The Winner's Game

Playing consensus games

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Holding too many cards

In 1997, Charles D. Ellis delivered a speech to the Association for Investment Management and Research where he made a compelling case for why diversification is misunderstood. Investors often fall into the trap of over-diversification, thereby diluting their ability to exhibit deep insight into their collection of companies.

“The more you diversify by increasing the number of different investments you must understand, the more you risk increasing your not knowing as much about each investment as your best competitor investors”.

Charles D. Ellis

A little diversification is good; owning five stocks will result in a significant reduction in standard deviation (risk) than if you were to own just one. However, this practice soon exhibits diminishing returns. It varies depending on who you ask, but around the 20-30 mark is where the benefits of diversification end. At this point, you could add 30 stocks to the portfolio, and in theory, the only thing you are reducing is potential return.

Forget the academic rationale for a second; having 60 stocks in a portfolio is hard work for a one-man operation. The hidden costs are abundant. You either dedicate your waking life to performing maintenance due diligence, you attempt to do so but do a poor job of it, or you plead ignorance and only carefully monitor a select few of your investments. Whether it results in a poor quality of life or a poor quality of due diligence, neither outcome is efficient. By trying to operate the Noah’s Ark of investment vehicles, the investor reduces their ability to make mission-critical decisions.

Ellis remarks that “disturbingly, the very portfolio diversification intended, in theory, to protect us from risk may, in practice, actually be increasing our true uncertainty”. In another of Ellis’ papers, ‘The Loser’s Game’, he makes a distinction between winner’s and loser’s games using a tennis analogy. In a match between two professionals, the gameplay is hard-hitting, precise, and the players are attempting to play the ideal sequence of shots to put their opponent at a very slight disadvantage. The margins are fine, and the points will be dictated by the skill of each player. They are playing to win. For two average joes schlepping it at their local court, each game is likely to be decided by whoever makes the least unforced errors. The next time you play tennis or table tennis with an equally matched friend, try focusing solely on returning the ball to the other side of the court and avoid making any fancy shots. Let them make the errors, and watch the points roll in. The point is that Ellis is describing two entirely different ways of playing tennis, and this phenomenon of winner’s and loser’s games exists everywhere.

It becomes increasingly difficult to samba when there are sixty people in the dance hall. By being too preoccupied with a vast collection of stocks, the individual investor is reducing their ability to engage in second-level thinking when it matters most. Second-level thinking is what Howard Marks feels separates those who are playing a winner’s game and those who participate in the loser’s game as far as investing is concerned.

Howard Marks and the Winner’s Game

Much like tennis, people can be successful investors by playing their own version of the game. What makes investing unique is that the court is shared by everyone at the same time. Regardless of which game you play, you are still competing with the professionals, whether you realise it or not. The idea of winner’s and loser’s games in the investing landscape has become more relevant over time. When Ellis wrote his paper nearly fifty years ago one-fifth of trading volumes were institutional. Today, it’s closer to 95% and concentrated between as little as fifty gargantuan institutions.

“It’s getting tougher and tougher to do better than the market because the market is increasingly dominated by people who are brilliant, very hard-working, have fabulous, but equally fabulous, information, and have been working at investing for quite a long time”.

Charles D. Ellis

Marks states that “first-level thinkers think the same way other first-level thinkers do about the same things, and they generally reach the same conclusions. By definition, this can’t be the route to superior results”.

First-level thinkers make general assumptions about a business; they will continue building out stores, generate more free cash flow, take market share, and increase dividends. They may even do some work to ascertain what an attractive acquisition price is or how reliable the management team appears to be. Yet, because anyone can have this same insight, it won’t lead to market-beating results, says Marks. I want to express that there is still merit in this investment style. Not everyone cares about return optimisation, and some people can generate life-changing returns with a careful selection of businesses, a sprinkling of luck, and some steady emotional discipline. But this doesn’t take away from the fact that it’s the loser’s game. To play the winner’s game, one has to become a consensus monkey. One has to have an opinion that deviates from the consensus, be right, and bet enough to make a difference.

Stanley Druckenmiller is no stranger to taking sizeable bets that go against convention. During his speech at the Dollar Tree Club in 2015, he talked about the most important lesson his first mentor taught him:

“It doesn’t matter what a company’s earning, what they have earned. He taught me that you have to visualize the situation 18 months from now, and whatever that is, that’s where the price will be, not where it is today”.

