Running on Parallel (Base)Paths

When Jim and I were youngsters we rooted for our hometown baseball team, the Washington Senators. His dad would pile a bunch of us kids into his tiny VW Beetle and make the drive from his home in suburban Virginia to Washington D.C. I am sure we gave him headaches as we jabbered on with ever increasing excitement for the game we were about to see.

We were ultimately crushed when the team’s owner elected to move the Senators from DC to Dallas in 1972 and rename them the Texas Rangers. Like many Washingtonians who loved baseball but no longer had a hometown team to cheer for I switched allegiances to the nearby Baltimore Orioles and have been a fan ever since.

But after having gotten burned by giving unconditional love to a perennial also-ran that did not return my loyalty, I now will only follow teams that are building for long term success. Short term winning is of little value to me. If I expend the energy and time to root for a team, then they have to be investing in a strategy to deliver to their fans a competitive team for years to come. Those are my rules, like them or not.

I live west of both Baltimore and Washington these days and both the Washington Nationals and the Baltimore Orioles have invested in the future; therefore, I really do follow both teams. In the prior two seasons it was nice because over such a long season both teams, though good, lost a lot of games. The outcome of any one game was almost completely random, so when one lost the other would usually win so on a given day I almost always had a win to celebrate by one team or the other (but usually not both).

But a month or so ago I began to notice an interesting correlation was occurring between these two teams. When both teams played on the same day, they tended to either win or lose together on the same day. In fact, lately it has been happening almost two thirds of the time! I jokingly say to whomever I am watching a game with – if the Nats win the early game – “no need to watch the late game because we will win.” Or, if the O’s are behind late in the game after the Nats won earlier, I say – “this one is in the bag.”

As a parlor trick it really turns people’s heads as they wonder how I can predict the win or the loss so confidently and matter-of-factly. The key to all predictions is a ton of pervious history and data, and a total detachment of emotion. Who would not wager if you knew you would make money on two out three bets? If the wagers were the same every time the yield would be 33% consistently. Now we aren’t suggesting you start betting on baseball games; rather, I would like to explain our stock selection model for the readers using the correlation from the two baseball teams as illustrations.

The STI ratings are broken into two major components. The first is the BiQ which measures the extent to which a tech company possesses the necessary ingredients to ascend to a leading position within its product category. We assign a score for dividend yield and a score for growth in operating cash flow to confirm that the company has sufficient resources to be able to innograte, or acquire outside resources to supplement their internal assets.

We add to that a strategy score that is more subjective in nature, and reflects my opinion as to how well a company has organized all of its resources to move in the direction of effective innogration. Not only must a company be acquiring outside resources, but they must be the correct resources to address their specific areas of need. Simply buying a bunch of small companies like lottery tickets – similar to what Facebook’s Mark Zuckerberg appears to be doing – may keep the fans happy for a while but does not necessarily ensure long term success.

The strategy score is paralleled with the Nationals and the Orioles in terms of how they have constructed their teams. Neither one of them is a major market team like the New York Yankees; they know they can’t simply buy all the best free agent players to create an instant winning team. When the current owner of the Orioles bought the team he tried to do just that and the team went from a storied franchise to a perennial also-ran.

The owner of the Orioles, Peter Angelos, learned from this mistake and began rebuilding the team’s minor league system and then buying and trading for a few well-placed free agents. Not the famous names but a few players who they could integrate into their club to provide the skills they lacked. See our article last month on innogration as the parallel here.

If you look at Verizon, Apple or Qualcomm you will see that they don’t try to innovate and create all the technology in-house. Instead, they realize they can augment their products more effectively by acquiring exactly what they need from a supplier. For instance, Apple did create a tremendous amount of the technology for iPhones and iPods but also married that technology with an ecosystem for applications and music which Apple never invested any time or money to create. Apple generates billions in sales on reselling music on their iTunes store which work seamlessly on their products. They have made a similar bet on their very recent Beats deal.

