Is the stock market a casino?
Some years ago, an acquaintance of mine who is himself a successful investor in private markets wrote an article in which he asserted that the stock market is a casino. The impetus for his article was a big drop (completely irrelevant from today’s perspective) in the share price of META a day earlier. In his view, this clearly proved that the stock market is nothing but a casino. Naturally, this did not sit so well with me, and, in response, I wrote a short piece 6 years ago arguing, among other things, the following:
- A place where games are organized and where the probability of winning is on the house’s side can be considered a casino. For example, in the case of roulette, the queen of gambling games, the probability of winning on the casino’s side is 37:36 (European roulette) or 38:36 (American roulette with two zeros). Hence, players as a whole are at a disadvantage in the long run. Apart from roulette, this is true also for other games, such as sports betting, slot machines, horse racing, and state lotteries. Contrast that with players in the stock market (or better said, investors), who, in the long run and as the historical record shows, are generally in the black.
- Roulette and other casino games are so-called “zero-sum games,” assuming we include the organizer of the game into the overall outcome. In these games, one player’s loss (or of the players as a whole) equals the winning of another player (or of the casino). For the players themselves, roulette and other casino games are “negative-sum games.” The stock market is not a zero-sum game. Its value, and therefore investors’ wealth, is increased over the long term by rising corporate profits and the returns from reinvesting these. Not only is the stock market not a zero-sum game, but it even is a place where all of its participants (investors) can theoretically be in the black in the long term (a win–win game).
Since that time, I often have reflected on this topic, and I would say that from an individual investor’s perspective, one additional thing is important. While the stock market itself is not a casino, objectively speaking, for an investor to achieve returns on one’s investments better than those taken away from a casino, he or she must not treat the market as if it were a casino. In observing what is happening in the markets, however, it is possible to identify numerous signs that an increasing number of people have in recent years come to approach stock market investing precisely as gambling. Here are a few of them:
Small investors have become significantly more active. Their number has increased exponentially, especially from the time of the pandemic (since 2020). Most of them are complete novices in the markets with minimal experience and knowledge. Some trading platforms, such as Robinhood (HOOD), eToro (ETOR), and WeBull, are encouraging this trend. These platforms have attracted millions of users. Some offer trading (seemingly) with no fees. Moreover, trading is easily accessible anytime, anywhere. This goads investors (or better said speculators) to act quickly and impulsively.
Interest in options trading has increased greatly. The volume of trade in options, which are highly speculative and leveraged, has risen sharply. Options are derivatives whose prices are derived from their underlying assets. In some cases, however, the volumes of option trades are so large that it is the options themselves that determine the price of the underlying assets. Paradoxically then, the underlying becomes a derivative itself. The excessive use of options, and especially options with expiration dates of less than a week or even less than a day, is out-and-out gambling.
Masses of people are drawing their so-called “information” from social media. They often know virtually nothing about the companies upon whose shares they speculate on this basis. In no way do they conduct any sort of analysis of their own. This is a breeding ground for what are termed “meme” stocks (GameStop, AMC, etc.) and for “pump-and-dump” schemes, where rapid price run-ups are followed by precipitous drops.
Meanwhile, interest in long-term investing is declining. Fewer and fewer retail investors are focusing on traditional value investing and holding shares for the long term. Instead, they engage in so-called “day trading” and seek quick profits instead of stable growth. They often get drawn, too, into using margin accounts and leverage, which increase potential gains but at the same time, of course, also losses. Their combination of zeal and inexperience means that retail speculators have been burned many times on IPOs and SPACs having weak or even fraudulent fundamentals (e.g., Rivian, Lucid, Nikola).
One of the clear signs that people often view the stock market more as a casino is also the sharp reduction in the average holding period. In the 1950s, the average holding period for a stock in the U.S. was around 8 years. In the 1980s, this dropped to 2–3 years. Today, the average holding period for retail investors is around 6 months or even less. Some speculators hold shares for only days or even minutes.
