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Baseball and Benchmarks

Major League Baseball launched its 2017 season in early April. Optimism reigns, as usual this time of year, because it is the start of the season. No team can be certain what level of success fate has in store for it. Some players might have breakout years at bat or the pitching rotation might coalesce into a dominating force on the mound. Or perhaps a team might suffer key injuries or have an expensive free agent dramatically underperform. So much can happen in the six months until the playoffs.

The game of baseball has some interesting similarities to investing. Both keep score and both have a variety of metrics to measure performance. Both have long and arduous seasons--162 games between April and October for Major League Baseball and 20, 30, even 50 years for most investors. Winning and losing for both often comes in streaks. There’s nothing like a series of wins to bolster a team’s or an investor’s confidence and spirits. Contrarily, losing streaks are painful and dispiriting.

The 2016 World Champion Chicago Cubs won 11 games in a row during the regular season, but they also put together a string of five straight losses. The hapless Atlanta Braves, on the other hand, lost 9 in a row at one point and only put together a single 7 game winning streak. Of course it’s not the streaks themselves but the overall won-loss record that counts. The Cubs were 103-58 while the Braves were a dismal 69-93.

There’s a temptation for investors to set their “season” arbitrarily by the calendar, so they ask “How did my portfolio do last month, or last quarter?” rather than “How is it doing from the perspective of my long term goals?” We try to help our clients evaluate their investment record over the full market cycle—trough to trough, such as 1991 to 2003, or 2003 to 2009. It takes that length of time to truly capture how well an investment strategy has performed in both favorable and unfavorable times. Up until late last year value investing, our preferred investment style, had been lagging most stock market benchmarks. The muti-decade record of value investing dominates other styles of investing such as “growth” or “momentum” which is why we favor it. We have detected some signs that value is beginning to reassert itself, so we are hopeful that 2017 will bring satisfying results for our clients.

Remember too that unlike baseball, an investor’s season is cumulative. It doesn’t reset each year. Long losing streaks (aka deep bear markets) must be avoided or at least attenuated in order for investors to have a reasonable prospect for long term success. Imagine how the Braves would feel if they had to start the 2017 season with 93 losses! As we have often reminded our clients, the mathematics of deep losses is daunting. A 50% loss (drawdown) requires a 100% gain just to return a portfolio to even. In the last bear market it took the S&P 500 over 5 years to return to its 2007 high. It took the NASDAQ over 15 years to return to its 2000 high. Yes, the markets always come back, but it requires a lot of patience to make up big losses. We’d rather try to sidestep them as we did in 2008-2009.

Baseball has a delightful abundance of metrics and benchmarks which can help explain how teams generate their W’s and L’s. For a long time Batting Average (number of hits divided by number of official at bats) was the primary measure of a ballplayer’s offensive contribution. Fans benchmarked a player who hit .300 (300 hits per 1000 at bats) as a very good hitter. But think about that. Getting a hit just 30% of the time put a player in the upper echelon of offensive players. In the last fifteen years or so, On Base Percentage has risen as a more useful measure of a player’s contribution to winning. It calculates how often a player gets on base (whether by hitting, walking, or being hit by a pitch) because getting on base is the prerequisite for scoring runs. And a baseball team must score at least one run to win a game.

A parallel in the investment world might be “earnings per share”, EPS, versus “free cash flow per share” as a measure of how successful, hence how valuable, a company might be. EPS has many shortcomings from a valuation perspective. Management has numerous perfectly legal ways to massage reported earnings. It can adjust depreciation schedules, capitalize certain expenses, lease rather than own equipment and property and so on. It can use cash or even borrow to buy back its common shares and thus reduce the denominator in the EPS calculation. Free cash flow, on the other hand, is very difficult to manipulate. Free cash flow is the cash generated by the company less the capital expenditures required to maintain operations. Many analysts insist that comparing a company’s stock price to its free cash flow per share provides a better guide to its value than using price to earnings per share, the traditional P/E ratio.

Of course a prudent investor wouldn’t invest in just one security. A portfolio of holdings (stocks, bonds, alternatives, and cash) is normally required for long term investment success. Similarly a baseball team must have a proper diversity of assets: not just good hitters, but players who can field well; pitchers, both lefties and righties; utility players who can fill temporary gaps in the lineup due to sickness or injuries; a solid manager and capable assistant coaches. Just as it would make little sense to look only at a baseball team’s batting average (ignoring pitching and fielding), investors should not look at components of their portfolio in isolation. A baseball team needs the right blend of hitting, fielding, pitching, and managing to achieve wins. So too a portfolio truly is the sum of its parts and what counts is how well it moves towards the investor’s ultimate goals. We sometimes compare a portfolio to a stew. The combination of the ingredients and how they interact determines the tastiness and success of the dish.

A common error some investors make is forgetting that they have a blend of assets so the proper comparison is to a blended benchmark. The benchmark should reflect the typical composition of the portfolio. A “Growth” benchmark would give a heavier weighting to stocks than would an “Income” benchmark. Another common mistake is to compare a portfolio which is, say, 60% stocks, 30% bonds and 10% alternative investments to just a single benchmark such as the S&P 500 or the Russell 1000. That provides a highly distorted picture of how well the portfolio has performed. Fans don’t judge a pitcher by his batting average but by his earned run average (ERA). Investors must remember to match their benchmark to their portfolio allocation.

Investing, like baseball, requires doing a lot of things well, day in and day out. A prudent strategy consistently applied holds the key to long term success. The New York Mets’ great pitcher Tom Seaver said it well

In baseball, my theory is to strive for consistency, not to worry about the numbers. If you dwell on statistics you get shortsighted, if you aim for consistency, the numbers will be there in the end.

We think the same holds true for the game of investing.

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