Moneyball Revisited

If you’re a baseball fan, or a Michael Lewis fan, or even a Brad Pitt fan, you’ve probably heard of Moneyball. The book, and later the movie, was based on how Oakland A’s GM, Billy Beane, changed how professional baseball managers build teams.

Traditionally, baseball teams would measure the performance of a player using batting averages and earned runs. Scouts were former players, who would size up prospects using these traditional approaches plus their own “gut” feelings and subjective considerations. Billy Beane’s Oakland A’s had a tiny budget compared to other, larger teams, and were struggling to compete for top notch players. When he altered their strategy and started using sabermetrics to select their team members - a quantitative approach - he managed to take the A’s all the way to the playoffs, despite working with a payroll budget less than 40% of some of their competitors.

In the movie, Brad Pitt’s Billy Beane was treated like he was off his rocker - right up until he started winning. Beane had to shut out the noise, remove the emotion, and stick to his game plan.

His strategy eventually became so successful that within a few years, teams across the country were using the “Moneyball” approach. Today, major league baseball teams are competing against Silicon Valley technology companies like Apple and Google for the number-crunching talent that will take them to the next level.

Billy Beane spoke at a conference I attended recently in Miami. It wasn’t a sports conference - it was an investment conference and the analogy was obvious. The players on our team are the companies and instruments we choose for our portfolios. We could take the “gut feeling” approach, or we can choose to be analytical, tactical, and unemotional.

Understanding the playing field

The economy is firing on all cylinders right now. Unemployment is low. Earnings rates are at near-record highs. Consumer confidence is getting closer to the highest peaks it’s ever reached. Sales growth is running at its fastest clip since 2012. After-tax margins are on the rise - and thanks to recent tax changes, companies have more money, and they’re spending it. But on what? If you’re the Chief Financial Officer of a corporation and you’re sitting on a pot of cash, you know it’s not in the best interests of the company to remain seated. You usually have a few choices:

  1. You can return the money to the shareholders in the form of dividends. The problem with dividends however, is that you don’t want to reduce them in the future. Releasing a dividend sets an expectation for the years to come, so you need to be confident that it’s something you can do again. We’re not going to get another massive tax cut like we did in 2017, so it may not be in a CFO’s best interests to set shareholder expectations too high.

  2. You can invest the money in the business. You could put it towards growth - perhaps buying another business, or increasing payroll. But you’ll only do this if you know the investment will yield a strong return. If a CFO can’t make their required rate of return on that investment, then this option starts to look less feasible.

  3. You can start buying back your own shares, which allows you to return some of the money to the shareholders without creating a huge expectation for future income. With a reduced number of shares out in the market, the remaining shareholders will receive a larger percentage of future earnings, and the value of their holdings increases.

Share buybacks get kind of a bad rap in the industry, but it’s an easy way for companies to spread wealth without being penalized. Now why would a CFO avoid option 2, and think they may not get the return on investment they need?

When indicators like unemployment, confidence, and earnings are riding at all time highs, the truth is that it can be harder and harder to find value. Stock markets are a leading indicator of the economy. Everyone’s wildest expectations are already built into its values - and values are at an impressive high.

The problem with expectations is that they rarely play out exactly as predicted. It’s never as great - or as bad - as you think it’s going to be.

Low unemployment is great for the economy, but not necessarily great for the stock market. It means that there isn't a lot of room to grow. Where can we go from here? What will fuel the rocket? In the past when indicators such as earnings-to-price ratios and consumer confidence were this high, the returns that followed were muted at best.

If you look around the world at other economies, you simply don’t see the kind of growth we’re seeing at home.

Investors around the world are looking at this information and increasing their exposure to our market. Why not? That’s where the money is being made. For investors with a full “team” of players, it’s frustrating to have only one player that’s actually hitting home runs. It’s only natural to start focusing your efforts there, because that is where you’re seeing results.

Sticking to the plan

It’s times like these when investors who rely on statistics, data, and quantitative analysis, are often laughed at by those who are taking the biggest risks, and assuming the party will continue indefinitely. When everything looks amazing, people start to believe that things will never change. They get emotional, and they make mistakes.

If you were a baseball manager and your center fielder, first baseman and shortstop weren’t keeping up, would you take them all off of the field, to focus all your efforts on the pitcher who has been striking everyone out?

Right now the S&P500 is our heavy hitter. It’s been giving us home runs for a while. But do we want to spend our entire budget on one player? One player can’t win the whole game, no matter how talented.

Many investors are doing exactly that. They’ve forgotten the importance of the team, of diversifying risk, and managing the payroll prudently.

It’s important to take a multi-factored approach. If you made all of your choices on valuation and sentiment alone, you would have been out of this market some time ago - and that would have been the wrong choice. The tape has continued to grind upwards. You need to have more than just a few pieces of information to guide your investment decisions.

Long term success starts with a disciplined approach. When everyone else thinks you’re crazy for sticking to your strategy, because they are certain that today’s party will continue forever, that’s exactly when you need to dig in your heels, and shut out the noise. Remove emotion from your decision-making, gather as much data as possible, and look for opportunities in unexpected places. When you let emotions lead you into battle, you’ve already lost the war.

 - Greg Stewart, CIO