Q1 2021 Commentary, Review, & Outlook Investment Management Baseball and Investing: Dynamic Systems and Decision Making Robert G. Hagstrom, CFA Chief Investment Officer Senior Portfolio Manager Investment Commentary Robert G. Hagstrom, CFA Chief Investment Officer Senior Portfolio Manager April 5, 2021 Baseball and Investing: Dynamic Systems and Decision Making 2021 1st Quarter Commentary, Review, and Outlook “Baseball is 90% mental and the other half is physical.” —Yogi Berra, American baseball player, manager, coach Commentary also awarded the Nobel Prize in Economic The Major League Baseball season begins anew. Sciences, the laureate Daniel Kahneman.1 Fingers crossed, the worst of the pandemic is Thinking Fast and Slow was published in 2011 behind us and all 30 teams will play a full 162- and quickly became a New York Times bestseller. game schedule this year. It is our hope the return The book catalogues the research Kahneman to normalcy begins with the umpire yelling, “Play conducted over his nearly six decades of Ball!” research, much of it in collaboration with long- Opening day is always a special occasion. After time friend Amos Tversky. The book is dedicated spending a cold, dark winter hunkered down to Tversky who died before being awarded the inside, everyone is eager to get outdoors and Noble prize he surely would have received along once again feel the warm sunshine on their face. with Kahneman. There is no better place to welcome back spring The central thesis of Thinking Fast and Slow is a than at a ballpark filled with hometown fans recognition between two modes of thought. dreaming this may be their year at a shot to win “System 1” thinking is fast, instinctive, and the World Series. emotional. “System 2” is a slower mode of One can’t think about baseball without recalling thinking that is more deliberative, logical, and Yogi Berra. Not only was Yogi one of baseball’s time consuming. Although fast, instinctive greatest players—winning ten World Series rings, thinking is necessary, (e.g., there is not much time more than any other baseball player in history, to analyze what to do with a steering wheel when with an additional three more championships as a your car begins to slide), System 1 thinking causes manager—but he was also one of the sport’s most errors in decision making, particularly when greatest characters. For many baseball fans, Yogi individuals are confronted with complex Berra is also best known for his “Yogisms,” problems. simple, one-line paradoxical aphorisms like, What does a psychology book on complex “When you come to a fork in the road, take it,” decision making have to do with baseball? Many and “It’s like déjà vu all over again.” will recall Michael Lewis’ popular book, It has been argued that baseball is a simple Moneyball, which told the story of how Billy sport—you hit the ball, you catch ball, you throw Beane, the general manager of the Oakland the ball. There is not much more to it than that. Athletics, who took issue with scouts using You can almost hear Yogi Berra readying one of outdated, subjective, and flawed statistics to his zingers. But of course, baseball is more draft baseball players. The eventual success of complex than hitting, catching, and throwing a the Oakland Athletics was the story of how Beane baseball, particularly for managers and front re-wrote the math on optimizing a baseball team. (1) Lemire, Joe. office executives who struggle each year with In contrast, Thinking Fast and Slow is not about “This Book Is Not About lineup strategies and player evaluations. Even so, the math but the psychology of how today’s Baseball. But Baseball Teams Swear By It.” it was surprising to us that the most popular book baseball executives are working to overcome bad The New York Times, circulated by baseball executives this spring decision making in order to help improve their February 24, 2021. season was written by a psychologist who was teams. 2 Baseball and Investing: Dynamic Systems and Decision Making 1Q 2021 Commentary, Update, and Review Investment Commentary Despite the lack of explicit baseball examples in managers and analysts and are often discussed Kahneman’s book, front office executives at the when making investment decisions. We oversee Oakland Athletics, Philadelphia Phillies, and the portfolios similar to managing a baseball team, Los Angeles Dodgers swear by it. In addition, Sig contemplating how best to optimize and Mejdal, an assistant general manager with the assemble our lineup for the upcoming season. Baltimore Orioles, asks everyone he meets if This requires a System 2 investment decision they’ve read Thinking Fast and Slow. Keith Law, process, the objective of which is to build a World who wrote Inside Game, an examination of bias Series team. and decision making in baseball, said he was Even so, with all that we have learned about inspired to write his book after being pestered by investing at