Thursday, March 29, 2012

Volume 4 Issue 12: Intelligent Investing

Gambling Like A Value Investor

For those of you who think this is a shortcut or a method to break a casino by playing blackjack, I say, "Run, you fools!"

This is a story of a man who "broke" Atlantic City by winning USD6 million in a 12-hour run. Before the run at Atlantic City, he also took Borgata for USD5 million and Caesar's for USD4 million. 

On the surface, many of us would marvel at Don Johnson's skill at playing blackjack. One or two of us may even be inspired to try our hand at becoming good at blackjack. But as the article says, Don Johnson is very far from being a top-notch blackjack player, whatever that means. 

No matter how skilled you are, the odds of a blackjack hand are still around 50-50. And anyone who knows anything about gambling must certainly know about the Gambler's Ruin. Basically, it is a probabilistic concept which governs any betting scenario, even ones that have positive expectations (which means, the player has a higher probability of winning a hand compared with the banker). So here are some possible outcomes of what this Gambler's Ruin is all about:
  • The original meaning is that a gambler who raises his bet to a fixed fraction of bankroll when he wins, but does not reduce it when he loses, will eventually go broke, even if he has a positive expected value on each bet.
  • A gambler with finite wealth, playing a fair game (that is, each bet has expected value zero to both sides) will eventually go broke against an opponent with infinite wealth.
If you are curious about the reasons, just go ahead and click on the link provided above. Yes, that's right. The odds are highly stacked against the player simply because the casino's wealth is approaches "infinite" when compared with a typical player like you and me (or we call, "the Main Streeters")

So the only logical conclusion on how Don Johnson defeated the three casinos must be because he had more wealth than the casinos. Or is it? Here is how I see it. 

1. Skill
First, it goes without saying that Don Johnson is no fool. He may not be the best blackjack player in the world, but he is a good enough player. If you asked Warren Buffett if he is the smartest man on the planet, he would be the first person to tell you that he isn't. Like investing, blackjack does not require a lot of smarts. Just simple mathematics. So, armed with a slightly mathematically inclined mind, Don Johnson was ready to break the casinos. 

2. Wealth
Second, Don Johnson is a high roller. This means that he has millions and millions to spare, which is to say, the gap between his wealth and that of the casino, is significantly narrowed. As a result, the probability of the gambler's ruin being applied to Don Johnson is much much lower compared with a Main Streeter.

3. Margin of Safety
Third, Don Johnson applies one of the most fundamental rules in value investing. He keeps a huge margin of safety. If you get through far enough in the long article, you will see this:
Johnson is very good at gambling, mainly because he’s less willing to gamble than most. He does not just walk into a casino and start playing, which is what roughly 99 percent of customers do. This is, in his words, tantamount to “blindly throwing away money.” The rules of the game are set to give the house a significant advantage. That doesn’t mean you can’t win playing by the standard house rules; people do win on occasion. But the vast majority of players lose, and the longer they play, the more they lose.

Sophisticated gamblers won’t play by the standard rules. They negotiate. Because the casino values high rollers more than the average customer, it is willing to lessen its edge for them. It does this primarily by offering discounts, or “loss rebates.” When a casino offers a discount of, say, 10 percent, that means if the player loses $100,000 at the blackjack table, he has to pay only $90,000. Beyond the usual high-roller perks, the casino might also sweeten the deal by staking the player a significant amount up front, offering thousands of dollars in free chips, just to get the ball rolling. But even in that scenario, Johnson won’t play. By his reckoning, a few thousand in free chips plus a standard 10 percent discount just means that the casino is going to end up with slightly less of the player’s money after a few hours of play. The player still loses.

But two years ago, Johnson says, the casinos started getting desperate. With their table-game revenues tanking and the number of whales diminishing, casino marketers began to compete more aggressively for the big spenders. After all, one high roller who has a bad night can determine whether a casino’s table games finish a month in the red or in the black. Inside the casinos, this heightened the natural tension between the marketers, who are always pushing to sweeten the discounts, and the gaming managers, who want to maximize the house’s statistical edge. But month after month of declining revenues strengthened the marketers’ position. By late 2010, the discounts at some of the strapped Atlantic City casinos began creeping upward, as high as 20 percent.

The casinos started accepting more risk, looking for a possible larger return,” says Posner, the gaming-industry expert. “They tended to start swinging for the fences.”

Johnson noticed.

