Finding the Undervalued in Sports.

Market inefficiencies & innovation within professional sports.

I think I finally get Moneyball.

From reading Flash Boys, The Real Price of Everything, and “The No-Stats All Star”, I re-read Moneyball to conclude my journey in the Michael Lewis rabbit hole. Only this time, it read completely different.

Of course, Moneyball is an underdog story about baseball analytics. It’s about thinking differently from competitors in order to create a distinct advantage, even when the odds are stacked against you.

But underlying all of this is what I believe to be the true draw of Moneyball: the craft of recognizing and exploiting market inefficiencies. Here’s author Michael Lewis on a recent podcast:

“What interested me the most about the whole story was the way people got misvalued by markets. If professional baseball players could be over- or undervalued, who couldn’t?”

A market inefficiency occurs when the market price of [X] doesn’t represent its true value. In the finance world, this [X] variable often represents a stock or commodity. If Apple is valued at $152/share on most stock exchanges but $151/share on a certain exchange, the latter is operating under an inefficient market. In other words, the market price of Apple on this exchange — $151/share — doesn’t represent its true value of $152/share.

Sports Leagues are Kinda Weird.

The more one looks at sports under this rational, market-driven mind, the more utterly captivating it becomes.

Add in an unimaginable amount of market oddities — such as salary caps, spending floors, rookie wage scales, mid-level exceptions, soft caps and draft lotteries — and the professional sports market emerges a tangled, almost unsolvable web to the rational observer. The player draft, an integral and celebrated part of North American sports, epitomizes this ridiculousness.

Imagine a market where financial institutions are rewarded for losing shareholders’ money and thus, are incentivized to burn through consumer deposits (And with the first pick of the draft, Silicon Valley Bank selects…).

This doesn’t even touch the arbitrary nature of playing rules in sports. Here’s David Rosenthal from the Acquired Podcast on why basketball is played as a 5v5 sport:

David: The number of players—the five players in each team—gets standardized because American football was the big collegiate sport at the time. At that time, American football was played with 10 players. Football teams in the winter—once it got too cold to play football outside—they just come in and play basketball. They just divide the team in half, and boom. There you go, five on five. That's how it happened.

It goes without saying this decision wasn’t well-reasoned to optimize for a certain KPI. Had American football been played with 8 players at the time, basketball would be a 4v4 sport. Imagine if 4v4 basketball is the ‘optimal’ way to play basketball and the NBA could ink a 2x bigger TV deal as a result. Any tech company or financial institution would be eager to find their optimal bounds, but even a simple change like a pitch clock is generating controversy in the MLB.

I go on this digression to illustrate just how weird the professional sports market is. While traditional markets enable its participants to iterate under free market conditions (think: Meta’s bet on the metaverse), sports teams are seemingly bound by its arbitrary rules.

But what gets me excited is when an innovator in the sports industry can exploit market inefficiencies within this arbitrary rule set. Let me illustrate a few examples:

• Sam Hinkie and the NBA Draft: Hinkie recognized losing as an undervalued outcome and exploited the NBA draft market to his benefit. Hinkie escaped mediocrity by ‘tanking’ and ultimately netted the 76ers top 3 picks in 4 consecutive years. Intentionally losing has now become an NBA trend (think: Victor Wembanyama).

• The NFL and the Rookie QB Window: NFL rookies are capped by a defined pay scale for their first few years in the league. As such, capturing a top-tier QB for a bargain under their rookie pay scale has become an NFL trend. Joe Burrow, Justin Herbert, and Jalen Hurts are recent examples of this. In paying Hurts only $4M in 2022, the Eagles freed up spending power at other positions. Patrick Mahomes makes $50M, but he’s not 12.5x better than Hurts as their pay difference indicates. That’s the market inefficiency NFL teams have been aiming to expose.

• The Three-Point Line: Perhaps the most recognized move towards efficiency in recent years, the three-point line (a somewhat arbitrary rule change) is now the essential part of the modern NBA. A movement largely pioneered by Mike D’Antoni, Daryl Morey, and of course, Stephen Curry, the three-pointer has transformed how teams value basketball players. General managers like Morey recognized just how undervalued the three-pointer was and built teams around that very purpose. Again, the magic is in recognizing undervalued details.

Fancy Words to Explain Simple Concepts.

When these undervalued variables become recognized, however, the edge is mostly lost. Going back to our Apple stock example, financial market inefficiencies are often solved using arbitrage. If Apple is selling at $151/share on one exchange compared to $152 on all others, people are incentivized to buy Apple at $151 and sell it on other exchanges at $152. They’ll pocket the difference and over time, the buy pressure on our inefficient market will drive it to efficiency. This competitive advantage within the inefficient market will be “arbitraged out”.

As more MLB teams used statistical valuations on MLB players, Billy Beane’s competitive edge lessened. The same can be said for the three-point line, the NFL trend to “go for it” on 4th down, and the other market inefficiencies cited earlier. Quantitative finance terms this phenomenon as “alpha decay” but we’ve heard it thousands of times on talk shows: sports is a copycat league. Here’s Daryl Morey on Patrick O’Shaunnesy’s Invest Like the Best:

“Basketball’s edges are getting smaller and smaller. Baseball is facing this as well. And that's frustrating, especially for someone who's lived through the huge innovations, shooting optimization was worth a max contract. You could add essentially a near all-star just through strategy. Now the advantages we're trying to eke out are like a half win to a win to a win and a half at most.”

