17th August 2009
“If you can't beat them, arrange to
have them beaten.”
George Carlin
What does professional baseball have in
common with the stock market?
More than you might think. Research
Affiliates Rob Arnott, writing in last week's FTfm supplement, points
out the tendency of the stock market to routinely overprice prospects
for "growth” stocks at the expense of their "value”
peers:
“In the past, did the market overpay
for growth and over-punish struggling companies?
Yes. While premium
or discount valuation multiples are correlated with future growth or
future disappointment, the premium paid for the winners and the
discount assigned to the losers is too great.. the market pays an
average of about 100% premium for [companies with lofty growth
expectations], relative to [companies with poor growth expectations].
The market overpays for future growth – relative to its ability to
correctly anticipate that growth – by about two to one..
The market
discerns which companies are likely to do best and then overpays for
those future prospects..”
As Arnott says, this forms the basis of
the so-called value effect, the apparent anomaly whereby the stocks
of companies with low price / book and similar ratios tend to
outperform the stocks of companies with metrics pointing to high
confidence in dramatic future growth. But Arnott also points out the
extreme valuations now present in the market. Growth stocks are no
longer priced at “just” twice the valuation multiples of value
stocks; they are now priced at a 2 ½ times multiple;
“The market has so punished value
stocks in the market crash of 2008-09 that, even after a lofty
rebound since early March, the spread between growth and value is
wider than at any time in past years, with the sole exception of the
tech bubble in 2000. Either the market is right or the market is
overconfident in its ability to discern future growth opportunities.
If the latter, what a time to buy value stocks. And, what a terrible
time to bet on growth.”
Of course, it is entirely feasible that
the prices of all stocks might depreciate over the short to medium
term if growth expectations for the broader economy are frustrated.But in a (future) bear market environment, it is at least entirely
plausible that "value” will hugely outperform "growth”,
even if that means incurring a smaller negative return as opposed to
a more modest positive one.
But it would also seem that, in the
absence of conclusive evidence of a sustained economic recovery, the
premium being paid for "growth” stocks is more than usually
unwarranted – by anything other than the madness (or inherent
tendency to overconfidence) of crowds.
So where does baseball fit in to this
"growth” versus "value” debate ? In an absolutely
fascinating book called "Moneyball: the art of winning an unfair
game (W. W. Norton, 2004), former Salomon Brothers bond salesman
Michael Lewis shows how one of the poorest teams in American
baseball, the Oakland A's, under the leadership of its
anti-establishment general manager, Billy Beane, and his unorthodox
approach to buying talent – at deeply discounted prices –
managed sustainedly to outperform rivals with far bigger payrolls.
It admittedly took this correspondent
years to get round to reading "Moneyball”. Blame a complete
lack of interest in American baseball, for starters. But if you are
similarly afflicted and can hop over this minor hurdle, "Moneyball‟
repays the effort, in spades. Take Tom Wolfe‟s verdict, for
example:
“What does it take to turn a subject
like baseball statistics into a true-life thriller not even a
baseball-loathing bibliophobe could put down?
Answer: saturation reporting,
conceptual thinking of a high order, a rich sense of humour, and
talent to burn. In short, Michael Lewis. "Moneyball' is his
grandest tour de force yet.”
No synopsis of this marvellous book
could hope to do it full justice, so of necessity we can only
hope to share a tiny distillation of its rich savour here. The
essence of "Moneyball” lies in assessing the state of play of
a sporting industry – baseball – and the way it deploys its
financial resources, and then scrapping the conventional rulebook
entirely. In the view of "traditional” talent scouts, for
example,
“you found a big league ballplayer by
driving 60,000 miles, staying in a hundred execrable motels, and
eating God knows how many meals at Denny's, all so you could watch
200 high school and college baseball games inside of four months, 199
of which were completely meaningless to you.”
Then, fuelled by bloated payrolls and
oversized buying power, the bigger name baseball teams would impose a
relentless salary inflation upon the sport, taking their pick of the
supposed stars but driving up every other team's operating budget in
the process. (This sounds unerringly similar to the state of UK
professional football, with the key distinction that, Manchester City
apart, the most grotesquely moneyed teams are actually winning.)
Not blessed with an overabundance of
financial resources, Billy Beane and the Oakland A's are obliged to
cut their suit to a different cloth;
“Many of the players drafted or
acquired by the Oakland A's had been the victims of an unthinkable
prejudice rooted in baseball's traditions. The research and
development department in the Oakland front office liberated them
from this prejudice, and allowed them to demonstrate their true
worth.”
While "Moneyball” centres on the
role of Oakland manager Billy Beane, there is an exotic supporting
cast of near-grotesques. Like the overweight batter Jeremy “never
met a pizza he didn't like” Brown, with a physique not exactly
designed to sell jeans, for example; or pitcher "Country” Chad
Bradford, who throws underarm.
But this is really the point.
Appearances can be deceptive.
Big name teams routinely overpay for
high athleticism or seeming physical perfection; but what really
matters, as Beane discovers, is “the ability to control the strike
zone” – only to swing at pitches that can be hit well, and to
leave all the others well alone.
Everything else – “sacrifice
bunts”; “stolen bases”; pitching; fielding; their significance
is over-rated (and consequently overpriced) by traditional
practitioners of the sport.
And the "investment philosophy”
adopted by Beane has its origins in work done by Bill James and
other “sabermetricians” pursuing the work of SABR, the Society
for American Baseball Research, a loose confederation of amateur
statisticians tasked with replacing misleading baseball stats with
genuinely informative ones.
Don't know your batting average from
your on-base percentage?
Michael Lewis / Bill James / Billy
Beane and the success of the Oakland A‟s will sort you out. No
familiarity with the lexicon of baseball is required, because the
force and style of Michael Lewis' writing will sweep you
effortlessly along for the ride.
It helps, of course, that baseball is
one of the most codified and statistically rich sports in the world
– English cricket comes close – with metrics rigorously if not
obsessively studied by its resident geeks. (In investment markets,
they're termed quants.)
So professional baseball, if
"Moneyball' is any guide, turns out to have quite a lot to do
with the stock market. Particularly any stock market where traditional money managers routinely overpay to get growth,
when their and their clients' interests would be altogether better
served by a more contrarian approach that focuses on real values and
real returns rather than desired ones.
In markets as in baseball,
you can pay up for what's popular in competition with everyone else,
or you can look for more unconventional beauty at a fundamentally
more attractive price, and with a more realistic chance of enjoying
exceptional returns.
Tim Price
Director of Investment
PFP Wealth Management
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