“It’s unbelievable how much you don’t know about the game you’ve been playing all your life.”

— Mickey Mantle, New York Yankee Hall of Famer

Moneyball, the 2011 movie starring Brad Pitt as Oakland Athletics General Manager Billy Beane, is just as much about value investing as it is about baseball. Just as value investors analyze stocks objectively based on the relationship of a stock’s market price to quantitative measurements like its discounted cash flow (DCF) value, adherents of sabermetrics analyze baseball players objectively based on the relationship of a player’s salary to quantitative measurements like on-base percentage and fielding independent pitching (FIP).

In both the stock market and baseball, the question is whether the commodities at issue are efficiently priced. If they are, then value investors should just give up and buy an index fund and baseball teams with the most money will always win the World Series. But value investors historically have outperformed because stocks aren’t efficiently priced due to the behavioral flaws of most investors who exhibit reckless overconfidence and short-term thinking.

The question posed in Moneyball is whether the managements of major league baseball teams exhibit similar flaws when evaluating player talent. Traditionally, teams have relied on baseball scouts who evaluate players based on five skills: hitting, power, fielding, arm strength and speed. These are primarily physical attributes that measure a player’s potential rather than his actual achievement. In the movie, scouts also try to assess a player’s mental confidence by inane and completely untested criteria like the attractiveness of the player’s girlfriend. For example, one scout rules out a player because:

His girlfriend is ugly. A guy with an ugly girlfriend has no confidence.

Pop psychology at its worst!

Billy Beane is Living Proof of the Need for Sabermetrics

As a teenager growing up in California, Billy Beane was an outstanding high school baseball player who scored at the top of the list for each of the five skills measured by scouts. In 1980, he was drafted in the first round by the New York Mets and paid a $125,000 signing bonus. Yet, Beane was a total bust in his six major league seasons due to emotional problems (mostly a bad temper) and obsessive over-thinking (he was smart enough to get accepted at Stanford University) that interfered with his ability to concentrate and execute.

Although not mentioned in the movie, the original book by Michael Lewis compares Beane’s failure with the success enjoyed by fellow Met Lenny Dykstra, who had substantially less physical talent and was dumb. Dykstra’s stupidity turned out to be an advantage because he didn’t get scared or over-think things. The bottom line is that Beane knew from his own experience as a failed player that the criteria used by scouts didn’t work (p. 38):

A young player is not what he looks like, or what he might become, but what he has done. Most of what’s important about a baseball player, maybe even including his character, can be found in his statistics. The scouts even had a catch phrase for what Billy and others were up to – ‘performance scouting.’ Performance scouting in scouting circles is an insult. It directly contradicted the baseball man’s view that a young player is what you can see him doing in your mind’s eye.

Baseball Success Transcends Simplistic Stereotypes

Many highly successful players did not fit the physical stereotype used by scouts to judge talent. Examples include Chad Bradford who had a weird underhand pitching motion, catcher Scott Hatteberg who couldn’t throw but could still hit, and third baseman Kevin Youkilis who was fat and couldn’t run, throw, or field, but was the “Greek god of walks.” Paul DePodesta, Beane’s assistant in Oakland and the real sabermetric genius, refused to cooperate with the movie for some inane reason, so the writers changed his character’s name to Peter Brand, made him fat, and had him graduating from Yale instead of Harvard (the ultimate insult). Anyway, in the movie DePodesta’s character calls the A’s sabermetric-enhanced team the “island of misfit toys.” But it turns out that these misfits could really play ball and the story provides a perfect Hollywood message to resonate with theatergoers: you don’t have to fit a stereotype of beauty to be a success.

Dividend Investing is Like Sabermetrics

An investing analogy to the concept of “performance scouting” would be selecting boring dividend stocks over flashy high-tech growth stocks because academic research has shown that investors overpay for growth (causing them to underperform) and ignore slow-growth and low-beta stocks (causing them to be undervalued and subsequently outperform). Such investors also think it is mostly a waste of time to meet with company management, preferring to judge management performance simply by evaluating the company’s financial performance.

