The Boys of Summer

My five-year-old recently started t-ball and the games have been even more fun to watch than I imagined.  The kids are young enough that they don’t bother to keep score and the concept is just to introduce the game and help teach the rules.  Despite the best efforts of parents and coaches, there is a delightful regularity with which things tend to go awry.  Seeing a baserunner chase a ball his teammate hit into the outfield is something that never gets old.  Also, if you’ve never seen an entire team in the field swarm to a ground ball, I would recommend you catch a local t-ball game.  It’s great to see the kids enjoy themselves and full of entertainment for the spectators.

Baseball and investing have long been linked.  Nobody has done more to highlight the ties between the two than Warren Buffett, who hardly can conduct a single interview without making a baseball analogy.  He often talks about “no called strikes” in investing and waiting for the “fat pitch.”  My favorite baseball quote of his refers to focusing on underlying business performance instead of on stock price, “in investing, just as in baseball, to put runs on the scoreboard one must watch the playing field, not the scoreboard.”

The well-known book “Moneyball” by Michael Lewis was also popular in the investment community.  The story covered how the low-budget Oakland A’s used superior statistical metrics to assess player value versus traditional, less accurate metrics used by other teams.  This approach allowed the A’s to be highly competitive despite their meager payroll.  The book appealed to investors due to the idea of exploiting an edge versus others.

Going further, if you’ve ever dreamed of being an owner of a major league team, the Atlanta Braves are publicly traded.  And if you needed yet another link between baseball and investing, any questions about the Detroit Tigers, or perhaps the players in the team’s minor league system given the Tigers’ dismal start to the season, our very own Scott Horsburgh is your man.

I wanted to discuss another link between investing and baseball, the concept of slugging percentage.  While batting average measures a player’s ability to get on base via a hit, slugging percentage acknowledges not all hits are equal.  A home run is preferable to a single, and a player with a high slugging percentage is more likely to hit for power.  Someone who has done a lot to highlight the concept of slugging percentage in investing is Michael Mauboussin, an investor and professor at Columbia.  Some of this topic relates to a concept I have written about before—probabilities and the idea of frequency versus magnitude.

The idea is that frequency of correctness (batting average) is of less importance than the magnitude of correctness (slugging percentage).  People are wired to be risk averse and therefore look for a high batting average.  There are studies backing this up, indicating the psychological impact of a loss is roughly two times the impact of a gain.  This leads individuals to generally be happier when they are correct more frequently.  For example, would you rather invest in something with a 95% chance of gaining 10%, or a 10% chance of gaining 95%?  Most would choose the 95% chance of a gain, but the math says the investor should be indifferent between the choices given they possess the same expected return of 9.5%.  Of course, this is an artificial, simplified construct used to illustrate a point, but I do think it exposes some biases.

When discussing this topic, Maboussin highlights a story about an investor who was one of twenty portfolio managers managing money for a company.  The company’s Treasurer was looking to weed out poor performers and figured the best way to do so was by sorting performance by the percentage of stocks each manager picked that were winners versus losers.  This manager happened to be among the worst performers when measured by percentage of winners.  However, the manager’s total performance was among the best of the group.  When the Treasurer reached out to the manager for an explanation, this person indicated it is not only the frequency of correctness but the magnitude of correctness that matters. This manager clearly possessed a better slugging percentage than the other managers under review.

So why don’t investment managers focus much more on magnitude?  Just load up on a handful of penny stocks that could potentially yield huge returns?  I think the answer is fairly obvious and no conventional investment manager with a traditional mandate should sensibly pursue such a course.  However, certain areas of the investment universe absolutely capitalize on a low expected batting average, high slugging percentage model.  One example is venture capital, where the model contemplates a high failure rate coupled with a small number of large expected successes.

The Wall Street Journal recently profiled the Dodgers’ Cody Bellinger, who is currently making a run at being the first player since Ted Williams in 1941 to hit .400.  Impressively, he also possesses the highest slugging percentage in baseball.  Interestingly, Bellinger attributes his success this year to not trying to hit so many home runs and instead just putting a good swing on the ball.  This has resulted in fewer strikeouts and greater contact.  He’s quoted as saying, “there’s a happy medium you have to find” between power and contact.  When investing we do our best to find that happy medium.  It isn’t easy for any investor but thinking probabilistically while targeting growing companies at reasonable valuations is a good place to start.

James M. Skubik, CFA