Exchange-traded funds (ETFs) were originally intended as a long-term investment vehicle, but more and more people are trading them speculatively like they do stocks. Instead of holding index ETFs (e.g., SPY, QQQ) for the long term, many people buy and sell them during a single day. Some speculators apparently find even this is not enough and venture into trading leveraged and inverse ETFs that bear high risk (e.g., TQQ, SOXL, SQQ). Short-term speculation on the movement of the overall market in the place of now-traditional passive investing is another form of gambling.
We regard this speculative approach to the markets as foolish, but it is everyone’s private business what they do with their money. If someone decides to reject the opportunity to participate in a win–win game and is instead tempted by the apparent allure of the negative-sum game, we can only wish them good luck. Ironically, we are affected by the behavior of this part of the market in a positive way, and for two reasons. First, the fewer people who are dedicated to seeking out undervalued stocks and analyzing them, the better it is for us. Second, the greater the proportion of people who treat the markets like a casino and the more they skew the price behavior of various stocks away from their fundamental values, the more opportunities they create for us.
Our approach to the markets is very different. The letterhead of our monthly Fact sheets that you receive from us briefly describes our investment philosophy. Investment philosophy is important because it determines how an investor should make decisions. Ours is very simple:
We believe that stocks are the best long-term investment.
The basis of investing in stocks is the regular cash flow from companies to their shareholders in the forms of dividends, share buybacks, and the reinvestment of retained earnings.
This flow tends to grow strongly in good companies run by quality management.
The share price follows such growth over the long term.
The stock market sometimes allows attractive shares to be purchased at prices significantly lower than their intrinsic values.
Careful analysis should always precede any stock purchase. It is common for us to follow individual companies in detail for a number of years before we feel that we understand them sufficiently. Oftentimes, it is necessary as well to wait for a number of years for the moment when a sufficiently strong margin of safety lies between a company’s share price and its intrinsic value. In estimating intrinsic value, we look especially at return on capital, free cash flow relative to what is termed the “enterprise value” and which takes into account the company’s debt obligations in addition to its market capitalization, the possibility to reinvest capital with sufficiently high returns, and the quality of the management team’s capital allocation. In our case, the holding period for individual shares is measured in years.
All of a company’s fundamental value depends upon its future cash flows, and, because the future is both unknown and uncertain, our investment process must be underpinned by a certain degree of conviction as to its soundness. This conviction is based on logic and on historical experience of the markets and their functioning. The fact is that equity markets are not a place that gives quick and clear feedback to its participants. If you touch a hot stove, you burn yourself. The feedback you get is immediate, unambiguous, and always the same. That can be termed “kind” feedback. It enables a person to learn quickly and well. As a result, people do not normally touch hot objects. The feedback given by stock markets to investors and speculators is certainly not kind. Rather, it could be described as malicious and malevolent. If someone decides to carry out a transaction in the stock market, the feedback that the markets provide might come quickly, but it might also come only after a very, very long time. The feedback on a given transaction can be positive, negative, or completely unclear. Moreover, two different observers (investors) might interpret the same feedback differently. Views as to the role of random chance in the feedback process may differ, as well. It also is very often the case that the investor’s mind tries to make connections between the transaction itself and the feedback received that do not in fact exist or are only marginally influential.
Investors in equity markets are therefore operating in an environment that provides misleading feedback that is difficult to evaluate and to learn from. If an investor has a good understanding of how this environment works and the signals that it sends back to him or her, then one will be able not only to navigate it successfully but also be able to use it to his or her advantage. The investment philosophy and the investment process itself should be grounded, as I already have written, in logic and in historical experience with how markets work, and they should be pursued within a sufficiently far-sighted time horizon. A long-term investment horizon helps one to disregard the influence of random events and bring to the fore the influence of a logical investment philosophy and a sound investment process. Long-term investing is just the opposite of gambling.
If many speculators treat the markets like a casino, that is their private business. We, however, regard the stock markets as a place where, from time to time, it is possible to acquire ownership stakes in high-quality and well-managed companies at very attractive prices. Joint ownership in a company then entitles us to share in that enterprise’s business and financial performance. We own part of the company’s capital together with part of the returns that the company earns by using the existing capital and reinvesting it further. We own part of a snowball, which gradually packs on more and more layers of snow and gets bigger and bigger. This can easily be demonstrated in numbers.