Sabermetrics Means Thinking Outside of the Box

But sabermetrics – the term is derived from the Society for American Baseball Research (SABR) – goes beyond the concept of performance scouting and statistics. It asks the question: which baseball statistics are the most informative? Traditional baseball men focused on batting average, but sabermetricians discovered that on-base percentage  (OBP) was much more important. Winning games depends on scoring runs and the only way to score runs is to get on base. It doesn’t matter whether you get on base through a single or a walk or a hit-by-pitch. A .320 hitter who never walks is less valuable than a .290 hitter who walks often. Walks also serve the purpose of tiring out the opposing pitcher, because he is forced to throw many more pitches than would be the case if a hitter always swings.

Similarly for pitchers, tradition focused on earned run average (ERA) but ERA is dependent on the fielding team’s ability to prevent hits, not a pitcher’s skill. Sabermetrics determined that pitchers can only control walks, strikeouts, and home runs and thus should be judged on those metrics – as measured by fielding independent pitching (FIP) — not on hits and ERA.

Variant Perception Explains the Success of Both Sabermetrics and Value Investing

Back in 2002, when Moneyball takes place, most teams did not focus on OBP and FIP and consequently players with high OBP and FIP were not paid high salaries. Teams in low-revenue markets like Oakland that could not afford the $100 million player payrolls offered by teams in high-revenue markets like New York and Boston were able to remain competitive by loading up their roster with high OBP and FIP players. The value of high OBP and FIP was public information that was available to all, but only a few teams used sabermetrics and appreciated the predictive value of these novel statistical measurements. This is similar to the investing “Seeing eye” I wrote about in How to Beat the Stock Market Without Really Trying: Value Investing. It also meshes with what superstar hedge fund investor Michael Steinhardt wrote in his 2001 autobiography entitled No Bull: My Life in and Out of Markets about the importance of being a contrarian investor with a perception of value at variance with the crowd:

I began to consciously articulate the virtue of using variant perception as an analytic tool. I defined variant perception as holding a well-founded view that was meaningfully different from market consensus. I often said that the only analytic tool that mattered was an intellectually advantaged disparate view. This included knowing more and perceiving the situation better than others did. It was also critical to have a keen understanding of what the market expectations truly were.

Thus, the process by which a disparate perception, when correct, became consensus would almost inevitably lead to meaningful profit. Understanding market expectation was at least as important as, and often different from, fundamental knowledge. As a firm, we soon found that we excelled at this. We took exactly that approach during the early 1970s, when most of our success resulted from our implementation of perceptions that were meaningfully at variance with consensus wisdom. We shorted near the top, in the face of great bullishness, and we got long at the bottom, in the face of keen pessimism.

In an interview, Beane made his own analogy between sabermetrics and investing:

It’s all about evaluating skills and putting a price on them. Thirty years ago, stockbrokers used to buy stock strictly by feel. Let’s put it this way: Anyone in the game with a 401(k) has a choice. They can choose a fund manager who manages their retirement by gut instinct, or one who chooses by research and analysis. I know which way I’d choose.

Sabermetrics is Not a Panacea, But One of Many Tools

In watching the movie, however, something didn’t ring true. The opening scene is the 2001 American League Divisional Playoff between the Athletics and the Yankees. The Athletics won 102 games that year and beat the Yankees in the first two games of the playoff. Then momentum reversed and the Yankees won the last three games to eliminate the Athletics from the postseason. All of this success occurred before Beane had embraced sabermetrics. In other words, despite the fact that Oakland was a low-revenue market, it had managed to win 102 games under the old system of developing players internally through scouting. The movie completely trashes the value of traditional scouting – particularly the A’s head scout Grady Fuson – but the success of the scout-developed 2001 team speaks for itself.

After the 2001 playoff loss, the A’s lost three of its star players to free agency: first baseman Jason Giambi, outfielder Johnny Damon, and relief pitcher Jason Isringhausen. Beane couldn’t afford to replace these players immediately by paying the inflated salaries of other major leaguers with similar batting statistics, but he also didn’t want to wait for the scouts and Oakland farm system to develop new talent (which he didn’t trust anyway despite the 2001 season). What he could do immediately is buy a number of cheap players with high sabermetric ratings that collectively could come close to equaling the offensive output of the departed star players. Not in terms of traditional measures of output (e.g., batting average or home runs), but in terms of the offensive output that really mattered (e.g., run generation). 

