Investing From the Ball Field

I just finished reading Michael Lewis' insightful, entertaining new book, Moneyball, and was struck by the many lessons for investors (as was Zeke Ashton, who shared his thoughts in an insightful column last month). Lewis tells the story of Billy Beane, the General Manager of the Oakland Athletics, and how he has built a team that has consistently had one of the best records in baseball in recent years despite having one of the lowest payrolls. Beane's secrets of success are very similar to those required in investing.

Exploit market inefficiencies
Knowing that he could never compete with deep-pocketed teams for the players with widely recognized talent, Beane recognized that he would have to exploit market inefficiencies to scoop up available, inexpensive players that were underappreciated by other teams -- the same approach that wise investors have used for decades: buying dollar bills for 50 cents. It's exactly what Tom Gardner does in his Hidden Gems newsletter. And like stocks, the market for baseball players -- while generally rational -- has significant inefficiencies such as "the scouting dislike of short right-handed pitchers, for instance, or the scouting distrust of skinny little guys who get on base. Or the scouting distaste for fat catchers."

Data vs. beliefs
Investor John Henry, who bought the Florida Marlins in 1999 and now is the principal owner of the Boston Red Sox, commented on how both baseball and investing relied on conventional wisdom and emotion rather than empirical evidence:

People in both fields operate with beliefs and biases. To the extent that you can eliminate both and replace them with data, you gain a clear advantage... Actual data from the market means more than individual perception/belief. The same is true in baseball.

Reluctance to abandon long-held beliefs
Numerous studies have shown that humans tend to cling to long-held beliefs or behaviors, even in the face of overwhelming disconfirming evidence. This is certainly true in baseball, as famed baseball statistician Bill James commented: "When I started writing I thought if I proved X was a stupid thing to do that people would stop doing X. I was wrong."

One might think that the clear, quantitative way of measuring investment success -- the returns -- might lead rational investors to abandon failed approaches, but my experience is that this rarely happens. Day traders who have lost half of their money don't suddenly switch and become value investors -- they tend to continue day trading until their money is gone.

Have the courage of your convictions
Beane isn't afraid to fail doing something unconventional, despite the risk of enduring barbs from fans and the media. This attitude gives him a big edge over other managers who, according to baseball analyst Pete Palmer, "tend to pick a strategy that is least likely to fail rather than pick a strategy that is most efficient. The pain of looking bad is worse than the gain of making the best move."

A similar dynamic exists in the corporate and investing world. Warren Buffett once wrote:

Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)

It can therefore be hard to buy stocks that the market has discarded. Take McDonald's (NYSE: MCD  ) earlier this year. The company had made many mistakes and was reporting dismal numbers, so analysts and the media were falling all over themselves to heap scorn upon the company. Not surprisingly, the stock hit its lowest level in more than nine years, falling from nearly $50 in 1999 to a low of $12.12.

I had a different view: I thought McDonald's was still one of the world's great businesses, and it was trading at a single-digit multiple of both earnings and free cash flow. Equally importantly, I was convinced that McDonald's new CEO, Jim Cantalupo, had the right strategy to fix the company, was urgently executing on it, and would be successful, so I had started buying the stock at above $16. It was hard to watch the stock continue to sink after I purchased it, and even harder to double my position near what turned out to be the bottom, but having that kind of conviction -- and the courage to act on it -- is critical to investment success.

Bet on proven winners
Baseball scouts and managers often squander draft picks and huge signing bonuses on high school players despite the fact that, according to Bill James, "college players are a better investment than high school players by a huge, huge, laughably huge margin." A similar dynamic exists in the investment world, where an overwhelming body of evidence shows that investing in IPOs and richly valued early-stage companies in hot sectors is a recipe for disaster, yet investors continue to do so, blowing their money in a reckless, naïve pursuit of good stories and quick riches. It's far safer and more profitable to invest in established companies with a proven history of healthy profits (at the right price, of course). Similarly, Lewis points out that the best predictor of a baseball player's future success is his track record: "A young player is not what he looks like, or what he might become, but what he has done."

