The Stock Market's Box Score: Part I
...the most overrated question in the country is, "How'd the market do?"
I was talking to a new partner about my two favorites, baseball and the markets, last week. He was a professional ballplayer and major league scout for the better part of four decades. Talking to him about baseball (he once threw a no-hitter using only two more pitches than Larsen's perfecto) and the quantitative system he revolutionized in scouting and then comparing it to the quantitative research system we have built, is as close to nirvana as I get. He convinced me to share an old book report I wrote. Yes the only thing extraordinary about me is my willingness to demonstrate what a geek I am. I write book reports, for myself, after every book I read. A good lesson for all us parents though, is to not give up too quickly on junior because I was a below average student at best, and a stick of dynamite was needed for me to finish a book report (after an important double-header most of the time). But here I sit today, doing them by choice. So, there's hope Mom and Dad, you too could have a closet-capitalist-geek and just not know it yet!
On a Bigger Field
What takes shape every single day in every kind of market, good or bad, are perceptions that viewers congregate around. We like to take a perception and break it apart, sorting out all the pieces of data first. We then examine the conventional wisdom, and agreed upon viewpoints under a different lens. We are looking for two distinct images: Will they prove accurate? And even more importantly, are the odds of their success or failure priced accurately? Many investors know the risk of being incorrect, but few consider the even greater risk that can come with being "correct." Looking for good ideas that are clear to see often prove surprisingly disappointing investments if they already had "good" prices asked for them. What may be visible to most people, even when true, can provide terrible payoffs because the common knowledge was already inside the price of that asset. So, being correct can cost even more money than being incorrect; that is the danger of agreement.
Understand up front that, from our perch, we view the Stock Market as neither good nor bad. There is no sector or style of investing that is necessarily more "risky" than another, as a rule. For example, an investor can lose just as much money in a bond portfolio as in a stock portfolio. What dictates investment success or failure is price, and price alone. You can lose just as much money buying a great company at the wrong price as you can by buying a terrible company. Therefore, the key ingredient in striving for success is to not only understand a business, but to understand a stock, and its own customers – investors. Let me explain how this overlooked group can create value…
MoneyBall is the name of the last book my partner and I each reviewed. I finished it off between the burps of midnight feedings, while Mike flipped the pages into the breeze on a beach in Gulf Shores, Alabama. Thankfully, our partnership is stronger than my recent jealousy. The book had absolutely nothing to do with investing, yet came closer than any we have ever read in describing how we approach money management. The vocabulary for the book was from one of the two most beautiful languages in the world: baseball statistics. We will translate it here back into the other, a box score with a little more riding on the outcomes: the Stock Market.
The background to the book needs to be explained for baseball and non-baseball fans and should interest each because the comparison to the Stock Market will follow. A few years ago, a blue ribbon panel was assembled to address the economic landscape of Major League Baseball's completely un-level playing field for its competing teams. With no salary cap, rich teams could buy the best players. Money was seen as the only problem and the only solution. The Commissioner of Major League Baseball, Bud Selig, said that a team like the Oakland A's "…can't compete. They're not viable without a new stadium." The majority of the panel agreed that poor teams needed more money for better players, and the rest of the country agreed. There was only one dissenting opinion on the entire panel, cast by the only voter with a financial background. It was the former Federal Reserve Chairman Paul Volcker who asked, "If poor teams are in such dire financial condition, why did rich guys keep paying higher prices to buy them?" Another little noticed item drew some curiosity from the panel as well. "If poor teams had no hope, how did the Oakland A's, with the second lowest payroll in all of baseball, win so many games?"
The fascinating answers to that second question were explored in this book Moneyball, written by Michael Lewis, one of our favorites for many years but who had no knowledge of baseball before this story captured his interest.
If the conventional wisdom in baseball were correctly assessing the value of ballplayers, then all of the best talent would be bought up by the rich teams, and the Oakland A's would not stand a chance. Yet they not only stood a chance, they won. Why?
In a parallel story that we write every day in the Stock Market, if prices rationally reflect all known information then stocks would theoretically trade efficiently based on those fundamentals. Yet, in our opinion, they do not. Why?
