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IFB10: Making a Quant Investing Approach Inspired by Baseball Sabermetrics

Quant Investing

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Baseball and value investing have much more in common than one would think at first. The discipline and analyzation that you find in baseball can correlate to value investing quite easily. Great hitters like Ted Williams, Tony Gwynn, and Barry Bonds were extremely disciplined in their approaches and did an extensive study of the pitchers that they faced. All of this lead directly to their success, as well as their incredible talents. Great value investors like Warren Buffett have taken these ideas and adapted them to their value investing style. Using quantitative investing is the investing version of sabermetrics. Numbers can tell a story and value investors use quant investing to help tell that story.

  • Value Investing and baseball have more in common than you would think.
  • Ted Williams was the first player to take a scientific approach to hitting a baseball
  • Warren Buffett adopted these ideas to his investment philosophy.
  • Patience is key to being a great investor
  • Intrinsic value is found everywhere
  • Keeping your mind open to any possibilities can lead you to unexpected investment ideas.
  • The study of numbers or quant investing is the investing version of sabermetrics used in baseball. 

 

Dave: Welcome to session number 10. In honor of the baseball season starting this coming Sunday we are  going to talk a bit about baseball and investing and how they go together. That may be a strange topic for some people, I am sure we are getting some funny looks from people as they are listening to this.

But you would be surprised there are some very strong correlations and a lot of big value investors are very big baseball fans and they use a lot of analogies about baseball and how they look at their investing. They get a lot of great ideas from baseball and some of the strategies as well as the discipline that baseball players adhere too.

 

I will start and talk a bit about an article that I wrote just recently about Ted Williams and value investing. And for those of you not familiar with Ted Williams. First, of all, he is probably considered, in a lot of baseball circles the finest hitter in the history of baseball. Better than Babe Ruth, Willie Mays, Hank Aaron and he has the numbers to prove it. He played from the late ’40s thru the mid-’60s and he was the last man to hit over .400, and he hit .406 in 1941 and it has not been done since. So that is over 66 years since it was last done.

He was really the first guy to study hitting as a science and he was a huge influence on scores of players who followed him, most notably Tony Gwynn. But Williams was the first guy to take baseball and apply science to it and analyzation.

Andrew: I think that is key when you think about people that are excellent at their craft. There is this theory called the Prado Principle where 20% of the top performers make up 80% of the results. We see that in economics, and in the Olympics, where you see someone who is a half a second faster gets a far greater proportion of the results than the rest of their competitors. If you can study the greats you can see that a lot of the principles are shared, whether that’s baseball, chess, or investing. It’s something that you can study “peak performers” you can really glean a lot of things that you can apply to your own situation.

 

Dave: Great points. Before Ted Williams, most players hitting philosophy was “see the ball, hit the ball”. They didn’t study, they didn’t pay any attention to patterns, they just went up and swung the bat, hoping for a hit.

One of the things that Williams did was to break the strike zone down into 252 small little baseball sized zones. And he figured out that in certain zones he was much more successful than other zones. A pitch low and away, for example, Williams was not as likely to do as well against, so he just decided to not swing at those pitches. He just learned to swing at the pitches he could handle and do some damage with.

This transformed him into a world-beating hitter, his career batting average was over .350, he hit 521 home runs and in his last at-bat for the Boston Red Sox, he hit a home run. He numbers were very good but you have to remember that he missed over four years during the prime of his career fighting in World War 2 and the Korean War as a fighter pilot. He was an amazing man and he had some quirks as well. He is not as well-remembered by non-baseball fans because he was a little surly with the news reporters during his day, which hindered his popularity among the public.

 

Andrew: To put a .350 average in perspective for a non-baseball fan. If you hit the league average which is .255 and if you can hit .300 you are considered an All-Star. He hit .350 for his whole career and we haven’t seen anyone at that caliber ever.

 

Dave: As a matter of fact his last in the major leagues he hit .388 and he was over 40 years old. Which is still a record for batting average for that age.

So how does this all correlate to value investing? Warren Buffett, value investor extraordinaire, one of our favorite investor is a huge baseball fan. In fact, at one point he owned the minor league team in Omaha, his hometown, and was even considering buying the Chicago Cubs from Wrigley’s.

