Michael Mauboussin Is Unshaken
The head of Consilient Research at Morgan Stanley explains the power of narratives, his approach to fundamental analysis, his faith in markets and multidisciplinary thinking, and what moved him to write his latest book.
Michael Mauboussin brings an athletic curiosity to problem solving. He’s intrigued by what he doesn’t know. And this thirst to understand brings a vitality to everything he does, including this interview, which went way beyond the allotted hour.
Throughout decades working for asset managers, Mauboussin has been a director of research, head of global financial strategies, chief investment strategist, author, and adjunct professor.
He was repeatedly part of the Institutional Investor All-America Research Team (the 50th team was recently revealed) and The Wall Street Journal All-Star survey. At Columbia Business School, where he still teaches, Michael received the Dean’s Award for Teaching Excellence in 2009 and 2016. He was the 2021 recipient of the Graham & Dodd, Murray, Greenwald Prize for Value Investing.
But don’t expect this interview to reveal where Mauboussin thinks markets, or inflation, or interest rates, are heading in 2022. He won’t tell us.
Instead, Mauboussin generously explains how he thinks about companies, markets, and investing. And his commentary, like this October interview, engages readers like peers. In exchange, he hopes readers do some lifting of their own and takeaway something substantial from the interaction.
Before we get into things, tell us how your thinking has been shaped?
I grew up in central New York where my father was a small-town car dealer. I majored in government, then entered a Wall Street training program in 1986 where I found the lingo and rules of thumb overwhelming. Then a colleague gave me a book, Creating Shareholder Value, by Al Rappaport. It was an epiphany. Al spoke about three things that have become central to my work. First: it’s all about cash — not accounting numbers. This resonated with me because I saw how my father worked. Second: though they tend to be treated separately, valuation and competitive strategy have to be considered together. One can’t do a thoughtful valuation without understanding a company’s competitive positioning within its industry, and the litmus test of a successful strategy is that it creates value. Third: the stock market provides a useful signal for managers. As an executive, it’s important to know what expectations are priced into your stock to allow you to make better capital allocation decisions.
Then in the 1990s, venerable value investor Bill Miller introduced me to the Santa Fe Institute, whose global membership includes a remarkable collection of professionals scattered across various disciplines. This place has had a huge impact on the way I think about markets and company performance. (Mauboussin recently stepped down as chair of the SFI board after eight and a half years but remains on the board.)
Your primary goal is to cut through the noise to see what’s important. How do you do that?
My first piece at Counterpoint Global was entitled: “BIN There, Done That.” It addressed bias, information, and noise — the “BIN” model. When you look at really good forecasters and try to understand what they’re doing that makes them good, there are three possibilities. They’re less biased, they have better information, or they’re less susceptible to noise. Researchers at the Wharton School found noise is twice as important as bias in separating the best forecasters from the average ones. There has been a lot of work on bias, which is systematic error, and less work on noise, which is nonsystematic error. The relative importance of noise versus bias was an eye opener.
There are typically just two or three things that are extremely important to get right for an investment to work well. The key is to figure out, and focus on, what really drives value.
What distinguishes a good from a great investor?
This difference rarely has to do with the tools they’re using but rather relates to their skills in decision-making — especially during challenging and stressful situations. The main way to improve outcomes is to enhance the process of decision-making.
Your work focuses on equities. To help identify promising investments, you have a deep faith in fundamental metrics such as discounted cash flow. How has that approach been dovetailing with what’s been happening in markets since Covid struck?
First, it’s important to distinguish between investors and speculators. Investors are buying partial stakes in companies. They need to ground their thinking in cash flow models. Speculators, in contrast, are trying to find stocks that go up. While there are pockets of speculation (e.g., meme stocks), I think for the most part markets have been acting very sensibly. My faith in fundamental analysis has not been shaken by market behavior over the past 18 months. I don’t see the markets being broadly mispriced.
So, the market soaring since the lows of March 2020, before anyone really knew how the pandemic was going to play out, made sense relative to what S&P 500 companies were doing?
Yes, especially seen in the context of how central banks and governments have flooded the economy with liquidity when the likely severity of Covid’s impact was recognized in early 2020. These institutions learned from the Financial Crisis that a strong, robust response to a major crisis is essential to stabilize things. They borrowed from and expanded the 2008/2009 playbook. Expected returns on all assets shifted lower as interest rates dropped. We can see that quite clearly with credit spreads, which collapsed. That means the present value of cash flow is worth more today, hence the market’s good returns. But expected returns are more muted than those realized in the past.
