Editor’s Note: For Christmas day, a Christmas riddle: When does a weak hand beat a strong one? In today’s “best of” lookback, we compare investing to high stakes poker — two activities with a great deal of overlap — and explain why it is often the surrounding situation that matters most, with the shape of events sometimes making the weaker hand (or weaker company) the better play. –JCL
Say you have an investment choice between two gold mining companies. They are similar except for a single variable, the average production cost per ounce.
One miner produces gold at an average production cost of $900 per ounce; the other does so at $1,800 per ounce. Which miner is the better investment, in terms of 12-month price appreciation?
It’s actually a trick question. The answer depends on the price of gold, the price-action history for both companies, and what is happening in the precious metals investment cycle.
Say, for example, that gold is at $2,000 and on the way to $2,400 at the time of making the choice.
In a gold price transition from $2,000 to $2,400, the profit margin per ounce for the low-cost miner will increase by roughly 36%. At the same time, the profit margin for the high-cost miner will increase by 200%.
By the time gold is at $2,000 per ounce, the price of the low-cost miner will have already risen a significant amount. Between $2,000 and $2,400, the low-cost miner’s share price could comfortably rise by another 30 to 40% in proportion to its further profit margin expansion.
Whereas the high-cost miner, which had been underwater until the gold price crossed the $1,800 per ounce threshold, could see its profit margins triple between $2,000 and $2,400 — and see its share price double in that time frame.
The interesting takeaway is that, at a certain point in the cycle, gold miners with strong fundamentals could have a modest amount of share price upside left — because they have already gone up a lot — whereas gold miners with weaker fundamentals could have far more upside left, on the order of 400% more, because their margin expansion doesn’t kick into gear until gold breaks a late ceiling.
And so, in terms of the question, “Is it better to invest in a low-cost miner ($900 per ounce) or a high-cost one ($1,800 per ounce),” the answer is dependent on price-action history (which has already gone up, and which has not moved as much yet) along with the journey of the gold price itself, and the overall state of the precious metals cycle.
To put it broadly, what matters here is situational analysis and not fundamentals alone.
Poker players are well familiar with the situational analysis concept. The fundamentals of an individual company are like the strength of the players’ hole cards in a poker hand (the two cards the player is dealt before the flop) in Texas Hold ’Em.
The key thing is that no poker hand is ever played in a vacuum. The cards in one hand are only the start. There is always a surrounding situation, and sometimes the total situational impact makes a weaker hand better than a strong one.
For example, say you are playing deep stack No Limit Hold ’Em, and you are involved in a hand with four other people before the flop is dealt. Which would you rather have in that situation: Pocket kings first to act, or nine-ten suited last to act?
In this situation, nine-ten suited last to act is the more desirable holding, by far, because of the circumstances and the positioning in the hand.
In many cases, the pocket kings will be beaten by a concealed drawing hand, but the player holding the kings will have a hard time throwing them away (because the kings look so attractive). The player holding kings will also be “flying blind” to the extent they are first to act (with four other players acting behind the first player with each new card that is dealt).
At the same time, nine-ten suited last to act will be easy to throw away in most circumstances — and will completely miss most flops — but could turn into a hugely profitable hand with the right board flop (e.g., a board that delivers two pair, or a combination flush draw and open-ended straight draw).
At the same time, because the nine-ten suited hand is last to act — a key part of the situation as we described it — the player will have maximum information at each decision point. They will be able to see how all four opponents behave, and what their decisions are, before making their own decision in each round.
This makes nine-ten suited a better hand than pocket kings in the situation described, because it will be far less prone to unwieldy large losses — if the hand does not connect, it is thrown away — whereas if the hand catches the right card combination, it can generate a very large return (by winning a giant pot with a straight or flush, or bluffing opponents out on the strength of a strong draw).
The applicable poker lesson, related to investing, is once again the value of situational analysis: Look at the total picture, rather than just the cards alone (or the fundamentals of the company alone).
The fundamentals of an individual publicly traded company, when considered for investment, are like the strength of the cards one holds in a Texas Hold ’Em hand before the flop. The cards are never played in a vacuum; there is always a situational context. It is the same with investment opportunities.
Situational analysis also helps explain why it is dangerous to weigh the fundamentals of a company above and beyond anything else. In poker, this is known as playing your cards but not the table, or playing your hand but not your opponents. It is not the way to go.
If consumers are wildly enthusiastic about a product, for example, but wild enthusiasm is already factored into the share-price valuation, there is no edge to be found by investing on the basis of consumer sentiment.
This is one of the deep problems with, say, the narrow view of company fundamentals pushed by a majority of Wall Street analysts. It is never the company story in a vacuum that matters, because nobody ever invests in a vacuum. It is always the story in relation to situational context at a given point in time.
To what extent does the company’s valuation already reflect excitement for the product? To what extent have likely investors in this company already bought? What catalyst exists that could change the picture in a manner that is not priced in? These are crucial questions to ask.
For example, as shown with our gold miner example earlier, the lower-cost miner might be a better company in absolute terms, or at an early point in the cycle, but a higher-cost miner could be a far better investment, in terms of 12-month price appreciation, later in the cycle.
In the end, it makes perfect sense that weak fundamentals are sometimes better than strong ones, just as a weak poker hand is better than a strong one, because fundamentals and situational context matter together, side by side. It is never just one or the other. It is always the net combination of both.
Sometimes situational context subtracts from the value of an intrinsically stronger hand — as with pocket kings in a lousy situation — while adding to the value of an intrinsically weaker hand, as with nine-ten suited in a fantastic situation. The pathway to maximizing reward versus risk thus with understanding the bigger picture.
It is true that most investors are not well-versed in taking in the bigger picture, which is exactly what situational analysis requires.
This is probably related to the reasons why new poker players are not good at looking beyond the hole cards in their hand, and considering situational factors like the nature of their opponents, their positioning in the hand, and the relative size of chip stacks on the table.