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 second of five parts. Play ball!
Tom Gardner: Time for the first of the five tenets outlined in Moneyball that I find applicable to small-cap investing. I apologize in advance for the length of my questions, but I want to form a full idea to get your response. So, tenet No. 1 carried over from Moneyball to the stock market: Be Contrary. The mastermind behind all of this new thinking in baseball, Bill James, said, "Don't be an ape. If you challenge the conventional wisdom, you will find a way to do things much better than they are currently done." The net result is Bill James' decision to rebuild the scoring system for how to evaluate baseball players statistically, his Project Scoresheet.
The same thing happens in the financial markets, with accountants and strategic investors trying to build more accurate measurements of commercial success. So under this thinking, there's a reward for forcing yourself to rethink the scoresheets and statistical measures that the conventional investor applies to individual companies in the market. Do you see this as a carryover philosophy for investors -- namely, that there is value in even artificially trying to be contrary in order to reassess the way the whole game is being scored?
Michael Lewis: Yes. But I don't think it's exactly being artificially contrary. I see it as asking this question: If we weren't doing things this way already and we were starting afresh, would we do things this way? That's the sort of question that Bill James is always asking.
The thing about asking that question, if you develop a habit of asking it, is not only do you sometimes turn up real gems of new wisdom -- and you do; you find things that other people haven't found -- but it is also just tremendously more fun. Of course, in certain situations, your curiosity and hard work will only confirm that the conventional take is actual wisdom, is an effective way of viewing things. But that's fine, that's terrific, in fact. Because you can be more sure of it. You'll understand the first principles of things and that's what James is all about -- the first principles of baseball.
Here's an example. Bill James, all the way back in the early 1970s, starts asking questions about baseball statistics. He stumbles upon something like errors. Errors are used to measure whether a player is a good or bad defensive player. And James comes up with the radical notion that the errors statistic is complete baloney. Teams are judging all of their fielders by a system that is flawed. They're deciding who is a good defensive player on the basis of what a scorekeeper says is an error (a player mishandling a ball). But James forced everyone to ask: What is the easiest way to never get any errors? Just don't get to any balls. You can't mishandle any then! And anyone who does that is clearly a bad defensive player... someone who is too slow to even get to many balls. So he concludes that this clearly is an area where we need to rethink things.
But then he turns to pitching and concludes that the earned run average (ERA) is not such a bad way of looking at a pitcher. He does extensive work that only leads back to the conventional wisdom. It turns out there might be slightly better ways still, but in general, it's a good statistic. Nevertheless, the point is not just to find new things. No. You will not always find new interesting things in every case, whether we're talking about baseball or the stock market. Your goal must be to confirm the great measures, replace the poor ones, and capitalize on the loads of inefficiencies introduced by the underrating of smart conventions and the overrating of the many dumb ones.
Tom Gardner: OK, tenet No. 1 has officially been changed. It is not "Be Contrary." It is, instead, Make a Habit of Asking Why. Thank you.
Time for the second principle. I'll say: Stop Caring About Your Reputation. The traditions on Wall Street are perhaps not as immovable as those in baseball, but they exist. And when somebody is contrary publicly, it's human nature to reject their views. That's particularly true if the conclusion is not something that our eyes can see, not something that accords with the conclusions we've drawn through casual daily observation.
In Moneyball, I'm thinking of A's coach Ron Washington protesting how the front office was running the team, saying, "It's ludicrous what we are doing not stealing bases with Ray Durham." To him, it's absurd. To his eyes and experiences, you have to steal bases with a fast runner, but the applications of mathematics to the historical data of the game supports not stealing bases.
Michael, I see that happening on Wall Street in the love of traditional metrics like the P/E ratio, or the mainstream media's obsession with where the market is today, this hour, or any of a variety of habits that mutual fund managers form. A classic example comes from Peter Lynch, who wrote in One Up on Wall Street about his willingness to be contrary and risk his reputation buying Pep Boys (NYSE: PBY ) when other managers were out there feeling that they had to buy IBM (NYSE: IBM ) or General Electric (NYSE: GE ) -- to maintain their reputation.
Is there an advantage that can be gained for small investors in that they are not open to public ridicule? (At least from anyone beyond their spouse -- which I guess can be far worse!) But a money manager might resist a contrary stand if his reputation and even his job is on the line.
Michael Lewis: Yes. Here's the connection I see.
It is true in baseball. What you do is so public that if you draw different conclusions and take risks, you really are liable to ridicule. You're likely to be noticed and flogged and punished, unless you're instantly so obviously successful that people can't say anything. But in the money business, there are an awful lot of good money managers that can operate in obscurity. It depends on how they're managing money, what kind of funds they're managing, so on and so forth.
So, I would say that there is a general advantage for smart people in not being part of any well-structured industry. The best example is in the mutual fund business. If you are a mutual fund manager whose holdings are well known and who gets ranked every quarter or every day compared to the people in your asset class, then you're going to be subjected to unprofitable pressures. That's terrible. You're going to do things simply for the sake of appearance -- to maintain your job and avoid being mocked.
I would say if you're a smart guy or a smart person who wants to run money, the first step you would take, I think, is to structure your business so that you are not subjected to that kind of scrutiny or that kind of attention, because it is going to force you to act to protect your reputation. That will naturally create pressure on you not to do things on the merits, but rather to do things because that's the way people do things who are in this group.
Now, looked at from the opposite side, all of that reputational behavior creates inefficiencies. You've got this group of people that's pressured to behave like sheep. That creates opportunities in the market because they're all doing things together for uneconomical and wrong reasons, possibly creating distortions that you can exploit.
Tom Gardner: Taken one step higher, all the sheepish behavior is being shepherded. In baseball, you have Bud Selig or Joe Morgan, who having played shepherd to conventional behavior for so long feel particularly committed to the status quo. They have presided over conventional wisdom publicly, so they blindly fight to defend it.
Michael Lewis: Well, you find that in the money markets, too.
Tom Gardner: Give an example.
Michael Lewis: I hate to use this example because he is so successful, but Berkshire Hathaway's (NYSE: BRK.a, BRK.b ) Warren Buffett. My God. Warren Buffett has been a wonderful investor. He has been a wonderful influence on American life. But I can't believe Warren Buffett is always right.
And that means that if you can find a position that you can take with some conviction and certainty and it is the opposite of something that Warren Buffett is doing or saying, there is probably a huge opportunity in it. You may have to weather a little storm along the way. But with the markets following whatever he says and does almost instantly in a way that may be unprecedented in financial history, there are definitely inefficiencies being created.
Since the Internet bubble burst, he was right about that in a way. His reputation was already huge, but since what was it, January 2000 or thereabouts, his influence in the market has been out of all proportion to any wisdom that a human being could have. What he says is taken as pure gospel so there is an opportunity in that for someone.
Tomorrow: More tenets of small-cap investing.
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- Moneyball interview, Part I.