Investing Like Billy Beane.

April 15, 2013

Baseball season, gateway to the summer, has arrived. While my beloved Reds have dropped five in a row, including a sweep at the hands of the lowly Pirates, I remain optimistic.
Baseball and investing have much in common. Consider this:
1) While there are many fans, there are few aficionados. Rare are those experts with an insider's perspective of the game.
2) As in baseball, investing places a premium on total disclosure. An investor must rely upon a team's price-to-earnings ratio, much like a GM must rely upon a player's on-base percentage. Statistics and the ability to measure performance and value are vital.
3) Baseball teams, like investments, experience hot and cold streaks. A solid investment can decline in the short-term. An absolute dog can inexplicably appreciate for a while. Good squads will lose to bad ones. Yet, over the course of time, players, teams and investment options inevitably revert to the mean.
4) Baseball rarely crowns the same World Series champion in consecutive seasons. In other words, past performance is no indicator of future returns.
5) Trends and manias may temporarily prevail, but eventually fade into obscurity. Methodology trumps chance. Artificial turf. Polyester uniforms. Tulip mania. Tech stocks. Fads come and go. But the rules of the game never change.
Perhaps no story better captures the correlation between baseball and investing than Michael Lewis's classic book turned movie, Moneyball (click here).
Moneyball is the true story of the Oakland A's maverick general manager, Billy Beane. In the early 2000s, the small-market Athletics had a $40 million budget, one of the smallest in baseball. Compared to teams like the Yankees, and their $126 million budget, one understands what teams like the As (and Reds) were up against.
The As had a capacity for drafting talented players and turning them into successful major leaguers. Yet, as soon as they became free agents, they'd sign with big-budget teams like the Yankees.
Realizing he could not beat the big-market teams at their own game, Beane becomes determined to find a way to compete on a fraction of the budget. He turns to sabermetrics, a little-known methodology applying rigorous statistical analysis to the valuation of talent. Instead of building a team of expensive, high-profile stars (who are often not as valuable as they appeared), he builds his roster with cheap, unknown players laden with under-appreciated skills. The result? The As went on to win 103 games, including a record 20 consecutive victories.
Beane, utilizing the talents of his assistant, Paul DePodesta, a Harvard economics graduate and statistical whiz kid, used sabermetrics in much the same way that a talented investor will utilize fundamental analysis. He realized that the sum of the parts supersedes star power and current contract values.
Beane placed a premium on specific areas of maximum importance, which often contrasted with the means by which traditional baseball scouts viewed talent. In so doing, he debunked much of the traditional baseball wisdom. His system revealed that many statistics -- batting average, runs batted in, fielding percentage and a pitcher's win-loss record, say little about a player's real value.
Further, Beane showed that time-honored principles like the sacrifice bunt, the "clutch hitter" and the stolen base, despite their inherent appeal, had very low probabilities of success.
By taking a contrarian's view, Beane's As were able to find hidden value where other teams saw mediocrity. And so the As were able to assemble a very productive team for a fraction of the cost.
They won their division for the next two years, even as the Texas Rangers had a payroll of nearly three times their own. Over the next decade, the As assembled one of baseball's best overall records.
Sabermetrics enabled Beane to emphasize in-game statistics, as opposed to the industry norm of using career averages -- statistics so widely utilized so as to provide little real incremental value. Everyone ends up bidding for the same players and skill sets, thus pricing small market teams out of contention.
Some of the more colorful metrics Beane used included "late-inning pressure situations" (LIPS), and "narration, exposition, reflection, description" (NERD). The Yankees, Red Sox and Rangers had no idea what these terms meant, let alone how to use them in evaluating talent. This provided Beane's As with a much needed competitive edge from an analytical perspective.
Investing is no different. It is competitive. It involves winners and losers. And like Billy Beane, the average investor is playing against institutional investors with significantly more money and resources at their disposal.
If you invest in a company based solely on its price-to-earnings ratio, you've already lost. Because that data has been digested by every investor, so providing no competitive benefit. As the As developed different, more nuanced means of analyzing talent, so too must the investor who aspires to be better than average.
For instance, let's consider two little known yet theoretically effective measurements for valuing prospective investments that few investors have the willingness (or capacity) to determine. But, for those with time and patience, the result could be a better portrayal of an investments current value.
Realizing that many value stocks are often companies in distress, the Piotroski Score seeks to separate those distressed with good future potential from those more likely to be value traps. Based upon a series of nine criteria for evaluating a firm's financial strength, the stocks scoring highest outperformed a portfolio of all value stocks by 7.5 percent over a 20-year test period.
Conversely, those scoring lowest were up to five times more likely to file bankruptcy, or to de-list their shares.
The Altman Z-Score works similarly to the Piotroski Score in that it is a predictor of financial distress used by value investors. Altman Z-Score uses five ratios to predict the likelihood of bankruptcy within two years. It was found to successfully predict 72 percent of corporate bankruptcies two years beforehand. Only 6 percent of the time did it falsely predict a company's demise. Studies have shown the method to accurately predict financial distress 80 to 90 percent of the time.
Two unique, contrarian means of determining valuable probabilities capable of statistically stacking the odds in your favor. Why are they so valuable? First, they reveal a company's value with reasonable accuracy. Second, neither you nor most other investors have even heard of them.
Scarcity value dictates that a product or service has more value when demand is high but utilization is low. As in the case of these types of calculations. Everyone uses price-to-earnings and PEG ratios. Nobody uses Piotroski and Altman Z-Scores.
Beane would love them for their accuracy and anonymity.
Still, with no statistical edge, the average investor still prefers to imitate the Yankees. Buying big names on big news. Purchasing slick tech stocks with unknowable business models. Buying at the top. Selling at the lows. Running with the herd.
Moneyball showed that anyone willing to spend the time and effort can find an edge to exploit. If only briefly. Yet, it also showed that soon thereafter, everyone will adopt your successful metrics, rendering them much less successful. In which case, you'll endeavor to find new means of getting an edge.
In other words, those looking to succeed must continuously evolve. A truism in all of the games we play. Be it baseball, investing, or life.

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