My last installment of The Labyrinthian was about the value investing tactic of writing covered call options. Afterward, some people reached out to me via Twitter, email, Skype, and smoke signal to let me know that, although they liked the article, they felt overwhelmed because they know very little about the stock market. That’s totally fair. Although I think that the stock market-DFS analogy isn’t the best one available, it nevertheless is useful because more people speak the language of stocks than commodities, and so in this piece I want to boil the stock market down to one single number. As you’ll see, not only is this number applicable to fantasy sports. It’s also strikingly similar to our innovative Plus/Minus metric.

This is the 31st installment of The Labyrinthian, a series dedicated to exploring random fields of knowledge in order to give you unordinary theoretical, philosophical, strategic, and/or often rambling guidance on daily fantasy sports. Consult the introductory piece to the series for further explanation.

Joel Greenblatt’s Magic Formula

A decade ago, value investor extraordinaire Joel Greenblatt published a book entitled The Little Book That Beats the Market — which is pretty much what it purports to be. It’s a small book that contains within it the straightforward steps that historically have set one on the path to market-beating success. In his book, Greenblatt gives readers a “magic formula” that consists of really only two factors. In his words:

It turns out that if you just stick to buying good companies (ones that have a high return on capital) and to buying those companies only at bargain prices (at prices that give you a high earnings yield), you can end up systematically buying many of the good companies that crazy Mr. Market has decided to literally give away.

“Mr. Market”? By the way, did I mention that one explicit goal of Greenblatt’s book is to be simple enough for children to understand? Anyway . . .

Greenblatt’s magic formula is nothing other than a screen that looks for companies that have a high return on capital and earnings yield — good companies that are undervalued. That’s it.

Frankly, spotting good companies — just like productive players — isn’t all that hard to do. In 2003, it wasn’t hard to see that Apple was a good company. It isn’t hard now to see that Steph Curry is a good player. As humans, we are generally adept at identifying quality when we see it.

The hard part of the magic formula is the component that asks us to value companies, because valuation is something at which humans tend to be pretty bad. We often overvalue or undervalue. When left to our own devices, rarely do we assign a proper price to the objects we desire.

It’s not enough to know that a company is good or that a player is productive. In the stock market, we need to know if the company is overpriced. In DFS, we need to evaluate a player properly before we can put him in our lineups.

But how do we know if an asset in which we want to invest is priced reasonably? According to Greenblatt, “earnings yield” is the answer.

P/E Ratio: The Number That Matters the Most

In truth, earnings yield is the number that matters most in stock market. Even if a company is bad, if it’s cheap enough it still might be a worthwhile investment.

What exactly is “earnings yield”? It is the total money that a company has earned (usually within the last twelve months) divided by the price that the market has assigned to the company: E/P.

In practice, most people flip those numbers and look at “Price to Earnings,” or “P/E Ratio”: The price per share divided by the earnings per share. Again, P/E ratio (generally shortened to “P/E” or “PE”) is the most important number when it comes to investing in the stock market.

Whereas some people will foolishly look at a stock and say, “That’s trading for $100 per share — this other one is cheaper because it’s trading for only $25 per share,” the people who look at P/E ratio get a true sense of any given company’s valuation, as the number takes into account both market value and productivity, as well as everything that goes into those two separate numbers.

As you might expect, the lower the P/E ratio is (the lower the price per share and/or the higher the earnings per share) the more discounted the company is — and the more profitable it tends to be as an investment.

Per Christopher H. Browne, who wrote essentially a sequel to Greenblatt’s book (Browne’s text is entitled The Little Book of Value Investing), investing in companies with low P/E ratios is a proven method for making money:

Over the years, numerous studies have examined the results of buying stocks at low P/E ratios versus buying high price/earnings ratio stocks (the high-growth companies and market darlings). Each study — over time periods from 1957 to virtually the present, and measured over a period of 5 years to nearly 20 years — confirms that buying cheaper, less popular stocks brings far greater returns. This holds true across industries and developed countries. . . . Value investing, buying earnings cheaply, is the most reliable way I know to grow your nest egg, not because I say so, but because it’s also been shown to be so — time and again, throughout the decades in numerous academic studies.

If you wanted to be an investor in the stock market, and if all you did were buy a portfolio of companies with low P/E ratios and then periodically maintain the portfolio — by selling companies with P/E ratios that were no longer low and replacing them with new companies that did have low P/Es (more on this later) — you would probably do pretty well.

The Elegance and Simplicity of Plus/Minus

At FantasyLabs, our exclusive Plus/Minus metric is the equivalent of the P/E Ratio. It’s the number that matters the most.

Do you remember in high school when you learned the formula “Y = mx + b”? (Or do people learn that in grade school?) For us, Plus/Minus is “Y” — it’s the dependent variable for which we always solve.

