Moneyball and Value Investing: Variant Perception is Key to Success

“It’s unbelievable how much you don’t know about the game you’ve been playing all your life.”

– Mickey Mantle, New York Yankee Hall of Famer

Moneyball, the 2011 movie starring Brad Pitt as Oakland Athletics General Manager Billy Beane, is just as much about value investing as it is about baseball. Just as value investors analyze stocks objectively based on the relationship of a stock’s market price to quantitative measurements like its discounted cash flow (DCF) value, adherents of sabermetrics analyze baseball players objectively based on the relationship of a player’s salary to quantitative measurements like on-base percentage and fielding independent pitching (FIP).

In both the stock market and baseball, the question is whether the commodities at issue are efficiently priced. If they are, then value investors should just give up and buy an index fund and baseball teams with the most money will always win the World Series. But value investors historically have outperformed because stocks aren’t efficiently priced due to the behavioral flaws of most investors who exhibit reckless overconfidence and short-term thinking.

The question posed in Moneyball is whether the managements of major league baseball teams exhibit similar flaws when evaluating player talent. Traditionally, teams have relied on baseball scouts who evaluate players based on five skills: hitting, power, fielding, arm strength and speed. These are primarily physical attributes that measure a player’s potential rather than his actual achievement. In the movie, scouts also try to assess a player’s mental confidence by inane and completely untested criteria like the attractiveness of the player’s girlfriend. For example, one scout rules out a player because:

His girlfriend is ugly. A guy with an ugly girlfriend has no confidence.

Pop psychology at its worst!

Billy Beane is Living Proof of the Need for Sabermetrics

As a teenager growing up in California, Billy Beane was an outstanding high school baseball player who scored at the top of the list for each of the five skills measured by scouts. In 1980, he was drafted in the first round by the New York Mets and paid a $125,000 signing bonus. Yet, Beane was a total bust in his six major league seasons due to emotional problems (mostly a bad temper) and obsessive over-thinking (he was smart enough to get accepted at Stanford University) that interfered with his ability to concentrate and execute.

Although not mentioned in the movie, the original book by Michael Lewis compares Beane’s failure with the success enjoyed by fellow Met Lenny Dykstra, who had substantially less physical talent and was dumb. Dykstra’s stupidity turned out to be an advantage because he didn’t get scared or over-think things. The bottom line is that Beane knew from his own experience as a failed player that the criteria used by scouts didn’t work (p. 38):

A young player is not what he looks like, or what he might become, but what he has done. Most of what’s important about a baseball player, maybe even including his character, can be found in his statistics. The scouts even had a catch phrase for what Billy and others were up to – ‘performance scouting.’ Performance scouting in scouting circles is an insult. It directly contradicted the baseball man’s view that a young player is what you can see him doing in your mind’s eye.

Baseball Success Transcends Simplistic Stereotypes

Many highly successful players did not fit the physical stereotype used by scouts to judge talent. Examples include Chad Bradford who had a weird underhand pitching motion, catcher Scott Hatteberg who couldn’t throw but could still hit, and third baseman Kevin Youkilis who was fat and couldn’t run, throw, or field, but was the “Greek god of walks.” Paul DePodesta, Beane’s assistant in Oakland and the real sabermetric genius, refused to cooperate with the movie for some inane reason, so the writers changed his character’s name to Peter Brand, made him fat, and had him graduating from Yale instead of Harvard (the ultimate insult). Anyway, in the movie DePodesta’s character calls the A’s sabermetric-enhanced team the “island of misfit toys.” But it turns out that these misfits could really play ball and the story provides a perfect Hollywood message to resonate with theatergoers: you don’t have to fit a stereotype of beauty to be a success.

Dividend Investing is Like Sabermetrics

An investing analogy to the concept of “performance scouting” would be selecting boring dividend stocks over flashy high-tech growth stocks because academic research has shown that investors overpay for growth (causing them to underperform) and ignore slow-growth and low-beta stocks (causing them to be undervalued and subsequently outperform). Such investors also think it is mostly a waste of time to meet with company management, preferring to judge management performance simply by evaluating the company’s financial performance.

