Numbers game: Baseball's lesson for 'story' investors

Numbers game: Baseball's lesson for 'story' investors

Heydon Traub, Boston Business Journal, August 22, 2003

I usually don't mix in too much baseball talk in these investment columns, but it has been almost five years since I combined the discussion of my two favorite topics: baseball and the stock market. In the late 1990s, they were both breaking records. The market was hitting new highs regularly (and with record volume) while Mark McGwire and Sammy Sosa were setting home run records.

Things have changed in a big way in five years. The stock market is nowhere near record levels, and the S&P 500 is actually lower now than when I wrote my last baseball/stock market article in September 1998. So a discussion about the use of statistics and numbers, both well suited to stocks and baseball, seems appropriate again.

I just finished reading "Moneyball" -- even the title combines the subjects of money and baseball -- written by Michael Lewis, whose first best seller was "Liar's Poker" an insider's view of Wall Street, and in particular about the venerable Wall Street firm Salomon Brothers, now part of Citigroup.

"Moneyball" details the Oakland A's unorthodox system of scouting, player evaluation and overall strategy to consistently build a competitive team, despite paying one of the lowest payrolls in baseball. The organization focused on such things as examining data to determine which statistics were the best predictors of runs scored and what data was important in predicting which high school and college players would succeed in the majors. This book came incredibly close to being of greater interest here in Boston as Billy Beane -- who appeared to have accepted the general manager job for the Red Sox but later declined -- is the GM in Oakland and the driving force behind the A's adoption of this unusual approach to running a major league ball club. (Interestingly, who was it who recruited Beane to Boston? John Henry, the Red Sox owner who amassed his wealth by using quantitative analysis applied to the investment markets.)

Baseball bears some thought-provoking analogies to investing:

Scouts often fall in love with potential. Baseball talent scouts can quickly fall in love with the young player who has the intangible "look" of a great athlete, and often those who have great speed or a great throwing arm. This is especially true for a high school kid who is still raw. Scouts can build the case that they can further develop skills where they are weak. This essentially leads to drafting players based on their potential to become great even if they aren't great today. This is equivalent to those investors who fall in love with a stock based on its potential to become a great business and stock. We need look no further than the Internet mania to take this to an extreme. The reality is that most unprofitable, high-growth, exciting companies flame out, just as great high school prospects often do.

Scoring runs wins games. Beane has come to the conclusion that the most important thing to winning games is, not surprisingly, to score runs. And the most important statistical predictor of runs scored -- even better than batting average or home runs -- is on-base percentage (a ratio that roughly measures how frequently a player reaches base via a hit, a walk or being stuck by a pitch). Beane, for the most part, scrapped the "qualitative" scouting reports and focused on the numbers, looking for college players with high on-base percentages.

In stocks, you can forget the exciting stories of how some new company will be the next Microsoft, and ignore the media and Wall Street stories touting promising upstarts. Many successful stock investors look at the factors that have led to good returns in the past. Returns are driven by a company's ability to generate earnings, the ability to grow those earnings and the price you pay.

Essentially, you can usually earn better returns with boring stocks than the highflyers. This is borne out by the fact that, over the long run, value stocks -- those trading at low price-to-earnings ratios -- have done better by 1.5 percent per year than growth stocks (those trade at higher p/e multiples).

The average attracts. Bill James, as quoted in "Moneyball," says, "There exists in the world a negative momentum." Add to that the corollary, "Psychology tends to pull the winners down and the losers upwards."

James is talking about baseball, but his contention certainly apply to stocks. Companies that have done exceptionally well and have grown, say, 50 percent per year cannot grow that fast forever. If business is that good, new competitors show up, or new customers cannot be found at the same rate. Companies that have done poorly have incentive to make changes to improve things and often do. But often stock investors assume the recent past will continue indefinitely.

There is a significant minority of investment managers like myself, known as quants, who primarily focus on the data and who employ quantitative analysis to pick stocks. Their view is that spending much time meeting with company management -- how often do you think management doesn't put a positive spin on their outlook? -- and reading media reports introduce too much emotion into the process. Many small managers who are quite successful use this unemotional approach. In investing, as with baseball, more staff and money spent on research and portfolio managers does not necessarily equate to better results.