Good Reading -- December 2013

As in recent years, this last edition of the year will feature some "bonus" materials. I hope you find something useful, and here's wishing you a great end to 2013 and an even better 2014. - Phil

Miscellaneous

  • Reading List -- My updated list of the best books and articles that I've read on investing. As always, suggestions are welcome.

  • Investment Principles and Checklists -- A collection of principles, ideas, concepts and checklists compiled from great investors. I've distilled some of it into more usable form, but this is meant to be a resource, not a ready-to-go checklist. Actually creating a tailored checklist is a key part of its usefulness.

  • Investing Quotations -- Selected quotes, snippets and soundbites, mostly from the same sources as above.

Quoted

"I have never seen credit this good in my 32 years at the company." -- Wells Fargo CEO John Stumpf in a recent interview

Books

  • Best books of 2013 -- A better, more comprehensive list can be found here and here and here, but these were my favorites among recently released books:

  • The Manual of Ideas by John Mihaljevic

  • Mastery by Robert Greene

  • The Outsiders by William Thorndike

  • The Oracle & Omaha by Steve Jordon

  • The Map and the Territory: Risk, Human Nature, and the Future of Forecasting, by Alan Greenspan -- I alluded to this book last time and I've since finished it, so my parting thought is this: Read this book, but not because it's good. Read it for the head-spinning references to Danny Kahneman in Greenspan's "I-was-wrong-but-not-really" explanations of the change in his thinking. Read it for lines like this one: "Short-term investing is complex, and for guidance I defer to chartists." Read it for his criticism of "recent policy [that] has always seemed biased toward activism when, more often than not, allowing markets to rebalance and heal is the most prudent policy."

  • The Detective and the Investor, by Robert Hagstrom -- I have read all of Mr. Hagstrom's other books, but this one was left sitting in the pile until recently. I grabbed it to read with another book recently published on the same topic (see below). Like Hagstrom's other books, this one is excellent -- a little corny at times, but very much worthwhile for all investors.

  • Mastermind: How to Think Like Sherlock Holmes, by Maria Konnikova -- This is also a good read. It is very similar to Hagstrom's book, but there is still plenty of good material and lots of checklist fodder.

  • The Reporter's Handbook: An Investigator's Guide to Documents and Techniques, by Steve Weinberg -- This is recommended in Hagstrom's book, and despite being very dated it is a great source of information and ideas from investigative reporters as applicable to investors doing original research. The "documents state of mind" and dogged pursuit of information are essential frameworks, and the list of other resources is worthwhile as well.

Attachments

  • "Howard Marks: Equities are Underowned and Unloved" -- Interesting commentary as always. His most recent memo "The Race is On" is worth reading, as always.

Links

  • McKinsey says QE hasn't boosted stock prices -- And apparently they're serious...you can't make this stuff up.

  • Europe's Youth Unemployment Crisis in One Grim Map -- As bad as the labor market is in the U.S., it's fairly easy to lose sight of how truly awful it is in Europe. The numbers are astounding, and they've been this bad for years with little improvement. The implications for an entire generation are truly frightening. (Thanks to Jeff L. for passing this along.)

  • Joel Greenblatt on Value Investing -- Nothing particularly new, but a great overview of his philosophy.

Articles

  • "They Hate the Fed" -- Roger Lowenstein is currently writing a history of the Federal Reserve and I'm greatly looking forward to it. In the meantime, here is a review he recently wrote in the New York Review of Books about a new film about the Fed. I haven't seen the movie, but this review gives you the idea and adds some much-needed perspective -- it's an excellent essay in its own right.

  • Steven Crist in the Daily Racing Form -- A classic from the archives, and one that deserves a second or third reading. Charlie Munger has often compared investing to pari-mutuel betting systems, and this essay drives home that analogy.

