E303: What Blackjack Taught Me About Investing w/Ari Levy

Where does real edge still exist in public markets and how do you size risk when certainty doesn’t exist? In this episode, I talk with Ari Levy, Founder and CIO of Lakeview Investment Group, about applying probability theory, arbitrage, and disciplined position sizing to public equity investing. Ari explains how early lessons from card counting and game theory shaped his approach to risk, why small-cap markets remain structurally inefficient, and how activism, arbitrage, and management access can create asymmetric outcomes—without blowing up the portfolio.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00David Weisburd?

  You've said that probability theory was your first love. What made you love probabilities from an early age?

• 0:07Speaker 01

  Sports statistics, I would say, number one. Like to simulate baseball seasons when I was really little on the Apple IIe computer on a very early video game that didn't, you know, was a pretty much mostly statistics and not, not actually like interacting in the game as like a batter or pitcher, but just hitting SB if you're trying to steal a base. But I would simulate baseball seasons between, you know, you could have the 1927 Yankees play the 1955 Giants and have Willie Mays play against Babe Ruth. And so I always like, just love that concept and trying to think about advanced statistics at a young age. And, and just games of strategy, played a lot of cards, try to figure out how to

• 0:49Speaker 01

  win things, like good risk adjusted asymmetric calculated bets effectively.

• 0:56David Weisburd?

  And you ran a blackjack team when you were at Stanford. What did you learn about that? And how does that relate to how you do public investing today?

• 1:03Speaker 01

  I took a course my freshman year at Stanford, this would have been 1997, called Math and Sports. That was my favorite class I ever took. Professor Tom Cover at Stanford taught this freshman seminar. Small group of 15 like-minded folks, just thinking about this same kind of, you know, game theory, probability theory in both sports, which was the name of the class, but also the deck of cards. And Professor Cover had, had his own blackjack team in the seventies and just great stories. Fascinating statistics professor and a couple of us from the class, a friend Brad Griffith, who founded Game Time, which is a ticketing, the online ticketing platform.

• 1:47Speaker 01

  And I just took a real liking to it. We were, we were already friends, lived in the same freshman dorm and constantly were quizzing each other on the blackjack statistics. And so we just got excited about how we could optimize that, that game. And in, in cards, it's a, there's a known quantity, known set of, you know, there's four suits and 13 cards in each suit and all the rules that we all know. And so it's, it's much more of a fixed probability. In the stock market, they call it, you know, stock is more of a random walk. So it's a whole different distribution. There's no, history doesn't repeat itself exactly, but like the Mark Twain quote, "history doesn't repeat itself, but it rhymes." There's, you know, a lot of historical analysis to help figure out what the, what the future might hold to, to make educated, risk-adjusted.

• 2:33Speaker 01

  There's some principles from the things I learned in, in card counting. Specifically something called the Kelly criterion, uh, which is a, it's like a theoretical proof of, for a known set of, of odds. Again, with cards having a known set of odds, it tells you how much to risk, um, on any given wager such that you're maximizing your profit while also not putting your balance sheet, uh, at a big, it's called risk of ruin.

• 3:00David Weisburd?

  Most famously, long-term capital management had what they believe this, this risk-free arbitrage. And they hadn't thought about all the second order effects of it. And ultimately, uh, the, the fund blew up because of Russia and the divergence in pricing. How do you go about looking at your risk and assessing where your trade might go wrong?

• 3:22Speaker 01

  That is a really good point and a really, you know, something that we all think about. If you're a smart investor, you can't believe that it's going to, like what I said, with certainty. There's still, you know, events, idiosyncratic things that could happen. Uh, one that I can think of, for example, and this is more of a micro level versus like long-term capitals, models, multiple second order events happened. Uh, I believe that, you know, with plus some leverage, leverage is always an important factor. Uh, but for example, in the volatility space, VXX is the, the largest ETF. It owns a combination of front and second month futures on volatility. Almost in, it's the entirety of its history, you could create and redeem it, uh, which as I was saying before, keeps, keeps the ETFs in line.

