Some call it the best business book out there. Michael Lewis is the author of the best-selling Moneyball , a look into the roaring recent success of the Oakland A's baseball team gained through its 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-cap Hidden Gems . And since this is World Series week, we think it's a great time to share this with you. This is the third of five parts. Play ball!

Tom Gardner: My third carryover philosophy between value investing and the Moneyball take on baseball is a willingness to Embrace the Unloved. That means intentionally looking for bargains among merchandise with fixable problems or impermanent damage. Here I am thinking of the A's, as you repeatedly outlined, looking for players with something wrong with them, shopping for the secondhand engagement ring in Reno.

The great value managers pursue fallen angels, too. Think of someone looking for sound companies that missed a single quarterly earnings target. Everybody hates them the hour of the announcement and the day later. But all that negative sentiment can create opportunities. Not in every instance, but frequently. So if you methodically try to find unloved, temporarily damaged companies, mastering how to distinguish them from the permanently damaged companies, there are some beautiful investment opportunities there. Does the theory carry for you?

Michael Lewis: Yes, and you have got to accept that sometimes you're going to be wrong and you're going to mistake a permanently damaged company for a temporarily damaged one. The Oakland A's make that mistake sometimes as well. But, yes, if you can find companies or baseball players that are irrationally unloved, you'll get a great price on them. Missing earnings targets is a great example because really, quarterly targets are a very poor measure of a company's long-term viability.

So if the market is indeed punishing some company for simply missing this number, my God, that can be a huge opportunity. I don't know whether it's true that that happens. I hear it is true, but I don't know if the market behaves so stupidly.

Tom Gardner: Well, a classic example of a company that I've followed and recommended in our Stock Advisor newsletter is Trex (NYSE:TWP). They make outdoor decking out of recycled materials. After the hurricane season last year, they had a bad three-month period because, in a few primary markets, nobody was building decks in driving rainstorms. They had terrible earnings. Their stock got killed, down 30%-35% over a one-month period because short-term thinkers didn't want to wait for earnings to snap back. Classic temporary damage. I recommended it right then. It's been a beautiful performer since.

Michael Lewis: You know, that makes complete sense to me. And you know what? The other aspect of this issue is it isn't just finding companies that are temporarily unloved. The Oakland A's have found players and succeeded with players who continue to be unloved even though they've performed spectacularly by any standard. They are unloved just because of the way they look or because of the quixotic way they play the game. The rest of baseball doesn't fully understand and appreciate them, even though their performance is excellent. So, let's say this is the company that, if you can find such things, generated earnings at a remarkably steady and high level and that was forever underpriced because of something unusual in their approach to business.

Tom Gardner: Well, try this one. I really enjoyed Sam Walton's account of Wal-Mart (NYSE:WMT). And what happened there? Early on, the Wall Street analysts and investment banks just ignored them. When Wal-Mart was planning to go public, and even in the years after it went public, it was unloved -- in Walton's opinion -- because Manhattan's moneymakers concluded that these guys were just a bunch of hillbillies from Arkansas.

Michael Lewis: There you go!

Tom Gardner: Hillbillies just flipping inventory out onto the sidewalk trying to sell it. Even though their numbers were good, one of the greatest investments in history went unloved for a long time because Wall Street felt certain that retailers from Arkansas couldn't beat the veterans at Kmart (NASDAQ:KMRT), with tremendous resources back then and an enthusiasm for the superstore game.

Michael Lewis: There you go. That is a perfect example. Especially the bias against the hillbillies. That is a great example of a marketplace ignoring excellent performance because something doesn't look normal.

Tom Gardner: OK, our first three carryover theories are:

  1. Make a Habit of Asking Why
  2. Stop Caring About Your Reputation
  3. Embrace the Unloved

The fourth tenet is to Figure Out What to Count. Figure out what the numbers are telling you. This applies to everything from valuation to looking at slugging percentage or on-base percentage in baseball instead of the flawed traditional measure of a player's batting average. For investors, I'm comparing that to focusing on cash flow rather than earnings. Or following rates of return on equity rather than caring about what the company's stock price is doing this month. So I think a lot of investors don't yet really know what to count, and I'm wondering if you think that carries over.

