DRF Legend Steven Crist on Value Investing and Horse Betting

I’m not at all a gambler.

In fact, I used to be proud to say that, thinking that gambling was only for chumps.

But after reading Crist on Value, I’m beginning to reconsider my position on the activity.

Let me explain…

Crist on Value

Steven Crist is a legend in the world of horse betting.

A Harvard graduate, Steve Crist took a different approach to betting on horses than most other people, applying math, logic, and probability in making wagers, instead of simply picking the most likely horse to win the race. While by no means was this revolutionary, Steven Crist has been one of the most outspoken advocates for using this approach of finding value in wagers, and he’s used it to great success (Crist’s nickname is “King of the Pick Six” – the pick six is a wager where the bettor must select the winners of six consecutive races and is considered the most difficult type of bet).

In 1998, Steven Crist teamed up with Alpine Capital to purchase Daily Racing Form (DRF), a newspaper that has published the past performances of race horses since 1894 and is the gold standard statistical service for horse race handicappers (as one journalist put it, DRF is to horseplayers what the Wall Street Journal is to investors). While running DRF, Steve Crist also wrote a weekly column and a blog, where he often talked about his method of horse betting.

In 2001, Steven Crist wrote a chapter for the book Bet With the Best: Strategies from America’s Leading Handicappers. That chapter was simply called Crist on Value.

While Steven Crist doesn’t mention stocks, markets, the economy, companies, or investing anywhere at all in Crist on Value, the parallels between horse betting and investing are incredibly interesting. In fact, most of Crist on Value seems like it belongs in Benjamin Graham’s The Intelligent Investor, not a book on how to bet on horses!

Michael Mauboussin, a value investor and one of the sharpest thinkers in finance today, has called Crist on Value “one of the best 13 pages on investing I have ever read.”

I’d probably agree with that.

The Similarities Between Horse Race Betting and Investing

As it turns out, the connection between horse betting and investing runs pretty deep.

As a kid, Warren Buffett used to bet on horse races at Omaha’s Ak-Sar-Ben Race Track. And here’s Charlie Munger talking about horse race betting in his famous Worldly Wisdom speech:

The model I like — to sort of simplify the notion of what goes on in a market for common stocks — is the pari-mutuel system at the racetrack. If you stop to think about it, a pari-mutuel system is a market. Everybody goes there and bets and the odds change based on what’s bet. That’s what happens in the stock market.

Now, before you invite me to sit next to you at the bank of slot machines at the nearest casino, remember that what we’re talking about here are pari-mutuel betting systems – gambling games like horse betting and poker where you’re betting against all the other betters – and NOT fixed-odds betting – games like roulette or craps where the odds are fixed.

Winning these fixed-odds games is pure chance and making money off of them over the long-term is impossible because the casino is setting the odds. In roulette, for example, there are 38 spaces. If you were to bet $1 on each of 1,000 spins, you would have bet a total of $1,000 – but you would only have won back a total of $936, for a total loss of $64. The longer your play, the more you lose and the more the house wins (hence the phrase “the house always wins”).

Pari-mutuel betting games, on the other hand, are an entirely different story because it’s the public – not the house – that is setting the price of the bet. And somewhere between frequently, occasionally, and rarely, the public makes the wrong price.

Michael Mauboussin expands on this point in his book More Than You Know: Finding Financial Wisdom in Unconventional Places:

This is similar to what I wrote about in Why the Stock Market is So Hard to Predict. You see, roulette and craps are “level one” chaotic systems – chaos (i.e. randomness) that does not react to predictions made about it. Everybody in the casino can bet on red 32 if they want, but the roulette wheel won’t care and it won’t affect the 1/38 chance that the ball has of landing on red 32. Likewise, the casino could care less which numbers are played – the payoff remains the same.

In contrast, pari-mutuel betting games like horse betting and poker are “level two” chaos systems – these games react to predictions made about their outcomes. While the horses don’t care who’s picking them as a favorite to win and the cards that are dealt aren’t affected by a poker player’s wager, the betting within the game itself IS affected by the actions of other bettors. In horse race betting, your bet helps shape the odds for that wager – which might be better or worse than the actual odds a certain horse has of winning the horse race. In poker, the players determine the size of the pot – which might be large or small relative to the odds your hand has of winning. And the same is true of the stock market, where investors’ predictions of a company determine the price of that company’s stock – which might be more or less than the company’s true intrinsic value.

