Notes from the Diamond

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Part 2: Addition By Subtraction

Trivia Question #7 of 108.  Taken as a group, the 51 countries or dependencies comprising Asia are home to a bit more than half of the world’s 44,000 or so listed companies.  What is the median number of sell side research analysts following the roughly 22,000 Asia-based firms just referenced?  Hint: the correct answer equals the number of no-hitters pitchers in Major League Baseball (MLB) have thrown on their birthdays, which itself equals the number of times two batters on the same team have “hit for the cycle” (single, double, triple, home run) in the same game.  As regular readers know, approximately 220,000 MLB games have been played since big league competition commenced in the 1870s.  Answer appears below.

Pre-Game Jitters.  Tired of waiting for the best MLB player of this and perhaps any generation — 27 year old Angels outfielder Mike Trout — to make his next appearance in MLB’s best ballpark?  Me too.  Frustrated it’s taken me so long to take this swing at the curveball I left hanging in Part 1 of this post when it got published several weeks ago? Me too.  Skeptical I can smack the curveball just referenced — i.e., outline investment policies conducive to the achievement of plump real returns over the next few decades of Trout’s blessed existence — or indeed convey useful thoughts of any kind via sentences comprising fewer words than the number of times Trout reached first base on walks in 2018 (a stunning 122 times in 608 plate appearances)?  Can’t blame you: as a guy who’s spectated many games in the ballpark alluded to above without wishing any would end sooner than they did, I have a natural if unfortunate tendency to craft sentences that run longer than most readers presumably prefer.[1]

Adding insult to potential injury, quite apart from potential surtaxes on certain outlays a highly compensated pro like Trout might reasonably be expected to make from time to time (e.g., hefty levies on fuel for private jet travel), wealth taxes of the sort proposed by certain politicians of late could prevent Trout from amassing even as remotely as much real wealth over the next 12 years as he would if the dominant zeitgeist for this interval were to resemble that of the 12 years beginning in 1981, i.e., disinflation and generally reduced tax rates.[3]    

Similar anxieties confront most individuals, families and indeed institutions that have already amassed substantial wealth as 2019 unfolds, including well-endowed non-profits that IMHO would be unwise to assume their investable wealth or current income produced by same will remain untaxed indefinitely. 

Indeed, even if the wealth just referenced is subjected to little or no explicit taxation in coming years and beyond, it could as noted above be subject to the implicit tax known as inflation: to currency debasement of the sort that, along with other ugly and corollary trends, led ultimately to the appointment of the investment maven on which Part 1 of this two-part paean to Hittin ‘Em Where They Ain’t focused: Yale CIO David Swensen.  (Part 1 focused as well on a baseball maven discussed further below: Branch Rickey.)  Other observers may disagree, but I doubt Yale would’ve hired a 30-something finance geek with no investment experience to run its endowment in 1985 if it hadn’t suffered a 60+% erosion in endowment purchasing power over the prior 35 years. 

What Trout Needs.  Like all investment home runs of which I’m aware, the riches that Yale has garnered by tapping Swensen as its CIO 30-odd years ago constitute just if not inevitable recompense for deducing correctly that the perceived risks of such a move exceeded the actual risks.  This isn’t to say that the latter were non-existent: Swensen might have proven inept in crafting investment policies responsive to Yale’s presumed needs, or the policies he ultimately devised might have proven infertile if the investment zeitgeist that subsequently unfolded had been different.  To Swensen’s credit, and Yale’s great and good fortune, the investment model he built embodied nicely if somewhat unwittingly an attribute inherent in all sound approaches to conscious risk-taking: asymmetry. 

“Heads I win, tails I don’t lose.”  That’s the ticket, we’d all agree, as reflected among other happy investor tales in this arresting fact: for more than a quarter century following Swensen’s assumption of his current post, a key tenet of his model essentially proved fallacious, with high quality bonds of the sort Swensen’s model disfavored producing returns roughly equal to marketable stocks as a group.  Of course, Swensen didn’t invest in the broad stock market during the quarter century in question (1985 – 2010), nor has he done so since.  Rather, he’s employed more or less exclusively active equity strategies, with a hugely profitable tilt toward privately-traded equities, including venture capital. 

The undeniable fact that such strategies bent but never quite broke Yale nor Swensen when they produced large unrealized losses in 2008 – 2009 merely reinforces the point made above respecting asymmetry: wittingly or not, Swensen has deployed Yale’s endowment in a manner that’s caused its unitized as well as total value to grow materially in real terms since 2009 under conditions resembling in certain ways those that caused such values to shrink materially in real terms over the 30-odd years preceding Swensen’s appointment as CIO, i.e., “guns and butter” fiscal policies coupled with large dollops of central bank largesse. 

Where would Yale’s finances and in turn Swensen’s reputation be today if such largesse hadn’t materialized over the last decade?  Reasonable people can reasonably disagree in answering that counterfactual question.  Ditto for a question that’s top of mind for me if not also you and should certainly be top of mind for investment pros fortunate enough to be advising Trout on the deployment of his investable wealth: will the dominant investment zeitgeist over the multi-decade horizon under discussion here be marked by the continuance of such largesse on a more or less globalized basis?  I  doubt it, but I wouldn’t bet the ranch against it.  Rather, I’d do what all fiduciaries worthy of the name try earnestly to do when engaged in policy-making: craft policies likely to produce tolerable results at worst across the widest plausible range of market scenarios and pleasing results at a minimum if the scenario or zeitgeist deemed most probable does indeed unfold.

Less is More.  What zeitgeist did I deem most probable in formulating the policies commended below — an investment model if you will intended to function effectively over a time horizon rivaling the span that’s elapsed since Swensen activated “the Yale model” many years ago?  Truth be told, I didn’t spend much time crafting a best guess or base case scenario for the global economy and capital markets when building the model below — not because scenario planning isn’t valuable if done astutely but rather because ET’s co-founders have shown convincingly in their writings that less is almost certainly more for investors seeking to divine economic and market trends in coming years and beyond.

Indeed, so convinced or more precisely humbled am I by Ben Hunt’s core message in Three Body Problem — “there is a non-trivial chance that structural changes in our social worlds of politics and markets have made it impossible to identify predictive/derivative patterns” — that I’ve adopted a base case scenario even leaner than that sketched by Ben in his masterful notes on zeitgeists entitled You Are Here and This is Water.

Specifically, while not questioning Ben’s perspicacity in divining all four phenomena flagged in the nearby box, the worldwide and necessarily long-term prism through which I ponder policy options makes me wary of policies premised on a fully globalized and sustained flowering of the first three trends. 

This isn’t to say that I think the trends Ben espies will peter out or reverse in the foreseeable future.  Indeed, I think such trends could very well accelerate, especially in the US and Old Europe, and more particularly if Rusty Guinn’s forebodings in Free Range Kids / Free Range Capitalism prove prescient; as Rusty notes, if taken too far, the ongoing transformation of capital markets into utilities could render investors as a group “utterly incapable of determining whether we should provide capital to a business or government venture, and under what terms.”

As for the fourth element of Ben’s perceived zeitgeist as summarized above — the displacement of cooperative games by interminably competitive ones — I’ve assigned a high probability to this condition in crafting the policies outlined below.  Fortunately and crucially, the less sound this premise actually proves in coming years and decades, the better I would expect the investment program sketched below to perform.  That may seem delusional — most attempts to exploit perceived asymmetries in capital markets produce strikeouts or singles rather than extra base hits or homers — so the onus is on me to defend the assertion just made.  I try to do just that as the modeling exercise below unfolds — one that begins logically (for a series exploring parallels between investing and baseball) with a favorite example of less being more in baseball.

Addition by Subtraction.  As regular readers will recall, Note #1 in this series opened with a trivia question concerning a Hall of Famer catcher who posted a 75-3 record as a pitcher in high school.  The rocket arm that made Johnny Bench (MLB 1967 – 83) nearly invincible as a high school hurler spawned ultimately a seemingly odd stat for Bench as a big league catcher: a relatively low number of runners nabbed stealing bases via throws from Bench.  The throws themselves were unfailingly swift and accurate, as one might expect from an athlete who’d practiced them countless times as a youngster albeit over twice the 127’ span between home plate and second base on a regulation diamond.  (Bench’s father and first baseball tutor knew well how to show young Johnny tough love.)  In fact, Bench’s arm strength became so widely respected in MLB circles that managers of opposing teams nixed base stealing attempts by all but their swiftest players when doing battle against Bench’s Cincinatti Reds.

