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Of Slam Dunks, Layups and Risk-Adjusted Returns

July 27th, 2019

Market Views

Few things in life are as easy as a layup or as certain as a slam dunk. We have taken these terms from basketball to describe everyone’s favorite opportunity, a sure thing……..So why is everyone shooting the “Three?”

It’s called risk-adjusted return and it took an NBA team owned by West Coast VCs and operated by a team of quants to figure it out.1 The Golden State Warriors ran the numbers, drafted Stephen Curry, traded for Klay Thompson and told them to put up the Three, as often as they could. The results speak for themselves, with the Warriors appearing in the NBA Finals for the past five years.

Why bother attempting a shot from 24 feet to earn two points when you can step back one foot and shoot for three? During the 2018-2019 NBA regular season, Stephen Curry took 244 shots in the band from 20 to 24 feet from the basket, making 123 for an average of 50.4%. Incredibly, he took 554 shots from 25 to 29 feet from the basket, converting on 234 for a shooting percentage of 42.2%.2 Why, his coach must ask him constantly, would he ever pull up from 24 feet?

Of course, in the investing world, the court is a little different. First, there are no slam dunks or layups. The closest we get is a Treasury Bill. And the Wall Street court doesn’t have just one three-point line, it has a line every few inches, each one a little farther from the basket, making the shot just that much harder, but presumably paying a few more points. Imagine a basketball game where the dunk is .25 points the layup .50, the foul line three, top of the key four and the current three-point line worth five.

Perhaps the line investors should pay most attention to is the free throw line. Having been fouled by a player on the opposing team, the free throw shooters gets to stand alone, unguarded a mere 15 feet from the basket and attempt a shot they have practiced hundreds of thousands of times. If they can block out the distractions of a screaming crowd, methodically run through their pre-shot routine and let their muscle memory take over, they are very likely to earn another point for their team. The best score more than 90% of these shots. During his career, Curry has made 1,305 of 1,450 foul shots for a percentage of 90.4%!  Over the course of two seasons in 1993, a young man named Michael Williams made 97 consecutive free throws. Maybe that’s why they call this line the “charity stripe.”

In putting their teams on the floor, coaches and investors examine statistics. While coaches focus on shooting percentages from different spots on the floor — “shot selection” in NBA speak — investors concentrate on measuring risk-adjusted returns, or the return on an investment compared to the risk assumed to make that investment.  At the end of the day, it’s all about finding the shooter and the shots that best fit your overall plan and your tolerance for risk.

The newly crowned NBA Champion Toronto Raptors took a chance on Kawhi Leonard this year and it worked well, despite the fact that he took only 143 shots from between 20 and 24 feet last season, making a paltry 57 of them for an average of 39.9%. He did, however, manage to put up 333 shots from within 5 feet of the basket, converting 221 for an average of 66.4%. He also made 364 — or 84% — of the 426 free throws he attempted.

How do you spell MVP?

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