The NBA Small-Ball Revolution

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Transcript:

In the 2005 NBA Finals, the San Antonio Spurs defeated the Detroit Pistons 4 games to 3.  Spurs Center Tim Duncan was named finals MVP, averaging over 20 PPG and 14 rebounds per game.   In the prime of his career, Tim Duncan was a prototypical “back to the basket” big man, scoring over smaller defenders, out rebounding them, or dishing the ball out to open teammates as defenses collapsed on him.

Basketball is a possession-efficiency game.  Statistically speaking, a winning basketball team scores more points on average per possession than its opponent.  For decades, the route to per-possession efficiency was having a dominant center.  Prior to the 2005 finals, 75% of NBA champions since the dawn of the league were led by a dominant big man holding the court down near the basket.    The route to a championship was clear – find a dominant center who played well with his back to the basket and control rebounds – and your possession efficiency rises to a championship level.

However, since 2005, not a single NBA finals MVP has been a traditional center.   League MVPs have been smaller players located further from the basket, like Steph Curry, Steve Nash, Kobe Bryant, James Harden, and LeBron James.  LeBron is not exactly small, but he doesn’t play with his back to the basket very much.

So What happened?

The answer is a subtle but significant rule change.  If you guessed the institution of the 3 point line, you’re wrong.  That happened in 1979.  The change was a modification of a defensive rule called “hand checking”.  Hand checking is where a defensive player puts his hand on an offensive player’s body,  whether or not they have the ball.  This allowed larger and stronger players to channel smaller players and obstruct their movement around the court.  The rule was changed in 2004 to disallow this tactic.

The result was not immediate but turned into revolution – smaller and more athletic players, now much freer in their movement around the court, could exploit their athleticism and skill.  Scoring exploded, with average points per game up 19 points compared to before the hand-checking rule.  NBA basketball is now a perimeter game.  The keys to success are a squadron of perimeter shooters that can spread the floor, good passing around the perimeter, and long/quick defensive wings that can guard these guys.  As for the traditional center?  They still exist but are far from the focus of the game.

My name is Brian Barish, I am President and Chief Investment Officer of Cambiar Investors.  Our company has been in business for almost half a century.  We manage equity strategies in the U.S., internationally, and globally, up and down the capitalization spectrum.  All our strategies employ a value philosophy to uncover opportunity, manage risk, and defend against the inevitable unknowns.  This means we have a serious issue on our hands.

It’s certainly just a coincidence, but the success of value investing ebbed right around the same time as the era of NBA big men, in 2006.  Up to the year 2006, value investing’ s superiority over growth and other investing “styles” was unchallenged—kind of like the embedded wisdom of building a basketball team around a dominant big man.

The philosophy behind value investing is not dissimilar to that of building a basketball team around a dominant center.  Value investors believe that the price paid for a stock is a major determinant of its potential upside, and that by buying stocks very cheaply in comparison to their intrinsic value, value investors embed a “margin of safety” relative to the price paid.  Low downside, high upside. It’s the investment equivalent of per-possession efficiency.

For most of the 20th century and the first part of the 21st, Value investing enjoyed a gold plated philosophical and quantitative edge over other approaches to stock picking.  Value… worked better.

But starting a bit before the 2008 financial crisis, value started not working so well.  Through the crash of the financial system and the economy, value stocks underperformed noticeably.  And since the market lows in 2009, value indexes have continued to lag.

In fact it’s now been 14 years of steadily weaker returns than comparable growth indices.  With the world economy thrown into a deep recession and uncertainty due to the Covid 19 virus and Great  Lockdown, value stocks entered the 100th percentile of valuation relative to growth stocks.  They have literally never been cheaper, relatively speaking.

The long dark winter of value means that statistics like this don’t scream of opportunity anymore to the financial press.  They bring questions and sarcasm.

Last Fall, Forbes magazine ran a piece titled “Has Value Investing Stopped Working?”, while Institutional Investor magazine ran a piece around the same time with the catchy title “Why Value Investing Sucks”. In 2020, the world’s most renowned value investor, Warren Buffett, has been lampooned for inaction in the depths of the Coronavirus selloff and deep losses on major portfolio positions.

It’s getting tough out there.

I want to share with you my journey into this issue.  It hasn’t been easy. But after looking at lot of different forms of data, from macroeconomic to accounting to specific industry structures and evolution, there are emerging and investible conclusions.