Though such circumspection by Cincy’s opponents didn’t prevent the “Big Red Machine” from winning six divisional titles plus four league and two world championships during Bench’s 17-year playing career, it did boost opponents’ odds of beating the mighty Reds.  Addition by subtraction, one might call it: achieving more by doing less — by shunning endeavors in which one lacks a reliable edge or would otherwise confront unattractive odds.[4]

Edge and Odds.  I haven’t canvassed creatures fortunate enough to inhabit Little River Farm to ask how often Farmer Ben mutters “edge and odds” as he tends to their needs, but judging from how often Dr. Hunt chants that mantra in human interactions I’m guessing they’ve heard it many times indeed.  With good reason: in addition to pursuit of attractively asymmetric returns — the stated if sometimes unachieved aim of active managers and the only legitimate reason to invest in broadly diversified indexes like the S&P 500 on a buy-and-hold basis — savvy investors logically seek to focus their energies on opportunity sets in which they have an actionable edge in exploiting favorable or mispriced odds.[5]     

Millions of words having been written or spoken about “edge” in investing, I’ll say nothing about it here except that I’m defining it for purposes of this model-building gambit as know-how useful to the generation of above-market net returns if and when applied in an effective manner.  As noted above — and this is crucial to the model commended below — “edge” as just defined is most productively applied to markets in which an investor enjoys favorable or mispriced odds. 

Successful examples of such productivity include the two mavericks on whom Part 1 of this post focused.  As the first MLB GM to add black and Latino players to the talent pool from which his teams drew, Branch Rickey enhanced hugely his odds of assembling world-beating rosters; and while MLB franchises not headed by Rickey weren’t long in expanding imitatively their own talent pools, by the time they took such steps Rickey and his subordinates had developed a valuable edge in discerning which players of color most merited pro contracts. 

Similarly, David Swensen has enhanced Yale’s odds of partnering with market-beating managers by tilting Yale’s portfolio toward asset classes in which manager returns tend to be most dispersed; and while other allocators (big and small) weren’t long in expanding their own portfolios to include such holdings after Swensen showed the way, by the time they ramped up allocations to private equity, venture capital and other size-constrained niches favored by Yale, Swensen and his subordinates had developed a big edge in discerning which PE and VC managers most merited funding.  Fortunately for Swensen, and regrettably for allocators keen to be “like Yale”, this edge compounds over time, with Yale being a coveted client for managers seeking to maximize time spent investing by minimizing time spent fundraising.  Ain’t no better way to do that at present than to have Yale serve as one’s bell cow.

Pinpointing the Problem. And there ain’t no better way to convert a big fortune like the one Trout is poised to amass into a small one than to invest in volatile but potentially high returning assets without knowing them well enough to avoid ill-considered sales during inevitable bouts of punishingly poor returns.  What might Trout do to avoid such impoverishment?  Presuming as I do that he lacks the time if not also peculiar personal qualities needed to gain and hold an edge in investing, Trout should do what most individuals, families and institutions logically do when deploying substantial wealth: delegate the task to trustworthy pros who walk the talk set forth above — who focus their mental bandwidth and in turn clients’ capital on opportunity sets in which they have or can develop an actionable edge exploiting favorable or mispriced odds.

Tautologically, no opportunity set or selection universe meeting the criterion just specified can be boundless, because no pro’s or team of pros’ circle of competence is boundless (Herb Washington’s diverse talents notwithstanding).  Conversely, no person’s or team’s investment edge in a given asset class or sub-class is so acute that they can safely be relied upon to achieve the ambitious aims conjectured here (5+% annualized real returns over a multi-decade span) without doing one or both of two things: (1) deploying at least some capital outside their chief hunting ground or (2) violating liquidity and volatility constraints typically applied in the stewardship of substantial fortunes. 

Accordingly, when crafting limits on how capital under their ultimate control might be deployed, thoughtful principals strike a sensible balance between edge and odds, preserving needed flexibility while also keeping the breadth of assets or strategies deemed eligible for use within bounds consistent with the time-tested principle of knowing what you own and owning what you know.  After all, the seemingly boundless skills of an all-star allocator like Swensen or an all-star baseballer like Trout notwithstanding, in investing as in athletics, no one knows it all — not even Bo. [6]

Admiring Tackling the Problem.  Assuming the long wind-up above hasn’t caused Rusty ET faithful to dismiss me as a charlatan for merely Admiring the Problem, I’ll tackle the challenge conjectured here by outlining as concisely as I can the game plan I’d propose if Mike Trout or other well-endowed principals sought my best thinking on means of achieving 5+% real returns over the next few decades. 

As promised at the outset of this note, none of the tenets comprising my game plan contains more words than Trout’s current age of 27.  Nor do any of these tenets address directly the concern most commonly raised when I’ve shared the blueprint below with US-domiciled principals seeking my counsel, such as it is: shouldn’t investors who pay their bills in US dollars invest primarily in dollar-denominated assets?  My answer, in a nutshell: not necessarily — not if one assesses currency risk as we all should on a rigorously look-through basis, dissecting all anticipated liabilities to reveal the currencies underlying such potential outlays while dissecting similarly the currencies underlying assets available for investment.  Of course, the latter task is often easier said than done, with the true attributes of even seemingly straightforward assets like dollar denominated S&P 500 index funds differing greatly from their perceived attributes due to the geographic breadth of constituent firms’ operations.

Hold that thought — and the corollary thought that currency shifts tend to be accompanied over time by offsetting valuation shifts — as I outline my preferred investment analog to the convention-busting views on baseball that Rickey felt compelled to serve up in the Life magazine piece celebrated in Part 1 of this note.  Like Rickey, and indeed like Swensen when he submitted his preferred approach to capital deployment to Yale’s trustees for their initial approval back in the day, I recognize that what follows might be “most disconcerting” to many allocators; like Rickey — from whose Life piece I drew the self-aware red flag just quoted plus the following phrasing — I’ve “come upon [a method for deploying capital] that has compelled me to put different values on some of my oldest and most cherished theories.”  As will be seen, the game plan I’ve devised owes much to contemporary thinkers and doers who’ve displayed Rickeyesque cheek in challenging what Rickey referred to unflatteringly as “considered opinion”.  Here’s the plan, with its key tenets listed from most general to most specific and with noteworthy premises underlying such tenets appearing beneath each:

Tenet 1 – Create and maintain a sub-portfolio comprising cash, or liquid investments reducible thereto, in proportions equal to at least three years’ net cash needs under worst case conditions.

In theory, cash is a drag on returns of equity-oriented portfolios like the one commended here.  So too is an all-purpose hedge viewed even more skeptically by most allocators: gold.  Unwilling as I am to deem impossible over the multi-decade planning horizon conjectured here either of the disasters that can befall equity-oriented portfolios — depression-induced deflation or very high rates of unanticipated inflation — I deem it imprudent to “park” less than the equivalent of three years’ net cash needs in the “low returning” assets just mentioned, with a bias toward high quality debt instruments whose currency profile resembles closely that of the net cash needs such hedges seek to defray.

Tenet 2 – Favor ownership over creditorship, with the maximum feasible bias toward the only type of equities worth owning on an indefinite basis: stocks of owner-operated companies (OOCs).

Though further research on this all-important topic remains to be done, studies done by Steve Bregman and his colleagues at Horizon Kinetics  (HK) suggest that more than 100% of the vaunted “equity risk premium” that Yale’s equity-centric approach to endowment management presupposes is attributable to OOCs.[7] You read that right: exclude OOCs for purposes of comparing stocks’ long term rewards to bonds’ and the latter take the crown.  Needless to say, as has happened with every verifiably superior investment (or baseball!) gambit ever devised, the excess returns or “alpha” derivable from OOCs will likely get arbitraged away in due course.  That caveat having been filed, there are parts of the world where the supply of OOCs (listed as well as private) continues to expand invitingly — geographies that the investment model commended here rather fancies, as will be revealed shortly.

Tenet 3 – Maintain a very high bar for private investments, accepting long-term lock ups only when doing so provides exposures to specific forms of capitalistic activity not obtainable via other means. 

Venture investments occasionally clear this bar, though less frequently than most allocators currently clamoring for such exposures surmise.  As discussed in prior notes in this series (here and here), private equity (PE) investments clear the bar under discussion here even less frequently — a dirty little secret about the current apple of many an allocator’s eye that’s becoming less secretive by the minute as a young investment pro with Rickeyesque gifts for clear thinking and writing intensifies his assault on “considered opinions” respecting PE.  If you’re among the rapidly shrinking universe of allocators not yet exposed to Dan Rasmussen’s admirable assaults on such opinions, you’d do well to get acquainted with same via the musings posted on his firm’s website, including especially Dan’s fine essay in the Spring 2018 edition of American Affairs. 

To be sure, the company attributes that Dan and his team have come to fancy, including small market caps, limit how much capital he or other investors using similar screens can deploy without causing potential returns to sink below tolerable levels.   Since these screens, like the OOC-focused (and partially overlapping) screens that Bregman et al at HK employ, work at least as well outside the US as within it, Verdad deploys capital on a global basis — just as HK does, and just as Rickey did when populating his innovative farm system for the St. Louis Cardinals nearly a century ago.

Tenet 4 – Favor equity investments in companies employing or serving primarily people with abundance as distinct from scarcity mindsets.

