Size-Based Batting - A Different Perspective On Stock Selection

How do you determine if an investor is a good stock picker? One commonly used measure is to count the number of positions that make money (winners) divided by the total number of positions. This metric is commonly called a Batting Average, analogizing stock picking with baseball hit-rates.

The problem with Batting Average is that several inconsequential positions that lose money can really bring down the total. We saw this with our clients. They have historically outperformed other funds (every year for the past six) but have a batting average, adjusted for the move in the bench, of only 51%.

We decided to take a different approach and measure the total exposure of positions that made money versus the total gross exposure of the fund. For instance, if 60% of a fund made money on an alpha-adjusted basis and the fund was 120% gross exposed, then the fund had a Sized-Based Batting Average of 50% (60/120).

Our clients had a Sized-Based Batting Average of 54% versus the non-sized based average of 51%. That means that our clients were good at selecting investments and at sizing them, but they were harming their overall returns with small losing investments.

Alpha-Adjusted Batting Average¹

In the table above, Size-Based Batting, while not perfectly consistent, is generally better from year-to-year for our clients (exceptions being 2012 and 2015).

We’ve performed other analyses that have proved this point, specifically that our clients’ positions under 1% dramatically underperform the rest of the portfolio, but Sized-Based Batting presents a compelling way to highlight the “small position” issue (see the “Concentration Manifesto” for other issues with small positions).

In our profession, it is incredibly difficult to detangle skill from luck and, as cathartic as it would just rely on returns, returns are actually negatively correlated with next year’s returns for most funds (i.e. funds that outperform in year N have a higher likelihood underperforming in year N+1 – there are multiple research sources that analyze mean reversion in funds, here is one).

Sized-Based Batting is a nice addition to the allocator’s tool bag for finding managers with stock picking skill. In much the same way, managers should use Sized-Based Batting as a way to highlight their strengths and compare it to traditional Batting Average as a way to potentially point out weaknesses.
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¹ S&P 500 for US securities and MSCI WEI for non-US securities

² Why is “All Time” so low compared to each year? Reason #1: There are many more observations in the more recent years which skew the overall results to be more similar to the more recent years. Reason #2: There were many assets that were losers over “All Time” while being winners for multiple years (small win in 2015, a small win in 2016, big loss in 2017 = 2 winning period vs 1 losing but a loser in the All-Time bucket).