A Quick Primer on Some Important Horse Betting Terms

Before we actually get to Crist on Value, I think it’s helpful to know some of the most important horse betting terms (so that you can understand some of the nuances of what Steven Crist is actually talking about). Here are the horse betting terms you should know:

• Pari-mutuel betting: In pari-mutuel betting, all bets are placed together in a pool, the “take” is paid to the house (see below), and the remaining amount is disbursed to the winners in proportion to the amount wagered. This is in contrast to fixed-odds betting, where the odds are set by the bookmaker. In pari-mutuel betting, the final payout is not determined until the pool is closed. In fixed-odds betting, the payout is agreed at the time the bet is sold.
• The house: The institution organizing the betting (e.g. the racetrack, casino, or bookmaker).
• Takeout: Also called the take, cut, rake, or vigorish, this is the amount the house takes before paying out the winnings. For horse race betting, this is often 15-25% depending on the type of wager.
• Breakage: The winning payoff is always rounded down to the nearest 10 or 20 cent increment. This is called breakage, and the delta is kept by the racetrack.
• Payoff: This is the amount actually paid to the winning bettors. Here is an example of how payoff is calculated:
  • If $1,000 is bet in total on win bets, and $200 is bet on the winning horse, then:
    1. First, the track collects it’s cut. Let’s say the takeout is 17%, which leaves $830 ($1,000 x 83%).
    2. This ratio of winnings to winning bet is $830/$200 = 4.15. This ratio is then applied to the minimum $2 bet: 4.15 x $2 = $8.30. The $8.30 is rounded down to the nearest 20-cent increment, or $8.20.
  • So $8.20 is the final payoff per $2 bet. All winning bettors will be paid at this ratio. For example, a $100 bet will win $100 x (8.20/2.00) = $410.
• Odds: Converting percentage probabilities (like a horse’s winning chance) into betting odds is easy. If I think a horse has a 20% chance of winning, then that horse will win 1 out of every 5 times – in other words, it will win once (20% of the time) and will lose 4 times (80%) out of every 5 races. So the odds of that horse winning are 4-1 (80%/20% to 1). If I think the horse has an 80% chance of winning, then the odds of that horse winning are 1-4. As you can see, odds of winning are listed as LOSE-WIN. Converting odds into probabilities is a similar task. If a horse is listed as paying off at odds of 3-2, then the implied probability of that horse winning is 2 / (3+2) = 40%. In the case of 3-2 payoff odds, the payoff on a $2 wager would be $5 ($2 original bet + $3 in profit).
• Horseplayer: Some one who bets on horse races.
• Daily Racing Form (DRF): The Daily Racing Form (DRF) provides the past performances of all the horses running on the day’s program and includes informative horse racing articles and handicapping by DRF staff. The cost of a DRF issue is usually just $4.
• Handicapping: The practice of assigning predicting the outcome of horse races by assigning percentages to each horses chance of winning.
• Long / short odds: A horse with long odds has apparently no chance of winning (e.g. 19-1, or a 5% chance of winning). A horse with short odds is favored to win (e.g. 2-3, or 60% chance of winning).
• Overlay / underlay: An overlay is a good bet – the horses odds of winning are longer (worse) than they should be. An underlay is a bad bet – the horses odds of winning are shorter (better) than they should be).
• Win, place, and show: The most basic bet is picking the horse that you think will finish first (win). You can also bet on a horse that you think will finish first OR second (place) or will finish first, second, OR third (show).
• Exacta, trifecta, and superfecta: The exacta is a bet on the horses you think will finish first and second – but they must be in the correct order. The trifecta is the same type of wager but on the horses you think will finish first, second, and third, and the superfecta is a bet on the horses you think will finish first, second, third, and fourth (again, the horses must finish in the correct order).

• Daily double, pick three, pick four, or pick six: The daily double is a bet on the first place horse in two consecutive races (usually the first two of the day). The pick three and pick four are bets on the first place horse in three or four, respectively, consecutive races. The pick six is a bet on the first place horse in six consecutive races (usually the last six of the day). If nobody calls all six correctly, part of the winning pool is paid to those correctly picking five of the winning horses (or less if nobody picked five), and the rest is carried over to the next pick six pool.
• Minimum bet amounts: A minor – but important – detail: the minimum bet at racetracks is generally $2 on win, place, and show bets, and $1 on all other types of bets.