2002 was the first year that Beane utilized sabermetrics (after firing head scout Grady Fuson). The result was a 103-win season, one game better than the year before. Furthermore, the A’s broke the American league regular-season record for consecutive wins by winning 20 in a row. But the A’s didn’t do any better in the playoffs, losing in the first round to the Twins. Funny thing, the 2002 playoff loss didn’t make it into the movie. So did sabermetrics really improve anything? According to one analysis, the A’s success in 2002 was a combination of luck and the performance of the pitching staff, all of whom were developed by the traditional scouting system and none selected by Paul DePodesta’s sabermetric computer screen. The A’s still couldn’t win the big game despite sabermetrics. In fact, under Billy Beane’s continuing 13-year tenure (1998-2011), the A’s have never reached the World Series, let alone win it. Furthermore, since getting swept by the Tigers in the 2006 playoffs, the A’s suffered five consecutive losing seasons and not advanced to a single playoff berth despite sabermetrics.

But Beane is making a comeback! In 2013, the A’s were crowned champions of the American League’s Western Division for the second consecutive year and it marked the seventh time the A’s had made the playoffs in Beane’s 16 years at the helm. He is still widely considered the best general manager in baseball.

Popularity is Sabermetrics’ Downfall

Until the renewed success of the last two years, a large cause of Beane’s failures was that sabermetrics has been widely adopted by most major league baseball teams, so highly-rated OBP and FIP players are no longer undervalued and Oakland no longer has a “variant perception” advantage. Soon after the book was published in 2003, the Boston Red Sox became a believer (thanks to its commodity-trading owner John Henry who recognized the investment analogy). The Red Sox owner (played by himself in the movie) offered Beane $12.5 million to move to Boston but Beane declined, allegedly because he didn’t want to leave his daughter. Henry had previously hired sabermetric guru Bill James for a lot less money and the Red Sox won the World Series in 2004 for the first time in 86 years.

If you look at baseball statistics today, sabermetric measures like OBP, OPS, and WHIP are always included. So sabermetrics definitely has value, but it is now widely recognized and exploited by the rich teams just like all other measures of talent, leaving poor teams like Oakland back where they started prior to 2002. Even rich teams like the New York Mets aren’t finding success (yet) with sabermetrics since they adopted the approach in October 2010 with the hiring of former A’s general manager Sandy Alverson. And the Phillies were able to win 102 games in 2011 – more than any other team in baseball – despite rejecting sabermetrics.

Just like investment styles temporarily fall out of favor with the market — only to come roaring back — so too does sabermetrics. While the sabermetric A’s won the American League West this year, the non-sabermetric Phillies finished fourth out of five in the National League East.

Critical Thinking Never Goes Out of Style

Still, I think sabermetrics has a bright future because it is based on objective reason and analysis, and those qualities never go out of style. There will always be new insights to learn about baseball that others have not yet realized. As sabermetric guru Bill James said in an interview:

Well, that window has closed. But, you know, there will never be a shortage of ignorance. I mean, there will always be things that people don’t understand, and you just have to move on to the new areas of better understanding and master those to have the advantage that you had 10 years ago. And that’s in the nature of any progressive field, you know? The things that worked 10 years ago aren’t going to work anymore. I mean, that’s true, but it’s a limited truth. And there are still great advantages to be had by understanding the game better just as there were 10 years ago.

The Ultimate Irony: Grady Fuson Returns

With the Red Sox World Series victory in 2013, Billy Beane perhaps regrets not taking John Henry’s $12.5 million offer, but he’s not giving up. He’s pushing to have the A’s move to San Jose, which is a higher-revenue market than Oakland. And – the most ironic of all – he’s rehired old-time scout Grady Fuson, the Moneyball anti-christ.

Sometimes reality is stranger than fiction.

Around the Roadrunner Portfolios

Diamond Hill Investment Group (Nasdaq: DHIL) released strong third-quarter financials that saw earnings per share up 27%, revenues up 23%, and assets under management (AUM) up 14%. A booming stock market has definitely helped Diamond Hill’s AUM growth, but the company also saw fund inflows (page 19) for both its proprietary mutual funds and sub-advised funds.