• 4:05Speaker 01

  So VXX, if you just look on a Bloomberg machine at any given time, typically isn't below 10 basis point discount or above a 10 basis point premium. And, you know, they charge a fee to create and redeem it. And so it's not, it's not, there's, there's another cost, uh, but that's what keeps it alive. So if you could buy that at a 50 basis point discount and redeem it that day, you'd make 50 basis points in that day. And that would be obviously credible if you spread it to something that was trading at now. Now, this, in this example, I'm talking about a sort of idiosyncratic risk where. The underwriters of VXX, this happened a few years ago, had not not properly registered new share issuances with the SEC. No one could effectively know that, I guess, unless you're a super smart lawyer and could figure out that they they hadn't registered something

• 4:47Speaker 01

  correctly. And so what happened was you they could not issue new new new shares, you couldn't create redeem. And there was effectively like a like a squeeze, a short squeeze on it where it traded at a 20% premium for an extended period of time until they resolved their SEC issues. And so that mechanism went away. So you so if you have this rule that you can create redeem and that's going to keep it at NAV, well, what else could go wrong? That was an example of something that was kind of out of left field. There's however many thousands of ETFs out there that that do it right with the SEC and VXX underwriters eventually got it back in line and now it trades in line. But could that happen again? Something like that, in the case of long term capital, yeah, could there be, you know,

• 5:31Speaker 01

  sovereign risk or whatever you're trading that that things come out of left field? You think you're trading something that is the same as some other thing, but the underwriter of one of those things had fraud and they were they were buying something else. We've, you know, we've seen that in different cases throughout history. There was the MF Global, which was a perfect arb there, but that you thought you were buying something that was something else and someone was going rogue with the the investment that you made. And you got to be really careful about that.

• 5:59David Weisburd?

  And the catchall solution for that risk management is position sizing. So even if it's even if it blows up, and even if you have 10%, maybe you lose 2%, 3%. So you don't have to know how it'll blow up to size it correctly and to keep your entire portfolio from from getting ruined. One of the hardest things of investing is seeing what's shifting before everyone else does. For decades, only the largest hedge funds could afford extensive channel research programs to spot inflection points before earnings and to stay ahead of consensus. Meanwhile, smaller funds have been forced to cobble together ad hoc channel intelligence or rely on stale reports from sell side shops. But channel checks are no longer a luxury, they're becoming Stable stakes for the industry.

• 6:44David Weisburd?

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• 7:44Speaker 01

  Yes, so you have to, yeah, you have to cap the size of the exposure you have to, to any one individual thing.

• 7:51David Weisburd?

  The only risk to the overall portfolio is if you're making the same trade over and over that has the same underlying catalyst that drags it down.

• 7:59Speaker 01

  Yes, if they all, or multiple of your spreads or trades or investments, whatever you want to call it, have some similar idiosyncratic risk that hits them all at the same time, or multiple of them, then, you know, if you lose 2% on multiple different 10% trades, obviously it adds up to more than 2%.

• 8:17David Weisburd?

  Last time we chatted, you said that 5,000 to 10,000 small cap companies are inefficiently priced. Tell me about that and what are the opportunities there?

• 8:29Speaker 01

  So I don't know how many small cap stocks exactly there are. I know there's thousands and it depends if you look globally or in the US. They tend to be less efficiently priced than large cap stocks because there's informational inefficiency there. In the large cap stock world, you see a lot more analyst coverage. So many more people have read Apple's filings, however many multiples versus. Some little nichey company in a industry you didn't even know existed or didn't weren't thinking about that that's a hundred or five hundred million dollar market cap versus a trillion dollar market cap. And over time, we've seen that kind of spread diverge. We've had, we've seen, and we've had a decade, for example, where large cap, decade and a half, where large cap has just crushed small cap. That there, there are different reasons for that.

• 9:13Speaker 01

  There's been much more of a regulatory burden on small cap companies where

• 9:18Speaker 01

  a public company typically needs to spend five plus million dollars to be public. It's, it's obviously more for the, the larger companies, but as a percentage of their size and their profit and cash flow for the small companies, it, it hurts a lot more. And so the, the Sarbanes Oxley and other, other costs make it just difficult. And they're, you know, there are companies that we own that add to 20 million of free cash flow a year. Well, if they were private, they would, they would do 25 million because they didn't have to spend that $5 million to do that. I can tell you from being on the board of a public company, which was Del Taco, a small cap stock. We probably spent a third of our board meetings just talking about things that had nothing to do with other than regulatory Sarbanes Oxley and compliance costs that that just add up to much more meaningful amount for a small company as a percentage than a large company.