Steven Crist on Value (Investing) and Horse Betting

Sweet! Now we’re at the exciting part – breaking down Crist on Value.

Here are my 6 key takeaway insights from Steven Crist on value investing and how to make better decisions:

1. Price versus Value

“The point of this exercise is to illustrate that even a horse with a very high likelihood of winning can be either a very good or a very bad bet, and the difference between the two is determined by only one thing: the odds.”

As Steven Crist explains, a horse with a 50% chance of winning is a good bet if his payoff is better than 1-1 and a bad bet if his payoff is less than 1-1. For example, a 10-1 shot (which would imply a winning chance of 9%) would be a great overlay (good bet) if you think he actually has a 15% chance of victory, and a terrible underlay (bad bet) if his true chance is only 5%.

What Crist is doing here is separating out price (the payoff and the payoff’s implied winning percentage) and intrinsic value (the horse’s actual chance of winning). This is the fundamental principle of value investing that Benjamin Graham and David Dodd first set forth in Security Analysis in 1934:

Price ≠ Intrinsic Value

This, of course, is directly applicable to investing. Any stock can be a great investment or a bad investment – even if the company is amazing. It all depends on the stock’s price and it’s comparison to that company’s true intrinsic value.

2. You Need to Have the Right Temperament

There’s so much wisdom is this short passage. Let’s break it down.

First, Steve Crist is saying you shouldn’t be asking which horse in the race is most likely to win. Your job is to figure our which horse is offering odds that exceed its actual chance of victory. This is what famous value investor Howard Marks calls “second-level thinking” in his book The Most Important Thing Illuminated: Uncommon Sense for the Thoughtful Investor.

First-level thinkers only consider one variable at a time, often the one that is the most obvious: What horse is the best? What company is the best? Second-level thinkers take many thing into account and ask the complicated questions: Which horse is disliked by the crowd but actually provides a good return given its true chance of winning? Which company does the market dislike due to certain short-term headwinds, but actually has great long-term value that everyone else is overlooking?
Then, Crist says that you MUST stick to your guns, even when your friends and your own emotions are tugging at you to abandon your approach and join the crowd. Rudyard Kipling would remind you to “keep your head when all about you / are losing theirs.”
It’s the only way to win in the long run. If you want to make money – whether it’s in horse betting or in the stock market – you must adopt a cold-blooded and unsentimental approach to the game. And you have to do this despite the egotistical impulse to stick with your initial selection at any price. 
You have to be willing to change your mind and strong enough to walk away from an investment if the price isn’t right. This approach requires the confidence and Zen-like temperament to endure watching victories at unacceptably low prices by such horses  – or to watch other investors  make money on a stock that they bought for far more than its intrinsic value (a product of luck,
instead of skill).

3. Invest with a Margin of Safety

I included Steven Crist’s entire anecdote about betting on the horse Two Item Limit so that we could set the stage for his last two lines.

Crist calculated Two Item Limit’s chance of winning to be 60%. But this is a rough calculation – Crist admits that he wouldn’t be able to argue that the horse’s victory was exactly 60% and not 57% or 63%. In fact, that degree of precision is probably impossible. What Crist DID do, however, was apply his considerable experience in horse race handicapping and combine that experience with a margin of safety.

The 6-5 odds on Two Item Limit right before the race started implied that the other bettors thought the horse only had a 45% chance to win, not the 60% Crist had calculated. The 6-5 odds result in a payoff of $3.60 for every $2 wager (assuming a 16% takeout and normal breakage), which translates into an 80% return – given that Two Item Limit wins. Run this scenario 50 times with Two Item Limit winning 60% of the time, and Crist would have bet $100 and won $108. The difference between Crist’s calculated 60% chance of winning and the implied 45% chance of winning gave Crist a big margin of safety. He would’ve had to have been way off on his prediction of the race’s outcome to not come away with a profit – even after takeout and breakage.

(An important note here: Crist, of course, had a 40% chance of losing that wager – something that he isn’t able to control. And he wouldn’t be able to repeat this scenario 50 times like I described above. But he COULD bet on 50 other races with similar probabilities – something a professional horseplayer would naturally do. Over time, the law of averages makes the percentages true – even if in any one scenario the outcome isn’t favorable).

