Some call it the best business book out there. Michael Lewis is the author of the best-sellingMoneyball, a look into the roaring success the Oakland A's baseball team has achieved recently through contrary thinking and unconventional means. Tom Gardner found the lessons from Lewis' book quite applicable to general stock investing and very relevant in his search for undiscovered, unloved, and undervalued small-capHidden Gems. And since this is World Series week, we think it's a great time to share this with you. This is the first of five parts. Play ball!
Tom Gardner: Michael, I recently completed an interview with a small-cap money manager focused on value investing. His name is David Nierenberg; he's out in the state of Washington. He's had extraordinary returns through the difficult bear market. In our conversation, I asked him what his favorite investment books were. Here's the beginning of his reply:
"This is a very strange answer, but the favorite book around here among all three of our investment partners is a book about baseball called Moneyball by Michael Lewis. We think Moneyball may be the best business book that we have ever read."
Michael, why do you think that he and others believe that in your analysis of the game of baseball, you've ended up with an outstanding book on business and investing?
Michael Lewis: Well, Moneyball is about how the Oakland A's, on a low budget, win so many baseball games. The way they've done it is by finding value in players that other people have overlooked. And the way they do that is actually rather complicated. It involves a sophisticated and, in some cases, original use of baseball statistics to measure a player's performance. What they've had to do in Oakland, out of economic necessity since they are a small-market team, is to question all the traditional statistics that get used to evaluate players. They've challenged the traditional measures, asking if they really are a good way to measure what a particular guy brings to a team and how much he contributes to winning.
Believe it or not, the answer in most cases is "no" -- traditional measures are not very accurate. It turns out that you can find much better ways to measure value, if you approach the game unconventionally. And once you've done that, you can find value that other people haven't.
Now, what about the connection between this and an investor buying stocks? Well, it's just what your investors are trying to do, looking to find value that the market has not seen. Because if it has seen it, then it's already priced it accordingly. So there's the first point of inspiration.
Now, take that a little further. What academics say about the stock market is that you can't find any opportunities. That the market is efficient and therefore all value is appropriately priced. There is some truth to that, but only some truth. I think the reason that Moneyball resonated so much with stock market investors is that the asset that the Oakland A's are evaluating, baseball players, is just like any other asset, like stocks. And naturally one would think that the value of baseball players would be perfectly understood by now. After all, this sport has been around for 100 years. You've had generations of experts who think they know what they're doing, writing articles teaching people how to value these players. The players have statistics attached to their every move.
Tom Gardner: And there are 50,000 people watching them on the field and millions watching them on television. You would think they'd be efficiently priced, like a General Electric (NYSE: GE ) or Coca-Cola (NYSE: KO ) .
Michael Lewis: Yes, exactly. Who would've thought that there would be so many unseen hidden values in baseball players? So I think my study of that excites the imagination of a money manager because he thinks, "Look, if this is true of baseball players, it's probably true of everything." So there is definitely opportunity and inefficient pricing in baseball players and in stocks.
Tom Gardner: Having studied both, do you have an opinion about which market is more inefficient, the stock market or the market for baseball players?
Michael Lewis: Well, here's exactly what I shouldn't do: give you a gut-feel answer. But my gut tells me that the market for baseball players is more inefficient, only because I've been around money managers for years. I worked in that business, the money business. Now I've been around professional baseball people. And I think professional baseball people have even less aptitude than money managers at valuing things.
Also, baseball is simply more hidebound. There are traditions in baseball more powerful than those in money management. These traditions constrain people from thinking differently about their market. People get punished for being original in baseball. The baseball organizers are a kind of club; if you think differently about baseball players, you get ostracized. So there are forces at work in baseball that create these distortions in value.
However, I don't think the stock market or any market is perfectly efficient. A market is a human construct. It's made up of human beings making decisions in the way human beings make decisions. And that's as true of the stock market as of any other market. Human beings often make irrational decisions. Those who can see through that irrationality and emotion have and will always have an opportunity for superior returns.
Tom Gardner: Michael, I've written down five tenets outlined in Moneyball that I find applicable to small-cap investing. Hidden Gems has a bent toward small-cap value stocks. Despite the inevitable occasional loser, I've had good success with stocks like FARO Technologies (Nasdaq: FARO ) and Middleby (Nasdaq: MIDD ) . Statistical research by Dimensional Fund Advisors and others on these four groupings of common stocks (small and large, value and growth) consistently shows that over long periods of time small-cap value stocks are the best-performing class.
Those studies had me nodding again and again through Moneyball, seeing in the approach of Billy Beane of the Oakland A's a common philosophy with the great small-cap value managers. Together, they're looking for the unknown, because with fewer people bidding in an auction house the chances of getting attractive prices improves - whether you're buying stocks or ballplayers or antiques, for that matter.
And similarly, the A's are looking for the unloved, the forgotten, or discarded. You noted that General Manager Billy Beane's job when he first came into the front office was to go out for Sandy Alderson and the A's and find minor league players that were unknown, unwatched, and grossly undervalued. This is the foundational philosophy of the classic small-cap value manager.
Michael Lewis: You know, I think that is right. When you asked me generally about the financial markets, there are markets within the financial markets that are clearly less efficient than other markets. The market for large cap stocks, for the famous stocks listed on the New York Stock Exchange, I am sure that those are more efficiently priced markets than the market for small-cap stocks.
Similarly, anytime you have a new class of asset on Wall Street, like interest-rate swaps were or futures and options once were, whenever some new investment vehicle gets invented, for some period of time the market for those assets tends to be grossly inefficient. People haven't got their minds around them. So I think, yes, there's no question that within the financial markets, there are markets that are especially poorly understood and badly valued and I am sure that small-cap stocks are on that list.
Tomorrow: Five tenets of small-cap investing.
Tom Gardner publishes dozens of CEO and investing expert interviews for Hidden Gems members. Click here to read about our 30-day no-risk free trial.