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How Betting The Horses Makes Better Investors


Both require a piercing eye for value, absolute discipline - and superhuman patience.

With most of the major Kentucky Derby preparatory races already run -- and the rest to be run this weekend -- I thought it might be a good time to compare the investing and horse-betting processes.

An investor finds a relatively new strategy, exploits it, and makes a lot of money. A couple of others notice, figure out the technique, and do quite well. Word begins to spread. More shingles get hung. Impressive results are posted, and meetings are arranged with wealthy individuals, major pension funds and other institutions. On the strength of recent performance and the impressive backgrounds of those presenting, billions of new dollars get committed to the strategy. At first, the new money looks smart - prices keep getting bid up, which makes all investments in the strategy look good.

This is where the trouble begins.

The original returns were earned largely because of the very obscurity of the strategy. If you knew where to look and how to structure an investment, you could probably buy dollars for pocket change.

But just as success in any other form of capitalism invariably attracts competitors (and thus compresses its own future profits), so too in the world of "alternative" investment strategies. Such strategies include private equity, venture capital, convertible bond arbitrage, "capital structure" arbitrage, distressed-debt investing, volatility trading, merger arbitrage - you get the idea.

The attention-getting returns get earned during a time of relatively little competition. This isn't to say it's easy to make money, but that the key is recognizing not only value, but the right time to go after it.

I was reading about Calpers' big private-equity investments. A few short years ago, private equity was all you could read about anywhere. Bigger and bigger deals were getting done. Five years ago, convertible-bond managers -- including my then-partner and I -- were badly burned when MGM (MGM) bought Mandalay Bay. We had naively figured the company -- with about $5 billion in market value -- was probably too big to be bought for cash. A couple of years later, deals many times that size were talked about as if they were as unremarkable as dew on a spring leaf.

But anyone who follows horse racing will tell you that a lot of horses can run big-speed figures when unchallenged. Only the very best horses run those same numbers -- or better ones -- when they have to compete with comparably gifted animals.

Similarly, it's a lot easier to generate big returns without competition in your way. It's easier when you don't have to bid in competition and rush your analysis. It's easier when you don't have to concede critical terms to win a deal.
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