Baseball and Efficient Markets

CBS Marketwatch reports on a recently circulated research paper by Ronald Kahn at Barclay’s Capital that makes a very good analogy between investing and baseball:

The New York Yankees and Florida Marlins may match swings on the field, but given what they spent on player salaries to get to the World Series, the two rivals couldn’t be more different in their investment styles.

The miserly Marlins, with the fifth-lowest payroll among 30 major league franchises, are typical of price-conscious value-stock buyers. The team’s $48 million salary budget averages $1.7 million a year for each player.

The freewheeling Yankees, in contrast, are the big league’s big spenders. The club’s $150 million payroll comes to more than $5 million on average for each player. The Yankees’ investing behavior is more akin to a growth-stock buyer who looks to capture a stock’s momentum regardless of price.

“The way investors succeed is not through emotion and gut instinct,” Kahn explains. “It’s through a very logical, rational, scientific approach.” Trouble is, most investors don’t embrace this strategy, creating opportunities in the marketplace for those who do, Kahn says.

That’s the secret to the Oakland A’s success, and why the one of the poorest teams in baseball — with a $50 million payroll — has consistently outperformed wealthier teams, Kahn says. The [A’s have] reached the American League playoffs in each of the past four seasons, even though its thin wallet would suggest otherwise. Only the Yankees can also make that claim.

“[The owner of the A’s] didn’t have the money to go out and pay any amount for the players he wanted,” Kahn says. “The way he was going to build a team is similar to what value investors do — to try to identify stocks that are mispriced.”

Just as a keen value buyer scours the market for mispricings and unrealistic assumptions, Beane discovered that professionals in his business frequently failed to properly value a player’s true worth — what a value investor would call a stock’s intrinsic value.

I like this example. Unfortunately for many economists, however, it provides evidence against the efficient markets assumption that economists typically make.

The efficient markets notion can be summed up by the following joke: An economist and his daughter are walking down the street one day, when the girl sees a $100 bill lying on the sidewalk. “Dad, look, a hundred dollars!” the daughter says. “Nonsense,” the economist replies, continuing with his daughter past the bill. “There can’t be $100 lying there, or someone would have already picked it up.”

The A’s – and now the Marlins – are apparently finding $100 bills all over their sidewalks.