I understand your new book, which we’ll get to in a moment, got caught up in the supply chain mess.
Yup. Our release date got delayed by a month. As a New York Times article recently reported, every major facet of publishing is experiencing delays — from printing and shipping, distribution, and trucking. I guess this is a good example of work and reality colliding.
What do you make of the current supply chain issues — short-term or structural?
Probably a combination of both. These things will get worked out. But the current problem raises an issue about efficiency. We’ve developed supply chains that allow us to move goods cheaply and effectively. This is wonderful when the world doesn’t change. But efficiency introduces fragility. That becomes evident when the environment changes. The result has caused things to break down, bringing a lot of downside. We’re experiencing that now in all sorts of ways. Companies may respond by diversifying their sources of supply and creating more redundancy. This can be costly in the short run but introduces more robustness in the long run.
Beyond DCF, what other metrics do you advise investors pay close attention to?
The spread between the return on invested capital and the cost of capital, the trajectory of sales growth, and the strategic positioning of the business. Many folks are concerned about macroeconomic conditions. It’s essential to be aware of potential macro-outcomes. I try to be macro aware but am macro agnostic. I’m honestly skeptical macro analysis can add value for most fundamentally driven investors.
Investors should focus first and foremost on a firm’s economic returns. A simple proxy for that is return on invested capital. Growth amplifies economic returns. If a business earns its cost of capital, you’re essentially on an economic treadmill. Whether it’s growing fast or slow, you’re not creating value. If your return on capital is high, growth is positive. The faster a firm grows, the more wealth gets created. However, if returns are below the cost of capital, increasing growth destroys more value. Bottom line: consider economic returns first and growth second. Doing this demands an understanding of a firm’s strategic positioning and competitive advantage within its industry. If a company has such an advantage today, the next question is how sustainable it is?
What metrics should investors pay less attention to?
The big one is multiples as a measure of valuation, such as PE (price to earnings) and EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation, and amortization). Multiples are a short-hand for the valuation process — not valuation per se — and no one should fail to make that distinction. What’s good about multiples, which I use myself, is they save you time. What’s bad is they incorporate a lot of economic assumptions that need to be unpacked for investors to accurately understand what they actually mean.
A good example: the rise of intangible investments (assets such as software code, brands, and training), which show up as an expense on the income statement, distorts earnings. As a result, today’s multiples convey very different information than those of the past.
Does your fundamental approach toward valuation and investing work when markets are at an extreme?
I think so. Market efficiency means information is being accurately processed so price and value equal one another. Efficiency, or the wisdom of crowds, tends to prevail when three conditions are satisfied. The first is that investors have diverse views. Second requires a properly functioning aggregation mechanism — a way to tap all of that diversity. Markets are designed to do this. And the third thing is incentives: rewards for being right and penalties for being wrong.
Extremes are often the consequence of the failure of one of these conditions. The most common one to fail is diversity. Instead of thinking for ourselves, we tend to correlate our beliefs.
There is a line that I love from Seth Klarman, founder of the hedge fund Baupost: “Value investing is at its core the marriage of a contrarian streak and a calculator.” This statement acknowledges the crowd is often right. That said, when there’s a breakdown in diversity, he wants to be a contrarian and at least examine the other side of the argument. The calculator helps to explain when that becomes an opportunity. When everyone shares a particular belief, expectations will run to extremes. Extremes don’t happen often, and they are difficult to time. So a willingness to think differently, supported by a desire to understand expectations, creates opportunities for generating excess returns.
Let’s talk about your new book Expectations Investing: Reading Stock Prices for Better Returns, written with Alfred Rappaport.
The original book came out in September 2001, right before a national tragedy on 9/11 and in the midst of a three-year bear market. Talk about bad timing. One couldn’t have picked a worse moment to release a book about investing.
The revised and updated version builds on the original core ideas, but incorporates new developments and case studies. It also addresses changes in the economy and accounting standards. The target audience includes professional investors, students, executives, and motivated individual investors.
The book’s main concept can be described in three steps. The first is to determine what expectations are currently priced into a stock. How well do key value drivers have to perform to justify that price? Step two brings in strategic and financial analysis to assess those expectations. If the expectations are too low, you should buy and if they are too high you should sell. More often than not, the answer is the market has it about right. And step three is to buy, sell, or hold based on the difference between the stock price and expected value. Expected value, in turn, is based on scenarios for and probabilities of various outcomes. We develop a specific framework, which we call the “expectations infrastructure,” to guide the scenario analysis.
