With limited capital, investors must go up against deep pockets – institutional and professional investors – in the most competitive arena on earth. Everyone is in it to win, so investors need to look at the market differently if they want to beat it.
As the baseball season gets into full swing, the big news to me is the massive contract the Angels’ Mike Trout signed in March. At $430MM ($36MM per year), it is the largest contract in the history of any sport. Trout is considered by most to be the best all-around player in the game, maybe in the history of the game. But is that huge contract worth his value as a player? Anyone who knows baseball would probably answer with a resounding “yes!” After all, his peak years are still ahead of him.
However, the question remains whether he has enough value to get the Angels to the playoffs – something they’ve accomplished just once since he joined the team in 2011. Let’s say for the sake of argument the Angels don’t make the playoffs the next five years. Could the team have generated a better return on investment by signing four or five lesser players with the ability to score the runs needed to get to the playoffs?
The “Moneyball” Analogy
If you’ve seen the movie or read the book, “Moneyball” (and if you haven’t, I strongly recommend it), you probably know where I’m going with this. I bring it up not to talk about baseball, but as a valuable lesson for investors.
In the movie, the general manager of the Oakland A’s, Billie Bean, had just lost his three superstar players to teams with much deeper pockets and had to find players to replace their production with the smallest payroll budget in baseball. Utilizing a purely statistical approach to valuing players, he selected players based on their ability to get on base and score runs as opposed to their perceived value based on their athletic ability, batting average or slugging percentage. Why? Because only runs win ballgames.
In other words, he was buying bases rather than buying players for their perceived growth potential. He looked for players who were considered “defective” by other teams but who had a track record of getting on base. In doing so, he compiled a roster of great talent at bargain basement prices. After a slow start in the season, the A’s went on to win a record-breaking 20 consecutive games, win a record 103 season games, and make the playoffs where they lost to the Twins in the first round.
Valuable Lessons at the Intersection of Baseball and Investing
There are a number of timeless lessons investors can take away from “Moneyball”, particularly for value investors. The fundamental objective of value investing is to purchase the most earnings power or asset value possible for the least amount of money. Successful value investors don’t allow surface impressions, stereotypes and subjectivity to guide their decision-making. And, in many cases, the opportunities with the greatest potential can make value investors uncomfortable initially because of their obvious defects, but they wouldn’t be undervalued without them. As long as the market undervalues assets, there will always be opportunities to profit.
If you think about it, investors are in a similar position as the 2002 Oakland A’s, with limited capital going up against deep pockets – institutional and professional investors – in the most competitive arena on earth. Everyone is trying to win, so investors need to look at the market differently if they want to beat it.
You Need to Get on Base to Win
We all yearn for a grand slam in our portfolio. But, as history shows us, the long ball doesn’t necessarily win championships. It’s typically the team with players who find a way to get on base – drawing walks, spraying singles to all fields, and occasionally powering one to the outfield. If a player gets on base four or five times out of ten, he creates more opportunities to score runs than the long-ball hitter who can’t hit the ball 75 percent of the time. This is not to diminish the importance of the long ball; we all need one occasionally to help us win a game. But, if you’re not getting on base enough, you’re not creating enough opportunities to score.
Long-term investors need to get on base by minimizing errors and picking companies that offer a compelling combination of low valuation and above average quality. The right companies will find a way to grow their earnings and compound their capital over time. If a long-ball hitter emerges among them, that’s a bonus. But, for a long-term time horizon, getting on base should be a minimal expectation with the ability to ride out the price fluctuations as part of the game.
Avoid Paying for Future Performance
Many high profile companies are overvalued because their future potential, based on massive projected earnings growth, growing market share, and robust financials, is already reflected in the value of their stock. This can lower the ceiling for future appreciation while increasing downside risk, even as earnings continue to grow. Investors continue to push the stock higher based on its perceived value without analyzing if that perception has over-influenced the price of the stock. This detachment of market value from intrinsic value increases risk if the intrinsic value is lower than the market value.
Billy Beane purposely avoided seeking out “overvalued” players – that is, stereotypical players whose current price tags were based on their perceived value and future potential. As an investor with limited capital, Beane chose instead to focus on players who demonstrated the ability to produce in certain ways but who didn’t fit the typical “superstar” stereotype. Collectively, they were able to produce at a higher level than an overpriced superstar. Beane avoided overpaying for future potential by paying for the intrinsic value of the players’ current level of production.
There are hundreds of well-managed companies across the globe with perceived defects whose stocks are influenced by factors that are external (industry headwinds) and circumstantial (bad news, earnings disappointment). They’re not perceived by the investing public as a safe bet, so their stock prices are not inflated by their promise of future potential. As such, many are selling near or even below their intrinsic value. And, the ones who have the capacity to march forward with solid returns on invested capital and earnings growth, will keep raising their value ceiling while raising their risk floor. It’s the advantage investors need in a highly competitive market.