In the same way arbitrage bridges the gap between $151 and $152 on our Apple stock, what may have started as a +10 win advantage is now a +0.5 win advantage as more teams recognize Morey’s strategy. Morey understandably calls it frustrating but it forces participants to innovate. In sports, this innovation just so happens to lie under an arbitrary rule set.

Piecing Together a Lens of Viewing this Market.

People much smarter than me are working on exploiting future market inefficiencies in sports. While I can’t offer an AI/ML-driven solution or a loophole nested in the NBA’s 598 page CBA, I do want to present my broader perspective.

A market inefficiency occurs when the market price of [X] doesn’t represent its true value. And who sets this market price in sports? The other 30-32 teams in a given sports league. Fundamentally, it’s absolutely worth recognizing what other teams are valuing and then determining whether it’s under/overvalued. Unbiased observation is the first step towards recognizing a market inefficiency in sports.

Basketball analytics wiz and author of The Midrange Theory Seth Partnow describes his field in sport as “a mode of thought seeking to reduce the cognitive biases we all suffer from”. He argues that math/statistics & computer science are simply tools to assist this end goal and are not the end goal itself.

The encompassing trend I’d like to argue for is that the best way to recognize market inefficiencies in sport is to apply effective learnings from other fields/industries.

Betaball — an Eric Malinowski publication — describes how the spirit of Silicon Valley built the Golden State Warriors dynasty. Owner Joe Lacob, a transcendent venture capitalist, applied startup growth techniques to the Warriors and it bled onto the court. Draymond Green is perhaps the ultimate example of this. Startups value adaptability, a fast-paced environment, and ultimately a desire to challenge the status-quo. The Warriors’ “Death Lineup” — featuring a 6’6’ Draymond Green as the team’s center — embodied each of these characteristics. They played fast, switched every screen, and led the NBA in net rating despite not playing a true center. What the group lacked in height, they more than made up for in speed and adaptability — a maxim that’s been endlessly applied to startups challenging industry incumbents. It’s no coincidence that Kevin Durant, Draymond Green, Andre Iguodala, and Stephen Curry are all prominent startup investors. Joe Lacob deliberately infused the ethos of Silicon Valley into the Warriors and its effects are evident both on the court and off of it.

Inspired by investor Charlie Munger, Sam Hinkie validated this concept in his resignation letter, writing “whenever possible, I think cross-pollinating ideas from other contexts is far, far better than attempting to solve our problems in basketball.”

He’s also on record saying he believes Wall Street is “two or three decades ahead about how they might think about risk and return and how to be objective in decisions” compared to the NBA. With the canonical example being Steve Cohen’s Mets, we’ve seen Wall Street slowly step into sports and the cross-pollinations between these industries seem boundless. From Hinkie’s aforementioned risk management to applying valuation models to players, the best learnings of Wall Street will soon permeate on the playing field/court if it hasn’t happened already. That’s not even mentioning the more obvious off-field applications such as capital raising.

To reduce cognitive biases in player evaluation, it seems logical to hire people from outside of the industry — those who haven’t been exposed to these biases in the first place.

What’s so captivating to me about all of this is just how interdisciplinary a field sport is. Math, psychology, statistics, economics, venture capital, startups, and more were (albeit briefly) covered just in these 2,000 words through the context of sport. Game theory, medicinal studies, data science, and many other vast fields of study weren’t even touched on.

Wrapping up:

Eagles GM Howie Roseman actually attended law school in order to thoroughly understand the NFL’s collective bargaining agreement. Jets GM Mike Tannenbaum advised him to carve out this niche in salary cap manipulation to get his foot in the door.

This niche proved to be evident in this year’s Eagles. Jalen Hurts was an MVP candidate making $4M while his on-field play was valued at $50-55M. In a market where spending is capped, this difference is especially enunciated. Because Hurts was generating only 2% of the Eagles’ spending power, the Eagles had an extra $50M to spend and their roster talent proved it. But do you think Patrick Mahomes cared about this market inefficiency? On just one ankle, he tossed three touchdowns and quite literally willed the Chiefs to a Super Bowl victory. 

The perfect end to this piece would have been a picture of Howie Roseman hoisting the Lombardi Trophy after ‘cross-pollinating’ his wisdom from law school to the NFL. But alas, it wasn’t meant to be.

The beauty of sports is that the culmination of all of these intense fields of study gets packed into succinct playing times — 90 minutes for soccer, 60 minutes for football, 48 minutes for basketball — where anything can happen.

The Warriors’ “Death Lineup'' expressed all the romanticized qualities of a startup, but LeBron James laughed at the Cavs’ proclaimed 6% win probability en route to defeating the 73-9 Golden State Warriors.

Which brings me to my next point that may be dramatic but is worth sticking with: I believe we’re captivated by sports because it’s a compelling form of humanity. LeBron James and Patrick Mahomes sell out stadiums because of their exceptional physical ability, but the display of human ability is shifting. Now, medicinal advancements like the COVID-19 vaccine, products like ChatGPT, and other non-physical human acts are taking the spotlight.

I believe that’s why I — and so many other people — are fascinated by Billy Beane, Sam Hinkie, and the many other trailblazers referenced in this piece. It’s inspiring to witness innovation, especially in the context of sports.