The reason why Apple does not try to build it all is because there are too many variables and expenses are too great to try and build 100% of the technology required to address market opportunities. This is also analogous to the Washington Nationals and Baltimore Orioles. Their winning and losing are correlated not because of their physical proximity to each other but rather to their commitment to integrating their farm system players to their trades and free agents via a well thought-out and executed innogration strategy.

The Orioles and the Nationals both signed free agent first basemen a few years ago. Chris Davis of the Orioles hit over 50 homeruns last year while Adam LaRoche hits for a solid batting average and drives in runners consistently. These acquisitions reflect not only the strategy score in the STI BiQ but also the dividend value in the equation as well.

Another major component in the BiQ is the scores for tech company dividends. We recognize that at this point in time there will be volatility and therefore we grade companies higher that pay higher dividends. Cash is king today for tech companies. The requirement for cash on hand to make investments is critical for their success. Good tech companies like Verizon and Ricoh understand this and not only generate good cash flow but they demonstrate it via their dividend payouts.

In baseball the trend over the last ten plus years has been smaller ballparks. Not only are they cheaper to maintain but they bring the fans closer to the action. This more intimate experience provides for a larger gate because the fans come for the experience beyond simply watching their team play. Both teams also added unique foods to further reinforce a more personalized fan experience.

In the stock market good companies not only get less beaten down during corrections but also pay good dividends. This is what sets them apart from the companies which rocket up in value and then are pummeled when the market becomes volatile or suffers a sustained correction.

The third and last element of the BiQ is our measurement in the change in cash flow. Dividends are great but if the gravy train is coming to a halt we factor this into the equation by measuring how their earnings are not for just the last quarter but beyond that as well. We think this element is critical for investing at any time and therefore this parallel to the Orioles and Nationals is personified by their pitching staffs.

Just as good pitching is an absolute necessity for a championship baseball team, cash flow is huge for tech companies. If they are not generating good cash flow then they are in trouble and could cut their dividends or see their stock price drop as well. If an investor doesn’t want to do this work for tech companies they can subscribe to STI and we’ll do it for you, or be at the mercy of stampedes which regularly occur with mutual funds.

After calculating the BiQ, we then convert that score to a “Smart Tech Rating” (STR) by adjusting it according to the extent to which a company is trading at a reasonable valuation compared to its peer group. To do that we take the forward (12 months) estimated price-to-earnings ratio for a company and divide it into the same ratio for all the tech stocks in its category. A company trading at less than its peer group ratio will see its STR increase, while one trading at a premium will see its STR adjusted downward.

In baseball the parallel is the team’s age and vitality. For baseball teams it is most important to have multiple players that can hit 20 or more home runs in a season and steal bases on a consistent basis. Having batters hit homeruns when there are runners on base is critical for success. If there is only one player who hits many homeruns, then too many runners will be stranded on base and not score during a season.

The same is true for stolen bases. A player who is walked and then steals second can be driven home by a simple base hit. It is the age of the team which is the single largest factor in determining stolen bases for a baseball team. The Oakland O’s became famous for applying this form of quantitative analysis to its roster in the book (and movie) “Moneyball”, not at all coincidentally written by a former Wall Street bond trader.

The correlation of the Nationals and the Orioles is interesting to me because it demonstrates what I will invest my personal time following. Those characteristics, in a nutshell, are building for long term success and investing in the fundamental factors which give these two teams a slight but meaningful advantage.

At the end this season you won’t see the Nationals or Orioles holding fire sales where the best players are traded away or released because the payroll grew too large. Those dynamics are typical for teams not managing their farm teams, age of players, pitching staffs and free agents. Those are teams I won’t root for.

Tech companies are in a very similar position. New technologies are constantly being created and evolving. We look to find the ones which won’t win the World Series every year but provide a better winning percentage over the long term creating opportunities to win the World Series in any given year.

In the Sector Spotlight article I will examine two such companies that are former champions, now working very hard to implement an innogration strategy to achieve long term success. Play ball!