Buffett grew up a die-hard Red Sox fan and as a kid, Ted Williams was his favorite player. He discovered when he was looking for ideas and in that gathering knowledge mode when he was younger, he actually is still kind of in that mode. When he was younger he was very interested in learning all that he could. He came across this book called the “Science of Hitting” that Williams wrote about his philosophy on hitting and analyzation and discipline. It doesn’t have any direct correlation to value investing but Buffett saw the discipline that Williams put into his analyzation of pitches and how he chose to only swing at the ones he knew he could do something with. And Buffett thought about the myriad of millions of stocks that you get to look at and you have choices to make and invest in. And if Ted Williams is being that disciplined in baseball why can’t I be that disciplined in my investing?

He decided to adopt that philosophy of waiting for his pitch and then when he found his pitch like a Coke, Geico, or Amex he went all in. Just like Ted Williams would when swinging at a baseball. All these ideas helped correlate into a forming Buffett’s style. He adopted that philosophy of letting the pitch go by. If this was a pitch that he didn’t think he could do anything with he would put it into the too hard pile. It doesn’t mean it was a bad company it just meant for him it was not the right fit at that time.

And I think that is something that we can apply to our investing is the fact that we don’t have to go running off to rush to buy something. there are going to be opportunities that are going present themselves through time. And being disciplined like Buffett is and Ted Williams was, and Micheal Jordan was, Michael Phelps was, Phelps was extremely disciplined.

 

Andrew: A quick note on Phelps, he actually trained every day for years. His advantage was he knew that most people would take Sunday off, so he would train on Sundays’ too.

 

Dave: Talk about focus, discipline. Those are huge keys to his success, besides the phenomenal talent. The same idea applies with Buffett, he took his natural talent and looked at the discipline he gathered from these great baseball players and used that discipline for his value investing.

We don’t have to swing at every pitch, you don’t have to run out and buy something just because it is the hot new thing, or your friend gives you this great stock tip. Those, as we have found out can a lot of times lead to a lot of lost money, hurt feelings, and a lot of getting burned so you never return to investing again. As we have talked about before, being invested in the market for a long period of time and being disciplined about it is how you grow your wealth and how you retire wealthy.

 

When I was reading these stories about Ted Williams and Warren Buffett and how they correlated, I thought that it was awesome and especially with my love of baseball. I thought it was kind of a natural fit for me to write about this and talk about this today. Especially with my San Francisco Giants taking the field on Sunday. And with Andrew being a die-hard Los Angeles Dodgers fan, this is going to be a fun year for us.

 

Andrew: I really like how you talk about how Buffett waits for the perfect pitch because I am reading a book called the “Art of Value Investing” by Whitney Tilson and John Heins, they brought all this knowledge together from value investing and something they really highlighted was the idea of having your circle of competence.

A lot of these successful fund managers who are value investors, instead of really focusing on what there maybe are good at, or what they have a sort of edge on, or what kind of analysis or industry they want to focus on. Instead, they take the opposite approach and they talk about industries that they want no part of. Nobody says you have to be an expert in every industry, nobody says you have to buy stocks in every industry.

A lot of value investors, myself included completely stay away from the financial industry for the most part. I have one position in my eletter which makes up maybe a quarter of my holdings now because the portfolio is still small. As it grows over time it will naturally get smaller, that single position. that’s in the financial services industry but it’s a very low levered company, a ton of cash on their balance sheet. Really easy to understand.

But if you talk about the financial industry companies. Banks, insurance companies, and you look at their balance sheets and it is absolutely absurd how much leverage, and how many liabilities they have. Your talking about a house of cards that’s going to crumble.

Certain business models are better than others and that’s just the bottom line. A bank, for example, I wrote an email about how the basics of their business models are that they need to essentially gain a liability to gain an asset. You think about how a bank works, they take in a deposit and that deposit comes from the average consumer. Now they have cash in hand, they still owe that money to the consumer, who can come in at any time and withdraw that cash. So the bank gets an asset, but they also get a liability. Whereas a lot of other companies make revenue by selling a product, they do have to pay some money to create the product, but they have profit and not nearly as many liabilities as the bank.