For reasons flagged in multiple works by another Rickeyesque researcher — demographer par excellence Neil Howe —the US and major European economies generally flunk the test just articulated:  like not a few “rich” families with which I’ve had the pain privilege of interacting, the world’s “richest” nations at present (measured by GDP per capita) comprise an overabundance of individuals who lack the skills or drive needed to generate fresh wealth commensurate with their appetites and social ambitions. Small surprise then that the “widening gyre” and related societal maladies that Howe as well as Ben and Rusty discuss so arrestingly in their writings are most conspicuously manifest in corners of the global economy characterized by (1) relatively but perhaps unsustainably high per capita incomes (2) rising dependency ratios (i.e.,  retirees relative to working stiffs like me if not also you) and (3) relatively high debt ratios (i.e., unpaid bills for goods and services consumed previously). 

Add to the potentially toxic mix just described such intractable problems as the Eurozone’s fatally flawed currency union, America’s unsustainably undemocratic approach to self-government, and corporate America’s unsustainable addiction to the “financialization” whereof Ben speaks unlovingly, and it’s tough for any investment pro worthy of that label to defend non-zero policy allocations to US stocks as a group or to their European counterparts.[8] 

N.B.: I’d include non-zero allocations to Japanese stocks in the list of dubious policy fixtures just furnished but my own studies of evolving business and societal norms in Japan plus insights into same provided by my go-to guy on such matters (Andrew McDermott of Mission Value Partners) suggest that abundance trumps scarcity in most Japanese mindsets, i.e., expectations are low relative to most plausible outcomes (however unexciting such outcomes might be).  

Tenet 5 – Apply the tenets set forth above to the narrowest universe of eligible investments that gets the job done.

Having test-driven the investment model now unfolding with several savvy principals before finalizing this note for publication, I know that while Tenet 5 might appeal to my arborist friend Ben (for reasons outlined here), it won’t sit well with many readers.  After all, diversification being the “only free lunch” available to investors — or so financial economists would have us believe — why would thoughtful principals view less as more respecting assets eligible for purchase? 

They’d do so because, presuming sensible cash flow planning of the sort embodied in Tenet 1 and asset selection consistent with Tenets 2 – 4, the chief if not sole risk of the investment program sketched here is the potential jettisoning of inherently sound strategies during their inevitable bouts of disappointingly low returns (a/k/a whipsaw).  Such bad spells are inevitable because plump net real returns of the sort targeted here (5+% annualized over meaningfully long horizons) can’t realistically be achieved without potentially prolonged periods of below-target returns.[9] 

The most reliable means of guarding against whipsaw is to know what you own and own what you know.  As previously noted, the only reliable means of meeting such standards is to limit one’s universe of eligible investments to the maximum feasible extent.  By my lights, the optimal universe for deployment of the total return-oriented or non-hedging part of the portfolio contemplated by the framework extolled here is one hinted at in Trivia Question #7 posed at the outset of this note: Asian equities.  Leaving aside Asian nations that are off limits to western investors, or have too few or too thinly capitalized public companies to merit inclusion here, the median number of sell-side analysts following the ~22,000 stocks of Asia-domiciled companies alluded to in TQ #7 is zero.  This compares to the corresponding median of seven analysts for the roughly 4,000 listed companies in the US at present (down from roughly 8,000 since I sank into money management in the early ‘80s).

How many of the ~22,000 Asian stocks referenced above meet all of the criteria embodied in the tenets propounded above?  I don’t have a verifiably accurate answer to this question, for two reasons: first, because the criteria are somewhat subjective, with Tenet 4 (favoring abundance mindsets) serving as the poster child for such subjectivity; second, because I know what I don’t know (yet), namely many things I need to know about Asia in order to gain and hold an edge deploying capital in that region.  Strike that: taking Tenet 5 to a logical and IMHO entirely justified extreme, if granted unfettered discretion to shape the universe of assets eligible for purchase within the total return segments of long-term portfolios of the sort conjectured here, I’d enhance my odds of both avoiding whipsaw and gaining an edge relative to other investors by focusing my attention and capital on private as well as publicly-traded companies domiciled in but a dozen of Asia’s 51 nations and dependencies, as follows:

Surrendering Preconceived Ideas.  “If the baseball world is to accept this new system,” Rickey noted in the heretical essay on baseball stratagem referenced repeatedly in this post, “it must first give up preconceived ideas.  I had to.  The [system] outrages certain standards that experienced baseball people have sworn by all their lives.”  The investment paradigm sketched above will outrage some readers, methinks, especially those who view the world’s biggest national economy at present [the U.S.] as the “safest” place to deploy capital and, as a corollary, the biggest economy making the above cut as an unsafe place to deploy capital. 

Truth be told, I myself generally view China as such, due largely to its suspect fidelity to the rule of law.  That said, the scarcity mindset growing increasingly prevalent in the US and Old Europe poses different but clear and present dangers to the rule of law! in such geographies, with the meme just mentioned (rule of law!) serving as shorthand for the intricately woven but increasingly frayed fabric of legal, commercial, social and political norms on which investors in US- and Europe-domiciled companies have customarily relied to safeguard and indeed nurture their ownership stakes.  All of which is to say that, while I’m as opposed to non-zero fixed or policy allocations to Chinese stocks as I am to such rigidities respecting US or European equities, I certainly wouldn’t exclude Chinese stocks from my hoped-for circle of competence (defined broadly to include Asia- or China-focused managers deploying capital entrusted to me). 

Nor would I pursue policies entailing unduly high bars to the ownership of equities denominated in currencies issued by any of the countries comprising my self-selected opportunity set, China not excepted.  Indeed, convinced as I am that Ben has divined rightly that “competitive and single-play games” have displaced “cooperative and multi-play [ones]” in international politics and economics, I’d assign better-than-even odds to the US dollar’s displacement as the world’s dominant reserve currency within the next quarter century or so.  I doubt the Chinese yuan or indeed any other currency excepting possibly gold will ascend to the throne that USD seems destined to vacate, of necessity or choice.  But I’m reasonably confident that by the time Mike Trout takes his rightful place in baseball’s Hall of Fame a decade or two from now, the global economy will be divided into three major currency blocs, with China, Germany and the US each spearheading the bloc in which their national currencies sit. 

I’m reasonably confident too that the scarcity mindset increasingly manifest in American politics and economics will produce ultimately a material downward revision in the US dollar’s value relative to both gold and a sensibly weighted basket of its “trading” partners’ currencies, with “trading” defined broadly to include services as well as goods.  Obviously and perhaps sadly for Americans lacking overseas holdings or other means of profiting from dollar debasement, USD devaluation to the degree divined here would generally flatter the Asia-centric investment program delineated above, spawning as it likely would currency-related gains on non-US stocks even after factoring in valuation shifts commonly associated with major currency moves. 

(If you’re unfamiliar with how and why such shifts occur, you should be especially wary of any raccoons investment pros seeking to manage your money for a fee while assuring you they have everything under control.  “Investing is simple,” one often hears, “but not easy.”  In fact, effective investing is neither simple nor easy, least of all for investment pros forced unavoidably and unendingly to balance their own pecuniary needs against their clients’ wants and needs.)    

Finally and not obviously, in the unlikely event that America scores decisive victories in the “competitive and single-play games” in which it seems destined to participate in coming years and beyond, I’d expect the Asia-centric investment program endorsed here to produce long term returns not merely matching but likely besting those produced by US-centric alternatives.  Why?  Because the restoration of Pax Americana that such victories would both presuppose and promote would almost surely put strong and steady winds into the sails of the Asian economies identified in the table above, including especially India (my single favorite target for capital deployment in coming decades) as well as smaller Asian nations likely to fare better on balance if Uncle Sam’s traditional values of liberty and justice for all triumph ultimately over Uncle Xi’s evolving ethics, such as they are.  Heads I win, tails I don’t lose.  That’s the ticket, we’d all agree — even if we can’t agree on the surest means of dialing such asymmetry into capital allocation protocols. 

Indeed, mindful as I am that the policy prescriptions proffered here may create a “widening gyre” (to quote Ben quoting Yeats) of opinions within the ET Pack respecting prudent approaches to capital deployment, I’ll try in my next note to inject centripetal forces into the mix by presenting to the Pack the single best metric known to me for gauging long term investment success.  By my lights, it’s as relevant today as it was when its principal modern proponent first drew it to my and other investment wonks’ attention in 2005.  Mike Trout was a young teenager playing baseball for free back then; and the so-called sabermetrics revolution that’s changed materially the metrics baseball cognoscenti employ for gauging ballplayers’ worth had only recently commenced.  As will be seen, just as sabermetrics is rooted in methods devised many years earlier by the great and good Branch Rickey, the money metric I’ll discuss approvingly in Note #8 is rooted in methods of gauging financial abundance devised long before the first MLB game was played 143 springtimes ago.

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PDF Download (Paid Subscription Required): Notes from the Diamond #7 – Hittin ‘Em Where They Ain’t (Part 2)

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On Deck

In search of excellence when gauging excellence

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[1] Many lovers of sport including some lovers of baseball think MLB games have become too long and devoid of action since computer-based analytics came to the fore in pro baseball several years ago.  I share such concerns, with a carve out for games unfolding glacially at Fenway, and plan to discuss them plus potential remedial measures in a future note.