Our oldest and longest-held position in our portfolio is Berkshire Hathaway. (BRK.A, BRK.B) When we included it into the portfolio more than 13 years ago, in January 2012, the stock was priced at $119,000. Book value per share at that time was approximately $100,000. By the end of 2024, the book value per share was approximately $446,000. The book value has therefore increased by almost 3.5 times in 13 years. How did this happen? Berkshire generates a profit every year through its businesses. The profit generated increases the company’s equity and the amount of capital available to it. The capital is reinvested again and again into the company’s businesses. As the amount of capital invested increases, the absolute amount of returns grows and the entire process accelerates as time goes on. At the same time, the amount of capital attributable to each Berkshire share that we own in the Vltava Fund also grows. The share price has gradually reflected this development, rising from an initial $119,000 to $680,000 by the end of 2024.
In Berkshire Hathaway’s case, book value is a good indicator of the company’s fundamental value because Berkshire is a financial conglomerate. Had we instead focused on the company’s profitability, we would have reached similar conclusions. Our estimate of Berkshire’s profitability at the beginning of 2012 was around $11,000 per share. Today, it’s about $47,000. So, while our first purchase had a P/E of approximately 10.8× and an earnings yield of 9.2%, the earnings yield today of our original invested capital is nearly 40% ($47,000/$119,000). (Note: Earnings yield is indicated by the ratio of earnings per share in a given accounting period to the share price. It is the reciprocal of the P/E ratio.) By our estimate, Berkshire Hathaway’s intrinsic value per share is currently growing at a rate of more than $200 per day.
Berkshire stock has been held in our portfolio the longest, and its process of capital and earnings accumulation has had the most-extended period to play out. The same phenomenon can nevertheless be observed for other companies in our portfolio, even though they have been in the portfolio for much shorter time periods. Earnings yields relative to our first purchases are now, by our calculations, approximately 20% for JP Morgan (JPM), 23% for Markel Group (MKL), 15% for Alimentation-Couche Tard (OTCPK:ANCTF), 15% for Asbury (ABG), and 22% for BMW (OTC:BMWKY). Quálitas Controladora (OTCPK:QUCOF), too, provides an interesting example of rapid capital accumulation. Not only does it now have an earnings yield of 19% relative to our first purchase, but over the period of our holding it has declared dividends equivalent to almost 40% of our original purchase price. These things work even in emerging markets.
High returns on capital and rapid capital accumulation are the main reasons for investing in equities as we understand and practice it. The logic of the matter and the historical experience of equity markets suggest that in principle nothing about this should change in the future. This is true not just for Berkshire Hathaway but also for the other companies in our portfolio and the stock markets as a whole. For those who approach it correctly, the stock market can be a win–win game.
Changes in the portfolio
We sold the rest of the Williams-Sonoma stock (WSM). This was a very profitable investment for us. How do we evaluate its feedback? We did not hold the stock for very long, only about 3-1/2 years. During that time, the stock price moved from less than $50 to more than $200. In the beginning, we could buy the shares at single-digit earnings multiples. The stock price was well below our estimate of the company’s value. The business itself is of very high quality, with high returns on capital, no debt, and an exemplary asset allocation. As such, we see the purchase itself as a good move and entirely in line with our investment philosophy. When we sold the shares, they were trading at about 25 times earnings. This was significantly higher than our current estimate of the company’s value. Any company, however good and promising it may appear, is a good investment at a low price but a poor investment at a high price. We are always reminded of this and therefore we sold the WSM shares. So far, we see this also as a good move and entirely consistent with our investment philosophy. At the same time, however, we are aware that the large total return on this investment was only partly the result of our transactions and analysis. Luck also played a large part. We expected that WSM would do well in its business. This was confirmed, and the shares also had been objectively very cheap when we bought them. However, all of this falls far short of justifying the rapid quadrupling of the share price. We therefore do not succumb to the temptation to attribute more to our own skills than is prudent. It remains important for us to stick to our investment philosophy and investment process in our stock selection and individual transactions. On average and over the longer term, they should continue to bring us solid returns, although in individual cases or over shorter periods they may deliver returns both much better than they deserve and much poorer than they deserve.
