The Longwave approach: Mad Men meets Moneyball
– David Wanis, September 2020
Moneyball was a true story about baseball. It was the story of the Oakland Athletics baseball team and their general manager, Billy Beane. It told how this team changed the way baseball players are selected and teams are built in pursuit of the goal of winning games.
Their observation was that biases in the way baseball players are selected or ‘scouted’ resulted in observable characteristics (like physical appearance) being given greater weight than statistical evidence (like on-base percentage). Their hypothesis was that broad statistical evidence was a better predictor of outcomes and could overcome human bias in selecting and bidding for players.
A Moneyball approach has real application in small cap investing. It helps us understand where and why the ‘scouts’ in our industry may be biased and helps demystify where small cap returns come from.
“They’re still asking the wrong questions…The goal shouldn’t be to buy players, what you want to buy is wins. To buy wins, you buy runs… The Red Sox look at Johnny Damon and they see a star worth seven point five million a year. When I look at Johnny Damon, I see an imperfect understanding of where runs come from.”
– Peter Brand, Moneyball (movie), 2011
Asking the right questions can uncover new insight.
“The goal shouldn’t be to buy players, what you want to buy is wins.”
As investors, is our goal to pick stocks or to generate better total portfolio returns? They are often assumed to be the same thing but perhaps they are not. Sometimes in the pursuit of picking stocks, we end up with Johnny Damon when what we really wanted was to win the World Series.
Moneyball: Where runs come from in small cap investing
Behavioural bias and misunderstanding in small caps relate to where returns come from. Small caps are fundamentally different to large caps. It feels like they should be similar, but they are not. These differences change how returns are generated and where active management can add significant value.
Three examples of these differences;
Drag from losers: There is almost twice the frequency of companies in the small ords that deliver a negative total return during their time in the index as compared to the ASX100, and those losses on average are more than twice as large. The drag on index returns from these ‘losers’ is 4-5x as much as for large caps.
Name turnover: The number of new names coming into the small cap index is around four to five times that in the ASX100.
Return skew: Not only does the small cap index have bigger losers, there are also much bigger winners on the other side. Alpha can be added both in limiting exposure to losers but also letting winners run and compound as small companies grow into large caps over time.
We use the term Moneyball as short-hand for an understanding of base rates, improving our control of losers and increasing our exposure to long term winners. Unlike baseball, markets have constantly changing rules so we can never stop using insight and judgement in our process.
Mad Men: Judgement, insight and the pursuit of quality
Mad Men is short-hand for creativity, judgement and insight. Good fundamental research is about more than reading accounts. It is about understanding business models and consumers and behavioural quirks and changing technology and regulation and social norms and everything else impacting the future cash flows of a business beyond the black and white numbers that are reported.
The world is changing all the time and small caps are changing more than almost every part of the market. Even using a data-driven approach, insight is still required to know what questions to ask of the data.
In 2020 data is plentiful. Good questions are scarce.
In our view, the golden rule, the thing that matters most in investing in small companies – and far more so than large caps – is quality.
- Quality is where returns come from in small caps.
- Quality is how to reduce the number of losers in the portfolio
- Quality enables holding onto the big long-term winners
- Quality is how an investor can start to tell if a small cap has evolved from an experiment into a long-term wealth compounding business
We seek value, but always within a group of quality businesses. By chasing value at the expense of quality, the risk of business failure increases considerably – once again far more in small caps than large. Value remains important as there comes a price where high-quality businesses become lousy investments – even though investors have had little evidence of that lately.