If you concentrate on having a circle of competence, you can eliminate yourself from a lot of potentially heart-breaking situations if you can just understand some business models are better than others. Buffett likes to focus on what he knows and where he can see a big opportunity.

And this is the same kind of thinking with Ted Williams. His “Science of Hitting” is definitely revolutionary and people still don’t use that today, A majority of players don’t, which is kind of shocking. A basic concept of that is that the pitch that is low and away is a very low percentage pitch and that is still true today. A lot of players know that intuitively but they aren’t disciplined enough to follow through. but if you think of the logic of it, a pitch that is down low and sinking. First off, you are going to have to extend your arms a lot farther to make contact, if you do make contact, you are just going to hit the ground. You are not going to be able to get the kind of solid momentum that you would if a pitch is higher and you can lever your body and get the greatest power.

It’s the same thing with the stock market, you want to put good money after good money like the Sharks says on Shark Tank. You don’t want throw good money at bad money. Throw good money at good money, find the circle of competence, and try to apply these principles that work in other areas of life. And apply them to things like your investing, that you can control today.

 

Dave: The circle of competence is something that is so critical to value investing, and looking at life in general. Working within things that you are comfortable with, working with things you know and have knowledge of. We talked about this before, but Peter Lynch is best known for “saying you should invest in things you know.” It doesn’t’ mean because you buy a Starbucks that you should buy the stock because you buy a coffee every day and you think you know how coffee shops work. but if you work at a bank like I do, you would have a little more insight into a bank. It doesn’t mean I am going to run out a buy banks just because I work at a bank. but, it will give you a little more insight into how some of those companies work.

And you’ll also learn as you go along, reading is the greatest way to learn things and acquire knowledge. Studying other people methods and how they do things is another great way to learn, and build your circle of competence. Warren Buffett reads five or six hours a day, Charlie Munger does that same thing. All the great investors read hours and hours a day and are studying and learning things, building up their circle of competencies so that they can find other opportunities to invest in.

You know one of the things that Warren Buffett talks about when you are just starting out in investing. It is to look at investing in a punch card with only twenty punches in it. If you can come up with twenty ideas in your lifetime that are great to aspire to. Monish Pabrai was saying in an interview recently that he’s happy if he can find two or three good ideas a year! That’s it, two or three a year, that’s not a lot. That certainly is not going to make TradeKing happy because if you are only buying two or three things a year, that is not a lot of trading fees.

But the point is that these investors are looking at their circle of competencies, and what they know and are comfortable with. they are taking their time and being patient. I think that is the biggest idea is to be patient. Fools rush in is a phrase for a reason. Because impatience leads to mistakes and getting burned by doing that. When an IPO comes out and it’s the hot new thing and everybody is super excited about the release and they run out and gobble it up. Then a week later the stock tanks because people start to realize that maybe this is what we thought it was going to be, and everyone sells out, which drives down to stock.

Twitter is a great example of this. Their IPO was big, and people went nuts for it and ever since their IPO they have struggled mightily and the stock is down a bit from the opening. They now have a part-time CEO and people on their board are jumping ship like they are on the Titanic. My point with all of this is that it is ok to be patient. And it’s ok to wait for your pitch and when you find that pitch then go all in on it.

Value investing is more on the conservative side, it’s about finding things that you know and are comfortable with, and you know ar going to be good businesses and you buy it. It doesn’t mean you don’t dollar cost average every month like Andrew does, that is obviously a great strategy as well. My point is that you don’t need to be in a hurry to buy something every single week or go with the flavor of the moment. It’s more about being solid, steady and being ready to hit your pitch, and once you get it to smack it with all your might. Why swing at Clayton Kershaw’s curveball when you have no chance.

baseball

Some other correlations to value investing in the baseball world. Think about when players sign contracts, there are always negotiations and give and take. The player walks into the negotiations wanting $20 million a year because that is what he thinks he is worth. The team, however, they have different metrics that they are going to use to assess the ball player.