They began offering deals that nobody’s ever seen in New Jersey history,” he told me. “I’d never heard of anything like it in the world, not even for a player like [the late Australian media tycoon] Kerry Packer, who came in with a $20 million bank and was worth billions and billions.”

When casinos started getting desperate, Johnson was perfectly poised to take advantage of them. He had the money to wager big, he had the skill to win, and he did not have enough of a reputation for the casinos to be wary of him. He was also, as the Trop’s Tony Rodio puts it, “a cheap date.” He wasn’t interested in the high-end perks; he was interested in maximizing his odds of winning. For Johnson, the game began before he ever set foot in the casino.
So how did all these casinos end up giving Johnson what he himself describes as a “huge edge”? “I just think somebody missed the math when they did the numbers on it,” he told an interviewer.
Johnson did not miss the math. For example, at the Trop, he was willing to play with a 20 percent discount after his losses hit $500,000, but only if the casino structured the rules of the game to shave away some of the house advantage. Johnson could calculate exactly how much of an advantage he would gain with each small adjustment in the rules of play. He won’t say what all the adjustments were in the final e-mailed agreement with the Trop, but they included playing with a hand-shuffled six-deck shoe; the right to split and double down on up to four hands at once; and a “soft 17” (the player can draw another card on a hand totaling six plus an ace, counting the ace as either a one or an 11, while the dealer must stand, counting the ace as an 11). When Johnson and the Trop finally agreed, he had whittled the house edge down to one-fourth of 1 percent, by his figuring. In effect, he was playing a 50-50 game against the house, and with the discount, he was risking only 80 cents of every dollar he played. He had to pony up $1 million of his own money to start, but, as he would say later: “You’d never lose the million. If you got to [$500,000 in losses], you would stop and take your 20 percent discount. You’d owe them only $400,000.”
In his own words, this is the very essence of the concept of "margin of safety". Being a high roller, he twisted and twisted the odds in his favor, banking on the desperation of the casinos for his "business". With a 20% discount, the odds were already heavily stacked in his favor. And note this: 
“You’d never lose the million. If you got to [$500,000 in losses], you would stop and take your 20 percent discount. You’d owe them only $400,000.”
He never plays until he goes broke. In essence, what he is saying is, every time he loses money, he would only lose 80%. But every time he wins money, he would win 100%. Essentially, even though at each hand, the game was 50-50, his expectations of winning are significantly higher. 

For those who are interested in the mathematics, His expected "earnings" for each dollar he brings into the casino are simply:
0.5 x (-0.8) + 0.5 x (1.0) = 0.1
What this means is that he is expected to make a return of 10% every time he goes to the casino. This is of course, assuming that he does not go broke, which goes back to my second point about having a huge bankroll to begin with. How many of us can have that kind of odds at a casino? 

4. "Luck"
Fourth, another point which is also one of the key concepts of value investing is what many of us think of as, "luck". But as the Roman philosopher Seneca says, "luck" is when preparation meets opportunity. Given his circumstances (i.e. being adept at simple arithmetic, and having the bankroll to play, along with an acute interest in gambling (how else would he know about such negotiating tactics?), he was presented with a "wonderful" opportunity in the sense of the casinos' desperation. The casinos were too desperate to make a quick buck of a big whale like Don Johnson and took more risk than they could truly afford by granting him all the tiny tweaks that he requested. If the casinos had not been suffering due to the recession in the US, this sort of opportunity would not have presented itself. 

5. "Greatness"
Fifth, and what I think is the most important of all, is what I termed "greatness", for the lack of a better term. I am not saying that Don Johnson was born great or anything like that. To me, having good "luck" is awesome, but it is very far from being enough. Don Johnson had the right skill set, the money to play, and the opportunity to take advantage of. But what separates Don from the rest, is the fact that he TOOK that opportunity. Some of us may call that balls of steel, guts, courage, instinct or what not, but I really don't care. I don't know the right term for it.

The key important thing here is the fact that he took advantage of an opportunity which presented itself in the midst of one of the greatest recessions since The Great Depression. This is one of the most important lessons I have learnt recently in my life, and I will most certainly write more on this in the future. 

But for today, the takeaway message from this issue of the Main Streeter is that the concepts of value investing applies just as well in other aspects of life. Think of value investing as a lifestyle. It is not necessarily just applied in the realm of investing, but it can be applied in any shape and form in pretty much every aspect of our lives. 

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