Sabermetrics Means Thinking Outside of the Box

But sabermetrics – the term is derived from the Society for American Baseball Research (SABR) – goes beyond the concept of performance scouting and statistics. It asks the question: which baseball statistics are the most informative? Traditional baseball men focused on batting average, but sabermetricians discovered that on-base percentage  (OBP) was much more important. Winning games depends on scoring runs and the only way to score runs is to get on base. It doesn’t matter whether you get on base through a single or a walk or a hit-by-pitch. A .320 hitter who never walks is less valuable than a .290 hitter who walks often. Walks also serve the purpose of tiring out the opposing pitcher, because he is forced to throw many more pitches than would be the case if a hitter always swings.

Similarly for pitchers, tradition focused on earned run average (ERA) but ERA is dependent on the fielding team’s ability to prevent hits, not a pitcher’s skill. Sabermetrics determined that pitchers can only control walks, strikeouts, and home runs and thus should be judged on those metrics – as measured by fielding independent pitching (FIP) — not on hits and ERA.

Variant Perception Explains the Success of Both Sabermetrics and Value Investing

Back in 2002, when Moneyball takes place, most teams did not focus on OBP and FIP and consequently players with high OBP and FIP were not paid high salaries. Teams in low-revenue markets like Oakland that could not afford the $100 million player payrolls offered by teams in high-revenue markets like New York and Boston were able to remain competitive by loading up their roster with high OBP and FIP players. The value of high OBP and FIP was public information that was available to all, but only a few teams used sabermetrics and appreciated the predictive value of these novel statistical measurements. This is similar to the investing “Seeing eye” I wrote about in How to Beat the Stock Market Without Really Trying: Value Investing. It also meshes with what superstar hedge fund investor Michael Steinhardt wrote in his 2001 autobiography entitled No Bull: My Life in and Out of Markets about the importance of being a contrarian investor with a perception of value at variance with the crowd:

I began to consciously articulate the virtue of using variant perception as an analytic tool. I defined variant perception as holding a well-founded view that was meaningfully different from market consensus. I often said that the only analytic tool that mattered was an intellectually advantaged disparate view. This included knowing more and perceiving the situation better than others did. It was also critical to have a keen understanding of what the market expectations truly were.

Thus, the process by which a disparate perception, when correct, became consensus would almost inevitably lead to meaningful profit. Understanding market expectation was at least as important as, and often different from, fundamental knowledge. As a firm, we soon found that we excelled at this. We took exactly that approach during the early 1970s, when most of our success resulted from our implementation of perceptions that were meaningfully at variance with consensus wisdom. We shorted near the top, in the face of great bullishness, and we got long at the bottom, in the face of keen pessimism.

In an interview, Beane made his own analogy between sabermetrics and investing:

It’s all about evaluating skills and putting a price on them. Thirty years ago, stockbrokers used to buy stock strictly by feel. Let’s put it this way: Anyone in the game with a 401(k) has a choice. They can choose a fund manager who manages their retirement by gut instinct, or one who chooses by research and analysis. I know which way I’d choose.

Sabermetrics is Not a Panacea, But One of Many Tools

In watching the movie, however, something didn’t ring true. The opening scene is the 2001 American League Divisional Playoff between the Athletics and the Yankees. The Athletics won 102 games that year and beat the Yankees in the first two games of the playoff. Then momentum reversed and the Yankees won the last three games to eliminate the Athletics from the postseason. All of this success occurred before Beane had embraced sabermetrics. In other words, despite the fact that Oakland was a low-revenue market, it had managed to win 102 games under the old system of developing players internally through scouting. The movie completely trashes the value of traditional scouting – particularly the A’s head scout Grady Fuson – but the success of the scout-developed 2001 team speaks for itself.

After the 2001 playoff loss, the A’s lost three of its star players to free agency: first baseman Jason Giambi, outfielder Johnny Damon, and relief pitcher Jason Isringhausen. Beane couldn’t afford to replace these players immediately by paying the inflated salaries of other major leaguers with similar batting statistics, but he also didn’t want to wait for the scouts and Oakland farm system to develop new talent (which he didn’t trust anyway despite the 2001 season). What he could do immediately is buy a number of cheap players with high sabermetric ratings that collectively could come close to equaling the offensive output of the departed star players. Not in terms of traditional measures of output (e.g., batting average or home runs), but in terms of the offensive output that really mattered (e.g., run generation). 