They Hate the Fed

Roger Lowenstein

November 21, 2013Issue

Money for Nothing: Inside the Federal Reserve

a film by Jim Bruce

America’s animosity toward central banks dates to the administration of George Washington, when Alexander Hamilton proposed the creation of a Bank of the United States to organize the debts of the states, establish a common currency, and promote manufacturing in the young nation’s economy. Thomas Jefferson feared that such a powerful joining of finance and state would lead to tyranny; Washington also had doubts but let the bank go ahead. Two decades later, Jefferson’s protégé, James Madison, allowed the bank’s charter to expire, only to realize he had made a mistake. He prevailed on Congress, in 1816, to create the Second Bank of the United States. It succeeded in establishing a uniform currency—a vital achievement—but Andrew Jackson loathed the bank as a bastion of financial privilege favoring East Coast elites. Jackson vowed to destroy the bank—and destroy it he did. Foreigners could scarcely comprehend Americans’ disdain for central banks, which by the nineteenth century were vital to the financial systems of England, Prussia, France, and other states. Alexis de Tocqueville, who visited the US during the Jackson era, diagnosed the “intense hatred” of the Second Bank as a sign of America’s enmity toward central government. Later, after several serious depressions, Wall Street lobbied for a lender of last resort and, in 1913, Congress created the Federal Reserve. But Jackson’s argument—that a central bank posed a dangerous threat to the private market, and would favor the interests of the powerful and rich—was raised by opponents of the Fed in 1913, and it has been raised one hundred years later by the critics of the current Fed chairman, Ben Bernanke. The difference is that while populist anger against central banks previously came from the political left, these days the attacks on the Fed come mainly from the right. Such is the case with Jim Bruce’s film Money for Nothing: Inside the Federal Reserve, which presents a historical account of the institution, focusing on the recent mortgage crisis, to mount a withering assault on the policies the Fed is employing to revive the economy today. The pivotal scene in Bruce’s movie takes place during the dark early days of the twenty-first century. America has just been through a recession (as well as the September 11 attacks), the country is in a demoralized state, and the then Fed chairman, Alan Greenspan, is worried that its torpid economy might slip into deflation. Not everyone agrees that this is a risk, but a fuzzily bearded Fed governor named Ben S. Bernanke is supplying Greenspan with intellectual backup. In 2002, Bernanke gave an address in Washington, “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” in which he outlined a program to avert the sort of deflationary trap that snagged the US in the 1930s and Japan since the early 1990s. Among the steps Bernanke recommended was cutting interest rates. And in the early 2000s, Greenspan cut the overnight interest rate—at which banks themselves borrow money—so low that a character in the movie says, “You could scarcely see it, it was so tiny!” This is meant to sound eerily familiar today—after all, we have just been through a much worse recession, and interest rates are even lower, close to zero. The film argues that cheap money caused the mortgage crisis that came to a head in 2007 and 2008. If reducing overnight rates to one percent didn’t work then, Bruce argues via the narrator and a series of interviews, why is Bernanke following a more extreme version of the same policy now? This question is sure to arise in the confirmation hearings for Janet Yellen, whom President Obama recently nominated to succeed Bernanke. Yellen, the Fed’s vice-chair and a strong Bernanke supporter, could face significant opposition. (Indeed, the same anti-federal rancor emerged in the recent controversies over the government shutdown and the debt limit.) Previous to Bernanke, the most recent Fed chief to encounter popular opposition was Paul Volcker, who presided between 1979, when inflation was running rampant, and 1987. Volcker jacked up interest rates to an astonishing 20 percent—effectively so, since this policy succeeded in taming inflation. However, working Americans paid a price—two brutal recessions—and Democrats charged the Fed with kowtowing to Wall Street. Critics today similarly assert that Bernanke is Wall Street’s tool. However, Bernanke has faced very different challenges than Volcker, and his responses have been correspondingly different. Essentially, Bernanke has tried to head off a depression by lowering interest rates and, by means of bond purchases, providing the economy with large doses of credit. Although inflation has been modest while he has been chairman, he is often charged with depreciating the dollar by printing too much money. The fear among monetary purists is that by purchasing bonds from banks, Bernanke is setting the stage for inflation later. On the far right, this is regarded as little short of treason. During the 2012 campaign, Rick Perry warned Bernanke not to set foot in Texas, and Newt Gingrich quite falsely labeled him “the most inflationary” Fed chief in history. Money for Nothing picks up this thread; indeed, Bruce begins by expressing astonishment that the dollars Bernanke prints are based on “faith” (that is, not on gold) and implies it is only a matter of time before the world loses confidence in greenbacks. Nostalgia for the gold standard is a staple of Fed detractors, who tend to depict bullion as an unalloyed, and infallible, arbiter of monetary policy. In fact, in the latter part of the nineteenth century, when the US actually was on a gold standard, the country suffered prolonged bouts of deflation and frequent panics and slumps that were exceedingly painful for farmers, laborers, and others. Bruce taps into gold’s sentimental appeal, with plenty of footage of shimmering gold bars and a closing shot of Ron Paul calling for an end to the Fed, which echoes the title of a book by Paul, as well as a T-shirt and a popular bumper sticker. The movie doesn’t explicitly advocate a return to the gold standard or an end to the Fed, but it does argue for shrinking the Fed’s mission. Bruce elicits an on-screen comment from the investor Jeremy Grantham that monetary authorities should concern themselves only with preserving the dollar’s purchasing power, and