Warren Buffett has talked about margin of safety using similar terms:

You have to have the knowledge to enable you to make a very general estimate about the value of the underlying business. But you do not cut it close. That is what Ben Graham meant by having a margin of safety. You don’t try to buy businesses worth $83 million for $80 million. You leave yourself an enormous margin. When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000 pound trucks across it. And that same principle works in investing.

When betting on horses, you don’t bet on a horse that you think has a 45% chance of winning the race if the odds imply it has a 40% chance of winning the race. That margin of safety just isn’t big enough for you to be wrong. As Steven Crist writes, you need to demand sufficient value to cover the margin of error.

The same thing works in investing. You don’t try to buy businesses worth $83 million for $80 million. You try to buy business worth $150 million for $80 million. Then you’ll have a margin of safety – the main purpose of which is to make an accurate estimate of the future (of a business or of a horse race) unnecessary in the first place.

4. Market Efficiency

“Does that mean today’s player faces nothing but higher vigorish and the remaining sharpies? Not at all. I firmly believe that, in general, the nitwits still outnumber the sharpies. More important, most sharpies aren’t as sharp as they think, and even the winning sharpies make plenty of egregious mistakes on individual races. As long as the volume of ill-informed money exceeds the takeout, there can be a positive expectation for the true sharpshooter who waits for the competition to make mistakes.“

Many people bring up the Efficient Market Hypothesis, claiming that the stock market is completely efficient and that it’s impossible to find undervalued securities. Any outperformance versus the market can only be attributable to luck.

Warren Buffett – and his incredible track record of 20% returns per year for over 50 years! – would obviously disagree.

It might be true that the market is more efficient today than it was decades ago and that it’s harder to beat the market – just like it’s become harder to make money from horse betting since attendance at horse races has declined (meaning less uninformed bettors) and takeouts at race tracks across the country have been increased to make up for that decline.

But if you’re sharp, there’s still value to be found. You just need to be patient and wait for your competition – and the market – to make a mistake.

5. Wait for the Right Race

Despite my earlier comments on market ineffiency, that doesn’t mean that every single stock is mispriced. Sometimes, the price IS right. In these instances, your best action is to – do nothing! Just wait for the race where you have a real advantage.

As Warren Buffet likes to say, “the stock market is a no-called-strike game. You don’t have to swing at everything – you can wait for your pitch.”

Of course, when your pitch does come, then you need to bet big on it – since great opportunities to pop up as often as they ought to. Here’s another quote from Warren:

When it rains gold, put out the bucket, not the thimble.

6. Beating Estimates Says Little About True Value

This is exactly like earnings estimates for stocks. When a stock beats consensus earnings estimates – either once, or say over a period of consecutive quarters – many investors automatically assume that it’s a great investment. But at the end of the day, the fact that the stock beat earnings estimates only tells you one thing – that the analysts covering the company got their earnings estimates wrong.

As Benjamin Graham used to say, a “stock investor is neither right or wrong because others agreed or disagreed with him; he is right because his facts and analysis are right.” In much the same way, a stock is not a great investment because it’s performing better than others’ expectations. A stock is a great investment only if you can buy it for much less than YOUR OWN calculation of its intrinsic value.

Warren Buffett on Horse Betting

I mentioned earlier that Warren Buffett used to actually bet on horse races when he was a kid. Well, Buffett’s biography The Snowball: Warren Buffett and the Business of Life tells the full story.

“The art of handicapping is based on information,” Buffett said in The Snowball. “The key was having more information than the other guy – then analyzing it right and using it rationally.”

Growing up, Buffett used to go to the race track – either Ak-Sar-Ben Race Track in Omaha (notice that it’s Nebraska spelled backwards?) or Charles Town, West Virginia when the Buffett family lived for a short time in Washington, D.C (Buffett’s father served in the House of Representatives for two non-consecutive terms). Since Buffett senior didn’t like attending the races, Warren usually went with his uncle or the mother of his friend Bob Russell.

