The Greatest of Market Inefficiencies Part I: Overview

I'll start by saying I have no damned idea. If I did, I'd have a corner office and I'd be lighting cigars with hundred dollar bills. I have questions though, and thought this might be a good conversation for us all.

Ever since Moneyball came out (as a book) those who understood it have looked at what the next market inefficiency would be. Seattle thought it was Defense a few years ago. Which, given their cavernous home park, didn't seem like a bad idea. However they wallowed in last place long enough to abandon the idea midseason; trade Cliff Lee for hitting prospects and trying to go a more traditional route.

I think it's obvious that everyone wants to develop as many top prospects as they can. Is there anyone good at it?

I think the takeaway is that the Rays clearly know how to develop Pitchers, but have the same struggles as everyone else with position players.

I want to start by looking at the financial implications of Prospect Development and to do that I'm going to relate it to an industry I'm probably more familiar with than most, Pharmaceuticals. People sometimes seem annoyed at how expensive medicines are and while not getting into details, I think there are a few similarities to prospect development. Drugs go through three levels of testing prior to reaching the market (sound familiar?), plus a level prior to human testing to confirm safety. So the stages are pre-clinical, followed by Phases I, II and III (sometimes with multiple studies at each level). For every 100 chemical compounds that are developed, less than 10 percent ever have a chance of reaching the market. Most are stopped in Pre-clinical or Phase I. Phase II is the most difficult Phase, as this is where it's determined if the product is at all efficacious (similar to ballplayer's jump to Double A, where thre challenges increase).

From the moment a Chemist develops the compound to the moment it hits the market a typical drug cost hundreds of millions of dollars to develop. for the purposes of this discussion let's say it took $500mm to develop Drug A. It has patent protection (think similar to cost control for a ballplayer) for somewhere around 20 years (depending on the country) and during that time it has $1 Billion in sales. That's a huge success right? Well, maybe. Remember, 9 other products failed at the same time this was developed. Let's aim low and say that cost $200mm. Then you have the manufacturing cost of Drug A, which we'll say here is $100mm. Then of course, there's advertising for the product. I'll go low here and say $50mm. And of course miscellaneous business costs associated with Drug A, we'll say $20mm there. That's $870mm in costs associated with drug A, which leaves $130mm in profit. Not bad, but not even enough to pay for another drug's development.

So, how does this relate here? Well, let's say Cole Hamels is Drug A (since he's now through his cost controlled years). Cole Hamels signed with a $2mm bonus in 2002 as a First Round draft pick. His contract was purchased by the club in 2006. He pitched with the Phillies most of 2006 and would have earned somewhere around $300k. He earned $400k in 2007 and $500k in 2008. The Phillies bought out his Arb years of 2009 ($4.35mm), 2010 ($6.65mm) and 2011 ($9.5mm). They then also reached an agreement to avoid arbitration in 2012 with Cole at $15mm. So Cole cost the team $38.7mm through his cost controlled years. During this time the team got 26.5 WAR from him. Assuming $5mm per WAR, that would have cost $132.5mm on the Free Agent market. That's nearly $100mm in savings there.

What are the hidden costs though? Well, they're kinda hidden (hence the phrase). Th Phillies drafted 48 players in 2002. The Phillies didn't sign several of them (the 2 most successful after Hamels, Sam LeCure (1.4 carer WAR) and Dusty Ryan (0.0 WAR) were subsequently drafted by the Reds and Tigers, respectively in later drafts). They did sign most though, and many had washed out of the Phillies Org. within 3 years. Is it fair to count all those other sunk development costs against the $100mm we saved on Cole's performance? Part of me says no, since I understand the Minor Leagues to be a fairly successful money making operation. Part of me says yes, as they are sunk costs, and were the team able to successfully develop more of them it would lead to even more savings against Free Agent WAR at the Major League level, and more profit to be spent to fill holes or upgrade the stadium, etc. With that in mind I take a stab below at figuring it out, roughly.

Using 2010 Minor League Pay scale based on a standard 7 year contract (Source). I counted up the total season(s) spent at each level (for example, the 1 season at Triple-A is actually multiple players with partial seasons). I stopped counting as soon as the player made his Major League debut, and also when the player was traded/cut, and a few spent several more seasons in other Organization's systems. A few notes on these numbers: They're almost certainly underestimated. Guys can negotiate for different rates, and can get higher pay for their second and third years at a level. I did not account for either of these, so even without these numbers being adjusted for inflation I'm probably off several thousand dollars. I also didn't account for Signing bonuses as, aside from Cole, they were pretty tough to find.

Of course, there's also costs for Trainers, Coaches, travels, meal stipends ($20/day, all levels), uniforms, equipment, etc. Still, unless the Phillies buy platinum helmets for everyone, it's not $100mm. So Cole worked out pretty well, even given all of the flops in the 2002 draft. Of course, most drafts don't include Cole Hamels, and several drafts for every team are barren wastelands where no one makes a significant contribution to the big club.

In Part II we'll take a look at stats as possible predictors. What are the red flags? Is anything reliable?