2006-07-25
Today’s Thought of the Day comes from Ryan Krueger at Minyanville.
This is longer than I like, but Ryan has a great tale to tell. Of course that means I had to add my 2 cents worth as well.

The following is all from Ryan until the end.
The transition from Ryan’s thought to mine will be at the very end starting with “Mish”. Here goes:

The Stock Market’s Box Score

I was talking to a new partner about my two favorites, baseball and the markets, last week. He was a professional ballplayer and major league scout for the better part of four decades. He convinced me to share an old book report I wrote. It follows:

Moneyball

Many investors know the risk of being incorrect, but few consider the even greater risk that can come with being “correct.” Looking for good ideas that are clear to see often prove surprisingly disappointing investments if they already had “good” prices asked for them. What may be visible to most people, even when true, can provide terrible payoffs because the common knowledge was already inside the price of that asset. So, being correct can cost even more money than being incorrect; that is the danger of agreement.

MoneyBall is the name of the last book my partner and I each reviewed. The book had absolutely nothing to do with investing, yet came closer than any we have ever read in describing how we approach money management. The vocabulary for the book was from one of the two most beautiful languages in the world: baseball statistics. We will translate it here back into the other, a box score with a little more riding on the outcomes: the Stock Market.

The background to the book needs to be explained for baseball and non-baseball fans and should interest each because the comparison to the Stock Market will follow. A few years ago, a blue ribbon panel was assembled to address the economic landscape of Major League Baseball’s completely un-level playing field for its competing teams. With no salary cap, rich teams could buy the best players. Money was seen as the only problem and the only solution. The Commissioner of Major League Baseball, Bud Selig, said that a team like the Oakland A’s “…can’t compete. They’re not viable without a new stadium.” The majority of the panel agreed that poor teams needed more money for better players, and the rest of the country agreed. There was only one dissenting opinion on the entire panel, cast by the only voter with a financial background. It was the former Federal Reserve Chairman Paul Volcker who asked, “If poor teams are in such dire financial condition, why did rich guys keep paying higher prices to buy them?” Another little noticed item drew some curiosity from the panel as well. “If poor teams had no hope, how did the Oakland A’s, with the second lowest payroll in all of baseball, win so many games?”

The fascinating answers to that second question were explored in this book Moneyball, written by Michael Lewis, one of our favorites for many years but who had no knowledge of baseball before this story captured his interest.

If the conventional wisdom in baseball were correctly assessing the value of ballplayers, then all of the best talent would be bought up by the rich teams, and the Oakland A’s would not stand a chance. Yet they not only stood a chance, they won. Why? [The book goes on to describe describe the Oakland A’s and their General Manager Billy Beane and his approach to the game – Mish]

In a parallel story that we write every day in the Stock Market, if prices rationally reflect all known information then stocks would theoretically trade efficiently based on those fundamentals. Yet, in our opinion, they do not. Why?

The Book:

“Too many people make decisions based on outcomes rather than process.”
Source: Moneyball, Michael Lewis

The Market’s Translation:

Investors who read about the Stock Market being up or down 100 points, and believing their investments had a “good day” or a “bad day” are focusing on the outcome, and a misleading one at that. We believe the most overrated question in the country is, “How’d the market do?”

The Book:

“Traditional yardsticks of success for players and teams are fatally flawed.”
“The naked eye was an inadequate tool for learning what you needed to know.”
Source: Moneyball, Michael Lewis

A good portion of the Oakland A’s general manager’s Beane’s advantage is described as simply doing better homework. After graduating from Harvard, one of his assistants input the raw statistics of every baseball game ever played in the 20th century into their computer to analyze what most correlated with winning and losing. Think about how much sense this makes, yet realize that for those 100 years, assumptions trumped these facts that had never been compiled.

The study proved that almost all of the widely-followed statistics in a game of baseball never consistently correlated with which team won or lost. There were two striking exceptions: on-base percentage and slugging percentage. Simply having players getting on base any way they could, and having players making each successful contact count as much as possible, were the two Holy Grails. These two measurements proved superior to all others yet they are not followed as closely as the more popular statistics like batting average, runs batted in, and speed. These three were not only inferior indicators, but the players who possessed them became over-priced because everybody was bidding for the same wrong things.

The Market’s Translation:

It is our belief that, just as in baseball, managers in the Stock Market rely on statistics that often do not help them. In our experience, the two most often used are P/E’s and Earnings. Over time, it has been difficult to prove the ability of either to give you a consistent edge in predictive power. Yet, until the end of time you will always read about stocks with “low P/E’s” and stocks with “better earnings growth” even though this data may not help performance when managing money. The only thing worse than owning something that does not work is paying dearly for it. Investors pay premiums for the assumptions of conventional wisdom since they all end up bidding for the same stocks.

Many people are willing to accept the risk of losing 50% if they can make 80%. But instead of looking for that kind of hit, do the math. $100,000 is worth $50,000 before becoming $90,000. You are not up 30%, you are down $10,000. Few investors consider that losing might hurt them more than winning helps them. But, that is the camouflaged truth and it will remain invisible in plain sight until a vaccine is developed for a debilitating disease called human nature.

The Book:

There were several little examples of scouts for baseball teams looking at the wrong things because of their inability to trade their subjectivity, based on years of “understanding baseball” with the objectivity that clear thinking, better data, and an open mind could have afforded them.

