Just like superior investors, superior football general managers -- such as Scott Pioli of the New England Patriots -- look for value, not hype. Take a look at what round of the NFL draft several superstars who helped the Pats win three of the past four Super Bowls were picked in:
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Tom Brady, Round 6
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Tedy Bruschi, Round 3
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Kevin Faulk, Round 2
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Troy Brown, Round 8
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Patrick Pass, Round 7
The Pats have proved that you can build a dynasty by finding late-round values, not by overpaying for unproven first-round college stars. But why can't other teams replicate that model? It's because the other NFL franchises have yet to escape from three biases -- overconfidence, expectation inflation, and false consensus -- that Duke University professor Cade Massey and University of Chicago professor Richard Thaler found behind the draft.
These biases are behind bad stock picks as well. And if you escape them, as Pioli has, you can put championship potential in your portfolio.
Bias No. 1: Overconfidence
Information is good, but more information is not always better. Decision makers must be careful of overconfidence.
In football, the best draft pick is not always the guy with the fastest 40-yard-dash time or the highest vertical leap. As Massey and Thaler found, although that lightning-quick leaper will always command top dollar as a first-round draft pick, he may not help your team. Remember Ryan Leaf? He was drafted No. 2 overall by the Chargers in 1998. In 1999, Leaf used his "superior arm strength" to throw 15 interceptions and only two touchdowns.
Overconfidence got the best of many Build-A-Bear Workshop (NYSE:BBW) shareholders. The timing of the company's IPO was perfect -- shares were quickly bid up as investors overweighted the most current data. But the premium investors paid to jump aboard the Build-A-Bear ship hasn't really worked out for them. The company's sales continue to grow, but that's a result of expansion; same-store sales are horrible.
Investors would have been better off picking up shares of a less-hyped market beater such as Guitar Center (NASDAQ:GTRC). Since the day Build-A-Bear went public in October 2004, Guitar Center has continued its steady growth, rising about 27%, while Build-A-Bear shares have shed about 12%.
Bias No. 2: Expectation inflation
First-round draft picks are often expected to deliver the goods within months of joining the team. Fans want Pro Bowls, playoff berths, and above all, Super Bowl victories. As a result, many executives and fans become disappointed with their one-time "savior." Not so for the Patriots.
Despite several stellar seasons, running back Corey Dillon wore out his welcome in Cincinnati. He cost too much to keep and wasn't delivering wins. The Patriots gladly added him to its backfield, and Dillon was a vital part of last season's Super Bowl victory.
Cabela's (NYSE:CAB) recently went public to fund its growth plan as it changes from a catalog-based business to a store-based business. The stock has trended downward since last year's IPO.
How will it perform as a retailer? How much capital will it need? Will Sportsmen's Guide (NASDAQ:SGDE) get stronger as retail stores cannibalize Cabela's catalog sales? Will same-store sales grow as it competes with Bass Pro Shops and Dick's Sporting Goods (NYSE:DKS)? Why haven't margins increased faster? And why does its credit card business seem to be the only thing growing?
The questions mount up quickly. After the IPO, I think inflated expectations haven't been met and the stock has declined as a result. Down the road, Cabela's will likely be a retailing force for two reasons: loyal customers and a low cost structure due to owning its buildings and the land they sit on rather than leasing them.
Bias No. 3: False consensus
False consensus is the tendency to believe that others are thinking and behaving very similarly to the way you are. As a result, people overestimate the value others put on the investment. In football, it's almost like paranoia: someone is going to come in and snatch your pick away. So you pay up to make sure you get what you want. According to Massey and Thaler, a great example of false consensus comes from the 2004 draft, when the New York Giants paid a steep price for quarterback Eli Manning. The assumption was that the rest of the league wanted Eli Manning just as much as the Giants did.
Personally, I think the boys at Google (NASDAQ:GOOG) are amazingly smart for using the notion of false consensus to their advantage. Before its IPO last year, slews of people wanted to own a piece of Google, and management exploited that with its Dutch auction. Since then, investors keep bidding it up with the thought that someone else will come behind them and do the same. I see false consensus like the great fool (lowercase "f") theory: the belief that there is always a bigger fool out there you can sell to. Don't get me wrong: Google continues to post amazing numbers, and there's no shortage of ideas about where to reinvest the cash. But as time moves on and the price goes up, the probability of missing expectations gets a bit higher. And if Google misses expectations, the last buyers are the ones who will be hurt the most.
The winner's curse
When multiple bidders vie for a player or company of uncertain value, the eventual winner will always overpay. And overpaying inevitably leads to diminishing returns -- or in the case of the NFL, luxury taxes and salary-cap constraints.
The solution? Never overpay. At Motley Fool Inside Value, lead analyst Philip Durell always calculates the fair value of his picks and recommends a buy-below price that gives investors a margin of safety -- and the opportunity for outsized returns. That same value mindset has helped the Patriots control salaries during their championship run, and it can help you beat the market for years. Philip's Inside Value recommendations -- boosted by the likes of Omnicare (NYSE:OCR), which is up 56% since it was picked, and MCI, up 42% -- are on average outperforming the S&P 500 Index 12% to 3%.
To learn more about Philip's value strategy and the stocks that make the cut, join us for a free 30-day trial to Inside Value. There's no obligation to subscribe, and a trial includes access to all back issues and previous picks, mid-month reports, and the Inside Value discussion boards, where Philip posts regularly and where you'll find hordes of like-minded investors sharing wisdom, ideas, and analysis. Click here to learn more.
Fool contributor David Meier does not have a financial position in any of the companies mentioned. The Motley Fool has a disclosure policy.
