Baseball, Buffett and Value Investing
A few weeks ago, I mentioned how Michael Lewis’ book Moneyball was one of the most influential reads in my lifetime.
If you didn’t read the article, I explain how Billy Beane took over the struggling Oakland Athletic’s as General Manager. The team operated at a severe disadvantage compared to their American League rivals like the Yankees and the Red Sox. Their total team payroll is often a fraction of those teams. But Beane took a disadvantage and turned it into an advantage. He couldn’t afford the expensive free agents the Yankees and Red Sox were always fighting over, so he got smarter. He learned to underpay for underrated players rather than overpay for all stars.
He leveraged a new generation of statistical measures, or metrics, to build a competitive advantage over teams with higher payrolls. Analyst Bill James made a compelling case that too much attention was paid to stats like batting average and runs-batted-in (RBIs), and not enough to lesser-known stats like on-base percentage and slugging percentage. If a player got on base more often than another player with a higher batting average simply because he was more patient and drew more walks that, in the long run, would contribute more to winning. So Beane stacked his line-up with players with a slightly higher on-base percentage and, over the course of a long season, that small advantage compounded and translated into a poorer team significantly outperforming many teams with higher payrolls.
Michael Lewis, not coincidentally, has written a great deal about Wall Street as well. And Beane’s ‘Moneyball’ approach is a kin to a well-known approach to investing called ‘value investing’.
Value Investing is a contrarian strategy. It goes back to Ben Graham and the tough lessons he learned from the Crash of 1929. His book The Intelligent Investor became the bible of the value investor, and caught the eye of a young Warren Buffett, who would become Graham’s protégé and later emerge as one of the most successful contrarian investors of all time.
Its essence is simple: Any investing decision must start with an assessment of the underlying or intrinsic value of a stock or other asset, and then consider that value in relation to its current price. For a variety of reasons (most of them involving institutional impediments to trading, human psychology and irrationality), an investment can at a given time be priced well below its intrinsic value. It is these undervalued assets that are the primary target of the value investor, who believes that, while irrationality can result in under and overpricing in the short term, the market will in the long run reflect real value. As Graham put it: “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
One of the central tenets of accepted financial theory (the Efficient Market Hypothesis) is the importance of diversification. The basic principle of diversification is not to put too many eggs in one basket: to spread risk across a variety of investments in order to reduce the negative impact of any single investment going south. There is considerable merit to the idea of diversification, and value investors don’t entirely dismiss it. But the more diversified your portfolio is, the more likely it is to mirror the market, and you can’t beat the market by mirroring it. A broadly diversified portfolio is one without much concentration. Value investors, by contrast, often have a good deal of concentration in their portfolios. Warren Buffett, for example, once had over half his money in GEICO, which his Berkshire Hathaway company would later take sole ownership over. In other words, contrarian investors are often willing to put a lot of eggs in one basket.
While an index like the S&P 500 should reward investors with handsome returns during extended bull markets, it will also lose big in bear markets. Contrarian investors believe strongly that bull markets and bear markets call for very different strategies. Even if your objectives are modest and you are mostly seeking to capture the long-term upward trend of the market, it is one thing to ride a bull, and another thing entirely to ride a bear.
For the contrarian investor, price and risk are inseparable. While high risk may often come from high prices, low prices, on the other hand, can potentially reduce risk—dramatically. The central question for the Value investor is always what the price of an asset is in relation to its underlying value. If price exceeds or is even comparable to that value, the investment is risky, regardless of its statistical measure of risk (beta, variance etc.). High prices increase the likelihood of sub-par returns; the law of reversion to the mean suggests that high-flying stocks will eventually come back to earth. And if that high price reflects an excess of enthusiasm in the market and a bubble waiting to burst, it also carries the possibility of a significant and possibly permanent loss of capital.
This is where the Value investor’s emphasis on uncertainty comes into play. Good value investors know that there are things they don’t (and can’t) know. Multiple variables that can bring down a stock or the market as a whole are beyond the individual investor’s control and forecasting ability. Understanding and respecting that uncertainty, the Value investor insists (in all but the most conservative investments) on a margin of safety that is the difference between a stock’s underlying value and its current market price. This margin of safety represents an alternative to the traditional equity reward premium—one that rejects the assumption that greater reward necessarily involves accepting greater risk.
Again, this is easier said than done (or everyone would be doing it). Value investing demands you do your homework (or hire a trusted advisor to do so), and requires a temperament comfortable with going against the crowd. And it carries its own set of risks: the risk that you have misjudged the company’s fundamentals and picked a losing stock (what one might call valuation risk), or that its price takes longer than expected to return to its true value.