August 23, 2016

Baseball Therapy

If I Had A Million Dollars

by Russell A. Carleton

A few years ago, I had a conversation with my brother. We were talking about (surprise!) baseball, but then his finance degree started talking. He pointed out to me that baseball is actually a really bad business model to be trapped in. The majority of your costs are fixed. You will be paying them, no matter what. Unlike the NFL, MLB contracts are largely guaranteed, so once a team signs a big expensive free agent, they are on the hook for paying him, sometimes on the hook several years into the future. On the other side, a lot of the revenue sources that teams have traditionally counted on (attendance, concessions, merchandise)—items that even in the age of huge TV contracts and regional sports networks being big feeders of the bottom line are still important—are variable. Fans usually come out to support a winner and a lot of times it’s hard to know how good you’ll be in three years. Will there be enough revenue to cover the cost of that fancy new second baseman? Teams aren’t completely operating in the dark when it comes to budgeting, but unlike a lot of other industries where if demand slows down, you can simply slow down production (and save money that way), baseball doesn’t let you do that.

Baseball on the field is a game of resource allocation under some rather rigid constraints. You can pick the nine players who will bat for you and the order in which they will bat, but after that, you must follow that order no matter how the game unfolds. It would be lovely to have the top of your lineup due up as you go into the ninth inning down by a run, but sometimes, you’re stuck with the 7-8-9 guys. Off the field, teams are also playing a game of resource allocation, sometimes with similar constraints. But this time, the resources are dollars.

The question of how to spend money in baseball is as old as the game itself. (I’m told that there was a book about money and the ball that came out a few years ago, but I haven’t read it yet.) Baseball teams spend plenty of money, and yes a lot of it on the major-league payroll, but a good amount on other things. The question of where that money is best spent is the one that probably keeps most GMs up at night. No team has unlimited funds, and a million dollars spent in one place on the balance sheet is eventually a million dollars that can’t be spent in another place.

What does the evidence say about where teams should spend their money? It’s worth noting that just about all teams spend money on all of these items. It’s just a matter of resource allocation as to where. So, let’s take a look. Where should I put this extra million dollars that I have lying around.

(Can I type that sentence again? I’d like for it to actually be true in my life.)

Warning! Gory Mathematical Details Ahead!

Free agents (or re-signing your own players to extensions)

· Price on the open market: Roughly $7.5 to $9 million per win, depending on whom you believe.

· Time horizon: Free agents in general have an impact almost immediately. Not always a positive impact, but you at least know what you’ve bought fairly quickly.

· Ability to actually spend on it: Generally, free agents are the most expensive things, sticker-price wise, that teams allocate resources to. If a team wanted to, it could rack up nine digits in free agent bills.

· Risk profile: moderate

Free agents are something of the gold standard when we talk about allocating dollars. It’s easy to say “Well, we can project that (strategy X) costs less than $7.5 million per win, so it’s a good deal” and justify anything that way. But I think free agents deserve a bit more of an investigation than that. For one, there’s an entire sub-genre of research on which types of free agents are the best values. There was the craze over good-framing backup catchers. There’s been the recent run on high-end relievers. I’m sure that at some point, left-handed hitting third basemen with six letters in their last names will have their day in the sun. The problem with these fads is that they are quickly corrected and eventually, the “newly discovered” way to be valuable is simply baked into the price on the market.

There’s also the fact that we know that the market rate is not exactly linear. There’s a certain compression at the top of the market with high-end free agents—the kind that generally put up 5 and 6 WAR in a season—only (only!) able to command salaries of $25 million-$30 million per year. While that’s a lot of value to concentrate in one human body, it does seem a somewhat more efficient use of dollars. Stars and scrubs has its place.

Free agents (and here, we should probably throw in trading for major-league talent) are useful for two things. One is that a team has to put someone on the field, so free agents are useful for making up numbers. If your crazy yoga-infused developmental plan hasn’t produced an MLB-ready second baseman for the team, they’re going to need someone to play there. It’s great if you can take the players who are going to make the majors and make them all half a win better, but major league teams need warm bodies. (Once upon a time, I worked in a day care center. We used to call them “pulses.”) A good developmental plan needs to account for that as well, otherwise a team will just end up in the very free agent market that you are trying to undercut.