Let us explain, using a couple of lines and lessons from a few guys that were discussing their own investing disciplines throughout this book (quotes from the book are in italics), along with the translation onto the pages of our own playbook.
"Too many people make decisions based on outcomes rather than process."
Source: Moneyball, Michael Lewis
The author described sitting with the Oakland A's General Manager Billy Beane: "I'm watching the whole game, and responding the way an ordinary fan responds. I'm looking for story lines and dramatic events and other fuel for my emotion. They (Beane and staff) are watching fragments – not the game itself but derivatives of the game – and responding, so far as I can tell, not at all." Beane will not sit in the crowd to watch the team that he built. Instead he has a remote office in the bowels of the stadium from which he monitors the game, not on television, but rather from a direct feed from a camera above centerfield with the only clean look at the strike zone.
The Market's Translation:
Investors who read about the Stock Market being up or down 100 points, and believing their investments had a "good day" or a "bad day" are focusing on the outcome, and a misleading one at that. We believe the most overrated question in the country is, "How'd the market do?" The notion that the market had a good or bad day would confirm a very bad seat amongst the crowd. Before you confuse us with contrarians who strictly go against the crowds, my partner correctly created a word that better describes our money management: Apatharians. We have no feelings about what we are watching with investments.
It takes a strange bird to occupy such an anonymous perch, where there is no room to flap your wings. Beane could watch games objectively though. It would seem his peers would do the same, with a camera angle and monitor to focus on each pitch, watching the process of each piece inside the puzzle put together the outcome. But instead you are almost certain to find the majority of his fellow general managers sitting in a sky box watching the game waiting to see the outcome with the rest of the crowd. With possibly the worst angle to see the game, could it be to afford them the best angle with which to BE seen? There are different perches for different birds, but this proves the notion that all of the best information is factored in to a market's price of a ballplayer or a stock is simply not true. In other words, they are not all looking at the best information, even when it is available.
"Traditional yardsticks of success for players and teams are fatally flawed."
"The naked eye was an inadequate tool for learning what you needed to know."
Source: Moneyball, Michael Lewis
A good portion of Beane's advantage is described as simply doing better homework. After graduating from Harvard, one of his assistants input the raw statistics of every baseball game ever played in the 20th century into their computer to analyze what most correlated with winning and losing. Think about how much sense this makes, yet realize that for those 100 years, assumptions trumped these facts that had never been compiled. The study proved that almost all of the widely-followed statistics in a game of baseball never consistently correlated with which team won or lost. There were two striking exceptions: on-base percentage and slugging percentage. Simply having players getting on base any way they could, and having players making each successful contact count as much as possible, were the two Holy Grails. These two measurements proved superior to all others yet they are not followed as closely as the more popular statistics like batting average, runs batted in, and speed. These three were not only inferior indicators, but the players who possessed them became over-priced because everybody was bidding for the same wrong things.
The Market's Translation:
It is our belief that, just as in baseball, managers in the Stock Market rely on statistics that often do not help them. In our experience, the two most often used are P/E's and Earnings. Over time, it has been difficult to prove the ability of either to give you a consistent edge in predictive power. Yet, until the end of time you will always read about stocks with "low P/E's" and stocks with "better earnings growth" even though this data may not help performance when managing money. The only thing worse than owning something that does not work is paying dearly for it. Investors pay premiums for the assumptions of conventional wisdom since they all end up bidding for the same stocks.
Going back to on-base-percentage, think about why that works in determining success far more than even the industry experts of baseball realize. That statistic is not derived from what you did. Rather it is calculated from what you did not do – make an out. So, the most valuable players are often the least noticed because wins and losses are not determined by great hits, but by the ability of each player to avoid outs.
It works the same way in the Stock Market where losing hurts you more than winning helps you. Many people are willing to accept the risk of losing 50% if they can make 80%. But instead of looking for that kind of hit, do the math. $100,000 is worth $50,000 before becoming $90,000. You are not up 30%, you are down $10,000. Few investors consider that losing might hurt them more than winning helps them. But, that is the camouflaged truth and it will remain invisible in plain sight until a vaccine is developed for a debilitating disease called human nature.
Check out The Stock Market's Box Score: Part II
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