Scout: “He is a bad body catcher.”
Beane: “A bad body who owns the Alabama record books.”
Scout: “When he walks his thighs stick together…put him in corduroys he’d start a fire.”
Beane: “We are not selling jeans here.”
Scout: “He can’t run.”
Beane: “He’s leading the country in walks.”

They drafted him. Not only because Beane thought he was better than other teams believed, but due to that conventional wisdom he could underpay. To sign him to a contract, the Oakland A’s did not have to agree to traditional first round prices. They wanted a better player, and they wanted to underpay.

The Market’s Translation:

When it comes to stock prices, we are focused on the same combination of better analysis along with the selectivity of only agreeing to prices when they are favorable to us. We need to be patient enough to wait for our price on the way in, but just as willing to part with those same shares however dear they may seem, if we are offered prices even more dear.

The best players in the draft are analogous to the S&P; 500, the group of the biggest and best companies in the U.S. Those 500 blue chippers have an average of 20 scouts following each company. The scouts in this case are Wall Street analysts.

Price measures popularity, in ballplayers and stocks. The average market value of stocks in a dollar weighted S&P; 500 Index is just under $90 billion per company as of this writing. By comparison, over 90% of our holdings are below (well below) that size. What is the point? The emptier the stadium of scouts and the more unrecognized the company, the more chances we have to find something others will not. The blue chippers attract all of the attention in any sport. Wal-Mart (WMT) is followed by 21 scouts, Cisco Systems (CSCO) has 22 scouts, General Electric (GE) has 19 scouts, and Johnson & Johnson (JNJ) has 23 scouts. If you take the sum total of all their scouts’ different opinions you would see the very highest 2006 earnings per share estimates compared to the very lowest are separated by a grand total of 30 pennies, combined!!! That comes out to an average difference between the extreme hi-low estimates of only 3% based on earnings per share, and it took 85 teams of analysts, countless hours and countless millions to create these “ different opinions.”

We believe the best ballplayers and the best companies do not often make the best investments because we are not looking for the most agreed-upon estimates; we are looking for the most disagreement.

The Book:

“When I started writing I thought if I proved X was a stupid thing to do that people would stop doing X. I was wrong.”
Source: Moneyball, Michael Lewis

The Market’s Translation:

We believe this last quote is the most fascinating and timeless lesson from the book and from the story on Wall Street. No matter how much proof you have to support doing something a different way more successfully, people still like doing things the way they always have. This provides the mother of all misperceptions, and what we enjoy working on every day.

Mish:

How can Ryan Krueger possibly be more correct?
Intel, Home Depot, Malmart, IBM, Citycorp, Microsoft? Where are those “leaders” going. Yet, just this past week Barron’s came out with what I think may be one of the greatest contrarian magazine covers on equities that we have seen for a long long time.

I talked about it on July 22 in Time To Sell.

Odds of a continued bear market selloff increased today with this cover of Barron’s. Magazine covers like this (especially at the end of a three year cyclical runup) are typically very contrarian in nature.

Overly depressed stocks — particularly large caps — look poised for a second-half rally, even if global political and economic turmoil lingers. The biggest bargains include familiar names such as General Electric, Home Depot, Cisco, Nestlé and Lehman Brothers.

Supposedly this is the best buying opportunity in big caps since 1994. What a bunch of nonsense. We are headed into a consumer and housing led recession.

This is the best selling opportunity on “familiar names” since 2000. The best selling time for the Nasdaq was earlier this year.

In 1994 we had an internet boom to look forward to. In 2000 we had a housing boom to look forward to. The entire time we had a financial boom to look forward to as lenders were willing to finance anything, and the Fed was willing to accommodate the entire mess with what has become to be known as “The Greenspan Put”.

Supposedly after all of this we have the greatest buying opportunity since 1994 on the basis of a mere 5% pullback in the S&P.; Is this a joke?

Now we see a classic case of herding. Tech is out so SOMETHING must be in. The troops are now rallying around Home Depot (even though housing is collapsing), and other “bargains” such as Cisco (a company that is now nearly as irrelevant as Micron).

It is a classic case of plowing into yesterday’s favorites 5 to 10 years too late. I have news for Barron’s. The internet bubble has popped and the housing bubble is popping as I type. There is no “value” in most of the companies that everyone is following.

Just because I do not like tech does not mean I have to like non-tech. Just because I do not like big caps does not mean I have to like small caps. Yet the mantra of the day, day in and day out is to be 100% invested in stocks 100% of the time.

No one it seems likes treasuries.
I do as do a couple of other Professors on Minyanville.

Please take a good hard look at a piece I wrote back on July 16th called Time Preferences. No one domestically likes US treasuries. Cash is trash. Inflation is soaring. “The bond market is wrong”. “Treasuries are manipulated by Japan and China”…. and so on and so forth.

Value exists where no one else sees it. That may not make treasuries a screaming buy, but it sure beats the heck out what nearly everyone else is screaming about.

Mish Note: I have no idea of Ryan’s views on treasuries. He may hate them for all I know. That is not the point of this article. If you missed the point, here is the three sentence summary:

  1. Think outside the Box Score.
  2. That is where the profit lies.
  3. Profit is not found on the cover of Barron’s touting yesterday’s news.

Thanks to Ryan Krueger and Minyanville for today’s thought of the day.

Mike Shedlock / Mish/