But more importantly, free agents are really the only category of expenditure that has a time horizon of “right now.” A lot of strategies that people put forth (the ones that end with, “…and it costs less than $7.5 million per win”) are also strategies that take two or three years to fully unfold. And sometimes teams have immediate needs. So, if you are tempted to use the free agent dollars-per-WAR as a battering ram to “prove” that your great idea is indeed great, let’s remember that a) the free agent market serves a very important purpose and b) your plan may be more efficient on a dollars-per-win basis, but it might not take away the need to go to the free agent market to begin with.

The frustration of signing (or trading for) free agent-aged talent is that it represents at once the most well-understood present value and risk, and even being the most well understood, it isn’t all that predictable. By the time a player is old enough to sign a free agent contract, he’s generally in his late 20s or perhaps has hit an age starting with three. We know that by this point, players have reached their peak. We also know that All-Stars tend to lose that All-Star sheen much faster than is generally thought. In fact, in a quick study of position players, I found that among players aged 29 to 32 years, last season’s WARP was correlated with the next season’s WARP with a coefficient around .5. Two years out it was .4 and three years out it was .3. It doesn’t mean that everyone goes downhill, it just means that when a team signs that three-year contract based on a player’s recent history, they may or may not get that sort of production later on.

This shouldn’t surprise anyone that free agents are risky. There are plenty of stories of the free agent that flopped (and the out-of-nowhere free agent bargain bin bonanza breakout!) Funny to think that they are such an unpredictable investment with the exception of just about everything else.

The Manager

· Price on the open market: Surprisingly, manager salaries are not widely known. We have numbers for a few of them, and it’s assumed that Joe Maddon, Mike Scioscia, and Bruce Bochy top the list at $5 million per year each.

· Time horizon: Theoretically, a new manager brings his impact immediately. Although, we’re still not entirely sure what it is a manager does

· Ability to actually spend on it: Well, a team only needs one manager.

· Risk profile: seemingly low

The more we study managers, the more it becomes apparent that all of the strategic things that managers are theoretically doing don’t add up to much. Things like setting the lineup and bunting and all that sort of thing has some value, but not a lot. The real value in managers seems to be in how managers shepherd their charges through the long season. I’ve found previously that a manager, just by helping players to avoid falling prey to “The Grind” can have an effect somewhere in the neighborhood of 30 runs over the course of a season. The effect is stable across years (and oddly enough, the manager who rated the best when I looked at the issue—Bud Black—is currently unemployed). For one of the higher-end managers, $5 million for even 20 runs of value sounds like a bargain. But remember, you only get one.

Scouting/Player Development

· Price on the open market: “Cost-controlled players” tend to produce wins at about half the cost of free-agents, but…

· Time horizon: “The Future”

· Ability to actually spend on it: Well, the biggest costs for what is loosely termed “scouting and player development” are bonuses paid to draft picks and international signings. And those are (softly) capped.

· Risk profile: Off the chart.

The fact that teams have shown blatant disregard for the caps placed on the international market shows that they believe that corner of the market might be a tad underpriced. In the aggregate, they’re probably right. The major expense in obtaining these cost-controlled players is the signing bonus, and if they are returning value at half the cost of free agents, then bidding up those signing bonuses is the logical outcome of the market. But let’s leave that aside. Let’s talk about spending more money on things like scouts and player developers.

Here we need to talk about marginal dollars. All teams have a scouting department. All teams have minor-league affiliates. All teams have instructors and roving coaches. A few years ago, when I asked around, I found that the whole operation costs about $20 million to run. If a team wanted to throw an extra million dollars into that line of the budget, what would they spend it on and what would they actually get for it? This is a question that we haven’t even begun to answer. What exactly is the value of an extra scout? What is the value of another roving pitching instructor? What would be the value of increasing wages or feeding the minor leaguers better? We have no idea.

Worse, what data that we do have suggests that scouts have a hard time picking out who is going to be a star and who might not even make the majors. They all seem to be afflicted by this disease. (The diagnosis isn’t “Scouts are stupid” but rather “Trying to look at an 18-year-old and figuring out what he’ll be at 27 is hard.”)

When you know that an asset class is volatile, although profitable in the aggregate, the best course is to grab a lot of it. The problem is that… well, it’s really volatile and we know very little about how it works. Good luck.

