Minimizing Type 1 Errors (Excerpt From Our Latest Letter)
The following is an excerpt from our fall 2024 investor letter. As a reminder, premium subscribers will receive a full copy of our investor letter, including a description of every position we own and why we own it, in 45 days (November 15th).
“The first rule of an investment is don’t lose [money]. And the second rule of an investment is don’t forget the first rule. And that’s all the rules there are.”
– Warren Buffett
Investors can learn a lot from one of baseball’s greatest “sluggers” of all time – Ted Williams. Williams had a career slugging percentage of 0.634, second only to Babe Ruth's .690.
A slugging percentage is a lot like an investment track record. Slugging percentage measures the average number of bases a hitter earns per at-bat. Just as a great investment can deliver outsized returns, slugging percentage rewards extra-base hits (like doubles, triples, and home runs). Investors care not only about making a winning investment but also about the magnitude of their gains. A few big wins can outweigh smaller losses or missed opportunities.
Williams explained his “selective swinging” strategy in his 1971 book, The Science Of Hitting, He carved the strike zone into 77 cells, each the size of a baseball, and refused to swing except when the ball was in his most favorable cells.
Williams wrote:
“My first rule of hitting was to get a good ball to hit. I learned down to percentage points where those good balls were. The box shows my particular preferences, from what I considered my “happy zone” - where I could hit .400 or better - to the low outside corner - where the most I could hope to bat was .230. Only when the situation demands it should a hitter go for the low-percentage pitch.”
Williams accepted the possibility of missing a good pitch or letting a strike go by. His discipline to wait for the “fat pitch” more than compensated for these missed opportunities.
In investing, as in baseball, there are two types of mistakes. Type 1 errors occur when you make a bad investment, much like swinging at a poor pitch. Type 2 errors arise when you miss a good investment, or let a prime pitch pass by.
Ted William’s “selective swinging” strategy minimized type 1 errors. Williams had the discipline to be extremely selective and only swing at the best pitches. This minimized the odds he would strike out and maximized his chances for a big hit.
It is the same in investing. Investors should make fewer investments and hold the investments they do make exceptionally high standards. This minimizes the risk of loss and maximizes the odds of a big gain.
Pulak Prasad proves minimizing type 1 errors is the right approach in What I Learned About Investing From Darwin.
Imagine there are 4,000 publicly-listed stocks in the U.S. 1,000 are good investments and 3,000 are bad. If an investor has a 20% type 1 and type 2 error rate:
He correctly buys 800 of the 1,000 good investments and mistakenly discards 200, a type 2 error.
He correctly discards 2,400 of the 3,000 bad investments and mistakenly buys 600, a type 1 error.
Overall he makes 1,400 investments, of which 800 are good, for a 57% hit rate.
The table below shows how improving the investor’s error rates impact his overall hit rate.
Reducing type 1 errors has the biggest impact on an investor’s hit rate. There’s many more bad investments available than good, so being selective pays off.
An investor with a higher hit rate will likely have a higher slugging percentage because losses are difficult to make up. Losing 20% requires a 25% return to get even. Losing 50% requires a 100% return. A 100% loss takes you out of the game completely.
We aim to reduce type 1 errors by making fewer, better investments. Ted Williams knew that swinging without discrimination leads to more misses than hits. We aspire to Ted Williams’ discipline to wait for the fat pitch.
We aim for a high hit rate by putting the base rates on our side. Profitable companies with high insider ownership, aligned incentives, high ROEs, durable competitive advantages, fortress balance sheets, and below-average valuations tend to outperform, so we focus on them. The companies in our sweet spot are in “replication mode” – where their future resembles their past – and are not overly reliant on factors outside of their control.
We aim to convert a high hit rate into a high slugging percentage by letting our winners run. We avoid what Peter Lynch called “trimming the flowers and watering the weeds.” This can sink an otherwise buoyant portfolio. We keep our portfolio “fresh” by replacing our lowest return investments with higher ones when we find them.
We try to avoid all of the rest: businesses priced for perfection, using excessive leverage, with a narrowing competitive advantage, issuing excessive share-based compensation, or overly reliant on factors outside of their control.
Avoiding these will mean missing out on plenty of profitable investments, and we’re okay with that. Failing to invest in Nvidia and the AI frenzy was a type 2 error. We don’t have any regrets because these “pitches” weren’t in our “happy zone.” Our first priority will always be to avoid losing money.
As Joel Greenblatt said:
“If you don't lose money, most of the remaining alternatives are good ones.”
In investing, as in baseball, it’s tempting to swing at every pitch, especially when markets are rising and fear of missing out takes hold. The most dangerous mistake is swinging at the wrong pitches. Selectivity is key. Minimizing type 1 errors keeps us in the game long enough to let our winners compound. Investing, unlike baseball, has no called strikes, so we’re free to wait as long as it takes to find an investment in our “happy zone.”
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Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.