• 10:01Speaker 01

  And with index funds just going larger and larger, there, there's been a huge increase in assets going from active to passive. Honestly, throughout my, been in the public markets for 25 years. Of course, there was the S and P 500, uh, but the whole time and the Russell 2000 that I've been in business. But the, the increase in, uh, just number of passive funds, it's now, I believe, over half of the market. And, and with that, there is, uh, most of it is in the major that they, we look today, for example, the S and P 500 versus the S and P 600, which is their small cap index, has what is known to be 17 times the amount of dollar assets in the, in the S and P 500. It's actually way more than that.

• 10:41Speaker 01

  If you factor in all the private funds and indexing, or, or even like quasi index funds, they might say they're somewhat active. But they, but in their index huggers, we call instead of having a seven precision percent position in Nvidia, they've got a 6% position or something that still makes them look a lot like the S and P 500 or, or the NASDAQ 100 or whatever. And, and the small cap companies, uh, just get much less efficiently priced. So, um, You know, you can you roll up your sleeves and you and you look at some niche industry, some niche business that you think is asymmetric. Well, you're going to get much better access to management. You'll be able to talk to the CEO and CFO of the company versus trying to do that with.

• 11:24Speaker 01

  Apple. Good luck. You got to be a, you know, the 300 billion dollar mutual fund company or something to get that, you know?

• 11:31David Weisburd?

  And how do you marry those strategies of meeting management and get trying to get a better read on management versus kind of these arbitrage opportunities that are basically in the spreadsheets or in the trade versus kind of this this EQ level insight?

• 11:47Speaker 01

  My first love, my favorite are the more arbitrage trades. If you if you could give me only trades that make five basis points a day instead of, again, the one basis point that the that the government's offering you.

• 11:58Speaker 01

  You know, I it's hard to make that adds up to, let's say, 18% of your return that.

• 12:05Speaker 01

  It's hard to get some an 18% year return compounded in picking stocks. There's more risk. And so I would take that all day long, but finding those things that pay you five bips a day with with low risk is is few and far between. A lot of what we manage is just our own capital to take positions where

• 12:22Speaker 01

  we we we take an activist approach and where we will buy five to 15% of a of a company. It depends on their bylaws, if they have a poison pill, you want to look at the shareholder profile, but based on all sorts of different inputs and analysis. If if the company is really under the radar, you believe it's trading at a big discount to its private market value. And that's not just your instinct, but because you've talked to a bunch of different industry players and investment bankers. There's there's a bunch of private equity firms, for example, that would love to buy a bunch of these small cap companies. And if if all these companies were for sale, I think, talked to enough of them that they would drop everything and just focus on those opportunities rather than

• 13:02Speaker 01

  trading assets to each other in the private market, you know, doing their typical game of cutting costs and then trying to sell at the whatever the adjusted EBITDA looks like the highest, but there's a lot of these niche little companies that these private equity firms would like to own it. They are not willing typically to take positions in public companies, certainly not willing to be activist. They're always, we call ourselves friendly activists, but if there's if you have boards and management teams that are not acting in shareholders' best interest because

• 13:29Speaker 01

  for whatever reason, there's there are a bunch of the board members or retirees that like saying they're on a public board. They like the compensation from it, but they don't own any stock. They are not aligned with you, the shareholder that owns 9% of the company. And so, you know, we will, we will try to get board seats. We've gotten board seats on a number of different companies. And ultimately, if they're too small to be public, too nichey, too hard to understand, they're never, they're going to have to grow many multiples to be, become relevant and you kind of get on someone's radar. They shouldn't be public and, and if they're.

• 13:56David Weisburd?

  Is that what you're typically doing? You're taking these public companies and you're selling them in private markets?

