Stock Investment Lessons From the World of Baseball

March 29, 2012

Greg Forsythe
CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research

I loved absorbing sports statistics as a kid, but never dreamed that comparing Johnny Bench to Pete Rose would be career preparation for using quantitative techniques to evaluate the stock market. So you can imagine my delight when I read the book Moneyball, written by business author Michael Lewis (and now an Academy Award nominated movie). Moneyball tells the story of the Oakland A's, who used a unique statistical approach to analyzing players and game strategies to compile one of the best records in baseball from 1999 to 2006, despite being limited by a shoestring payroll budget.

The parallels between what Oakland learned from objectively researching baseball success and what Schwab has learned about successful stock selection are fascinating. In this article, we'll highlight two particularly relevant lessons.

To play the odds, you have to know the odds

Obviously, baseball managers prefer to have the best players on their teams. In close games, managers seek strategic advantage by substituting relief pitchers or pinch hitters and by attempting to manufacture runs with a stolen base or sacrifice bunt. But how does one determine who are the best players? How does one decide whether a sacrifice bunt is worth the risk?

Traditionally, baseball teams have used experienced managers to make such decisions, who supplement gut instinct with selected statistics. Hitters are measured by batting average, fielders by fielding percentage and pitchers by the speed of their fastball. But the game of baseball can be subjected to much more intensive scrutiny. By doing so, the Oakland A's discovered that conventional baseball wisdom is often wrong.

For example, they learned that on-base percentage is a better indicator of a hitter’s run contribution than batting average and that attempting a sacrifice bunt significantly lowers the likelihood of scoring. By explicitly linking player statistics and game scenarios to actual outcomes, i.e., runs scored, the A's were able tilt the odds in their favor as they selected players and executed game-situation strategies.

Similarly, in investing, you can do better than rely on your own experience or that of a money manager to make stock-selection decisions. By rigorous analysis of investment outcomes, i.e. stock returns, Schwab has discovered key statistics that historically have increased the likelihood of finding stocks that may outperform the market.

For example, we think recent free-cash-flow growth is a better predictor of subsequent stock returns than the much more commonly used earnings-growth measure. Also, companies that report earnings per share (EPS) above consensus forecasts in the previous quarter are much more likely than average to report another positive surprise in the following quarter.

Past performance and future potential are important, but not priceless

Baseball teams constantly make personnel changes in an attempt to field a winning team and make a profit while doing so. Decisions about draft choices, trading players and contract offers are based on judgments of a player’s particular skills, current performance and future potential. The difficulty is that the wisdom of today’s decisions will only be known later.

Rather than relying strictly on judgment, the Oakland A's used statistical analysis to correlate future performance to past performance and current contract costs. Once again, the A's found exploitable patterns. For example, drafting high school players based on simple athleticism and upside potential tended to cost more and produce poorer results than drafting less-flashy prospects who'd demonstrated success in college baseball. They also learned that teams were often too quick to offer large, long-term contracts to players who'd had one big year, or to aging stars based solely on past performance. In other words, the A's learned that certain player attributes were consistently overpriced: future potential, recent performance and long-term past performance.

At Schwab, we believe we've found similar patterns in the pricing of stocks. For example, stocks with high forecasted long-term EPS growth have historically underperformed stocks with lower expected growth potential. Stocks with recent strong EPS growth often lead investors to extrapolate such rapid growth too far into the future. And finally, stocks with the highest historical five-year EPS growth are generally unable to sustain above-average growth in the following five years.

An exclusive solution, just for Schwab clients

Not surprisingly, the baseball establishment has reacted defensively to the decision-making approach used by the Oakland A's, despite the A's having by far the lowest "player cost per win" statistic in baseball. Wall Street likes to cling to the tradition of using analysts to recommend stocks. At Schwab, we have a different approach—Schwab Equity Ratings.

Few individual investors have the time or tools to research the stock market to the extent the Oakland A's have studied the game of baseball. But fortunately for Schwab clients, we've done much of the work for you with Schwab Equity Ratings. By studying thousands of stocks over decades of time, we believe we've isolated many of the key current attributes of stocks with the potential to be future market winners and losers.

While Schwab Equity Ratings don't guarantee investment success, they're designed to help tilt the odds in your favor. Since inception in May 2002¹, the average A-rated stock has outperformed the average of all rated stocks on a 52-week buy-and-hold basis by a wide margin, 19.07% versus 14.06%. We encourage you to talk to a Schwab representative to learn more about how Schwab Equity Ratings and investment products might help you become a more-successful investor. Schwab clients can also login to learn more.