Not all horse racing punters are losers. The winners stick to a simple strategy. That same strategy will help you pick the huge stock market winners of tomorrow.
I've done a bit of wagering at the casinos. But most of what the casinos have to offer I don't bother with. Most games are set up so that no matter what you do, the house always has the edge. Always. Oh, you can win, but stay at the table or the machine long enough and you'll always end up paying it right back.
Horse racing, however, is a little different. When placing a bet at your local William Hill (LSE: WMH) or Ladbrokes (LSE: LAD) you are basically competing against the bookmaker rather than the house -- so the odds aren't automatically stacked against you. What I've found even more interesting about horse racing, though, is that there are important lessons that we can shovel up and bring over into the investing world.
The Best Horses Usually Win
It almost sounds too obvious to mention, but much of the time the best horses take the top spots in their races. These are the horses that have shown the top speed, have previously raced against the toughest competition, and have the best trainers and jockeys working with them.
Similarly, the shares of the best companies tend to perform well year after year. Tesco (LSE: TSCO) shares for instance, are up more than 100% over the past 10 years, not including the substantial amount of dividends paid out over that period.
Capita Group (LSE: CPI) has been one of the best performing shares over the past 16½ years. Shares in this giant of the outsourcing world have risen from 16p to over 700p, a gain of over 4,000%. It's no wonder Capita's shares haven't been nearly as battered by the global recession as some less-robust businesses. Capita is simply a great company that keeps growing and keeps delivering. In other words, it's one of the best horses in the field.
Valuation Matters
Now that I've told you that the best horses usually win, it's time to couch that by saying that the best horses don't always win. Sometimes a good horse runs a bad race and ends up in the middle of the pack, or another horse could run the race of its life and edge the favourite by a nose.
For this reason, it's important to make sure that you're getting odds that compensate you for the risk you're taking. If you always settle for low odds, then your winning horses will pay you very little and your losers will sink you.
US Horse racing expert Steven Crist spoke at a Legg Mason investing conference in 2007, breaking it down very simply for thoroughbred handicappers -- and investors:
What you really want to do is determine which most-likely winners are good prices and which most-likely winners are bad prices. It is a very simple equation: Price x Probability = Value
Bringing this to the investing world, we can look at a company like Imagination Technologies (LSE: IMG), which currently trades at nearly 40 times its estimated 2010 earnings. Imagination appears to have good technologies, as witnessed by companies like Apple recently increasing their stake in the company, but even still, it's highly debatable whether the probability of continued earnings growth justifies that hefty multiple.
On the flip side, Astrazeneca (LSE: AZN) has seen its shares knocked down to a price-to-earnings ratio of less than 8. There's little doubt that the company faces significant headwinds from the economy and competition from generics, but the stock's valuation is attractive enough that the company doesn't have to grow very much for investors to be handsomely rewarded.
Buying shares with high valuations will often lead to modest gains from companies that continue to do well, but those wins can be offset by disastrous losses from the stocks of highly valued companies that get tripped up. This is why you'll lose money by betting only on the favourites at the track.
Buying shares with more attractive valuations, on the other hand, offers the potential for larger gains on the upside and more moderated losses on the downside.
Quality, Meet Value
Putting the two concepts together, we can find an ideal strategy for horse racing or investing: Bet on the best horses (buy the best companies) when the betting public (other investors) has provided attractive odds (low valuations) and watch your bankroll (portfolio) grow.
This quest for quality at an attractive price can be very difficult due to the sheer number of investors following giant companies like BP (LSE: BP) -- a £90 billion enterprise that sees nearly 20 million shares trade hands every day. It's very difficult to have an informational advantage against the thousands of other investors in this oil behemoth.
However, Chief Analyst Maynard Paton at The Motley Fool's Champion Shares premium share tipping service has found that by searching among lesser-known small companies, some sweet price/quality combinations can be found. Just like the sharp punters at the racetrack, he does far more research and has much better information than most small company players. You can check out all the current Champion Shares buy recommendations by taking a 30-day free trial of the service.
More on the economy and the markets:
> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who does not have an interest in any of the companies mentioned in this article.