For the first nine months of the year, however, fund outflows from sub-advised funds and institutional accounts have worsened. Not sure why outflows have occurred, since the company’s investment performance has improved as of late, but sometimes there is a time lag before improved performance is recognized. In any event, Diamond Hill’s stock keeps rising and is now the second-best-performing Roadrunner recommendation with a 68.5% return. Investors are probably bidding up the stock in anticipation of another hefty special dividend at the end of the year.

LeapFrog Enterprises (NYSE: LF) reported third-quarter financials that saw GAAP earnings per share beat analyst estimates and adjusted earnings grow by 19%. Revenue growth of 4% was little light of expectations. The real news, however, was lowered guidance for the all-important fourth-quarter holiday season. Retail stocks have been hit by weak consumer spending and LeapFrog is not immune to such macroeconomic forces.

In the Nov. 4th conference call, CEO John Barbour said that the company is well positioned despite the macroeconomic softness and LeapFrog products are flying off the shelves:

We are well-positioned for the holidays with our best product lineup, significant off-shelf promotions and a strong marketing plan for Q4. I personally store checked 8 stores yesterday morning and found substantial out-of-stocks in our key items despite stronger retail inventories than last year.

There’s no question the market is tougher going into this holiday season. When you add to that the 6 fewer days, which does have an impact the tighter the market becomes, that’s why we have some caution going into this quarter.

On September 3^rd, a director purchased 25,000 shares of LF at 9.10, which is a nice endorsement for the company’s long-term business prospects!

LeapFrog is a real bargain below $9. Even with reduced guidance, analysts still expect the company to grow earnings by 17.5% annually over the next five years and the forecast for 2014 earnings of $0.57 are 32.5% higher than this year’s $0.43. As the global economy becomes more knowledge-based, early childhood education will increasingly become a necessity for U.S. competitiveness. LeapFrog is perfectly positioned to benefit from this education megatrend. I continue to believe that LeapFrog — the company with the best products — will eventually succeed and the stock is super-cheap at an EV-to-EBIDTA ratio of only 5 with no debt!

Ocwen Financial (NYSE: OCN) reported third-quarter financials that missed analyst estimates for both earnings and revenues, but Chairman Bill Erbey convincingly explained the shortfalls as due mainly to a timing issue:

Notwithstanding our record revenues, revenues were suppressed due to delays that have now been resolved in boarding the OneWest transaction. As expected, margins were below historical levels due to the timing involved in transitioning ResCap and OneWest.

Analysts were divided on the importance of the earnings miss, with two brokers downgrading the stock to market perform and two brokers raising price targets to $58 and $65, respectively. The downgrades are unpersuasive and appear to be knee-jerk reactions to both the earnings miss and a mistaken belief that the stock’s outperformance can’t continue. On November 12^th, Standard & Poor’s sided with the optimists and raised Ocwen’s credit rating to B+ from B, stating:

Following a year of large acquisitions of mortgage servicing rights portfolios, Ocwen Financial appears to have successfully added about 2 million mortgages to its servicing platforms–significantly boosting its EBITDA and alleviating some of our concern about its rapid balance sheet expansion.

Even though Ocwen missed estimates, revenue shot up by more than double (128 percent) and earnings rose 19 percent. Looking forward, earnings are expected to rise 88.7 percent in the fourth quarter, 43.7 percent in the first quarter of 2014, 57.6 percent for fiscal 2013, and 135.9 percent for fiscal 2014.

Further growth appears assured by the fact that all of the large banks continue to sell off mortgage-servicing rights (MSRs) in order to comply with stricter capital requirements. For example, Citigroup recently announced plans to sell off MSRs on $63 billion of its mortgage loans, or about 21 percent of its total contracts. Ocwen is sure to be one of the largest acquirers of these MSRs. As I’ve stated before, the more MSRs Ocwen owns, the more fees it collects and the higher its earnings.

Couple that amazingly strong growth with a trailing 12-month P/E ratio of 31, and you get a PEG ratio far below 1.0. It’s no surprise that Steve Eisman (who made millions in the 2008 sub-prime mortgage crisis) continues to tout Ocwen as one of his favorite stocks with 50% more upside.

Stepan (NYSE: SCL) reported third-quarter financials that exhibited healthy revenue growth of 8%, but nearly flat earnings growth of only 1%. Earnings missed analyst estimates by a penny, whereas revenues beat estimates. Stepan enjoys the third-highest sales per share in the specialty chemicals industry.