Focus on what's important
One of Beane's assistants said, "What gets me really excited about a guy is when he has warts, and everyone knows he has warts, and the warts just don't matter." I feel the same way about investing: I love finding a company that is encountering difficulties, causing its stock to collapse, yet the problems are likely to be temporary.

David can beat Goliath
According to Lewis, Beane believes "that the market for baseball players was so inefficient, and the general grasp of sound baseball strategy was so weak, that superior management could still run circles around taller piles of cash." I think the same is true in the investment milieu. While one might think that the largest investment organizations could generate higher investment returns than small operations because they can hire countless analysts, commission in-depth research, buy the most advanced analytical software and so forth, my experience is precisely the opposite. I can only think of a small handful of mutual funds that I think are likely to beat an index fund over the next decade, yet I know plenty of small, even one-person, money management firms that I'm virtually certain will crush the market indices over time.

To be fair, size is a big handicap in the investment business, but that's not the difference. The key is that the investors I'd bet on are playing an entirely different game than the big boys: They ignore short-term volatility, macroeconomic forecasts, the quarterly earnings expectations game, statistical models, and other such nonsense. They simply scour the investment universe, waiting patiently for the market to make a mistake and provide the opportunity to buy a dollar bill for 50 cents.

Build a team
When the A's lost star first baseman Jason Giambi to the Yankees, Beane knew he could never find another player to replace him, especially given his tight budget. But he was not discouraged: "The important thing is not to recreate the individual," he said. "The important thing is to recreate the aggregate." So, Beane acquired three players that, together, had most of Giambi's desirable characteristics. In the same way, successful investing is more than just finding a few stars (which might flame out): The key is to build a diversified portfolio of solid stocks that will deliver strong gains in a variety of market environments.

Scuttlebutt
Having better information than your competitors is critical in both investing and baseball. Lewis described how Beane:

Flailed about, seemingly at random, calling GMs [general managers] and proposing this deal or that, trying to make a [big] trade. 'Trawling' is what he called this activity. His constant chatter was a way of keeping tabs on the body of information critical to his trading success: the value other GMs were assigning to individual players. Trading players wasn't any different from trading stocks and bonds. A trader with better information could make a killing, and Billy was fairly certain he had better information.

Five rules
Beane has five simple rules that guide his efforts to acquire players:

1) "No matter how successful you are, change is always good...There can never be a status quo. You have to always be upgrading."

2) "The day you say you have to do something, you're screwed. Because you are going to make a bad deal. You can always recover from the player you didn't sign. You may never recover from the player you signed at the wrong price."

3) "Know exactly what every player in baseball is worth to you. You can put a dollar figure on it."

4) "Know exactly who you want and go after him."

5) "Every deal you do will be publicly scrutinized by subjective opinion... Everyone who ever picked up a bat thinks he knows baseball. To do this well, you have to ignore the newspapers."

These are very good rules for investing as well -- especially 2, 3 and 5.

Conclusion
The key elements of successful bargain hunting tend to be similar -- whether one is trying to acquire undervalued stocks, baseball players, real estate, antiques, etc. -- so wise investors would be well served to study and learn from those, like Billy Beane, who are successful in other fields. Be forewarned, however: The strategies used by Billy Beane and Warren Buffett appear simple, yet they are far more difficult to embrace and successfully execute than they appear. Perhaps this is the reason that both men are so willing to share their secrets -- there is little evidence that a critical mass of people are adopting their approaches and competing with them.

Whitney Tilson is a longtime guest columnist for The Motley Fool. He owned shares of McDonald's at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Mr. Tilson appreciates your feedback on the Fool on the Hill discussion board or atTilson@Tilsonfunds.com. The Motley Fool is investors writing for investors.


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