• 14:01Speaker 01

  That, that is the goal in a lot of our activism. But, you know, a lot of the management teams and, and boards don't, don't like that. So we're, we're, we're, we're open to all sorts of different alternatives. A lot of them will want to divest something at a premium to the multiple that they're trading for a division. Or, or, or often we see a lot of them try to make acquisitions to grow into a bigger thing. That comes with its own, own risk. You take, let you leverage up to, to do that. And it's a lot of what my partner and I like to call like empire builders, where the board is like, hey, let's do a roll up in the public markets. Well, if you're a nichey little hundred million dollar public company, for example, I can say this work because we, we're on file. We've filed a 13G on a company called Quipped Home Medical. That does, uh, they're about a, about a hundred million dollar market cap. They, they trade for four times EBITDA.

• 14:43Speaker 01

  They're a provider of home health services, specifically in the niche that is the respiratory space. So think CPAP machines, first things for sleep apnea, oxygen. Most of it is respiratory related in-home sales and rental and servicing around that. Well, they've made some acquisitions, but the stock, the stock price is ultimately the, the, the scorecard is the stock price. And so, you know, in the short term, it could be a voting machine. In the long term, it could be a weighing machine. But if it's been, if you're five or 10 year, 15 year IRR as a public company is really subpar. You have more vulnerability. There's an annual meeting and an election in those companies. Ultimately shareholders have certain rights. You gotta look at the bylaws of the companies. We've ever, like, we haven't.

• 15:28Speaker 01

  We've typically settled with companies and gotten board members that way. And when you have board members, you have more influence. When I was on the board at Del Taco, because we were trading a big discount to private market value, we got a number of different inbound bids typically from private equity, some from, you know, large known quantities and some from funds that we never heard of that you kind of get to see how well funded are they, are they for real? Well, first, there's that, but just if you take away public company costs and also you're not focused on the next quarter, which public companies are too focused on versus the next five years or whatever. I saw it firsthand, like we were, their LBO math suggested that, that, that they were going to get, they were going to be able to pay a big premium to public market value, take it private and still make a good IRR. Now that's them levering up typically and taking a lot of risk.

• 16:11Speaker 01

  In the case of Del Taco, we sold it to Jack in the Box. The best buyer typically is the strategic because there's synergies versus private equity. We sold to Jack in the Box, Jack in the Box is its own public company. We sold to them in 2022. They just, I believe the enterprise value on the deal was six or 700 billion. They just, they just sold it for the low 100s. There's been a whole bunch of things negatively affecting the restaurant industry, fast food, GLP ones and things I could go on and on about, but that was the risk that they took.

• 16:38David Weisburd?

  How long does it take you to build a case to go activist? How many conversations? Talk to me about that process.

• 16:45Speaker 01

  It depends on the company, you know, we've just having been in the small cap markets for my whole career, the more, actually the more arbitrage like things have been more for the last 15 years, but the full 25 years I've been in the public markets has been, I've always been picking stocks. So if you have some historical knowledge of the companies, we're finding companies through screens, but a lot of it's just from having knowledge of founding it, however we found it before, you could talk to other fund managers or whatever. You're trying to do as comprehensive of analysis as you can. Now there's limitations in that there's quarterly public filings. You don't always get full access. You don't want inside information, of course, based on all those inputs and some instinct, you, you, you think that, that the LBO model for that particular company suggests that

• 17:28Speaker 01

  if you take away the $5 million of public company costs and you make certain assumptions and LBO model is only as good as its assumptions, that's the private equity, that's the scorecard for them for private equity. It's like, and such an important metric for the LBO model is what are you going to sell it for five years? And you see so many models that just show consistent growth and then they sell it for a big multiple five years out. Well, that there's plenty of uncertainty in that and a lot that can go wrong. Certainly you could exceed it, but the average model is probably too aggressive. And if you're trying to auction off a company, the highest bidder could have the most aggressive model or the cheapest cost of funding or the most synergies.

• 18:03Speaker 01

  We want to know everything we can. So we're, we're, we are not by no means experts on respiratory home health services and equipment. We've learned as much as we can. In importantly, in that case, just to continue with that example, there is a public bid. It's, it's been in a public press release from another investor that owns nine percent of the company. That's the largest shareholder. I think the stock closed at $2.52 today, but has been traded way lower than that recently. They have a non-contingent bid at $3.10 a share. So they, they want to buy the company. They've said at $3.10, their best bid is $3.10 a share. It's not contingent on diligence or financing. Of course, things could change. They, they, that, that came out in a press release. Could they back off of that?