abandon the Fed’s other congressional mandate—job promotion and economic growth. Bruce is the coproducer of a previous film on Sierra Leone and, according to the publicity material, “a student of financial markets for over a decade.” Before the mortgage crisis, he shorted (that is, bet against) stocks of financial companies, the profits from which helped to fund his movie. He seems to believe that virtually everything bad that has happened to the US economy since the 1970s can be laid at the Fed’s door. According to experts—investors, journalists, former regulators—quoted in his chatty documentary, first Greenspan and then Bernanke twisted the Fed’s mission beyond recognition. Instead of focusing on keeping the currency strong, they circulated large amounts of dollars and weakened the dollar on the international exchanges. Instead of leaving markets to sort out winners and losers, they bailed out Wall Street after the 1987 crash and in every subsequent crisis, encouraging speculation while punishing savers with ultra-low yields. According to what the journalist Jim Grant says in the film, Greenspan, ironically, ditched his right-wing principles for a leftish program of “the socialization of risk.” Bruce grudgingly acknowledges that Bernanke halted the panic in 2008, but the chairman still comes off very badly, never more than when he is seen asserting, before the crash, that home prices were unlikely to collapse because they had never done so before, or when, more recently, he expressed “100 percent” confidence in his present course. Bernanke has hardly been perfect; he might have shown some humility. But did he or Greenspan cause the mortgage crisis—and if so, how did they do it? Any fair rendering of the crisis—already the subject of three hundred books, according to a count by the financial analyst Gary Karz—should start with the fact that mortgage lenders created a bubble, of the type that has afflicted capitalism time and again. Banks provided mortgages to people without verifying whether they had any income or means of repaying loans, which set off an avalanche of borrowing. In myriad forms—subprime loans, teaser loans, “liar loans”—bankers issued mortgages that were destined to fail, and that they counted on reselling before it was clear whether payments on the mortgages would or would not be made. This is the classic bubble behavior. Various other factors helped to promote, or failed to inhibit, this private market bubble. The list of contributing causes includes (a) faulty incentives that rewarded Wall Street traders for buying unsound loans; (b) incompetence or corruption at rating agencies that endorsed mortgage securities as safe investments; (c) abject failure to regulate new mortgages at various levels of government, including the Fed; (d) reckless behavior by Fannie Mae and Freddie Mac, the government-sponsored housing agencies; and (e) low interest rates, set by the Fed, that arguably motivated investors to seek the higher yields of mortgage products. Catastrophes that have multiple causes do not lend themselves to simple theories of blame, and Money for Nothing is plainly dismissive of analyses that rely on a number of causes. Peter Fisher, a former Fed official, is seen in the film lampooning such an approach as “the great coincidence theory.” Bruce espouses what might be called “the grand villain theory,” for he almost exclusively blames the crisis on the Fed, specifically for inducing speculation through very low rates. The film even says banks that took foolish risks were merely responding, in a rational way, to Fed policy. Don’t blame Angelo Mozilo, the chief of Countrywide Financial, liar loans, or reckless traders—it was all the government’s fault. Thus, Money for Nothing uses the Fed’s assumed culpability to turn what was above all a private market failure into one by government. Bernanke has argued that cheap money had very little to do with the mortgage crisis. (Other countries, such as Canada, also had low interest rates but did not have a bubble.)*Certainly the Federal Reserve failed to crack down on shoddy standards in the mortgage industry. Before the crash, Greenspan, an ideologue hostile to regulation, rebuffed the suggestion of the late Fed governor Edward Gramlich that the Fed investigate mortgage lenders. While raising rates might have cooled risky lending, banning excessively risky mortgages could have stopped it. In other words, the problem wasn’t too much government, it was too little: regulation was woefully deficient. Bernanke doesn’t get to defend his policies in this film (we see him only in carefully spliced canned footage), nor is anyone else allowed to make a case for him. Alan Blinder, a former vice-chairman of the Fed, is quoted thirteen times, but Blinder—either because he wasn’t asked or because such comments were excluded—never says here what he has routinely argued elsewhere: that Bernanke has been dead right to aggressively lower interest rates. Earlier this year Blinder wrote in The Wall Street Journal, “When it comes to supporting growth, the Fed is the only game in town.” Bruce does not mention this opinion either. Indeed, viewers of Money for Nothingwould probably be surprised to learn that Blinder, and a majority of American economists, support Bernanke’s current policies. The film quotes a skeptical remark in which Blinder raises a very good question. “We can borrow tons and tons of money at very low interest rates,” he says toward the end. “The problem comes in the long run: When is this game going to end and how is it going to end?” Blinder means that Bernanke’s large-scale bond purchases have put the Fed in uncharted territory. We cannot know how difficult it will be for the Fed to unwind its $3 trillion balance sheet—that is, to sell off its extensive bond portfolio without precipitating a recession—and to return, in time, to normal interest rates. Bruce is right to wonder whether the medicine administered by Bernanke and Yellen is working, and right to question whether it may possibly be sowing the seeds of some future distress. But the film’s answer is freighted with the emotionalism that Americans tend to bring to the topic of central banks. In 1913, the Fed’s framers had to overcome a deep distrust, bordering on paranoia, so that America, like other countries, could have a lender of last resort as a bulwark against depressions. Money for Nothing is the latest installment in an old American tradition—bashing the central bank.