[2] You can check my math here, applying to Trout’s newly contracted pay package the 52% effective tax rate I’ve assumed here or whatever alternate rate you deem sensible given the idiosyncratic manner in which salary payments received by peripatetic entertainers like Trout get taxed.  Like rock stars on tour — which Trout essentially is — MLB players pay state-level income taxes pro rated to the number of days they play in a given state each season, taking credits against their home state’s levies.  As a New Jersey resident for tax purposes, Trout is poised to fork over a minimum of at least 9% of his pay in state taxes, with half or more of his salary being subjected to the ~13% tax extracted by the state in which Trout and his Angels teammates play half of their regularly scheduled games each season: California. 

[3] As Ben Hunt wrote when elevating the term to its rightful place as a key concept in Epsilon Theory (here), “zeitgeist” “is the macro scale of our social lives as investors and citizens.”

[4] Bench’s extraordinary gifts as a ballplayer are captured nicely in the brief profile posted here.

[5] Though capitalization weighting stocks for passive investment purposes is demonstrably inferior to other portfolio construction methods on a pre-tax basis, even a cap-weighted index like the S&P 500 has displayed historically and will likely continue displaying asymmetry of the sort alluded to here: the longer one lengthens the time periods over which returns are examined, the higher the percentage of positive outcomes rises.  Hence, even if the odds of investing in broadly diversified portfolios like the S&P 500 aren’t mispriced (and good luck diving inflection points in such mispricing), they are unarguably favorable in positive payoff terms for truly long-term investors.  The defects of cap-weighted portfolios are catalogued cleverly in a 2006 paper by Jason Hsu posted here and in a 2018 research note by Jason and his former Research Affiliates colleagues Rob Arnott and Vital Kalesnik posted here.

[6] Using the least-worst available metric for gauging baseballers’ on-field contributions to their team’s success (a cumulative measure known as Wins Above Replacement or WAR), Trout’s achievements as both a batsman and outfielder since his big league career commenced at age 19 in 2011 have already elevated him to a Top 150 spot in MLB’s all-time list of players ranked by WAR: when his ninth season as a big leaguer commenced in March 2019, Trout had compiled a lifetime WAR of 64, which is roughly equal to the median WAR for the 261 players (including four 2019 inductees) comprising baseball’s Hall of Fame.  Think Trout will join their ranks eventually?  Me too, especially since he’s already 16^th in WAR all-time among center fielders, ahead of nine of the 19 such players who’ve been elected to the Hall.    

[7] As noted in its white paper on OOCs, HK defines an “owner-operator” as “a principal or an owner — often a founder — who is directly involved in the management of a corporation in which he or she maintains a significant portion — ideally the majority — of his or her wealth.”

[8] “Unsustainably undemocratic” as used here refers to the inevitable reformation of arrangements that today give roughly 30% of the American electorate a de facto veto (via the US Senate) over laws governing the residual 70%.  Of course, the same imbalance is manifest in US presidential elections decided ultimately by the electoral college — an artifact of logrolling by America’s founding fathers whose eventual elimination could and likely will entail political if not also social unrest inimical to the interests of passive investors in broadly diversified portfolios of US stocks.

[9] Ping me via dsalem@epsilontheory.com if you’d like to review data supporting this assertion.  Alternatively, take a look at the characteristically fine Wall Street Journal piece that my pal Jason Zweig crafted after he laid hands on the data in question.

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Part 1: Zest in the Pursuit

Keeping Busy.  To help myself and perhaps other members of the ET pack move through the current MLB off-season more productively than Rogers Hornsby moved through the many off-seasons he endured,[1] I’ve crafted a two-part note about a cardinal challenge in both baseball and investing: hittin’ ‘em where they ain’t.  Part 1 focuses on pros who’ve met this challenge uncommonly well; Part 2 (slated for publication as spring training shifts into high gear later this month) will focus on means that investors might employ to meet this challenge in coming years and beyond.

Pet Peeve. The prior note in this series (Note #5) focused on personal traits enabling certain players to achieve greatness in investing or baseball, and ended with a question about one such great:

What would’ve become of the PE [private equity] industry if, instead of devoting a large fraction of Yale’s endowment to PE, [Yale CIO] David Swensen had deployed all such capital via managers investing exclusively in publicly traded stocks of owner-operated firms?  ‘Tis hard to say, but I’ll try … in my next note.

Before tackling the foregoing question, I feel compelled to do two things.  First, I’ll encourage readers who haven’t digested fully Note #2 (on excessive “juicing” by private equity and baseball pros) and the aforementioned Note #5 (on excessive mimicry of “the Yale model”) to do so before reading what follows, parts of which may seem naïve absent such auguries.  Second, I’ll raise and answer a question that’s both central to this series and worthy of more attention than it typically attracts in discourse about greatness in investing or baseball: what metrics should be used to distinguish truly great practitioners from merely good ones? 

To be sure, with computer-based analytics having transformed both the playing and business of baseball since the current century dawned, pros in that arena devote not merely ample but arguably excessive airtime to quantifiable metrics when grading past or current pros, be they on-field players or execs.  But there’s scant agreement on optimal metrics for divining true greatness in baseball, even and indeed especially respecting criteria for election to its Hall of Fame, and frustratingly scant discussion of optimal metrics for divining competence let alone greatness in finance. 

Pray tell, when was the last time you heard Paul Krugman an “expert” in finance articulate the precise metrics and time horizon underlying whatever critique of the Fed’s evolving policies they’re serving up on Bloomberg or CNBC?  Dunno ‘bout you, but I haven’t encountered such exactitude from a talking head since the San Diego Padres last won the World Series (WS).  That would’ve been … never, the Padres being the longest established MLB team to never win it all: 49 years and counting.[2] 

Gold Standard.  Why demand precision respecting both the metrics being used to gauge results and the time horizon over which they’re being applied when grading fiat-enabled capital allocators like Fed chair Jay Powell as distinct from return-oriented allocators like Swensen or me or perhaps you?  Why not?  If, as Ben Hunt argues persuasively in You Are Here, modern capital markets have morphed into political utilities, it seems not merely fair but essential that we ask whether such utilities’ ongoing administration is producing the optimal deployment of capital — taking due care to define optimal, of course.  By my lights, optimal in this context means the deployment of financial capital that enables the maximum number of citizens to achieve their full potential under whatever boundary conditions the allocators being judged are laboring and neither created themselves nor have the power to change. 

The italicized caveats are crucial, as exemplified by the tenures of the greatest and least-great Fed heads in my lifetime: Paul Volcker, Fed chair for eight years starting August 6, 1979; and William Miller, Fed chair for 17 months ending the date Volcker started.  Miller didn’t create the stagflation that gripped the US economy in the late 1970s; indeed, given Volcker’s not insignificant role in Richard Nixon’s decision to end the greenback’s convertibility to gold in 1971, Volcker arguably deserves no less blame than Miller for the stagflationary conditions both men encountered during their tenures atop the Fed.[3]  That said, Miller himself took no effective steps to end such torpor — a scourgewhose ultimate purging by Volcker makes his tenure at the Fed the gold standard for greatness in not only central banking but arguably also in capital allocation broadly defined.

For me, that standard or test is simply stated: did the person being graded act boldly enough for long enough to boost materially and sustainably the achievement of human potential? 

Strikingly Similar.  Which past or present players in investing or baseball meet the test for greatness just proffered while also serving as useful case studies for contemporary readers seeking to elevate their own games? 

Many candidates come to mind, some of whose achievements were flagged in prior notes and will be discussed further as this series unfolds, e.g., investor par excellence Jeremy Grantham and baseballer par excellence Joe Torre.[4]  Here and now, however, the tidiest answer I can give to the question just posed while also moving toward an eventual answer (in Part 2) to the counterfactual query raised at the outset of this note is by comparing the words and deeds of the investment pro mentioned in it to those of a legendarily accomplished baseballer whose temperament and indeed origins resembled Swensen’s: Branch Rickey.

Clear Eyes.  Like Rickey, who lived in central Ohio from his birth through completion of his undergrad studies at Ohio Wesleyan, Swensen trod a conventional path to and through college, earning a bachelor’s degree from the UWisconsin branch where his father served as dean of the college and chemistry department chair (UW-River Falls) and from which all five of Swensen’s siblings would also ultimately earn degrees.  So far as I can tell from published accounts of both men’s dealings as well as conversations with Swensen himself, their early 20s were essentially the last intervals in their lives when either Rickey or Swensen fancied getting along to even remotely the same degree as getting ahead.

