What Baseball and the Stock Market Have in Common

by: Tim Price

“If you can’t beat them, arrange to have them beaten.”

- George Carlin.

What does professional baseball have in common with the stock market? More than you might think. Research Affiliates’ Rob Arnott, writing in last week’s FTfm supplement, points out the tendency of the stock market to routinely overprice prospects for ‘growth’ stocks at the expense of their ‘value’ peers:

In the past, did the market overpay for growth and over-punish struggling companies? Yes. While premium or discount valuation multiples are correlated with future growth or future disappointment, the premium paid for the winners and the discount assigned to the losers is too great, the market pays an average of about 100% premium for [companies with lofty growth expectations], relative to [companies with poor growth expectations]. The market overpays for future growth – relative to its ability to correctly anticipate that growth – by about two to one. The market discerns which companies are likely to do best and then overpays for those future prospects.

As Arnott says, this forms the basis of the so-called value effect, the apparent anomaly whereby the stocks of companies with low price / book and similar ratios tend to outperform the stocks of companies with metrics pointing to high confidence in dramatic future growth. But Arnott also points out the extreme valuations now present in the market. Growth stocks are no longer priced at “just” twice the valuation multiples of value stocks; they are now priced at a 2 ½ times multiple;

To read more,

Download Hitting it out of the park (.pdf)