Steven Crist Publisher and Columnist, Daily Racing Form

I was well on my way to becoming a professor of Renaissance literature way back in the mid-1970s. One night a classmate invited me to the dog track. I said, "What's that?" About forty-five minutes later, my academic career was over! It was that easy. I had what we Joyce scholars like to call an epiphany. Something about the lights and the animals and especially the blinking numbers on the tote board struck a very deep chord with me. It probably had something to do with a childhood largely mis-spent playing Strat-O-Matic Baseball. I have discovered that many horseplayers used to play this game as children. You rolled dice and with statistically-based cards, you could play out an entire season. This is very similar to the horse racing and gambling that I have been doing ever since.

I am here to talk about why most of what you have heard about horse racing is wrong, and why horse racing is much more similar to what you do than other forms of gambling. The general public probably thinks that for the most part, horse racing is just like the state lottery or playing craps or roulette in a casino, except that you have horses running around in circles rather than ping pong balls or a spinning wheel.

In fact, horse racing is entirely different from those forms of gambling for one simple reason. In horse racing, you are not betting against the house. In other casino games, you cannot win, with the exception of blackjack and poker. A good litmus test for someone being a liar and an idiot is if someone ever tells you, "I am really good at roulette," or "I win at craps," or "I have a system for beating the slot machines." There is no such thing. These are games with fixed percentages. The casino might as well attach a leach to your forehead when you walk in the door because the longer you stay, the more you will lose, except for short-term, meaningless fluctuations.

The exceptions to that rule are blackjack and poker. If you count cards diligently in blackjack, you can get a 1.5 percent edge over the house. Casinos, of course, don't get built by players having edges, so the casinos will eject you if they figure out that you're counting cards. This happened to me - I was playing a friendly game of blackjack at the Barbary Coast in Las Vegas about ten years ago, and suddenly a floorman came up to me with an Instamatic camera. I thought, "Wow! This guy recognizes me from horse racing telecasts!" I thought he would take my picture and put it up on the gambling wall of fame or something. Instead, he took my picture and said, "Sir, you are no longer welcome to gamble in this casino." Even though I was only playing five and ten-dollar blackjack, I was still counting cards. That is a very small edge that they don't let you have.

The only other game in a casino that you can win at is poker, which is always situated right next to the horse racing area. The reason that you can win at poker and horse racing is the same - you are not betting against the house; you are betting against the other players. This is such a crucial and fundamental difference, and it is lost on the general public. The house is not setting the odds. In roulette, there are 38 spaces on the wheel, and if you pick the correct one, the house will pay you off at 35-to-one, and they will keep the difference. The longer you play, the more you lose and the more the house wins.

When the other players are setting the prices, it is an entirely different story because somewhere between frequently, occasionally and rarely, the public makes the wrong price. That is the beginning of the successful equation in horse racing. It took me about ten years as a racing reporter and columnist, trying to track down the elusive method of picking the winner of every race, to realize that that was a fool's errand. In ten minutes I can teach anyone in this room how to pick the most likely winner of a horse race. There are data about past performance that we publish in the Daily Racing Form that correlate very strongly with the most likely winner in the race. Most horse players spend their lives thinking that if they just studied a little bit harder or got a little bit smarter, they could pick the winner of the race enough to make some money. There is no such thing. Picking the most likely winner is no great feat.

What you really want to do is determine which most-likely winners are good prices and which most-likely winners are bad prices. It is a very simple equation:

Price X Probability = Value

The entire world of investing is that simple too. Here is what I mean. If a horse has a 33 percent change of winning a race, and if you can get odds of 2-to-1 on him (which means tripling your money), there is no value - the horse is priced correctly. If a horse is 6-to-5 (which means you will only get back 120 percent of your bet) and he is only 33 percent to win, then he is a terrible bet. If you're going to get 4-to-1 (quintupling your money) on a 33 percent chance winner, then it's a great bet.

The majority of people who play horses refuse to think that way. They sometimes say that no horse is worth taking a short price on. That's just not true. If a horse is 90 percent to win a race and you're going to get a 50 percent ROI, then he is one of the greatest bets in history. They sometimes say that all long shots are over-bet and that you should never bet on a long shot. That's not true either. If a horse has a 10 percent chance of winning a race and he's 20-to-1, then you're getting double the value than you should.