Indeed, as Lee Lowenfish’s fine biography of Rickey makes plain, and as the ever-expanding universe of writings by and about Swensen makes equally clear, both men rose to the top of their chosen professions by practicing doggedly what Rickey’s fellow Hall of Famer Willie Keeler preached in his oft-quoted response to a reporter’s query about hitting: “I have already written a treatise [on the subject]”, Keeler crowed, “and it reads like this: Keep your eye clear and hit ‘em where they ain’t.”[5]

Man vs. Machine.  While never easy, practicing what Keeler preached is markedly more difficult for current pros in both baseball and investing than it was in Rickey’s day.  There are multiple reasons why, including the adoption in both fields of genuinely meritocratic criteria for recruitment and advancement (more on which below) as well as a more dominant catalyst for change that Rickey lived and died too soon to have confronted in the workplace (and likely mastered if given the chance): computer-based informational technologies and the quantitative methods for deploying capital they facilitate. 

Importantly, in both pro baseball and investing the capital being deployed via increasingly quantitative or formulaic methods comprises human as well as financial capital, with the latter (money) being used routinely to obtain the former (talent) in baseball, via market-clearing contracts for free agent players and coveted executives, and with money in the form of fees being used routinely to obtain the asset management talent institutional investors deem essential to achievement of their stated return goals.[6]

Crowded Trades.  As the fine folks at Vanguard among other straight-shooting investment pros have observed, many institutional funds are pursuing return goals they have little or no chance of achieving.  More precisely, such funds have little chance of achieving their stated return goals with their current policies and strategies — means not uncommonly adopted with the specific aim of being “like Yale.”  Paradoxically, as suggested in Wannabes Beware, one reason among others why most institutional funds bent on parroting Yale will fail in the effort is because Swensen has proven so maddeningly effective in preaching publicly what he’s practiced during his commendably long (1985 – present) and ongoing tenure as Yale’s CIO.

Swensen’s success surely has, as did Rickey’s in developing a system for player recruitment and development that’s served as table stakes for MLB teams since it began producing riches for the Rickey-led Cardinals a century ago. 

Kevin Kerrane tells the tale briefly and well in Dollar Sign on the Muscle: The World of Baseball Scouting:    

[F]rom 1913 to 1917, [Rickey] experimented briefly with the idea of a farm system—direct control of minor-league teams by the major-league parent organization … The farm system was a strategy for saving money: instead of bidding against other major-league teams for minor-league players, Rickey wanted to grow his own.  After World War I, when the minors were in a financial slump, Rickey put his strategy into effect … [B]y 1939, the Cardinal empire included 32 minor-league teams and about 650 players. 

The Cardinals bought pitcher Jess Haines in 1920, and purchased no more players until 1945.  The system did save money. But it made money, too. Rickey was able to generate such a steady supply of young talent that he could sell off the excess at a nice profit, while providing the Cardinals with enough manpower to win nine pennants by 1946 … The competition among so many young players in the system operated as a kind of natural selection.  The minor-leaguers could be left on the farms until, as Rickey liked to say, they “ripened into money.” [Emphases added]

Searching Far and Wide.  As noted in the nearby box, building the pro sports equivalent of an early stage venture program was but one of several innovations Rickey conjured to better the various MLB teams he headed. 

Famously, one such initiative bettered not merely Rickey-led teams but America’s national pastime and indeed the nation more generally: the recruitment and ultimate promotion to the big leagues of non-white and foreign-born players. 

Like Swensen’s move decades later to expand materially the pool from which Yale draws money management talent by adding a globally diverse array of proven or promising players in illiquid investing to it, Rickey judged correctly that expanding the pool from which his teams drew talent by adding blacks and foreigners to it would pay off big time.  It did, with the more genuinely meritocratic criteria for roster construction that Rickey pioneered — like other innovations with which he’s rightly credited — ultimately becoming table stakes for MLB franchises seeking to field winning teams.[7]  Indeed, as of the most recent date for which reliable data are available (Opening Day 2018), 38% of players on MLB rosters were African-American or foreign born, including many of the sport’s most talented if not also most beloved stars.

Told You So’s.  No one can know for sure until the blessed day arrives how many African-American or foreign-born players will grace MLB rosters when the 2019 regular season commences on March 28.  Barring injury, however, one non-American who made his major league debut in 2018 will likely make the cut — for reasons that would’ve elicited cheers if not also an “I told you so” from Rickey.  Born and raised in Venezuela, 27 year-old Willians Astudillo hasn’t done anything as a pro baseballer that would’ve commended him to MLB front offices during Rickey’s many years heading such offices, unless they were headed by Rickey himself. 

Ever heard of Astudillo before reading this note?  If yes, it’s for one or both of two reasons: (1) an attractively brief and hugely fun video of his homer in a recent winter league game went viral or (2) Astudillo’s remarkable consistency in avoiding strikeouts — a prized skill indeed at any level of play in baseball — has created a big buzz in MLB circles, teeming as they are in the post-Moneyball era with quant jocks cranking out advanced statistics.

There were no such geeks holding full-time posts in pro baseball, and no advanced stats worthy of the name being compiled in baseball circles, until Rickey hired an immigrant to crunch numbers for the Brooklyn Dodgers in 1947.  Over the next four decades, a Montreal native and former NHL statistician named Allan Roth helped first the Dodgers and in due course not fewer than 20 MLB teams develop enhanced methods for allocating both human and financial capital — on the field (via shrewder defensive positioning and other tactics) and off it (via shrewder personnel policies). 

Roth also helped burnish Rickey’s reputation as “the Brain” of pro baseball by ghost-writing parts of “Goodby [sic] to Some Old Baseball Ideas” — a storm-the-ramparts piece published in Life magazine in 1954 that Michael Lewis mentions briefly in Moneyball, his 2003 bestseller on Billy Beane’s surprisingly lonely efforts as a modern GM to practice what “the Brain” had preached a half-century earlier.  

Lonely No Longer.  However lonely Beane (or Rickey) might have felt using methods that rival GMs deemed imprudent or distasteful, such loneliness was destined to fade.  And so it did, rapidly and rather fully as the Aughts progressed, owing partly to Lewis’s authorial skills and in larger part to Beane’s and later Red Sox GM Theo Epstein’s conspicuous success implementing such methods (a/k/a sabermetrics).[8] 

Similarly, however lonely Swensen (or his longtime and unfailingly supportive investment committee chair Charley Ellis) might have felt using methods that rival CIOs deemed offputting, such loneliness was also destined to evaporate, owing partly to Swensen’s powers of persuasion and in larger part to the stunningly good returns Swensen notched in the years surrounding his pathbreaking book’s initial release.[9] 

Selfish Concerns.  Having fretted publicly at the time of Pioneeering Portfolio Management’s initial publication in 2000 about its potentially deleterious impact on my longtime and highly rewarding vocation (managing money), I fretted privately at the time of Moneyball’s publication in 2003 about its potentially ugly impact on my favorite and generally lovely avocation (watching baseball). 

Sad to say, the concerns just referenced have proven well-founded, with low hanging fruits as well as most harder-to-reach edibles in the illiquid niches that Swensen helped popularize now getting eaten by institutional pachyderms even before they ripen, and with MLB games getting longer and generally more predictable as quantitative methods increasingly supplant intuition as the primary basis for decision-making in dugouts as well as front offices.

(Please don’t tell my kids, whose company I’m keen to continue having for Bosox games at Fenway, but the fraction of plate appearances ending with balls put into play has slumped discernibly since the so-called sabermetric revolution in MLB commenced — from about 74% in 2003 to about 68% in 2018— with strikeouts as a percentage of such appearances moving steadily and depressingly in the opposite direction: roughly 22% in 2018 versus roughly 16% in 2003.  More on such trends — and parallel trends in institutional investing, such as they are — as this series unfolds.[10])

Multi-Tasking.  Don’t get me wrong.  I still love investing, and watching baseball, and — please don’t tell my clients — doing both simultaneously.  And I’m confident both domains will continue producing greats as defined above: pros acting boldly enough for long enough to boost materially and sustainably the achievement of human potential. 

Rickey and Swensen certainly qualify as greats by my lights, passing the test just mentioned and in certain respects an even sterner test of greatness for capital allocators of all kinds including but not limited to baseball execs and endowment CIOs: did the allocator being judged not merely handle effectively the external boundary conditions he or she confronted but take effective steps to reshape them in a socially beneficent manner?

Rickey obviously did, as Americans will be reminded anew in coming months via festivities MLB has planned to mark the centennial of Jackie Robinson’s birth.[11]  Swensen’s reshaping of boundary conditions governing his professional labors, while less obvious and momentous than Rickey’s earlier reshaping of his, has been material and laudable nonetheless.  By shifting meaningful fractions of Yale’s investable wealth out of marketable securities in general and tradable bonds in particular into illiquid assets better suited to the profitable exploitation of endowed charities’ perpetual life status, Swensen has created the proverbial win-win, lowering the cost of capital for enterprises in which Yale has invested while simultaneously boosting returns on Yale’s investable wealth.

As this unlocking of institutional potential has progressed — initially and most intrepidly at Yale and in due course at other institutions with so-called permanent capital to deploy — it  has catalyzed a parallel unlocking of human potential, with many intelligent and energetic investment pros granted opportunities that earlier generations of workaholics lacked to deploy such capital in a manner befitting its presumed longevity.