When you use our Trends tool to backtest DFS ideas, the main number you consider when determining whether your idea is actionable is Plus/Minus. When you use our Models tool to create your own models with which you can create hundreds of lineups, you rely on the model’s backtested Plus/Minus to tell you that the model is actually worthwhile. When we created our Pro Trends, we specifically selected those had high, positive Plus/Minus numbers. And when we gauge Consistency, we do so by considering the frequency with which players reach their salary-adjusted expectations. Just as P/E is for the stock market, Plus/Minus is everything for DFS.

Like P/E Ratio, our Plus/Minus metric does more than simply consider price and production separately. We understand that true value can be determined only by appreciating the extent to which price and production are intertwined.

Just like shares in a company, a player should never be owned or avoided simply because he is (or isn’t) expensive or productive. Rather, the decision on whether to invest in an asset should be made through a consideration of how that asset’s price and production relate to each other.

Ultimately, Plus/Minus is simple. It’s intuitive. That’s one reason it’s elegant. It knows that value is determined by more than a price tag.

What Does it Mean to Be a Pig?

You probably know who Jim Cramer is. He’s a former hedge fund manager who now hosts Mad Money on CNBC. He also writes a lot of best-selling books that talk about how good he is at two things:

  1. Buying and selling stocks
  2. Telling other people about buying and selling stocks

He is a great entertainer and self-promoter. I’m not sure how good he actually is at investing anymore, but he is clearly a smart guy who has some very memorable soundbites. In his 2005 book, Jim Cramer’s Real Money (yes, he actually included his own name in the title of his book), Cramer has this passage, which has stuck in my head since I first read it years ago:

Twenty-Five Investment Rules to Live By

1. Bulls and bears make money; pigs get slaughtered. My favorite expression of all when it comes to the market is that bulls make money, bears make money, and pigs get slaughtered. . . . It makes sense that a bull can make money when the market moves up, and it makes sense that a bear can make money when the market moves down; both going long and shorting are noble endeavors. It’s when you act piggish, when you refuse to take anything off the table after a huge run, that you get hurt.

I love that this is Cramer’s first rule. Anyway — from the text surrounding this excerpt, one can see that Cramer is talking in general about selling when P/E ratios of companies increase — but this quotation does touch on what I believe is a harmful inclination that some investors have: The inclination to sell simply because the price of shares has gone up and because one has made money and doesn’t want to be greedy.

Some investors enter a position thinking, “I want to make 15 percent on this investment” or “I’m selling when the price reaches $30.” Such thoughts stem from a price-based (instead of value-based) approach and I believe can lead to sloppy investing.

The problem with this perspective is that it shifts focus away from the investment and toward the investor. Instead of focusing on the earnings of the company and making sure that those are still in line with the price of the shares, one is focusing on the earnings that the appreciation in share price has added to one’s portfolio. The focus should always be on the company, not on what the company has done for you lately.

When (Not) to Fade DFS Players

I admit that there is a certain logic to avoiding assets that have increased in price. If you went to our Trends tool, you could easily create a trend showing you that players whose salaries have increased over a set period of time have generally underperformed their salary-adjusted expectations. So, intuitively, avoiding assets that are more expensive than they used to be makes some sense.

But, as we know by considering P/E Ratio and Plus/Minus, price alone is pretty insignificant. One should never sell a stock or fade a player merely because of price appreciation. One should divest oneself of an investment or avoid it entirely only once the relationship between price and production reveals the investment to be too expensive.

If a company has a share price that has doubled over the last year and is now at $200, the company could still be cheap if its productivity has kept pace over that timeframe and looks as if it is likely to remain strong in the future. If a company still has a low P/E Ratio, it doesn’t matter how much its price has appreciated. Per the rules of value investing, the company is still a fine investment.

The same applies to DFS players. Even if a guy is expensive — even if his salary has risen and is likely to continue rising — as long as he has consistently submitted strong Plus/Minus performances as his salary has risen and is likely to continue doing so even at elevated salaries, he is a player whom one should not be afraid to roster on a regular basis. If a high-priced player consistently beats the market by outperforming not only expectations but also his peers with similar salaries, he isn’t an expensive player. He’s actually a discounted player.

It’s possible that such a player might not fit into some lineups because of the players available in any given slate. That’s fine. I’m not saying that you must roster him. I’m just saying that you shouldn’t purposely avoid him. His price shouldn’t preclude your attempt to put him in lineups — because his price is only half of the one number that really matters.

Playing DFS isn’t that hard. Pay attention to Plus/Minus. Fade the players who don’t meet expectations. Use the players who do. Don’t overestimate the significance of price. Don’t get slaughtered.

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The Labyrinthian: 2016, 31

Previous installments of The Labyrinthian can be accessed via my author page. If you have suggestions on material I should know about or even write about in a future Labyrinthian, please contact me via email, [email protected], or Twitter @MattFtheOracle.