What you wait for as a horse player (and investors tell me that they wait for the same thing) is mispricing, for the public to make mistakes. I cannot say for sure why the public makes mistakes in your world, but I know why they make them in mine. The people who most influence the odds in racing are known as "public handicappers". These are the guys at the local paper who run a set of picks every day. "Clocker Joe" or "Cowboy Jim" give you their 1-2-3 picks in every race. Their 1-2-3 picks have an entirely different motivation than your presumptive motivation to make money. Clocker Joe and Cowboy Jim want to pick the greatest possible number of winners so that they can remind their boss at contract time that they picked 31 percent winners in the previous year. That's pretty good for a public handicapper. Yet, with a typical payoff structure, Clocker Joe will still have lost his customers money. We have already taken this analysis to a level of investment and mathematical sophistication far beyond the ken of any metropolitan sports editor. The sports editors continue to reward the Clocker Joes of the world who pick 31 percent winners at very low prices because they don't understand the equation of Price X Probability = Value.

There is also a highly-misunderstood thing at the track called "the morning line". For every race every day, a track employee writes down a set of odds on each horse. These are not the actual prices that you get when you place a bet. They are the prediction of one overworked track employee for how the public is going to bet the race. That employee is not saying, "I believe that horse #1 has a 20 percent chance of winning the race, so I will make him a 4-to-1." He is in effect saying, "For a horse whose past performances look like this, the public is going to make him a 4-to-1 favorite." Those are two extremely different things, and this is not at all understood by the wagering public at large. The public routinely thinks that it means something when a horse is lower than the morning line odds predicted. If a horse is going at 2-to-1 odds when the morning line was 4-to-1, the public thinks "There's action here! THEY know something."

There is a mythical creature at the racetrack that is called "They". The vast majority of people playing the horses believe that there is a "They" - some cartel of brilliant analysts with foreknowledge of the outcome of the races, and when a horse is going off at much lower than his morning line odds, "'They' know. 'They' are betting today." I used to believe in "They" when I first came to the racetrack, but the longer I hung around, the more I recognized that there is no "They." "They" don't exist. Once you believe this in your heart, you have made a huge stride. Some people might argue that it is a stride towards incredible arrogance, and that may well be true, but you cannot play intelligently or profitably laboring under the myth of "They." At least in my world, there really is no "They."

My best guess is that there are maybe 100 people making a good living betting on horses. It is a very tough game. It is much tougher than the investing game for one simple reason. There is a thing in horse racing called the "takeout". You have something in the investing world known as "inflation". The difference is that your $100 today will be worth $103 or $108 by next year. In horse racing, the $100 that the player begins the day with is decreased by 20 percent every time he makes a bet. This is the economic underpinning of horse racing.

In the first race of the day, say the public bets $100,000. The first thing that the track does is take out $20,000 for itself. That $20,000 is used to keep the track operating, to put up the prize money for the horses, to bribe politicians, etc. That is takeout. Takeout in horse racing is much much higher than in other forms of gambling. In blackjack, without card counting, the house edge is about 1.5 percent. In football betting, it's 4.5 percent. It's about the same in roulette. In slot machines the edge is still only set at 6 to 8 percent, and usually the maximum is 10 percent.

The takeout in horse racing is set at 20 percent, and it is kind of an historical accident. Fifty years ago in the U.S., horse racing had a legal monopoly on gambling. The government felt that it was its legal right to extract money from it. The takeout began at 10 percent, which most economists say is probably the optimal rate of takeout for horse racing. That is the number at which people will not notice it, and people will churn their money enough that it is ultimately to the track's benefit. Every five years or so, however, whenever there was a budget crisis, some politician would suggest raising the takeout by a point or two to get more money from the dumb horseplayers. 10 percent became 11 percent became 12 percent became 15 percent and eventually 20 percent. That is the reason that I would be surprised if more than 100 people are making money at horse racing. Fighting that 20 percent bite from the pool race after race is very difficult. If you do the math, if you locked the doors at the race track and people just kept betting, it would take 37 races for every nickel in every customer's pocket to be transferred over to the racetrack. That's one reason that they don't run 37 races per day. Instead, they run nine or ten races, let everyone go home, they go to the ATM to get some more ammo, and they come back the next day. It is extremely difficult to turn a profit over time. You have to really wait for those public mistakes.

Fortunately, there are enough public mistakes that an extremely disciplined and hard-working person can make a living at it. But please do not quit your day jobs. Please. It changes dramatically when you try to do this for a living. Playing horses is a much better hobby. How many hobbies can you show a profit on at the end of the year?

