And They’re Off!

In less than a month, the oldest continually performed American sporting event will take place at Churchill Downs in Louisville, Kentucky.  The Kentucky Derby will see a field of about twenty or so, three-year old thoroughbreds load into the starting gates for their run at racing legend.  Last year, wagering from all-sources was the highest all-time on both the Kentucky Derby Day program and on the Kentucky Derby race.  Wagering from all sources on the entire program totaled $194.3 million while wagering from all sources on the Kentucky Derby race alone totaled $137.9 million.  Churchill Downs returned $154.3 million to bettors on the Kentucky Derby Day race program plus purses of $10.7 million that was paid out to horsemen during the remainder of the 2015 race meets.

Despite the high dollar figures produced by markets on major race days, the real money is in the breeding, not the racing of horses.  The horse business is a $39 billion dollar industry driven by the thoroughbred.  These horses are prized for their pedigrees.

Keeneland Association Inc. in Lexington, Kentucky is best known for its race track.  They recently provided the setting for the richest two days in American racing, when they hosted the 2015 Breeders Cup last November.  Keeneland is also home to the most important thoroughbred horse auction house worldwide.  This is where values are set on thoroughbreds throughout the world.  Horses are bought for hundreds of thousands or sometimes even millions each.  The Keeneland Yearling Sales feature over four thousand yearlings, none of which have ever been saddled.  Formal competition does not begin for these horses until they are at least two years of age.

Without any help from past performance records or speed figures, prospective bidders at the Keeneland sales study bloodlines and speculate as to whether the biological characteristics of a horse deserve a market order.  A black-type pedigree and progeny is what buyers want.  Black-type is the font applied to stakes winning members of a yearling’s family tree.  A stakes race is the highest class of race and the desired level of competition that most buyers at the Keeneland sales would like to see in a thoroughbred’s family.  Depending on how the black-type is positioned in the family tree, more black-type means a higher price tag at the Keeneland sales.

These criteria lead to speculation at best considering only 50% of thoroughbreds ever win a race and less than 1% will win a stakes race.  Imagine sitting at a playground with four thousand children and picking one of them with $1 million of your hard earned dollars to be the next Tiger Woods or Serena Williams.

The highest price ever paid for a thoroughbred at auction was $16 million in 2006 for a bay colt named The Green Monkey.  As a descendant of both Northern Dancer and the great Secretariat, big things were expected.  On the race track, The Green Monkey was a complete failure.  He ran three races before being retired and never finished better than third.  His career earnings totaled $10,440.  The Green Monkey’s progeny have not performed any better and currently he stands at stud in Florida for a fee of only $5,000.

Over the same time period of January 2006 to present, SPDR S&P 500 ETF (SPY) increased 60%.

This level of speculation and opportunity cost could not continue to exist if not for the small probability of extreme upside.  A thoroughbred named Tapit was bred and raced by his owner, Winchell Thoroughbreds LLC.  He ran six times in his career, achieving 3 wins including the Grade 3 Laurel Futurity Stakes and the Grade 1 Wood Memorial Stakes.  Tapit made it to the starting gate of the 2004 Kentucky Derby and was sent off as the 5-1 second choice.  He finished ninth.

During his race career Tapit earned $557,300, but in the breeding shed Tapit has become the definition of a stud.  In his lifetime at stud, Tapit has produced 73 black-type winners, 159 black-type horses 17 Grade 1 stakes winners, 45 graded stakes winners, 11 millionaires, six champions and 5 Breeders’ Cup winners.  He has been the leading American sire the last two years.  Because of his success, the market has set his stud fee at $300,000.  He was bred to 134 mares in 2015 alone.

The probability of a thoroughbred making it to the starting gate for The Kentucky Derby is extremely low, but that is the dream.  The possibility of joining “The Run for the Roses” is why such risk is assumed and large sums of money are paid out for such speculative operations.  The current points system in place to join the Kentucky Derby field pretty much guarantees that a horse that makes it to the starting gate has earned black-type which will make him more valuable at stud, at least initially.

Fusaichi Pegasus made it to the starting gate and won the Kentucky Derby in 2000.  He ended his racing career with six wins from nine starts and earned nearly $2 million.  After being retired Fusaichi Pegasus became the most sought after horse for breeding.  He was bought by Coolmore Stud, the world’s largest thoroughbred breeding operation for an estimated $70 million.  Initially his stud fee was set at $150,000.  He proved to be a disappointment as a stud horse.  He now resides in Kentucky with a stud fee of only $7,000.

Race fans and horsemen alike waited thirty-seven years for American Pharoah to win the Triple Crown.  Since then American Pharoah has been retired and will begin his stud career with a fee of $200,000.  It will be at least two years until anyone can determine whether or not that price is justified.

In less than a month, a field of twenty or so three-year old physical embodiments of pure speculation will break from their gates at Churchill Downs in the 142^nd running of the Kentucky Derby.  There is expected to be 160,000 plus in attendance and another 20 million watching at home for horse racing’s next legend.  Horse breeders and owners will also be watching and aware that despite the performances on May 7^th the best, or worst is yet to come.