I’m okay with the flat earnings because they were caused by necessary investment expenses in R&D and emerging-market growth initiatives plus one-time charges associated with both the start-up of a Singapore manufacturing plant and the shut-down of a China plant that the Communist government required be moved to another location.

In the conference call, the company isn’t holding its breath that the Chinese government will provide adequate compensation for the plant dislocation, but the growth potential of China remains undeniable. Brazil and Singapore business is picking up the slack. As for the exciting move into the oilfield services space, the sale of enhanced oil recovery (EOR) chemicals is going a bit slower than expected with “some delay in project implementation.” In 2014, however, the delays will be history and the company expects “improved performance.”

CEO F. Quinn Stepan Jr. is upbeat about the future:

We remain optimistic about our long-term growth. The slow start to the year has made achieving full year earnings growth difficult, but we continue to pursue investments that will accelerate our growth.  In 2014 we will realize the benefits of our recent acquisition and other capacity expansions.

In addition, the company increased its quarterly dividend by 6%, marking the 46^th consecutive year that the dividend has been raised. I like Stepan because it is such a shareholder-friendly company that focuses on returning excess cash while waiting for the global economy to strengthen. We are paid to wait!

United Therapeutics (Nasdaq: UTHR) continues to thrive in the three months since I labeled its second-quarter conference call the most optimistic in history. In fact, it is the best-performing stock in the Roadrunner universe – up 75% since it was recommended less than a year ago. Third-quarter financials continued the trend of strong results, with revenues up a strong 24.6% and adjusted earnings (i.e., before non-cash charges) up 23.6%. Revenues beat analyst estimates with all three main products (Remodulin, Tyvaso, and Adcirca) performing well. Even better, the company raised its guidance for full-year revenues and now expects to exceed the upper end of its previous guidance of $1.05 billion.

In the conference call, CEO Martine Rothblatt’s discussion about Remodulin’s future refers to Winston Churchill and is very inspirational. Although Remodulin has been around for more than a decade, a revolutionary new application – the implantable pump – promises to make the drug an even-bigger winner going forward:

I’m extremely pleased with the results of the third quarter. Our medicines are now prescribed for more PAH patients in the U.S.A. than any other company. United Therapeutics’ revenues are clearly on an upward trajectory. And when I take a look at our, at our leading revenue generator, Remodulin, I’m kind of reminded of this quotation back from the 20th century. I believe it was Winston Churchill, World War II, but don’t hold me to this and don’t hold it against me if I didn’t know for sure that it was Winston Churchill, for our English holders. But I believe he said something along the lines of, “This is not the beginning of the end, but the end of the beginning.” And he was speaking with reference to World War II. But for me, I’m speaking with reference to Remodulin. It’s kind of extraordinary for a drug that was launched in 2002 to 13 years — 11 years later, still have striking revenue growth quarter-over-quarter, year after year. And somebody might say, “Well, is this the beginning of the end?” I mean, that’s a long run for a drug, especially in an orphan market. But in fact, I feel very confident that it’s actually only the end of the beginning and nowhere near the beginning of the end.

And the reason it is just the end of the beginning is because we are now moving into an inflection period, where our Remodulin revenues are driven predominantly by parenteral delivery via subcutaneous or intravenous infusion attached to a pump that is carried outside of the patient’s body. And among the patients and the doctors and the nurses in the pulmonary hypertension community, this is referred to as being on “the pump.” And it’s always said with kind of scary music in the background, that people are frightened that they have to go on “the pump.” And it is, of course, something that any of us who are healthy enough not to need that, should really have a world of respect for those who do have to walk around 24 hours a day, 365 days a year with a catheter winding outside of their skin connected to a mechanical pump that is literally pumping medicine into their body with the full knowledge — they all know that if that pump was to stop for any number of hours, they could face instant death. And people have died instantly from rebound hypertension due to an interference with parenteral prostacyclin delivery. So the pump is scary. Now despite that, as I just mentioned, we’ve grown revenues of Remodulin and are now — actually have $0.5 billion a year revenue run rate within our eyesight. We’re not there yet, but it’s something that seems to be visible on the near horizon.