The "wisdom of crowds" phenomenon is common to both horse racing and investing. Over the course of a year, the best public handicappers (all of whom, of course, work for the Daily Racing Form) do not do as well as the assimilated public. We have a guy named David Litfin who is by far the best public handicapper in New York. He picks about 30 percent of the winners each year, which is a very high percentage. This does not get him even, however, because he is forced to make a pick in every race, even races that he doesn't like and wouldn't bet on with his own money. But the public always picks 33 percent winners. How can the public at large, which includes drunk people and crazy people and people betting on the cute one and the one with pink silks, be better than the Daily Racing Form's ace handicapper?

I found the answer to that in James Surowiecki's book, The Wisdom of Crowds. This book popularized a lot of research being done in this area. The most accessible example comes from the game show, "Who Wants to be a Millionaire?" Contestants could request help from three different "lifelines" when they found a question too difficult. They could ask a friend, ask an expert or ask the crowd at large. What they found over the several years of the show was that the crowd was much more likely to be correct than the expert. This may appear to be counterintuitive.

Another example was from the early 20th century in England. There was a contest at a local fair in which the public could guess the weight of an ox. Hundreds of people submitted guesses. Not one individual guess came within five pounds of the correct answer, but the average of all the guesses came within a tenth of a pound of the correct weight. There are certain situations where having hundreds or thousands of pairs of eyes on a problem helps create a higher winning percentage over time. That is why there is no great trick to picking the most likely winner of a horse race, and that is why picking the winner is not ultimately a profitable pursuit.

On the theme of disruptive innovation, I would say that half of the 100 people making money on horse racing are doing so because they came up with an extraordinarily clever idea a few years ago. As you might imagine given the increasing speed and capacity of personal computers, people thought that there had to be a way to feed all of the racing data that's out there into a computer, analyze it, and figure out a way to beat the game. A lot of very smart people backed by some very serious money have taken on this project. They have found that you can beat the crowd this way, but no one could get the return higher than 94 or 95 percent because of the takeout. With a 20 percent takeout, you are doing very well to earn a 94 percent return, but you're still not making any money. This was a huge source of frustration for these guys who couldn't push the program past doing 15 percent better than the general public. Unfortunately, you had to do 20 percent better than the general public just to break even at the game.

So they tried going through the back door. They acknowledged that they probably couldn't push their programs much beyond 15 percent, but they asked how they could lower the takeout. They couldn't ask the legislature to reduce the takeout because they wanted to make a lot of money. Instead, they decided to go into the bet-booking business themselves - "What if we became the house?" They only needed 4-5 points of the 20 percent takeout for their own operations, and they could pay themselves a rebate using the rest of the takeout. Over the last five years, rebating has become the biggest issue in horse racing.

I will probably lose a few of you here, but I will give you the very quick version of why rebating works. The 20 percent takeout model is based on live racing, where the track is responsible for paying for the upkeep of the physical race track, and paying out purse money. About 20 years ago, however, live racing began to be replaced by "simulcasting" - we can sit in a room here in Baltimore and bet on races being run in New York or California.

When that idea came along, the race tracks had no idea what to charge us in Baltimore for the privilege of betting on their races. They couldn't charge the whole 20 percent because someone else was putting on the show, feeding the gamblers, etc. In one of the great arbitrary decisions in history, the race tracks decided to charge 3 percent. It was a ridiculously low number, and it has come back to devastate the industry because 20 years ago, 90 percent of the betting was done on a live basis. Today, only 10 percent of betting is done live. If you are running a race track, you are only getting 20 percent on 10 percent of the bets made on your races. On 90 percent of your business, you are only getting 3 percent.

Here at the Baltimore trading pool, I only have to pay the New York racetrack 3 percent. The other 17 percent goes into my pocket as the Off Track Betting (OTB) operator. Now I can go to the "whales" (the big players) who are using computers to get their return up to 95 percent, and I can offer them a 10 percent rebate on their $20 million or $50 million of bets placed at my windows. The guys who had gotten their programs up to 95 percent are now getting a 10 percent rebate, and suddenly they're making a 5 percent profit on their handle. This is the kind of completely counterintuitive, through-the-back-door thinking that has made a very small number of people able to win at horse racing.

There is another parallel to the world of investing. Just as the location of betting has gone from 10 percent off-track to 90 percent off-track, the types of bets being placed have also undergone a seismic shift. When you first went to the race track, you probably heard that there are three kinds of bets that you can make - Win, Place and Show. A Win bet is for the first-place finisher, a Place bet is for one of the first two finishers, and a Show bet is for one of the first three finishers. Only 25 years ago, over 90 percent of the handle was for these kinds of bets - people would pick a single horse in a single race and decide whether to bet the horse to win, place or show. The only other kind of bet was the "Daily Double", where you would pick the winners of the first two races of the day. This was a promotion to get people to come out for the first race of the day.