• 18:48Speaker 01

  Sure, there is risk. Could they, could they increase it? Well, we think it's worth more than $3.10 to share because it's, we think the cash flow, forward cash flow, particularly when with, you know, responsible leadership suggests that it's, it's worth more than that. But it's going to take a board to decide that they want to run a process. And so we're not sure. I mean, that would there, they, they had a lawsuit, an active lawsuit against that buyer. And we think that's incredibly wasteful. There's no known way that they're going to have to be forced to sell, to sell. Ultimately, there's an annual meeting and shareholders get to vote, just like, you know, a democratic election. We get to vote our eight or nine percent of stock for, for the directors that we want. And then, you know, hopefully those directors will do what's right for shareholders.

• 19:33Speaker 01

  And, and if, if the best risk adjusted return is to run a sale process and sell to the highest bidder, that's, that's what they ought to do. But there's, there's different, different ways to go at it. And it's not always what we think in this, in the case of this QIPTO Medical, though.

• 19:47Speaker 01

  Very small nichey public company. They've got some complicated accounting that makes it harder for other people to roll up their sleeves and fully understand it. And so, you know, we think the risk adjusted return is, is, is really good. But a lot of these companies are down and out. They weren't always micro cap and they, they went there and there's in, in this industry, there's reimbursement risk. Um, insurance, government reimbursement. So, so, you know, you gotta just factor in all the different things and say, this is among the best risk adjusted return I can find. And I'm going to take a X percent position.

• 20:15David Weisburd?

  What's one piece of timeless advice that you wish you could go back and give yourself? That would have significantly increased the chance of success in your career and/or decrease some of the risks?

• 20:28Speaker 01

  One really interesting thing is, is the,

• 20:33Speaker 01

  you know, we've seen so much technological advancement in the last couple of decades, such that

• 20:40Speaker 01

  growth has outperformed value. And there have been other periods historically that have, that's been the case. But growth has outperformed value by a wide margin in the last 20 years. And so, you know, in, if, if you read Intelligent Investor Benjamin Graham, or you, you look at a lot of data. There's some really good data from Eugene Fama and Kenneth French professors, uh, Chicago and Dartmouth. They would show, uh, and my, my mentor, uh, guy by the name of David Heller, you know, had be, we were very empirically focused, looking at a lot of historical data. Very, his, his philosophy was very deep value focused. And so if you go back almost any decade in the history of the markets before that, the smaller, deeper value companies outperformed.

• 21:24Speaker 01

  So if you just bought an index of those companies that were the small, among a certain peer group of small, small companies, trading at the biggest discounts to book value, and then those, the Fama French indices adjust every year, you would have outperformed. So if you're trying to find just sort of. Edge in a bucket of companies to buy. History would tell you to do that. Well, in the last 20 years, we've seen such incredible technological advancement and, you know, industries like retail, I mentioned before, we've made a bad investment in big lots. For example, you know, to be mindful of, more mindful of technological change, trying to understand what that means for some of these value companies to avoid value traps. So, and it's easier said than done, but, but I've, we've pivoted from very much deep value stock picking

• 22:07Speaker 01

  to more of a Joel Greenblatt style of, of, of value investing where it's, it's those companies trading at, at the biggest discounts, but also that generate the highest return on invested capital. And so, you know, we've gotten into different companies, whether they were previously super profitable and became unprofitable like big lots or other, or just the slowly competed way of the dinosaurs, the never invested in this company, but Deluxe Corporation prints some huge market share of handwritten checks for people's bank accounts. Well, can't remember the last time I, I probably still write a check here or there if my assistant helps me with. But, um, you know, it's, it, there, there's a world with technology where we've made such technological advancements that the Amazons of the world have made it very difficult for almost every category of retail. You can click a button from your home.

• 22:52Speaker 01

  Uh, and so, you know, to just buy deep value companies based on where they trade to book value is, is an important lesson that I've learned.

• 23:01David Weisburd?

  All right. This has been absolute masterclass. Thanks so much for jumping on the podcast and looking forward to continuous conversation live.

• 23:07Speaker 01

  Thank you. Yeah, likewise. Thank you. Appreciate it very much.

• 23:10David Weisburd?

  That's it for today's episode of How I Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.