EquityCompass, we never forget the Mejdal to read Kahneman’s book. What unites stock market, like baseball, is a dynamic system Moneyball and Thinking Fast and Slow is an that is constantly changing, learning, and examination of the biases and mental shortcuts— adapting. Certainly, whatever fixed ideas we may termed representative heuristics—individuals have about the stock market, rest assured they make in answering complex problems—answers will need to be updated in the years ahead. For that often prove to be wrong. In a nutshell, this reason, EquityCompass remains a dedicated individuals who make mistakes in decision learning organization, always eager to discover making often default to System 1 thinking while as much as we can about investing. And just as avoiding the more time consuming and laborious soon as we think we have it all figured out, we are System 2 process. reminded of the sage advice of the great Yogi At EquityCompass, we’ve observed investors’ Berra…“The future ain’t what it used to be.” mistakes and concur, errors most often happen Review when a snap System 1 decision is made—a decision, in and of itself, that is often anything but In our 2020 year-end commentary, we suggested simple to discern. For example, if a stock goes up November 9 would be remembered as a pivotal in price, many investors believe it is a good date in both the fight against COVID-19 and also investment and if it is going down in price it as a potential turning point for the stock market. should be avoided—a classic System 1 quick and On that date, Pfizer and BioNTech announced easy decision. their vaccine candidate was 95% effective in There is nothing wrong with pricing, but the protecting individuals against COVID-19. Five mistake investors continually make is thinking weeks later, the U.S. Food and Drug pricing equates valuation. The only way to figure Administration (FDA) approved Moderna’s out what an investment is worth is to dig through coronavirus vaccine. Two days before the end of the business to determine cash flow, return on the year, the United Kingdom approved Oxford- invested capital, and the duration of the AstraZeneca’s new vaccine for distribution. On company’s economics before comparing the the heels of these important announcements, value of a stock to its price. Only then can an Johnson & Johnson also announced it was close investor ascertain if a rising or declining stock to getting approval, which it subsequently price should be acted on or ignored. Of course, received, for a vaccine to help protect individuals this analysis is a bit more laborious than just against COVID-19. watching stock prices. Nonetheless, the thinking Collectively, we believed these vaccine errors many investors make entail not taking the announcements would help convince investors necessary time involved in System 2 thinking in the end of the global pandemic may be close at order to make optimal decisions about stocks and hand. At last, investors had some assurance the portfolio management. global pandemic might be arrested in 2021 to One should not be surprised the EquityCompass help lift the global lockdown of economies library has long housed both Moneyball and around the world and restore economic growth. Thinking Fast and Slow among its investment The stock market typically discounts new books. Both have been read by our portfolio information six months out. As such, conventional April 2021 3 Investment Commentary wisdom suggested the summer of 2021 would the first quarter, while the Russell 1000 Growth be the starting period when our personal and Total Return Index limped along up only 0.94%— economic lives might return to some sense of a very large relative outperformance gap normal. between value and growth stocks in just three The performance of growth stocks over value months and the largest in two decades. stocks in 2020 was perfectly sensible. Despite Parsing the internals of the stock market, the best the economic lockdown and recession that performing S&P 500 sectors in the first quarter followed, most growth stocks—technology included Energy +30.38%, Financials +15.80%, stocks included—continued to post strong sales Industrials +11.29%, Materials +8.93%, Real growth, cash earnings, and high returns on Estate +8.83%, and Communication Services invested capital—all the necessary ingredients to +8.00%. The laggards included Consumer help drive stock prices higher. Value stocks, on Discretionary +3.06%, Health Care +3.05%, the other hand, are dependent on a growing and Utilities +2.54%, Information Technology expanding economy for their business models to +1.90%, and Consumer Staples +0.94%. generate attractive economic returns. Since the Basically, the worst performing sectors in 2020 economy was largely hobbled throughout the moved to the front row in the first quarter, while year, not surprisingly, value stocks did not last year’s leaders have been shuffled to the rear.