The betting public eventually became bored with these three bets. Some of the more fringe types of racing like greyhound racing began to experiment with "exotic bets". Rather than just picking a single horse to win, place or show, they developed the "exacta", where you have to pick the first two finishers in the correct order. Then they developed the "trifecta," in which you pick the first three finishers in the correct order. The superfecta includes the first four finishers in the correct order. They also developed a set of multi-race bets in addition to the Daily Double. These include the Pick 3, the Pick 4, the Pick 5, the Pick 6, the Place 9, all of which are self-explanatory - you have to pick the winners of many races in advance. On one hand, this was just a sign of boredom and decadence on the side of the wagering public, much as it exists in the investing world, which leads you into things like derivatives, options-based assets and other fun games.

In horse racing, these exotic bets became not just a novelty, but also a real opportunity that had not existed previously. The very nature of the exotic bet offered value that was no longer available in the Win, Place and Show pools. There is not a great amount of value in the simple Win, Place and Show bets because the prices tend to correlate pretty well with the probabilities. So there may not be a lot of value to be found in picking horse number four to win a race, but the public might misprice the odds for a horse coming in second in an exacta bet. This new bet created a new opportunity for the public to make a mistake. If you are going to go three or four horses deep into a race, or if you are going five or six races deep into a racing day on a Pick 5 or 6, the chance that the public is going to make a serious mistake grows exponentially. It grows so fast and large that it is worth playing the bets almost blindly. The Pick 4 and Pick 6 routinely pay 50-100 percent higher than the parlay of those four, five or six individual winners does. It is because of inefficiencies in the betting pool and the increased likelihood of the public making a mistake.

The best friend that horseplayers have are the big race days. The saddest thing that has happened to the serious horseplayers has been the growth of casinos and racinos and slot machines over the last thirty years. The worst players (the best players from our point of view) - the ones betting on names and looks and colors - have all left the race track. They are now pulling handles on slot machines all day because of the higher leverage - they don't want to win 10-to-1 on a horse; they want the slot machine to pour out a life-changing amount of money. Horse racing cannot compete with that, so all of the crazy people are now gone from the grandstands. That is terrible for the serious horseplayers!

However, the crazies do come back a few times a year. Kentucky Derby day, Preakness day, Belmont Stakes day, Breeder's Cup day, almost every day at Saratoga, almost every day at Del Mar, the pools are filled with the money of tourists and amateurs - people paying attention to the selections of the public handicappers. It is really worthwhile to wait for those days and bet five times as much on those days as you would on a rainy Thursday at Aqueduct where you know that you are just playing against the other sharks. They'll make some mistakes too, but there will not be a lot of fat in those pools.

There is another phenomenon about the big days and the big races that is not only profitable, but also just as pleasing: once the general public and the media get involved in my little world of horse racing, the opportunities expand exponentially! They get it so wrong that there are wonderful opportunities. I will conclude with an example of that.

It was the spring of 2004, around the time when certain horses begin to emerge as contenders for the Kentucky Derby, which is run the first Saturday in May. It was an indifferent group of horses. There were no superstars or strong contenders from the previous year of two-year-old racing. A horse who began his career in relative obscurity - he was racing in Pennsylvania - slowly became one of the favorites for the Derby. He had a name that people loved - Smarty Jones.

By any historical measure (and there are some very good statistical metrics of pace and time), Smarty Jones was the best of a bad group. He didn't stack up with the great horses of history. As no other horses emerged, and as the general press began to jump on this story, Smarty Jones began to take on a buzz. He was the favorite in the Kentucky Derby, which most people forget because he was quickly recast as an outsider and a long shot. Come Kentucky Derby day, Smarty Jones was a kind of bad favorite. Most intelligent people bet against him. About an hour before the race, the skies opened up, and it began to pour at Churchill Downs. When it rains hard at the race track, the same, predictable thing happens - the horses with early speed do very well. There is a pretty basic reason - they get in front of the field and kick up mud, and the other horses get mad and decide that they don't want any part of this. One or two horses in the lead run their race and nothing much happens. Smarty Jones took the early lead and won the Kentucky Derby by four lengths. He was now certified as the only horse who could win the Triple Crown. People became very excited about him based on this victory in the slop.

Then another phenomenon started to happen. There is now only one horse that can win the Triple Crown since Affirmed did it in 1978. In the two weeks between the Derby and the Preakness, the general news media suddenly descend on the horse racing world. These are people who know absolutely nothing about horse racing. You could point at the stable pony and tell them that it was the Derby winner. You could tell them that the Preakness was 4.5 miles. They really don't know the difference. Since they don't have anything intelligent to say about horse racing, they do what most sports writers do today - rather than writing about sports, they write about human interest stories. This is my profession, but it is a profession that has sunk into the gutter. The journalists in every sport, including horse racing, basketball, baseball, football, hockey or whatever, live for somebody with a sick grandmother or someone with an exotic disease. More than anything, they want a rags-to-riches story or a plucky underdog story, whether or not there is any truth to it.