2002 was the first year that Beane utilized sabermetrics (after firing head scout Grady Fuson). The result was a 103-win season, one game better than the year before. Furthermore, the A’s broke the American league regular-season record for consecutive wins by winning 20 in a row. But the A’s didn’t do any better in the playoffs, losing in the first round to the Twins. Funny thing, the 2002 playoff loss didn’t make it into the movie. So did sabermetrics really improve anything? According to one analysis, the A’s success in 2002 was a combination of luck and the performance of the pitching staff, all of whom were developed by the traditional scouting system and none selected by Paul DePodesta’s sabermetric computer screen. The A’s still couldn’t win the big game despite sabermetrics. In fact, under Billy Beane’s continuing 13-year tenure (1998-2011), the A’s have never reached the World Series, let alone win it. Furthermore, since getting swept by the Tigers in the 2006 playoffs, the A’s suffered five consecutive losing seasons and not advanced to a single playoff berth despite sabermetrics.

But Beane is making a comeback! In 2013, the A’s were crowned champions of the American League’s Western Division for the second consecutive year and it marked the seventh time the A’s had made the playoffs in Beane’s 16 years at the helm. He is still widely considered the best general manager in baseball.

Popularity is Sabermetrics’ Downfall

Until the renewed success of the last two years, a large cause of Beane’s failures was that sabermetrics has been widely adopted by most major league baseball teams, so highly-rated OBP and FIP players are no longer undervalued and Oakland no longer has a “variant perception” advantage. Soon after the book was published in 2003, the Boston Red Sox became a believer (thanks to its commodity-trading owner John Henry who recognized the investment analogy). The Red Sox owner (played by himself in the movie) offered Beane $12.5 million to move to Boston but Beane declined, allegedly because he didn’t want to leave his daughter. Henry had previously hired sabermetric guru Bill James for a lot less money and the Red Sox won the World Series in 2004 for the first time in 86 years.

If you look at baseball statistics today, sabermetric measures like OBP, OPS, and WHIP are always included. So sabermetrics definitely has value, but it is now widely recognized and exploited by the rich teams just like all other measures of talent, leaving poor teams like Oakland back where they started prior to 2002. Even rich teams like the New York Mets aren’t finding success (yet) with sabermetrics since they adopted the approach in October 2010 with the hiring of former A’s general manager Sandy Alverson. And the Phillies were able to win 102 games in 2011 – more than any other team in baseball – despite rejecting sabermetrics.

Just like investment styles temporarily fall out of favor with the market — only to come roaring back — so too does sabermetrics. While the sabermetric A’s won the American League West this year, the non-sabermetric Phillies finished fourth out of five in the National League East.

Critical Thinking Never Goes Out of Style

Still, I think sabermetrics has a bright future because it is based on objective reason and analysis, and those qualities never go out of style. There will always be new insights to learn about baseball that others have not yet realized. As sabermetric guru Bill James said in an interview:

Well, that window has closed. But, you know, there will never be a shortage of ignorance. I mean, there will always be things that people don’t understand, and you just have to move on to the new areas of better understanding and master those to have the advantage that you had 10 years ago. And that’s in the nature of any progressive field, you know? The things that worked 10 years ago aren’t going to work anymore. I mean, that’s true, but it’s a limited truth. And there are still great advantages to be had by understanding the game better just as there were 10 years ago.

The Ultimate Irony: Grady Fuson Returns

With the Red Sox World Series victory in 2013, Billy Beane perhaps regrets not taking John Henry’s $12.5 million offer, but he’s not giving up. He’s pushing to have the A’s move to San Jose, which is a higher-revenue market than Oakland. And – the most ironic of all – he’s rehired old-time scout Grady Fuson, the Moneyball anti-christ.

Sometimes reality is stranger than fiction.