Michael Lewis: This is the thing. In most spheres of life, most people don't know what to count. In baseball, the problem isn't that people aren't counting things or that they are not quantitatively inclined. They are. It's that they are counting the wrong things. They make a fetish of certain numbers because they get told that this is important or that is important.

In baseball, people were told for generations that batting average was what was really important. Well, it turns out that when you actually ran historical studies to determine what correlated highly with a team's run totals, batting average was very low on the list. Imagine that! And that's because you have these teams that have high batting averages who never get on base with walks and who don't hit for power. Compared to a team that had a lower batting average but walked a whole lot and hit home runs, they weren't on base as much so they weren't scoring as much. A fetish was made of the wrong number. It's been that way for decades in baseball and persists even today. And this created a huge opportunity for the Oakland A's.

Naturally, there must be fetishes in the financial markets, too. Maybe they were made of either hitting earnings targets or of targeting particular price/earnings ratios or whatever it is that is fashionable and unscrutinized. Of course, there are intelligent fetishes, which help accurately measure the health of a company. But if it hasn't been scrutinized, who knows! Investors, just like baseball's general managers, have to start asking and continue asking if there is some better number, some better way to measure how a company is doing.

Tom Gardner: Time for my fifth and final tenet: Study Patterns in History. You have Paul DePodesta, now the general manager of the Los Angeles Dodgers, advising analysts to look at process rather than outcome. Study why teams win throughout history. Find the patterns that matter and emulate them.

In investing, the equivalent would be studying why companies win. Apply regression analysis and probability theory and seek patterns. Michael, I'm thinking specifically here about how difficult it can be to embrace the idea that everything is not new. We want to believe that it is.

You confess at one point in Moneyball that your problem is that you keep seeing every player and every situation as unique whereas Billy Beane and folks like him are seeing patterns that have evolved into trends over very long periods of time that enable the seer to make pretty accurate predictions about the future productivity of baseball players. There are investors using patterns as well, carrying this out methodically in a fairly private way, able to see the market as much more predictable because they have studied process in history rather than thinking that everything is new and being obsessed with immediate outcomes. Do you agree?

Michael Lewis: Yes. Let's take an example in baseball, since I just mentioned on-base percentage (which factors walks alongside hits). Two years ago, when I was hanging out with the A's, they got a guy named David Justice for a final year before he retired. All of baseball thought he was basically washed up, that he'd gotten too old. But the A's looked at him and factored in that he had been hurt the previous year. So they realized that some of the data there was possibly misleading. But then they looked at the kind of hitter he was throughout his career. He was a hitter who drew lots and lots of walks.

One of the things they found by studying process, by analyzing statistical patterns in player behavior over decades, is that that kind of hitter -- a hitter who walks a lot, a power hitter who walks a lot -- as he ages and as his career starts to fall off that cliff, yes, he doesn't hit as many home runs, but he continues to walk usually even more than he has walked before. Maybe because he can't run!

They knew they were going to get a high on-base percentage out of this guy and that that was very valuable. Whereas most baseball people just thought, "Here's an old guy with no value left." No one wanted him. But Oakland could see they could squeeze the last few ounces of on-base percentage out of him, something that would help them score more runs and win more games, which they did quite nicely. How did they find him? They found him because they didn't view him as an individual; they viewed him as a type that they recognized and valued.

So there must be, I agree, people in the stock market who think in terms of companies as a type. Sure, each company is unique in some ways, but each company is also a type. Investors have to look for the patterns. I would say the equivalent in the stock market for David Justice's final year would be companies that are going out of business but where there is still asset value.

Tom Gardner: Right. There is actually a recommendation in Hidden Gems by one of our guest analysts of a company named Arch Wireless (NASDAQ:AWIN). It's a paging business that is just gradually losing its subscribers to cell phones and other means of communication. But doctors still have uses for pagers and so they are actually very, very cash-flow positive. However, the profits are steadily dwindling. To carry the analogy over, they are still very productive relative to the average baseball player, but there aren't many years left. You can see an end point on the horizon and so the market doesn't know what to do with that valuation.

Michael Lewis: That is right. If the market doesn't know and the market misvalues it, it probably doesn't understand it and likely undervalues it. There is an opportunity for someone who understands how to milk the last few years of good earnings out of this company. So, yeah, I think there is a clear analogy there.

Tomorrow: Buffett and the Superinvestors.

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