value of all companies usually increases over time with economic growth, market outperformance by one investor is necessarily offset by another's underperformance."
-Seth Klarman, 2005 Baupost Value Partners Letter

"The model I like—to sort of simplify the notion of what goes on in a market for common stocks—is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what's bet. That's what happens in the stock market. Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so on and so on. But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2. Then it's not clear which is statistically the best bet using the mathematics of Fermat and Pascal. The prices have changed in such a way that it's very hard to beat the system. And then the track is taking 17% off the top. So not only do you have to outwit all the other betters, but you've got to outwit them by such a big margin that on average, you can afford to take 17% of your gross bets off the top and give it to the house before the rest of your money can be put to work."
-Charles T. Munger, A Lesson on Elementary, Worldly Wisdom As It Relates To Investment Management & Business, USC Business School, 1994

The following quotations intelligently sum up the conventional wisdom, but are only half true, or perhaps false? Life is full of paradoxes and investing is no different, so I present the proposition that "Investing need not be a zero-sum game."
Strict zero sum games are horse racing and casino games like roulette and blackjack. They are alike in that each have a set amount of money/capital/value being wagered, and a finite amount of players competing for the capital. No amount of game playing will increase the amount of capital in the game or society (social value), though players may glisten and redden with drinks late into the night, tip scantily-clad waitresses, and take in the thrill of gambling (while the hustlers clean up).

Investing is different because capital is being put into productive companies which promise and attempt to create new economic value. Depending on what the company does, that is, what is created, how the plan is executed, how good management is, etc., social value and capital can be created or destroyed. So investing is not a zero sum game. It can in fact be worse, a negative sum game, because if capital is destroyed, all the "players" are worse off than a zero sum game. So investing is like farming - inputs such as seed, fertilizer, water, etc. worth X are put into the ground, and the output is expected to be 2X, unless the farmer screws up and the harvest returns 1/2 X. Luck and uncertainty also matter, since no one knows what the future will bring.

The best example of positive sum investing comes from VC firms or IPO investing. If VCs didn't exist, it's possible that large, value-add companies like Google, eBay, Cisco, & Sun would never have been created, and society would be poorer (and so would many investors). Clearly, VC investing is not zero sum because it does not compete for a fixed pie with regular equity and debt investors. Likewise, if the IPO market didn't exist, then it's likely that successful small companies wouldn't grow and expand (or be limited by internal capital constraints), and so couldn't take over their industry. On the flip side, the burning of large amounts of cash/capital from 1999 to 2001 in the bonfires of internet madness was shameful and a loss of social value.

The best example for IPOs is Wal-Mart, whose growth for its first decade was constrained by internal capital and the debt that Sam Walton could personally borrow (his daughter even had nightmares about his guarantees). Once the IPO occurred, which incidentally was one of the 20th century's best to participate in, and whose largest investors were Scottish and not American, the company was free to grow and compete with less efficient retailers. All the while Wal-Mart increased social value. The social loss from K-Mart and Woolworth failing was much less than the gain from Wal-Mart succeeding.

The logic of the proposition applies beyond early-stage companies and IPOs, even to mature companies. For example, if GM, Chrysler, and their financing arms were not given easy/cheap access to capital by incompetent investors, then the reckless consumer car buying boom of 2001 to 2007 would never have occurred. Instead, capital could have gone to more effective uses, like student loans securitized into ABS for high school grads who want to go into trades, nursing, or other socially needed fields. Likewise, if investors hadn't bought a lot of RMBS, which led to houses now sitting empty and rotting, they could have placed that capital with biotech, health/nutrition management, or medical infotech companies deveoping cheap technologies (or processes) for making human beings healthier and more productive.
In sum, investing need not be a zero-sum game because investors can make the pie of total capital larger. However, the down side is that investors can also make the pie smaller, so investing can be positive-sum or negative-sum. With this perspective, the questions of who gets to allocate capital, how to select managers, and how to align incentives, are not just important for pension plans and endowments, but for society as a whole.

No comments:

Post a Comment