Story of Moneyball
I always wanted to read the book Moneyball by Michael Lewis but I never had the chance. In exchange, I just saw the movie on Lewis’ book (nonetheless, I still intend to read the book). For those who don’t have a clue what Moneyball is all about just read the wiki page but roughly the story behind Moneyball is how a man, a baseball team general manager, with little financial resources can compete against big powerful teams with a lot of cash (i.e. Yankees and the Red Sox). The “poor” team in question was the Oakland A’s and their General Manager used some similar concepts of value investing to find players that will give him the best bang for the bucks invested and remain competitive against teams that spend three times more on payroll.
Is it only about stats?
To get the best bang for your bucks invested in players, the General Manager heavily relied on stats (more than just RBI, hitting %, etc.) – in part, stats develop by Bill James. One of the goals of the GM was to line-up players with similar stats and pick the cheapest one. Hence, you get the biggest bang for your bucks. More importantly, if the player does not live up to its potential, you will limit the financial cost (similar to the margin of safety).
Here’s why money matters and why it is not only about stats
Imagine you have two or more players where the stats are almost identical. You will look for the cheapest players since you have a low salary cap. Here’s why money matters — by that I mean why spending more for someone with similar stats matters. Stats don’t incorporate all aspects of a player such as team leadership and sportsmanship. These qualitative skills tend to be incorporated into the salary some GM is willing to give to player – which are significant to win baseball playoffs games. So, if a GM selects the cheapest player among those with the identical stats, he is neglecting the qualitative aspect of a player and its unpredictable consequences (i.e. there are some players that carry with them a trouble-maker reputation).
The bottom line is that the more money you have, greater the possibility to invest more on a player with qualitative or even tacit skills that is hard to quantify but how crucial in order to win championships. Don’t get me wrong, the stats of a player is fundamental and I think what the GM in Moneyball did was brilliant but if he had more money to shop around he would have been able to pay extra for players with more qualitative skill. Nonetheless, the stats determine the price floor (i.e. the player that cost the less given the identical stats with other players is the price floor).
For the first time today (and some may say: it’s about time!) I read the classic article “the Superinvestors of Graham –and-Doddsville” written by Warren Buffett in the 80’s for the 50th anniversary of Security Analysis by Benjamin Graham and David Dodd. In this article, there is one of the best written lines on risk/reward. I always hated to learn in school that greater risk should legitimately lead to greater rewards. Really? Here’s what Buffett has to say on risk/reward:
I would like to say one important thing about risk and reward. Sometimes risk and reward are correlated in a positive fashion. If someone were to say to me, “I have here a six-shooter and I have slipped one cartridge into it. Why don’t you just spin it and pull it once? If you survive, I will give you $1 million.” I would decline — perhaps stating that $1 million is not enough. Then he might offer me $5 million to pull the trigger twice — now that would be a positive correlation between risk and reward!
The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case. The greater the potential for reward in the value portfolio, the less risk there is.
One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned thePost, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.
Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people that think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying $400 million for $80 million, particularly if you do it by buying ten $40 million piles of $8 million each. Since you don’t have your hands on the $400 million, you want to be sure you are in with honest and reasonably competent people, but that’s not a difficult job.
So why value investing is a great investment philosophy?
Not because Warren Buffett became rich thanks to value investing. Its because the premise behind value investing is this: Us, humans, are not so smart as we might think. Hence, we must come up with some tools and philosophy to protect us from our ignorance (and emotions) when we invest money.
In Security Analysis by Benjamin Graham and David Dodd (sixth edition, p.703) there is a great line on what makes security analysis (value investing) a great approach to investment:
In security analysis, the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid. the underlying idea is that even if the security turns out to be less attractive than it appeared, the commitment might still prove a satisfactory one.
Its a philosophy that shares the same thoughts of the great philosopher Karl R. Popper — “Our knowledge can only be finite while our ignorance must necessarily be infinite.”
I may also add that value investing offers the chance for investors to increase their odds to find company with a “black swan*” future success.
* A black Swan event does not necessarily leads to a negative consequence.
That is why value investing is great — not perfect — just great.