Moneyball Series Part 1 — Get on Base

I watched “Moneyball” back in 2014 and was fascinated by it even though I’m not a baseball fan.

The film, adapted from the book by Michael Lewis, is based on the true story of how the Oakland Athletics upended baseball by shunting tradition and putting their faith in the numbers. In doing so, the A’s are able to line up their roster with overlooked talented players at bargain prices. Despite competing with other teams with much deeper pockets, they managed to win 20 consecutive games during the regular season, the longest winning streak in Major League Baseball since 1935.

Likewise, value investing is based on buying assets with high earnings power or value for the least amount of money possible. I decided to start this series to look at some of the timeless lessons from Moneyball that are applicable to investing. I hope that you would have as much fun reading this series as much as I had writing them.

Get on Base

The Oakland A’s shook up the sport by abandoning the conventional way of scouting players and introduced a new statistical school of thought known as sabermetrics. Sabermetrics is an approach that allowed them to further refine commonly used statistics to allow for more accurate insights into players’ contributions in the game.

Billy Beane, Oakland A’s general manager, identified on-base percentage as the single most important predictive statistic in evaluating a player. It is considered a better statistic than the traditional batting average, which accounted for only base hits, as it disregard how the player got on base (ie. base hits and walks). Hence, all player assessment was reduced to this one metric and those found in this gap were systemically undervalued.

Instead of picking players for a baseball team that has a high percentage of getting on base, the investor must pick the right companies with historically good records that they will consistently grow their earnings over time. The question is, what are the metrics that will allow investors like us to find companies that can “get on base”?

Metrics

Sabermetrics places emphasis on in-game statistics rather than the industry norm of career averages. In investing, ratios such as P/E ratio, debt-to-equity and earnings per share are overused and offer relatively little value. Investors must look deeper into the numbers to find metrics that are more highly correlated with success but often overlooked.

To this, I will explore two methods that are not commonly used but have proven success.

Joel Greenblatt’s Magic Formula

In his book “The Little Book that Beats the Market”, Mr Greenblatt explains a special quantitative investment strategy called “Magic Formula Investing”, which is a method for choosing stocks to invest in based on value investment principles.

Mr Greenblatt identified 2 key principles in his approach to value investing; low stock price and high return of capital. Hence, to find companies which satisfy these 2 criteria, he relied on the following financial ratios.

1. Earning’s Yield (EBIT / Enterprise Value)
2. Return of Invested Capital [EBIT / (net fixed assets + working capital)]

This unemotional method is a successfully back-tested strategy with and average profitability of about 30% CAGR. Hence, by investing in companies with the high earnings yield and ROIC, investors can “get on base” and be able to beat the market.

Piotroski F-Score

In 2000, Joseph Piotroski, an associate professor of accounting at the Stanford Graduate School of Business, wrote the paper “Value Investing: The Use of Historical Financial Information to Separate Winners from Losers”. He outlined a series of 9 criteria for evaluating a firm’s financial strength. This is very similar to Sabermetrics as both methods involve looking at “in-game” statistics to find undervalued picks with a good future.

The scoring system is very simple where one point is given for each of the following criteria;

1. Positive Return of Assets
2. Positive Cash Flow from Operations
3. Increase of Return of Assets YOY
4. Cash Flow > Return on Assets
5. Decrease in Long Term Debt to Asset Ratio
6. Increase in Current Ratio
7. No Dilution of Shares
8. Improvement in Gross Margins
9. Increase in Asset Turnover

Stocks that are able to achieve a score of 7 or higher are viewed as value picks while low scoring stocks with 3 or less should be avoided.

Piotroski chose these 9 fundamental ratios as they can be used to evaluate the 3 key attributes most important to a company. Profitability, Leverage and Operating Efficiency.

This can be a suitable system for value investors to help assess financial stability and solvency, but in my opinion, relying on the F-score is not enough to build a winning strategy.

Closing

In seeking and acquiring players with high on-base percentage, The Oakland A’s constructed a team that was best positioned to maximise the number of wins with limited resources.

In one’s portfolio, getting on base should be the ground expectation for all stocks. Investors should establish a strategy that encourages consistency and achieve returns with compounding effects. By having a rational purchase decision system and minimizing low percentage tactics (eg. participating in IPOs), investors will be able to construct a portfolio of stocks that can “get on base”.

Of course, it is easier said than done. However, if you stay the course by focusing on the task at hand, you might have a chance to score a few home runs along the way.

Cheers

Note: In the next part of the Moneyball series, I will touch on the psychological aspects and how we can use it to improve our investment strategies.

Originally published at http://themosspiglets.com on September 17, 2019.