Stooping for Tickets

Buffett, who wasn’t even a teenager when he started going to Ak-Sar-Ben, was too young to bet so he made money stooping for tickets. According to Buffett:

At the start of racing season you get all these people who’d never seen a race except in the movies. And they’d think that if your horse came in second or third, you didn’t get paid, because all the emphasis is on the winner, so they’d throw away [second-] and [third-place] tickets.

The other time you would hit it big was when there was a disputed race. That little light would go on that said ‘contested’ or ‘protest.’ By that time, some people had thrown away their tickets. Meanwhile, we were just gobbling them up.

It was awful; people would spit on the floor. But we had great fun.

That analogy is highly reminiscent of the cigar butt strategy that Benjamin Graham used to use when investing in stocks (he would look for companies that other investors had essentially thrown in the crash, but that still had some value left in them).

Stable-Boy Selections

Buffett and his friend Bob Russell also began a tip sheet called Stable-Boy Selections, which they hawked at the race track:

“We got away with it for a while. They weren’t the hottest sellers in the world. I mean, a couple of little kids selling this thing we typed up in my basement on an old Royal typewriter.

We were at the track, yelling ‘Get your Stable-Boy Selections!’ But the Blue Sheet was the number-one tip sheet, and the race track was getting a commission on it. The Blue Sheet sold for a little more. At 25-cents, we were a cut-rate product. They shut down the Stable Boy Selections fast because they were getting a cut on everything sold in the place except us.”

Hundreds of Books on Horse Race Betting

And when the Buffett family moved to Washington, D.C., Warren just had one request for his dad:

“When we got to Washington, I said, ‘Pop, there’s just one thing I want. I want you to ask the Library of Congress for every book they have on horse handicapping.’ And my dad said, ‘Well, don’t you think they’re going to think it’s a little strange if the first thing a new Congressman asks for is all the books on horse handicapping?’”

But Buffett reminded his father of the help he gave him during the winning campaign, and pledged to be there for him again during his re-election. So Howard got Warren hundreds of books about handicapping horses.“Then what I would do is read all these books. I sent away to a place in Chicago on North Clark Street where you could get old racing forms, months of them, for very little. They were old, so who wanted them? I would go through them using my handicapping techniques to handicap one day and see the next day how it worked out. I ran tests of my handicapping ability – day after day – all these different systems I had in mind.”

Buffet on Value and DRF

Buffett noted that a bookie actually took action inside Washington’s Old House Office Building.

“You could go to the elevator shaft and yell, ‘Sammy!’ or something like that and this kid would come up and take bets.”

Even Buffett himself did some bookmaking for guys who wanted to get down on the big races like the Preakness Stakes. “That’s the end of the game I liked, the 15 percent take with no risk,” Buffett said.

Buffett got along well with his high school golf coach, Bob Dwyer, and the two frequently rode the Chesapeake & Ohio railroad together from Silverspring, MD to Charles Town racetrack in West Virginia. Dwyer taught Buffett how to better understand the Daily Racing Form. “I’d get the Daily Racing Form ahead of time and figure out the probability of each horse winning the race. Then I would compare those percentages to the odds,” said Buffett, who bet from $6 to $10 to win. “Sometimes you would find a horse where the odds were way, way off from the actual probability. You figure the horse has a 10 percent chance of winning, but it’s going off at 15-to-1.”

That last part sounds a lot like Crist on Value, doesn’t it?

Going broke one day at Charles Town

One day, Buffett went to Charles Town by himself. He lost the first race and his performance went from bad to worse until he was down $175. Feeling depressed, he went to an ice cream shop and bought himself a sundae with the last of his money.

While eating, Buffett thought to himself that he had just lost more money than he made in a week. “And I’d done it for dumb reasons. You’re not supposed to bet every race. I’d committed the worst sin, which is that you get behind and you think you’ve got to break even that day. The first rule is that nobody goes home after the first race, and the second rule is that you don’t have to make it back the way you lost it. That is so fundamental.”

This was an important lesson that definitely influence Buffett’s investing later in life. You’re not supposed to be every race. Instead, just wait for the right pitch.

Charlie Munger on Horse Betting

Here’s an excerpt from a speech Charlie Munger gave at the USC Business School in 1994 called A Lesson On Elementary, Worldly Wisdom as it Relates to Investment Management & Business. In this segment, Charlie Munger gives his thoughts on horse betting, pari-mutuel betting systems, and investing in the stock market:

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