Stanley Druckenmiller

The common takeaway from this passage is to never invest in the present. But the forgotten caveat is that your version of the future should be different from what the consensus believes it will be in order to maximise returns. The market is a forward pricing machine, and will typically price out that far ahead in the present day. As the years have passed, Starbucks has increasingly amplified its presence in China; its next growth runway. Suppose 18 months from now, most people believe that the story will be unchanged; perhaps they will have another thousand stores in the region, the pandemic recovery will have been and gone, and that’s that. If you also believe that to be true, that’s fine; but if something contrary to that widely held belief were to occur, you’d go down with the market. Now suppose you believe Starbucks will run into serious issues in the Red State within that timeframe; whether it be political, currency, or macro-related. If the widely held view remains the same, when the counterfactual evidence comes to light, your returns (if you made a contrary bet) will be dislocated to the markets’.

Second-level thinkers ask who else thinks this, how common is this view, what is the range of outcomes, how likely is the outcome you believe in, is the consensus psychology that’s incorporated in the price too bullish or bearish, what will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

For many, this work is all too taxing and so it is often ignored. I too find it taxing, as I optimise for spending as little time as possible doing maintenance work after the initial legwork. But I’m not driven by the goal of beating the market, and I don’t see investing as a competitive sport, so that’s just me. Most of the time, I am playing the loser’s game. But there are occasions when opportunities present themselves to dip one’s toes into the winner’s pool. I find these opportunities in two ways (there are more). One, in small caps. Because of the structure of the market, the lack of coverage, and the inaccessibility of institutional buying, it’s easier to have a non-consensus view because there are fewer people to make up that consensus. Furthermore, the dispersion of outcomes is wider because there is a lack of professional opinions influencing the market value. Or as Ian Cassel would say:

“If you want superior returns, find an inefficient and illiquid market, and work everyday to be one of the best investors in that market”.

Ian Cassel

But even in large caps, there are times when the consensus view is wildly inefficient. Something I feel is absent from Howard’s commentary is the impact of superior emotional discipline, which in some cases may just be retail ignorance. While I believe emotional discipline is an advantage, it’s not a bridge from the loser’s to the winner’s game, as players in either game can exhibit those tendencies. That said, the often glorified “hold and rarely sell” approach does reveal its weaknesses when you see the opportunities presented in times of consensus dislocation like that of Meta in recent years. If you owned shares of Meta while it fell 75% from prior highs, and climbed 150%+ from the bottom in less than two years that’s a considerable amount of downside one could have protected themself from, and a remarkable upside to capture. For all this potential return, the hold and rarely sell investor would have benefited little; holding a stock is not a badge of honour.

More recently, as Meta shares hurtled towards $80 per share, investors only thought of how much further it could go down; citing the end of the advertising conglomerate at the hands of TikTok. Today, no such things are discussed. Exactly as Marks said, investors who benefited from the downfall and recovery were right in their assertion that the consensus was wrong.

If Howard’s opinions jar with your own sense of investing, it’s probably because it angers you that he is right. That’s not to say you must devote yourself to the practice of fading consensus but it appears to be where the hard-fought alpha is. Some might argue that Warren Buffett does okay utilising his grandfatherly approach of buy and hold, but even he makes contrarian bets. When Berkshire

¹

first purchased Apple in 2016, iPhone volumes were falling and revenues came in 7% below the prior year. While the sub 15x PE ratio looks like theft today, at the time it was a reflection of the market's uncertainty and lack of confidence. The Berkshire team were wagering that the market's pessimism was unjust.

It does create somewhat of a contradiction when an investor claims they don’t care about beating the market, yet they acquire individual stocks. I myself am a walking contradiction, but I’m young and have all this to learn. As Marks says, these investors may as well buy the index and be satisfied with average returns.

“It’s a matter of what you’re trying to accomplish. Anyone can achieve average investment performance, just invest in an index fund that buys a little of everything. That will give you what is known as “market returns”, merely matching whatever the market does. But successful investors want more. They want to beat the market”.

Howards Marks

If you are not satisfied with market returns, then the buyer of individual stocks must, somewhere deep down, want to perform above average; it’s why they pick stocks. If you want to have above-average results, then it would seem logical that you attempt to play the winner’s game. Ultimatley, investment maxims are not a one-size-fits-all, and it's fine to play a loser’s game. But it doesn’t hurt to incorporate nuance into your process. I suspect the fear most investors have with trying to play the consensus game is that it forces them to have an opinion in the medium term; they can no longer rest on the crutch that is long-term thinking. It’s easier to have a rosy vision of the future and exercise unwavering commitment to that vision if the endpoint is decades out. You can simply say “Let’s wait and see”. To step out of your comfort zone and say “I think this is going to happen” puts you at immediate risk of being wrong, and most people are scared to juggle eggs.

Thanks for reading,

Conor

1. I realise it reportedly wasn’t Buffett who pulled the trigger originally on Apple.