No One’s Perfect.  I recognize that the prior paragraph may make some readers gag, the illiquid strategies it commends having destroyed perhaps more wealth net of fees than they’ve created for institutions employing them as a group.  I recognize too that, as could rightly have been said of Rickey, Swensen’s rigorously data-driven approach to capital allocation hasn’t produced uniformly enlightened decision-making.  Obviously, none of Swensen’s slips have been bad enough to knock him off his lofty perch in his chosen profession, as happened twice to Rickey after he became a big shot in pro baseball: “demoted” (as Rickey saw things) from on-field manager to “business manager” (and de facto GM) by the Cardinals in 1925, Rickey underwent similar humiliation four decades and multiple championships later, when the same Cards terminated Rickey’s contract as the team’s sage-in-residence following its triumph in the 1964 World Series. 

Regrettably for Rickey, but fortunately for Swensen and me and perhaps you, managing money tends to be a more forgiving line of work than managing big leaguers.  While there’s certainly truth in Rickey’s oft-quoted boast remark that “luck is the residue of design,” let’s be honest: to a much greater extent in money management than in baseball, pros can commit impactful errors and still come out on top.  This is especially true of errors of omission, which Swensen arguably made in applying the tenets flagged in the nearby box when and how he did, and that many US-based institutional investors are arguably making as the current century unfolds.

Admittedly, none of the tenets just referenced has proven fundamentally unsound since Swensen’s painstaking studies of capital market history caused him to apply them on Yale’s behalf starting around the time the aforementioned Volcker wrapped up his winning campaign to bend general price inflation downward.  That said, if it’s OK for Rusty Guinn Astros fans to disparage that otherwise superbly managed team’s 2014 decision to “outright” or fire J.D. Martinez at what proved to be the start of a multi-year (and hopefully continuing!) stretch as one of the best power hitters in baseball, it’s presumably OK for Swensen votaries including me to note that bonds have performed much better relative to stocks over the full sweep of David’s tenure than his grand design for Yale’s endowment supposed, especially on a risk-adjusted basis.

Walking the Talk.  My fellow ET contributor Peter Cecchini examined the phenomenon just referenced in a recent post, so I won’t discuss it further here, except to say this: as Peter hints, applying data-driven methods like those Swensen used to fashion “the Yale model” back in the day when fashioning investment policies in 2019 would be a mistake of potentially Snodgrassian proportions.[12]

Strike that: there’s nothing wrong with making data as distinct from tradition or intuition king in the policy-making process, as Swensen did as a novice CIO or as Rickey and Roth did for the Truman-era Dodgers, so long as one uses the best available data.

Having bemoaned above the tendency of finance types to opine on all manner of things without articulating clearly the metrics and time horizon underlying such judgments, I’ll walk that talk here by noting that “best” as I’ve just used it means data germane to the deceptively difficult task of enhancing the real or inflation-adjusted value of invested capital over the next 35 years. 

Why 35?  Because I haven’t a clue how materially societal and technological changes will affect the future duration of generational cycles; and the 35 year investment horizon that the estimable Dr. Hunt has referenced in Pricing Power (Part 1 and Part 2) strikes me as an attractively precise substitute for what I really have in mind: a mindset compelling fiduciaries deploying capital today to weigh the interests of future beneficiaries of such capital at least as heavily as the current generation of same.    

Clearly, not all readers are aiming to enhance real wealth over such an extended horizon, even with small portions of their investable wealth.  Just as clearly, many endowed charities are, with the typical publicly supported non-profit impliedly seeking annualized real returns in the range of 4-5%: ongoing enhancements to real wealth needed to offset such orgs’ customary endowment spend rates of 4-5%.[13]

What to Do?  Where in the world can today’s investors deploy capital with reasonable assurance of earning annualized real returns of 5% or more over long and potentially indefinite holding periods?  Just as no wonk worth listening to on monetary matters should critique the Fed’s evolving policies without stating clearly the metrics and time horizon he or she is using to gauge such policies’ success, no hired gun worth canvassing on the real return quandary just referenced should address it without first pushing the ultimate owners of any such capital to articulate with reasonable clarity the types and degrees of risk they’re able and willing to tolerate.  That said, I’m skeptical any strategies the typical investment committee at work today would readily endorse will do the trick, least of all US-focused PE of the sort Swensen funded aggressively and adeptly when most institutions would not and could not.  

Indeed, even as Yale wannabes continue ignoring data Swensen himself cited in Pioneering Portfolio Management respecting PE funds’ ugly tendency to underperform comparably leveraged investments in marketable stocks, stewards of long-term capital outside as well as within the endowment arena are generally ignoring readily available data pointing them toward plausible solutions to the real return quandary raised above.  I alluded to such data in the still unanswered! question with which this note opened and will discuss them and the investment pros who’ve brought them to my attention in Part 2 of this note.  As will be seen, like the astute allocators on which this post has focused — Swensen and Rickey — the pros in question seem to take special delight in hittin’ ‘em where they ain’t.

End of Part 1

PDF Download (Paid Subscription Required): Notes from the Diamond #6 – Hittin ‘Em Where They Ain’t (Part 1)

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On Deck

Hittin’ ‘Em Where They Ain’t – Part 2: Addition by Subtraction

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[1] Born in 1896, Hornsby was a player, player-manager, or off-field exec in pro baseball from 1915 until shortly before his death during the 1962-63 offseason.  Having notched 2,930 fewer MLB hits than Hornsby — generally regarded as the best right-handed hitter in MLB history — I’m hardly one to critique anything he did or didn’t do.  That said, Hornsby might have enjoyed offseasons more if he’d permitted himself to read or watch movies.  He refused to do either during his 23 seasons as an active player (1915 – 1937), convinced that doing so would harm his eyesight.  FWIW, Hornsby didn’t smoke or drink either.  He did gamble, however, compulsively and lucklessly enough (on horse races) to necessitate his working for pay during the entirety of his 25 years as an ex-big leaguer.

[2] Hope springs eternal in Sandi, however, especially for Padres fans with multi-year time horizons: taking a page from the team that won the most recent World Series using a strategy discussed at length below, the Padres have built what is widely viewed as the top farm system in pro baseball as the 2019 season approaches.  If the immediate past serves as reliable prologue to the future — a concededly shaky premise in baseball no less than investing, as also discussed below — the Padres will be world champs within a half-decade, that being the approximate interval between the Red Sox’s zenith in annual talent rankings of MLB farm systems earlier this decade and the team’s most recent World Series win (in 2018). 

[3] Readers seeking more info on Volcker’s role in Nixon’s abandonment of the gold standard in 1971 could do worse than start with the brief history of this decision published by an organization that, like this author, thinks Volcker subsequently did a superb job as Fed chair.  The Hoover Institution’s brief piece on the topic is available here. 

[4] I’m also planning to write about a pro whose guts and smarts would’ve made him a Hall of Famer if certain team owners hadn’t been so short-sighted and selfish: Fay Vincent, Commissioner of Baseball for a depressingly brief three years ending in September 1992.

[5] Lowenfish’s Branch Rickey: Baseball’s Ferocious Gentleman (2007) remains the best of the multiple Rickey biographies published to date IMO.  No full length biography of Swensen has yet appeared, but much has been written about David’s distinctive personality and methods, including the prior note in this series; a 2017 talk given by this writer (available upon request via dsalem@epsilontheory.com); and, most importantly and authoritatively, in Swensen’s pathbreaking book on institutional funds management and annual reports published by Swensen’s office  available here.

[6] Of the many books about the impact of computer-based analytics on pro baseball, the one I’ve found most illuminating is Travis Sawchik’s Big Data Baseball: Math, Miracles, and the End of a 20-Year Losing Streak, published initially in 2015.  With help from another brilliant baseball wonk (Ben Lindbergh), Sawchik has completed a second book on the steadily rising level of play in pro baseball (off and on the field) that’ll be released in June 2019 — The MVP Machine: How Baseball’s New Nonconformists Are Using Data to Build Better Players.  Perhaps because I’m more intimately familiar with the use and abuse of data science in finance than in baseball, I haven’t identified any books on quantitative methods for investing that I deem must-reads.  If I had to point ET faithful to a single such book while also honoring the principle that it’s better to teach hungry folks to fish than to hand them fishes, it’d be Benoit Mandelbrot’s 2006 classic The Misbehavior of Markets: A Fractal View of Financial Turbulence.  FWIW, I try to read every word written by my friend and quant jock extraordinaire Mark Kritzman; a compilation of Mark’s remarkably voluminous writings is available here.