But I really believe that this is just the end of the beginning because there is a revolutionary new product in our pipeline, which is the implantable Remodulin. And as I travel around the country and talk with physicians, I’ve not met one who is not tremendously excited and believes it will be transformative for their Remodulin patients.

Despite promising future growth and strong price appreciation, United Therapeutics continues to trade at a reasonable EV-to-EBITDA ratio of 8.6. And don’t forget that oral Remodulin could still receive FDA approval, with the next  FDA response scheduled for February 16, 2014.

US Ecology (Nasdaq: ECOL) skyrocketed more than 13% on October 29^th after releasing a superb third-quarter financial report.  The company generated record operating income (up 25%) and record adjusted EBITDA (up 20%). Earnings per share and revenue both easily surpassed analyst estimates. Even better, the company raised its earnings and adjusted EBITDA guidance for full-year 2013. CEO Jeff Feeler spoke very confidently about 2014:

Strong Event Business combined with steady Base Business and continued operational excellence across all of our facilities produced a second consecutive quarter of record financial results. Growth in our Event Business was driven by a combination of solid new project demand and accelerated shipments on longer-term projects. Our underlying Base Business is performing as expected and demand for our thermal recycling services remains strong.

With a healthy pipeline of business that runs into 2014 and a solid fourth quarter outlook, we now expect full year earnings for 2013 to range from $1.68 to $1.73 per diluted share, up from our previous range of $1.45 to $1.55 per share. Adjusted EBITDA is expected to range from $67 million to $69 million, up from our previous guidance of $62 million to $65 million.

In the conference call, Feeler emphasized the company’s focus on profitable growth, stating:

Our key financial metrics that we track remain at or near industry-leading levels, with us delivering almost a 17% return on invested capital, 13% return on total assets and 24% return on shareholders’ equity. Overall, I continue to be pleased with our execution, companywide. Our end markets continue to be healthy and our project pipeline remained solid moving into the fourth quarter, which should translate into a strong finish for the year.

Wunderlich Securities issued a research report after the earnings release entitled “Wow! Can FY14 Maintain a Solid Growth Rate? Yes!” The analyst reiterated his buy rating on the stock and raised his price target to $38 from $33.

Bottom line: the U.S. is producing a lot of waste and US Ecology is the one cleaning up (literally and figuratively).  

Western Refining (NYSE: WNR) skyrocketed 9.5% on November 12^th thanks to news that it was acquiring 100% of the general partnership interest and 38.7% of the limited partnership interests in Northern Tier Energy for $775 million in cash. The purchase price is only 4.5 times 2014 EBITDA estimates, which is a bargain price representing a 16% discount to the EBITDA multiples of peer companies. The merger is expected create $20 million worth of cost-saving synergies per year and will be immediately earnings accretive to Western.

Northern Tier is a variable-rate MLP and UBS upgraded Western on news of the acquisition with a $41 price target based on its belief that Western will transfer its refinery assets to Northern Tier’s tax-advantaged MLP structure. MLP-structured refiners have higher valuations than C-corp. refiners like Western.

Northern operates a Minnesota refinery with an 89,500 barrel-per-day capacity, as well as more than 230 SuperAmerica convenience stores/gas stations and a 17% interest in a crude oil pipeline. Since Western’s El Paso and Gallup refineries combined have a daily capacity of 151,000 barrels per day, adding Northern Tier’s refinery increases Western’s refinery capacity by a very-substantial 59%.  Furthermore, Northern Tier’s refinery is in close proximity to cost-advantaged Canadian crude oil that is much cheaper than Western Texas Intermediate (WTI) crude oil — $36.75 per barrel cheaper. This low feedstock price means high profit margins for Northern Tier’s refinery. Combined with a widening WTI discount to European Brent (7-month high),Western Refining’s profit margins should soar in 2014. 

Third-quarter financials suffered from declining profit margins and missed estimates, but I believe the third quarter will mark the trough. CEO Jeff Stevens stated:

In the fourth quarter, we are seeing improved refining margins as the Brent/WTI crude oil price differential has widened from the levels we saw in the third quarter. The Midland/Cushing price differential has also widened, which is having a positive impact on our El Paso crude oil acquisition costs.

Perhaps in anticipation of better times ahead, the company increased its quarterly dividend by 22% to $0.22 per share.