Nerds!

· Price on the open market: Interns are free. Computing power and data feeds are not.

· Time horizon: Variable

· Ability to actually spend on it: This is an interesting one. There are plenty of people who would actually pay for the privilege of working for a team. Compared to the multi-million dollar contracts that the athletes sign, even well-paid information professionals are cheap.

· Risk profile: How to even define this one…

Seeing that this is Baseball Prospectus, you might expect us to take the view that nerds are the ultimate market inefficiency and that teams should hire as many nerds (e.g., us) as they can. (And hey…) But let’s talk about the great unanswered question about the analytics movement. We have a replacement level for players. What is a replacement level statistical analyst? Is it an internet connection and a couple of bookmarks set for Baseball Prospectus and a few other sites?

And the problem with nerds is that they fall into the same trap as scouts. What’s the added value of bringing in someone who knows how to do a proper random effects model? Sure, it will provide new information. Maybe even really useful information. But we have no idea how to value that at this point. A lot of times it’s hard to disentangle things. If the proprietary metrics liked that relief pitcher on waivers, but so did the scouts, and it was the pitching coach who helped him with that new slider grip, who “found” the reliever? Well, everyone did. And no one did. And that’s pretty much how it runs. Analytics are there to help inform decisions, and hopefully they help.

It is one of the oddities of baseball that analytics can’t really conclusively prove that analytics actually works. We’re just pretty sure in our guts that it does.

So, should that extra million go to analytics? Sure. But teams are spending it in the dark. There is some evidence that the early adopters of analytics got a good bang for their buck, but as more teams have signed on, the advantage might be gone. Or it might still be there. While teams eventually have to reveal what players that they will have on their team, they generally don’t say much about the process that got them there. And so we have no way to formally evaluate that process.

Insurance

· Price on the open market: Well, it depends.

· Time horizon: The next few years?

· Ability to actually spend on it: Some teams do, some don’t, but a team could end up spending

· Risk profile: By definition, it’s a hedge against risk

On last Friday’s episode of Effectively Wild, Ben, Sam, and special guest Nathaniel Grow contemplated this one. We know that teams spend a lot of money on the items above, and all of it has a lot of risk inherent in it. How much should they hedge against that risk?

It’s not actually an easy question. The risk that they can hedge against is the risk of a player—probably a big free agent signing—having a catastrophic injury that leaves him out for an extended period of time. A lot of this decision depends on the rate that the insurance company charges versus the anticipated rate of injury. For the sake of simplicity, let’s say that a team has a player making $25 million, and that the insurance company will insure against a catastrophic injury for a $2.5 million premium. Let’s say that the team believes that the chances of such an injury are 10 percent. That makes it an even-up bet from an expected value framework.

I’d argue that in this case, it might actually make sense to get the insurance. There are two reasons in this case. For one, signing a contract that includes a salary of $25 million is something that’s undertaken by teams that are in the mix of contention. That means that they are likely at a place on their win curve that losing a few wins of production will actually represent a greater dollar value loss (because of a reduced chance of making the playoffs). So while the salary being signed might be driven by dollars per win, the revenue to be gained from that player might be driven by that win curve function, and the two might not be well-matched.

Of course, that leaves less money available to go out and get some extra relief help…

The other argument for taking the insurance on a high-priced player specifically is because of the aforementioned Guinness Effect, where players at the top of the WAR spectrum make less than they should because of a ceiling effect on salaries. Being able to recoup the salary of an injured $7 million player might only buy you one win again. The insurance relief from a big-ticket free agent allows a team to go back into that part of the market. There are asymmetries where insurance actually makes sense, even if the premiums are over-priced.

But Not A Real Green Dress, That’s Cruel…
Of course, there is no correct answer to what a team should do with an extra million dollars. Some answers are better than others, but if there’s anything to take away from all of this, it’s how much uncertainty there really is in trying to make some of these decisions. And it’s too easy to say “Well, just do all of it.” That’s not an option sometimes. There come moments where you have to make difficult decisions, decisions that could be made through a perfectly sane process, and then they don’t work and you lose your job.

If you see your friendly neighborhood GM anytime soon, be sure to give him a hug. He really does have a tough job.

Russell A. Carleton is an author of Baseball Prospectus. Follow @pizzacutter4
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