[7] Revenue-sharing protocols generally enable MLB franchises with aggregate big league payrolls beneath the threshold for MLB’s “luxury tax” ($206 million for 2019) to operate in the black even if their big league teams post losing records and miss the playoffs year after year.  How long this not unhappy condition for many team owners (MLB’s equivalent of closet indexing by active money managers?!) can or will last is an open question to be explored in future notes.  As will be seen, tensions between team owners on the one hand and an arguably overmatched players union on the other are mounting in a manner redolent of the widening gyre in American politics on which Ben Hunt has shed useful light in Things Fall Apart.  Whether America’s next national elections on November 3, 2020 will produce a day of reckoning for certain politicians or political views remains unclear.  But it’s virtually certain that a day of reckoning — and perhaps the first work stoppage in MLB since 1995 — will be upon us by this time in 2022, given the 2021 expiry of MLB’s current and increasingly outmoded Collective Bargaining Agreement (CBA).       

[8] This seemingly odd handle for the use of quantitative tools in baseball analytics derives from the leading association of such tools’ users: the Society of American Baseball Research (SABR), founded in — where else? — Cooperstown, NY in 1971.

[9] Over Yale’s six fiscal years ending June 30, 2003 — an interval embodying a wild ride for investors as a group — Yale’s endowment outperformed a 60/40 stock/bond mix by an eye-popping annualized margin of 12.3%: 14.3% per annum for Swensen’s bulldogs vs. 2.0% per annum for puritans maintaining a 60/40 mix of the S&P 500 and a broad US bond index (BBAgg).  Crucially for institutions pondering during the early Aughts whether they wanted to “be like Yale,” Swensen trounced the 60/40 bogey during both bull and bear markets for stocks: 23.1% vs. 6.1% annualized returns in the three years ending June 30, 2000 followed by 7.0% vs. -2.7% annualized in the three years ending June 30, 2003.

[10] Sports fans who deem football superior to baseball due to football’s seemingly zippier pace should note that the average NFL game takes roughly the same amount of time to play as the average MLB game (a tad over three hours) but with roughly one-third less ball-in-play time on average in the NFL than in MLB (12 vs. 18 minutes/game).

[11] MLB will surely and rightly stage similar events in 2034 marking the centennial of the birth of the greatest Latino player in MLB history: Roberto Clemente (1934 – 1972).  A fun and well-researched account of how the Rickey-led Pirates “stole” Clemente from the Dodgers during the 1954-55 MLB offseason is available here.

[12] Though He Who Must Be Not Named can plausibly lay claim to having made the worst error in MLB history (in Game 6 of the 1986 World Series), Fred Snodgrass of the then-New York Giants is viewed by most baseball historians as having committed the worst such gaffe: a dropped fly ball in the final game of the 1912 Series — won ultimately by the team that lost the Series in ’86!

[13] Unlike publicly supported .orgs and .edus that engage routinely in fundraising and are generally free to adopt whatever endowment spending rates (and corresponding return goals) they wish, private grantmaking foundations are subject to minimum payout requirements dictated by Congress. These strictures cause such foundations to  distribute mandatorily an average of about 5% of their wealth each year.

Trivia question #4 of 108: Who is the only player in major league baseball history to pitch in 10 games, steal 10 bases and hit 10 or more home runs in a single season?  Answer appears below.

John and Ray Kinsella in the closing scene of the 1988 film Field of Dreams:

John:     Is this heaven?

Ray:       It’s Iowa.

John:     I could’ve sworn this was heaven.

Ray:       Is there a heaven?

John:     Oh yeah … heaven’s where dreams come true.

Ray:       Then maybe this is heaven.

Essential Attributes.  Wanna dull happy hour spirits in the watering hole of your choice in Boston’s financial district?  Proclaim for all to hear that, in sharp contrast to the way things were when you entered the money management biz in the early ‘80s, rooting for the Red Sox these days is more of a disqualifying attribute than an essential one for alpha-seeking money managers.  Why?  Because the team’s success in recent years permits fans to inhabit comfortably the figurative realm known as Red Sox Nation without displaying in full measure two traits traditionally deemed essential for long-term investment success: (1) independent thinking and (2) and sufferance.  That’s an archaic word, I know — sufferance — but it’s apt here, because the topic on which this note focuses — the use and abuse of peer group comparisons in pro baseball and investing — can’t be explored meaningfully without acknowledging an important fact: truly independent thinkers in both of the fields of endeavor just mentioned are almost always made to suffer, often for prolonged periods.

Exceptions That Prove The Rule.  Almost?  Yes, history revealing that at least some pros in each field have been skillful or perhaps merely lucky enough to win big without incurring embarassing setbacks and hence sufferance beforehand, while others have avoided the latter by ignoring peer group comparisons altogether, focusing instead on the fulfillment of self-imposed standards for success better suited to their idiosyncratic circumstances.  Exceptional players of the first sort make fun focal points for happy hour chit-chat — e.g., Bill Simon and Ray Chambers in the buyout arena circa 1982 et seq., Mike Trout in big league baseball circa 2012 et seq. — but provide scant learning for mere mortals like me if not also you[1]  Accordingly, this note focuses on exceptional players of the second sort: baseballers and investors who’ve triumphed by their own standards through the sufferance of discomforts their presumed peers deem intolerable.  To illumine such achievers’ good works as brightly as possible while also serving up actionable ideas to readers seeking to emulate their winning ways, this note focuses as well on players who’ve suffered mightily and continue to do so through the vain pursuit of goals ill-suited to their idiosyncratic circumstances.

At the risk of getting banned permanently from sports bars in Wrigleyville, or dinner parties in Cambridge, I argue below that the first and generally content type of sufferer just mentioned is perhaps best typified by the Chicago Cubs during their long and recently-ended championship drought, while the second and generally discontent type of sufferer referenced above is perhaps best typified by the Harvard Management Company (HMC) during its long and ongoing struggle to shine relative to its presumed competition.

Sensible Standards. Heavy stuff, I know, certainly for Harvard votaries and likely also for Cubs fans for whom their team’s first World Series win in 108 years was pure heaven.  As the lifelong fan of a team whose own title drought also ran painfully long (86 years) before finally ending in 2004, I can certainly understand why Cubs fans view big league baseball even more sunnily now than they did before their team won it all in 2016.  That said, like the Kinsellas in Field of Dreams, Cubs fans might do well moving forward to measure their baseball-related happiness not by standards extolled reflexively if naively by the fans of most teams in most pro sports — i.e., league and world titles — but rather by the more sensible standards traditionally if somewhat ineluctably applied by their Cubs forebears, more on which anon.

Similarly, like the alum whose independence of mind and tolerance for discomfort produced enough wealth to buy Harvard the handsomest building erected on its grounds in decades (i.e., Klarman Hall, opened earlier this fall), Harvard votaries might do well moving forward to measure the university’s investment results not by standards extolled reflexively if naively by uninformed observers — i.e., HMC’s performance relative to “peer” endowments’ — but rather by standards better suited to the behemoth size and peculiar character of the roughly $37 billion investment pool that HMC deploys on the school’s behalf.  More on that anon, too, but first a little fun — not unrelated to the topic at hand — in the form of reflections on the two MLB stars pictured below.

Lovable Losers.  What standards worthy of being labeled as such did the Cubs uphold during their 108 year championship drought?  Consider this: from the Wrigley family’s assumption of a controlling stake in the Cubs in 1921 through the Tribune Company’s sale of the team to its current owners in 2008, the Cubs were consistently among the most profitable MLB teams, no matter how well or poorly they played.  Why? Because the club’s principals during this interval adopted and pursued unfailingly a cardinal goal as idiosyncratically well-matched to boundary conditions governing the Cubs’ labors as it differed from the cardinal and common goal of the Cubs’ MLB peers or more precisely these other teams’ title-hungry fans.  The Cubs’ foremost goal over the nearly nine decades in question?  Simple: to make Wrigley Field a splendid place for Chicagoans to spend a summer afternoon.  Make that summer afternoon or evening, the City of Chicago having blessed the installation of lights and hence also night games at Wrigley in 1988, albeit with a cap on the number of such games that today equals roughly 65% of the 81 regular season games each MLB team hosts.

Was winning truly secondary for the Cubs from 1921 through their purchase by the Ricketts family in 2008?  The answer depends on how one defines winning.  If victory is defined as winning hearts and minds, the Cubs over the period in question were unquestionably among the winningest organizations on the planet, within or outside pro sports — despite and in some respects because the Cubs’ home field inhibited the team’s effective use of personnel policies that well-managed MLB franchises commonly employ in pursuit of their own competitive edges.  Described summarily, these policies entail the construction of player rosters that give individual teams an edge on both offense and defense when playing in their home ballparks. 

