Moneyball Concepts No Stranger On Wall Street

Includes: BLK, CME, MA, MCD
by: Efficient Alpha
<< Return to part 1
By Mario Mainelli
This is part II in our "Moneyball" series, named after the movie, sure to be a home-run in theatres and a great investing analogy. Being big Michael Lewis fans, we couldn’t resist. We hope you have as much fun reading the articles as we had writing them.
Just in time for the baseball postseason, "Moneyball" is set to hit theatres today. The film, based on Michael Lewis’ bestselling book of the same name, drew its inspiration from Oakland Athletics General Manager Billy Beane and how he forever changed the way statisticians, coaches, and fans alike would value players. Beane, a once highly-touted baseball prospect, was determined to find a way to compete with the big boys of baseball (ie. the Yanks and the Sox) on only a fraction of their budget. His solution came in the rare form of sabermetrics, the concept of using often rigorous statistical analysis to value baseball players.
Beane didn’t simply adopt the decade-old concept of sabermetrics; he used the principles of sabermetrics to develop his own unique way of finding undervalued players. You can already begin to see the connection of a common goal between the methods used by Beane and those used to pick stocks. The purpose of stock analysis is to find value at a cheap price before it becomes common knowledge. I’ll come back to this connection shortly, as I first want to dig a little deeper into the Moneyball concepts.
Beane was given the difficult responsibility of competing with teams that had a much higher budget. The A’s 2002 budget of $41 million was less than a third of the Yankees' monstrous $126 million budget. Beane knew he had to be creative and unconventional and had to make every single dollar count. Armed with his assistant Paul DePodesta, a Harvard Economics graduate and statistical whiz, Beane drew upon sabermetrics to create a new way of valuing players.
Traditional scouts had a tendency to look at raw athletic ability, such as power and speed, instead of focusing on production. Beane did just the opposite, focusing on plate presence over raw ability. The high draft choices and bulky contracts were usually awarded to young players who could crush a ball 500 feet or throw a blistering 97 mile-per-hour fastball. Beane, however, realized that he could buy cheap, valuable talent by picking players that had a high on base percentage (OBS) and a high on base plus slugging percentage (OPS). If you haven’t already guessed, he is a big supporter of players that reach base often. After all, how can you score runs without base runners? Beane also voiced his opinion on the importance of players having a low strikeout ratio and having college baseball experience.
The baseball fan in me wants to go on and on about baseball stats and how they drive value, but I think it is time to start connecting the dots. Beane popularized taking a Wall Street analytical approach to value baseball players. He stressed using eccentric ways to find hidden value, which is something that stock pickers are all about. The price earnings to growth (PEG) ratio, as I’ve mentioned in a previous article, is a great way of unlocking hidden value in stocks. This is a perfect Wall Street example of a tool that Beane would approve of.
The fact that Beane looks for so many specific things in a ball player leads me to believe that he has likely created hundreds of screens for baseball players, similar to how investors create stock screens. A risk averse investor might create a stock screen for defensive stocks that filters through stocks with a beta of less than .75, a minimum market capitalization of $5 billion, a dividend yield higher than 3%, and a P/E lower than 8. Beane, on the other hand, might create a hypothetical screen, based on his preferences mentioned in "Moneyball," that filters through players with college baseball experience, an OBS over .360, an OPS over .700, a strikeout to total at bat ratio less than 15%, and priced under $2 million a year.
Analysts on Wall Street, much like Beane, have realized that sometimes conventional analysis is not always a good fit given specific situations. Highly publicized accounting scandals, namely Enron and Worldcom, brought to light the ease in which a company could distort its financials. Companies can legally distort their financials by using aggressive estimates (higher salvage value and longer useful lives of equipment to lower depreciation expense, lowering estimates of future employee compensation growth, which lowers pension expense, capitalizing interest instead of expensing it). They can also illegally distort their financials by falsifying their financials through the use of special purpose entities, as Enron did.
The accounting scandals have caused analysts to place a much higher emphasis on cash flows than before such scandals surfaced. It is more difficult to manipulate cash flows than it is to manipulate revenue, expenses, and subsequently profit. Analysts working with account data will usually have to make adjustments to reflect the assumptions made and ensure comparability. Operating cash flow is a particularly useful statistic because it is an objective measure; it is cash obtained from the company’s core business. For example, McDonald’s (MCD) operating cash flow would include its sale of hamburgers, fries, and pop, but would not include its sale of equipment. If a company can consistently have substantial operating cash flows year in year out, it is certainly performing well.
Here is an example of a stock screen you can do that would fit Beane’s style of finding hidden value:
  • Cash flow per share greater than 10 to ensure financial flexibility
  • Market cap greater than 10 billion as large-cap stocks are generally safer than small cap
  • Operating Margin percentage (Operating Income/Revenue) greater than 30%, which ensures the company is generating cash from its core business
  • Five-year net income growth rate greater than 25%, which ensures the company has had successful growth in past years
  • Total debt-to-equity ratio less than 25%, which will ensure the company can cover its obligations
This stock screen leaves three stocks, all within the financial industry: CME Group (CME), Mastercard (MA), and BlackRock (BLK). I would then compare the Price Earnings to Growth (NYSE:PEG) ratio for all three. A lower ratio is better because it indicates that earnings and growth can be purchased at a cheaper price.
BlackRock seems to be undervalued compared with the other two stocks. This is a good start for an analysis. I would still strongly recommend digging into the company’s financials in further detail and also doing an analysis of the overall economy and financial industry before making a decision.
The article definitely has me excited to see the movie this weekend. There is just one thing I’ve left unanswered. I’ve discussed the concepts of "Moneyball" and have yet to answer the most important question it poses: did it work? How did Beane’s Athletics place in the standings? Well, they didn’t win the World Series, but they did turn some heads, winning back-to-back division titles in 2002 and 2003. Beane must have appreciated the irony that the American League West division finished in opposite order of their payrolls. Oakland topped the division with a $41 million payroll, more than 31 games ahead of Texas, and its massive $107 million payroll.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.