Bet the Odds

 | Jun 02, 2014 | 3:00 PM EDT  | Comments
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Stock quotes in this article:

nmfc

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ainv

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whf

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tcrd

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gars

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ofs

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ivr

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amtg

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abr

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mitt

Over the weekend, I had a chance to play in a charity poker tournament to raise funds for a travel softball team that a friend's daughter is on. I hadn't played poker in several years, but before I got married in 2010, I played several times a week in small tournaments.

After all that time off, I figured that I would be pretty rusty, but I played surprisingly well. I stuck to getting as much money in the middle when I had the odds in my favor, and I played only the premium hands. The rest of the time I just folded and watched the ballgame that was playing on the televisions. We can take several market lessons from poker, and Saturday night provided several.

We should get our money in the game only when the odds are in our favor. Trading every day, like paying every hand, occasionally gives you some improbable wins, but most of the time you are just making donations to the stronger players. It makes sense for investors to look for situations that put the odds of winning in their favor and avoid those that have very high but very unlikely payoffs.

We know that stocks that trade below book value tend to outperform the market over time. We know that stocks of companies where insiders have been buying shares also have a strong statistical tendency to outperform. If we put these factors together, we should be able to find some stocks that have a high probability of moving higher over the next year or so and are worth our consideration as portfolio additions, regardless of market conditions or opinions.

I ran a screen to look for companies whose shares traded below book value and had substantial insider buying recently. The first thing that really caught my eye is that the people who run business-development companies really like their companies' prospects right now. Most of these stocks are cheap, as they have traded down after being kicked out of all the Russell and S&P indices because of accounting concerns, and insiders are taking advantage of the situation.

As I discussed Friday, business development companies are in a good position to fill a hole in middle-market lending right now as banks continue to avoid what they perceive as riskier loans. Leon Black of Apollo Global Management recently talked about the great prospects for illiquid direct loans, and business development companies will profit from this financial trend over the next several years.

New Mountain Finance (NMFC) is one of the largest business development companies that trade at a discount to net asset value, and it has had insider buying in the past few months. The company is managed by a subsidiary of the $12 billion private-equity firm New Mountain Capital, and it brings private-equity-level analysis to the loans it makes to middle-market companies. While New Mountain is something of a generalist in its approach, management says it has particular expertise in education, financial services, infrastructure and energy. The shares trade just below their asset value and yield 9.6% right now. Other BDCs that fit the bill include Apollo Investment (AINV), WhiteHorse Finance (WHF), THL Credit (TCRD), Garrison Capital (GARS) and OFS Capital (OFS).

Another group that saw a lot of insider activity and traded below asset values is the sector of mortgage real estate investment trusts, or mREITs. These high-yielding securities have been beaten up over the past year as shifts in interest rates and mortgage markets have caused asset values to decline. Insiders at some of my mREITS, such as Invesco Capital (IVR), Apollo Residential Mortgage (AMTG), Arbor Realty (ABR) and AG Mortgage Investment Trust (MITT), have all been buying shares of the companies they manage at below asset value recently. These high-yielding securities could provide substantial total returns if the sector is in fact close to a bottom and ready to move higher over the next year. Insiders would seem to think that's the case.

There were several other interesting observations, but they will have to keep until tomorrow. However, I do want to share one more lesson from Saturday that is highly applicable to trading and investing. As I didn't expect to play very well and was anticipating an early exit, I only got a sitter until 11 p.m.. At about 10:30, my wife started rather anxiously catching my eye and tapping her watch. Since we were playing for prizes and not cash, I decided I needed to dump off my chips and get out of there. It was really easy. I just played every hand, paid no attention to risk vs. reward and over-bet every card. I went from big stack to broke in less than 20 minutes.

Overtrading and betting too much when the odds are against you works as poorly in the markets as it does at the poker table. Look for situations that give you an edge and a high probability of long-term gains before committing your hard-earned cash to the markets.

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