Beware the Brackets of March

April 20, 2016

If you’re like 60 million other Americans, chances are you filled out a bracket for the NCAA Basketball Tournament. March Madness, the trademarked annual rite of spring, has become a national obsession.  President Barack Obama is even a participant, famously unveiling his bracket every year on national television. Investing legend Warren Buffet threw gas on the fire when he offered one million dollars per year for life, to any of his hundreds of thousands of employees, if any could pick the winners of the first 48 games perfectly.

 

My friend, Pat, runs a fun contest that I entered along with dozens of other March hopefuls. Now that the tournament has concluded (congrats to Villanova), let’s look at some of the key takeaways from the tournament and the lessons we can apply to investing.

 

You can go from first to worst in a flash.

After the opening round of 32 games (Thursday & Friday), yours truly sat atop Pat’s contest in first place.  I felt smug, especially after the popular Michigan State team was eliminated in the first round, effectively wiping out a quarter of the field. I was in the clear and on the way to bracket glory, until my pick as champion, Xavier University, sent my bracket into the abyss by losing 18 hours later. By Saturday night, I was out of the running.

Investing Lesson:  Unlike a basketball bracket, which is locked the moment you submit it, your investment portfolio can be changed on the fly. I’m not suggesting you make changes to your investments willy-nilly, but you can cut your losses whenever one of your stocks gets out of sorts. Oh, how I wish I could’ve hit the “Sell” button on Xavier as that buzzer beater by Wisconsin sailed toward the hoop.

 

A #16 seed has never beaten a #1 seed. Ever.

Before the games begin, the NCAA Tournament Selection Committee has the task of ranking the teams into groups of 16 across 4 regions. So far, they’ve been 100% accurate at identifying the worst team in each region. Since the expanded tournament began in 1985, the collective record of the #16 seeds is 0 - 124. That's a rare achievement in perfection.

Investing Lesson:  Bad news is usually more reliable than good news. If you like a stock, but the rest of the investing world is in unanimous agreement about how bad that company is, take a second look. And maybe a third and fourth. If you still have conviction about the stock, own it.  Maybe you’re right and everyone else is wrong. Then again, maybe you own a #16 seed.

 

Upsets happen early and often . . .

Only three times since 1985 has a #12 seed failed to win a first round game versus a favored #5 seed.  #11 seeds have split games evenly against #6 seeded opponents over the last 7 years. And it’s become regular habit for both a #13 and a #14 seed to beat tournament favorites. More often than not, these lower seeded teams are smaller schools without the storied reputations of the perennial basketball powerhouses. But in any given year, some of these lesser named programs can compete head-to-head with the bigs. It’s a virtual lock that upsets occur in the first two days of March Madness. Case in point: two #12’s, one #13, one #14 and even a #15 enjoyed opening round upset wins this year. 

Investing Lesson:  There are lots of smaller companies that pack a powerful punch in earnings or dividends. These underdogs might be regional or foreign, and may not be on the radar of the giant research firms.  Do your homework and you’ll find hidden gems that can add outsized returns to your investment portfolio.

 

But don’t rely too much on the dark horses.

Those plucky, upstart teams that pull the early upsets also tend to fade away as the tournament progresses. Over the past 31 years, only 14 teams seeded seventh or lower have reached the Final Four. That means it’s nearly a 90% probability that a favorite (ranked #6 or higher) will gain entry. Even more telling, 23 of the last 31 national champions were seeded either #1 or #2 in their region. This year, #2 seeded Villanova defeated #1 seeded North Carolina.

Investing Lesson: Over time, the best-of-breed rises to the top. This means the bulk of your investment dollars should be committed to the best companies across multiple industries and sectors. Look for the best balance sheet, best management, best growth plan, best product/service, best R&D, best barriers to entry.

 

To those of you lucky good enough to win, (like Ashley, winner of Pat's pool): Congratulations. The rest of us have a long summer ahead to review our mistakes, study the data, and come back next spring as even better Bracketologists. While we're at it, we should do the same with our portfolios and become better investors, too. And whatever happens, do not pick Xavier.

 

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