In the case of Smarty Jones, the entire American sporting press picked up on the idea that Smarty Jones was a blue-collar hero. He started his first few races in Pennsylvania rather than in Kentucky or New York, but that's only because his owners lived there, not because he had been "banished to the cheap seats". Smarty Jones' owner owned fifteen car dealerships in Pennsylvania, was a multi-millionaire, and was not much of a sweetheart. But the whole world decided that Smarty Jones now ran for the lame and the infirm and the downtrodden. It was unbelievable. It was front page news in the Times, the Post, theTribune and USA Today - "Smarty Jones Runs For The Little Guy!" It was absolute and utter nonsense. In Pennsylvania, two different orders of nuns got involved. They came to the track, sprinkled holy water on the horse and put religious medals under his saddle.

So then they ran the Preakness. All of the good horses who had stunk it up at the Derby were no longer eligible to win the Triple Crown. Many of them had been banged up in the slop, so they all skipped the Preakness. Smarty Jones ran against a small field of bums as a very heavy favorite, and he won the Preakness by twelve lengths.

Well, now the world went absolutely crazy. We now had a horse who would absolutely win the Triple Crown for the first time since 1978. Every year at that time, I start going on sports talk shows. By now, Smarty Jones was like the mayor of Philadelphia. Everyone loved him. On my first talk show, they asked me what the odds were of Smarty Jones winning the Triple Crown. "It has to be, like, 95 percent, right?" I told them that he was probably 30-40 percent to win. They attacked me. "Are you insane? Do you hate him? This is the greatest horse we have ever seen!"

Ten horses since Affirmed in 1978 had won the Derby and Preakness and had a chance to win the Belmont. We're not talking about a bunch of palookas. We are talking about horses that you have probably heard of - Alysheba, Sunday Silence and Funny Cide. These are serious horses, most of whom ended up in the Hall of Fame. Ten in a row had lost the Belmont after winning the Derby and Preakness. Statistically, ten in a row is a longer streak than you would expect, but Smarty Jones could not have even been 50 percent to win the Belmont after a streak like that.

I became Public Enemy #1 in Philadelphia for saying that Smarty Jones was not 99 percent to win the Belmont. I was hung in effigy at one Philadelphia talk radio station for saying so.

So we finally get to Belmont. Any reasonable analysis would tell you that Smarty Jones at best should have been even money - 50-50 to win. Even if you loved him and thought he was a wonderful horse (for which there was no empirical evidence), how could you argue against the streak of losses and think that Smarty Jones was more than 50-50 to win? On Belmont Stakes day, he went off at odds of 1-to-5. Five out of every six dollars bet on the race were bet on Smarty Jones. The betting public was saying that there was an 83 percent chance that Smarty Jones would win.

You don't get opportunities like this every day or even every year. This horse was between 30-50 percent to win, and he was being bet as if he were 83 percent to win. This was one of the most fabulous opportunities in the history of betting. You didn't even need an opinion about who would beat him. I bet on all of the other horses in the race, and I weighted and dutched my bets.

In all fairness, Smarty Jones ran the best race of his life that day. Two or three different horses took shots at him early, and he turned back the challenges. When he got to the deep stretch, he wasn't able to turn back any more challenges. A long shot came along and ran right by him. I have never seen a race track become so sad and so silent all of a sudden. It reminded me of a Charles Addams cartoon. The Addams family is at the opera. At the tragic death scene, everyone in the audience is weeping and wailing. And there is Uncle Fester sitting there with a huge smile on his face. That's what I felt like on that Belmont Stakes day. Every other person in the house was so sad that Smarty Jones had not won the Triple Crown, but the real horseplayers had just cashed the best horse bet that they had ever cashed.

That is how my world works. It probably has some parallels to yours. I would very much like to take your questions. Thank you.

Q: How much did you win? A: About a quarter of a year's salary.

Q: Are there better odds betting on college football games than pro football games because people's emotions are more tied up in college football? A: The people I know who play sports (and I am not convinced that there is a great deal of money to be made in betting sports) do what I do. They are waiting for a public mistake. There is no great mystery about who is supposed to win a particular game. The question is whether the line is 3 when it should be 9 or vice-versa. Serious sports bettors wait for those opportunities when the line is bad. There is a much better chance of the line being bad in a college game than in a pro game because there are so many more schools and a much smaller database about the participants. The sports bettors that I know see much better opportunities in betting college than pro, but I am not sure how important the emotional component is.

Probably the best opportunity in pro football is to bet against permanent public prejudices. I once saw

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