After almost a half year since our last new purchase, we have a new addition to the portfolio. It is the stock of United Rentals (URI). This marks one of those cases of companies we have followed for years through various economic and investment cycles. Now, we have reached a stage where we believe we have a sufficient understanding of both the company itself and the nature and dynamics of the sector within which it operates. At the same time, we find the share price attractive. What does URI do? United Rentals is the largest equipment rental company in the world. It operates throughout the United States and Canada and has smaller operations in Europe, Australia, and New Zealand. URI operates in two segments. The General Rentals segment rents general construction and industrial equipment, which encompasses vehicles, excavators, loaders, forklifts, earthmoving and material handling equipment, aerial work platforms that include boom trucks and aerial lifts, as well as general tools and light equipment including pressure washers, water pumps, and power tools for construction and industrial companies, mobile storage facilities, and the like. The Specialty segment rents excavation safety equipment for trenching, scaffolding, equipment for power, heating, ventilation, and air conditioning, such as portable diesel generators, power distribution and temperature control equipment, fluid solution and fluid containment, transport, and treatment equipment, surface protection plates, mobile storage equipment, and modular office spaces.
The company was founded only in 1997, but today it is the clear market leader in the U.S. with a 15% market share and annual sales of around $15 billion. That makes it larger than its two biggest competitors combined. Size is important in this business because it allows for more efficient and higher percentage utilization of borrowed equipment. The company’s growth to date is primarily the result of its acquisition strategy. URI has made dozens of acquisitions since its inception and we expect it to continue to incorporate smaller entities into its platform, further expanding its geographic reach and breadth of offerings. We believe the equipment rental industry is ripe for further consolidation, and we think URI will benefit from this. Approximately half of URI’s revenues are generated from the industrial sector and half from the construction sector, the latter being almost exclusively non-residential. A variety of reasons account for why customers prefer to rent machinery and equipment rather than to buy them. These include capital savings, the possibility to focus on their own core businesses, greater reliability, reduced downtime, outsourced maintenance, outsourced labor delivery, savings in storage costs, round-the-clock customer support, reduction of certain risks, and so on. URI is a solid and integral part of the construction and industrial sector. We like its business and management, market position, long-term growth potential, resilience to change, the counter-cyclical nature of its free cash flow, high return on equity, and efficient capital allocation. This is not an investment where we expect or could expect to get rich quick. It is, however, an investment where high returns on equity combined with good opportunities for further reinvestment have a significant positive long-term impact. The share price should continue to reflect this over time.
The Fund’s NAV was virtually unchanged in the first quarter and this information by itself would suggest that we have had a quiet 3 months in the markets. However, the opposite is true. Changes in U.S. trade policies and how they are being implemented, volatility in the technology sector, a greater investor focus on European markets, increased uncertainty about economic growth and corporate profitability, a reassessment of views on the strength of the U.S. dollar, the gold price rising to record levels and surprising geopolitical statements all made markets both interesting and volatile. Vltava Fund is now in the 21st year of its existence, spanning six U.S. presidential terms of office. In all that time, I cannot recall a single instance where we bought or sold a stock just because one individual or another was or was not the president. Of course, political changes have an impact on the economy and corporate profitability, but it is far more important to stay focused on selecting individual companies whose value is growing over the long term and that are managed for the benefit of shareholders. The recent volatility in the markets has been favorable in the sense that it has pushed individual stock prices more off their relative equilibrium values, giving us greater opportunities to buy and sell. We have tried to make the most of this in recent weeks. We have reduced our positions in Berkshire Hathaway and JP Morgan slightly, exchanged our remaining Stellantis shares for BMW stock, and increased our positions in NVR, Lam Research (LRCX), OSB Group (OTCPK:OSBGF), Alimentation Couche-Tard (OTCPK:ANCTF), Applied Materials (AMAT), Brookfield Corporation (BN), and Cenovus Energy (CVE).
Daniel Gladiš
Disclosure: https://www.vltavafund.com/disclaimer
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