Why hasn’t the Cubs’ front office implemented such policies at least as effectively as have competing clubs over the years? Conceding fully that the Cubs’ general manager since 2012 (Theo Epstein) is capable of feats unachievable by nearly all of his predecessors and most of the big league GMs at work today, Wrigley Field happens to have been situated and constructed in a manner that makes the winds buffeting it between the start of the MLB regular season in early April and its conclusion in late September too varying and unpredictable to craft player rosters in a manner affording the Cubs a true edge when playing home games.[3]

How did Theo become an exception proving the rule that Cubs GMs can’t build a world championship team?  We’ll discuss that topic at length in a future note, along with the intriguing question of whether and to what extent wind-blocking video boards installed at Wrigley during the run-up to Theo’s managerial triumph in 2016 facilitated its achievement.  Meantime, the record shows that attendance at Cubs home games has historically been the least sensitive to the team’s performance (measured by overall winning percentage) of any big league team.  In short, when P.K. Wrigley inherited the Cubs from his father in 1932 and promulgated a clear if somewhat unconventional metric for gauging the team’s future success, he laid the groundwork for decades of truly triumphant labors by the enterprise he headed.  As he told Harper’s magazine at the time, “The fun … the sunshine, the relaxation.  Our idea is to get the public to go see a ball game, win or lose.”[4] [Emphasis added]

CC Needn’t Sprint.  Turning back to investing in general and Harvard’s ongoing investment woes in particular, what would the manifestly brilliant Epstein do if forced to shoulder the uneviable task of piloting the world’s heftiest educational endowment?  I’m unsure, Theo never having managed money for his own alma mater (Yale) let alone the more heavily endowed university in his hometown (Boston) whose overseers have had such conspicuous difficulty crafting policies conducive to Harvard’s achievement of investment success as they themselves define it.  Of course, that’s precisely the problem — the problem underlying Harvard’s endowment woes and indeed those of all investors focused unduly on their presumed peers’ investment performance: as would be the case if Yankees management or even worse the Big Man himself defined athletic success for Sabathia as the stealing of more bases than Merrifield, equating success with the outperformance of presumed peers is foolhardy in an investment context if the boundary conditions governing one’s deployment of capital make defeat more probable than victory. 

Due primarily to the Harvard endowment’s heft relative to its self-selected peer group — i.e., 40% to 70% larger than this group’s next-largest members (Yale, Stanford and Princeton, in that order) in recent decades and multiples larger than most of the group’s other members — it’s unwise and arguably unnecessary for Harvard to attach utmost importance to beating Yale or indeed any of its putative peers in the investment arena.

Cardinal Sin.  Sadly, the powers-that-be at Harvard have customarily begged to differ with the argument just advanced, as confirmed by the board-approved investment objectives (paraphrased in box below) that Stephen Blyth propounded at the start of his perhaps predictably brief tenure as Harvard’s investor-in-chief not long ago.  To be sure, under the leadership of its current and eminently qualified CEO Narv Narvekar, HMC isn’t pursuing goals as numerous nor as inchoate as those propounded by Blyth — at least not publicly and explicitly.  That said, as the saying goes, no organization can be better than its board; and the board to whom Blyth reported is more unchanged than not since Narv resigned his role as Columbia University’s CIO to assume the analogous post at Harvard two years ago.

I like and respect Narv, and presume without knowing for sure that he’s not repeating his predecessor’s mistake of propounding multiple investment objectives without rank ordering them — a cardinal sin for investors given the tendency of goals rightly viewed as reasonable when viewed in isolation to come into conflict over time, especially under worst case conditions. 

Speaking of such conditions, I’d hope for Narv’s sake as well as his employer’s that he’s not committing additional sins of which his predecessor and the board to whom Stephen reported are justifiably accused, including most notably the articulation of goals incapable of being pursued in any sort of objectively verifiable manner, e.g., capital deployment consistent with Harvard’s “risk tolerance”.  Pray tell, how does one define the risk tolerance of an investment pool comprising 13,000+ sub-funds, many of which comprise restricted monies and nearly all of which are “owned” de facto if not de jure by one and only one of Harvard’s several operating divisions?  (See accompanying bar graphs.)

Sub-Optimal At Best.  I won’t discuss here the history nor perceived defects of Harvard’s longstanding budgetary policy respecting such divisions — a policy known colloquially as “every tub on its own bottom”  — except to note that the commingling of all such tubs’ wealth for investment purposes seems sub-optimal at best and irresponsible at worst.  Given the composition of what ET’s co-founders like to call the ET Pack, I likely needn’t defend the charge just leveled with many or perhaps any readers, the illogic of commingling investable wealth on behalf of the various tubs identified in the accompanying bar graphs being rather obvious.  But … just in case it ain’t obvious, what would happen to a financial advisor (FA) if he recommended the identical portfolio to two families, one of which relied on portfolio withdrawals to cover 88% of its annual outlays with the other using such withdrawals to finance just 16% of its spending?  I can tell you what’d happen if yours truly were supervising the FA in question: he’d undergo the same treatment that home plate ump James Hoye accorded Bosox manager Alex Cora in the fifth and final (for Cora) inning of Game 1 of this year’s American League Championship Series.

Less Is More.  What might an investment policy statement (IPS) meeting the criteria just outlined look like?  For better or worse, there are as many sound answers to this question as there are sound stances taken by hitters as they await pitches at the plate.  (I’ve pasted photos of two especially interesting stances at the end of this note, foreshadowing the next  installment in this series.)  The foregoing caveat having been filed, I’ll suggest humbly that the most useful IPSs I’ve encountered tend to be quite brief — indeed, shockingly so to fiduciaries who believe mistakenly that the utility of such statements correlates positively with their length.  As suggested by the following example of a solid if not heavenly IPS — heavenly in the Kinsellaian sense delineated at page 1 — the utility of such statements tends in fact to be negatively correlated with their length.

Might additional flesh if not also muscle be usefully added to the bare bones statement provided here? Sure, although experience teaches that many efforts to do so end up being counterproductive: the equivalent not of adding useful mass to an already fit body but rather of adding barnacles to an otherwise streamlined hull. That said, in the many instances in which I’ve participated in and indeed led investment policy reviews, I’ve applauded if not initiated efforts to reshape the risk parameters and return objectives set forth here so that they and all other aspects of the resulting IPS reflect truly and fully immutable boundary conditions governing the capital being deployed.

Unsolicited Advice.  FWIW, if the reshaping just described were to be done by the powers-that-be at Harvard, they’d be well advised to craft not one IPS for all of the university’s investable wealth but several, each governing one of the several pools into which Harvard’s singular and sub-optimally large master pool might usefully be sub-divided for investment management purposes.  Given the endowment reliance ratios implied by the accompanying bar graphs, something like three to five distinct risk pools would arguably do the trick, providing greater nimbleness of action in the deployment of each such pool’s capital while also achieving the important aim of removing Harvard from the performance derby in which it’s long been engaged.  To be sure, outside observers including news media might continue comparing Harvard’s overall investment results to that of other leading research universities by computing the weighted average return of the several risk pools commended here — results that Harvard would surely disclose publicly.  But the persons responsible for deploying Harvard’s capital could and presumably would ignore such peer group comparisons, noting for public consumption that the weighted average being cited is meaningless given Harvard’s idiosyncratic approach to budgeting (“every tub on its own bottom”) and hence also to investing long-term capital sitting within each of its tubs.

Taking the Long View.  As we’ll see as this series unfolds, the longer the time horizon over which a given pool of capital will be invested and eventually spent, the greater the opportunity and arguably also the need to define success in terms different than those employed by the typical investor, institutional or individual.  Of course, the more  unconventionally a player or group of players in any arena defines success, the greater freedom they potentially have to enjoy life as it unfolds, tolerating if not occasionally celebrating experiences that their apparent but perhaps not actual peers deem insufferable.

On deck: the shifting fortunes of wannabes in baseball and investing

Gar “The Batting Stance Guy” Ryness (left) and the Big Leaguer he’s most enjoyed impersonating over the years: Kevin Youkilis (MLB 2004 -2013)

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Contact David directly at:
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Endnotes

[1] Of necessity more than choice for a series of notes discussing both baseball and investing, I’m using “players” as shorthand for persons engaged in either of these fields of endeavor.

[2] Wins Against Replacement (WAR) seeks to quantify the wins a player adds to his team above what a replacement player would add.  Of the 100 top active MLB pitchers ranked by career WAR, CC Sabathia (62.2 cumulative WAR in 18 MLB seasons) ranks second, a tad behind Justin Verlander of the Houston Astros (63.8 cumulative WAR in 14 MLB seasons).  FWIW, the Royals have gotten truly outstanding value for money paid to Merrifield since the team promoted him from the minors in 2016, paying him the roughly half million dollars per season that most newbies pocket during their first few years in The Show, before they become eligible for salary arbitration: Whitfield’s WAR of 5.5 in 2018 placed him 25th among the roughly 1,300 players that appeared on MLB rosters at some point during the 2018 season.  Readers interested in exploring WAR in all of its glorious if not also controversial dimensions can do so here and here among other places.

[3] “True” as used here means a home winning percentage exceeding the remarkably stable long-term MLB average of roughly 54%.  Perhaps obviously, the Cubs have won fewer of their home games than this average implies since Wrigley became their home ballpark in 1916. A future note will explore the extent to which video replays and potentially other technological “enhancements” to officiating will cause the home field advantage (HFA) alluded to here to erode.   My hunch:  such changes will cause MLB’s single most perdurable stat (HFA) to erode materially.

[4] I lifted this quote from Scorecasting — The Hidden Influences Behind How Sports Are Played and Games Are Won by Tobias Moskowitz and Jon Wertheim.