There has been a revolution in baseball over the last ten years called “Moneyball”. there was a book written by Michael Lewis, “Moneyball”, where he analyzed the Oakland A’s quite a few years ago, they are a small market team who couldn’t compete with the big payrolls like Dodgers, Yankees, Red Sox, and so on.

 

They couldn’t afford these players os they had to find players that would fit their system and their scheme. They basically came up with math formulas to analyze a player skill set to find the best fit for what they really needed. They were looking for guys who walked a lot, got on base and scored runs. They realized that scoring runs were ultimately the most important thing you can do in baseball. It doesn’t matter how flashy your batting average is, or how many home runs you hit, it is really about how many runs you score. And the more men you get on base the higher your percentages of scoring more runs, just makes sense.

The A’s kind of adopted this philosophy of looking for guys who weren’t the highest average, or had the most power but they got on base and they scored runs, that became their key to success. This revolution has spread through baseball now and there is a huge movement to hire baseball geeks or Sabermetrics. The are looking for guys that study math at MIT and then they get a job in the front office of the Cleveland Indians. They know nothing about baseball but they know everything about stats, and they can help the team find players that are going to fit that skill set that they are looking for.

When the player is looking for his big contract the team is analyzing all these stats from a Sabermetric point of view. And placing a value on each of these metrics and they will enter the negotiations with a dollar amount assigned to each of those metrics. Instead of the situation where the big name gets the big bucks based solely on his reputation, now the team has placed an intrinsic value on his worth and have assigned a dollar amount to what they think his skills are worth.

 

Andrew: And you can see the contrast between the teams that embrace the Sabermetrics and those that don’t. the teams that have are succeeding and are very successful because the teams that haven’t had struggled. You can look at the example of the Anaheim Angels who have not heeded this system and recently spent a ton of money to sign a player that was obviously in decline but they thought he could fill seats because of his reputation. But the money they are paying him is hindering the team from competing in the near future.

You see this in the stock market as well. They get seduced by the big name, the flashy PR, and you ignore the fundamentals.

I love this idea of sabermetrics and looking past the emotion, looking at the numbers and calculating an intrinsic value and taking a contrarian approach. If everybody else is swerving right and you are going to swerve left I think that is really going to help to your chance. A team like the Oakland A’s who were the chief focus of the book really were able to do that with next to nothing.

The A’s were looking at value and how they could squeeze out every bit of value from whatever capital they had. It’s the same idea when you’re in the stock market and you’re trying to invest in as many companies as you can that are trading below their intrinsic value. It’s not that one stock pick is going to do it for you but as you do it in a group of diversified portfolio stock selections. A couple of those are going to hit and it’s going to bring your performance up higher. a more likely situation is that none of them will become home runs but a lot of them because they were trading at a discount they all kind of push the average up higher until your really compounding your money at a nice rate.

The Oakland A’s did that in that way where they were taking advantage of going for players no other team wanted. Secondly, they were also being contrarian in the sense that they were looking at metrics that nobody else was looking at. Like you mentioned earlier, the fans, owners, they like to look at home runs, rbi’s, batting average and teams tend to focus on players that can produce those stats. Chances are if the player is not hitting for a high average he is not bringing a lot of wins for the team. If you compare that to how much you are paying him, if you are not taking a sabermetric approach, then you are probably overpaying him in the same way you would for a Twitter or any other company.

When you look at a system like sabermetrics and things like on-base percentage, or how many pitches a player looks at. You can wear out the other team’s pitchers by watching more pitches, and with players that are patient, you can see value in that. I really think this is similar to having a value investing approach and taking metrics and looking at Wall Street is focused on earnings and growth.

But as value investors let’s look at different fundamentals that really contribute to how we can win this game. And how you win in this game is take it a step further. What creates earnings? That would be assets, right? Assets are things that you buy that create cash flow which turns into earnings. If we can find companies that are struggling with their earnings but have a lot of assets then we have a good chance that we are buying at a discount to what the company’s really worth and maybe we are buying the stock with the bad arm, or the bad hip, or that nobody wants to talk about. These are some of the ways that we can take lessons from sabermetrics and from Ted Williams and really apply it to our own approach and try to emulate the success of guys like Warren Buffett, who have done similar things in their own career.