What are the book’s key takeaways?
Most investors act as if their task is to figure out a stock’s value and then to compare that value to the price. Our approach reverses this mindset. We start with the only thing we know for sure — the price — and then assess what has to happen to realize an attractive return. Some investors think that’s what they’re doing, but few actually do it explicitly. We believe this approach charts a better path to finding excess returns.
Does your book address how to sell well?
There are three basic reasons to sell. One, an investor feels the stock has reached fair value. Two, selling because you made a mistake. And three, you find a more compelling investment that you expect may have higher returns.
Foster Friess, founder of the Brandywine Funds and who passed away recently, coined a wonderful concept called “pigs at a trough.” For a sow to get to the food, she has to nudge out another one. Sounds like the third point is saying that.
This is exactly the same as Foster’s concept. And its value is in the discipline it imposes.
Charlie Munger is keen on learning from others’ mistakes. Do you address this process?
It’s very important to be mindful of failure when you’re thinking about anything. Most investors tend to dwell more on success and assume there’s some sort of formula that they can learn and apply. That approach is severely limited because it tends to under-sample failures. In other words, the question is not, “Did all successes follow strategy X?” but rather, “Did strategy X yield only successes?” The answer to the second question is almost always different than the first.
Getting quality feedback is also essential for learning. One way to give yourself feedback is to measure calibration — the degree to which your subjective probabilities match objective outcomes. There’s a lot of evidence that when forecasters keep track of these assessments, they get more accurate over time.
It’s also important to recognize when you’re right for the wrong reasons. We saw that when Covid proved to be a boon for certain stocks. You can be sure many investors who held those stocks before Covid struck did not anticipate a global pandemic. And it’s really important to keep track of the decisions you decided not to make. Evaluating what you didn’t do can also enhance skill and discipline. But all of this takes time, and most people feel they are too busy to do it. But I think these kinds of ideas are really important.
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Anything else to add about your book?
We built a website — www.expectationsinvesting.com — that complements the book. It’s for investors, executives, and students and has online tutorials to help explain our process.
Tell us what you’re doing at Morgan Stanley and Counterpoint Global.
Dennis Lynch leads our team. I greatly admire him as an investor and a person. He offered me a wonderful opportunity, and I started in January 2020. Two months later we were forced to work virtually.
My responsibilities are threefold. I work with the investment team on improving investment process. That said, Counterpoint Global’s performance has been so good over the decades that I took a version of the Hippocratic Oath, “First do no harm.”
The second thing I do is research. Our team is called Consilient Research, and we write under the banner of the Consilient Observer — an updated version of a publication I launched 20 years ago. “Consilience” is an unusual word. It was a term coined in the 19th century and means “the linking together of principles from different disciplines.” Dennis is a fan of this approach and wanted to resurrect the name.
The case for consilience was put forth by Harvard Professor Emeritus E. O. Wilson in his book by the same title published in the late 1990s. He argues that many of our most vexing problems are at the intersection of disciplines, and that reductionism — which has been wildly successful — may not be the right solution going forward. Taking ideas from different disciplines and putting them together may do a better job. I’ve tried to apply this mindset to investing, believing it’s important to understand the big concepts from different disciplines to solve problems.
The third thing I do is external, including conferences, podcasts, and client-related matters.
A good example of practical consilient thinking came to us through a Columbia Ph.D. student. His thesis found publicly traded companies are spending 15 percent to 20 percent more on maintenance capital expenditures than what is reflected in depreciation. This has significant implications on financial reporting and assessing a company’s outlook.
There’s a fascinating parallel between this idea and how animals grow. When you’re young, most of your energy is dedicated to growth. But over time, more goes to maintenance and repair. At the point in which all of your energy is necessary for maintenance, you stop growing.
Looking at companies through this naturalistic lens helps us better understand capital expenditures necessary to sustain operations versus those dedicated to growth. Bottom line: companies with the largest gaps between maintenance spending and depreciation tend to have the most write-downs, the poorest returns, and the most sluggish growth.
What are the main disciplines being brought together at Counterpoint Global?
Economics, finance, psychology, competitive strategy analysis, and science.
What are you learning in using this multidisciplinary approach?
When you face a problem, you want to be able to pull the correct tool to solve the problem. A multidisciplinary approach expands your toolbox to help you understand and solve problems.
One area where we’ve seen a lot of benefit from this approach is in the understanding of intangible versus tangible investments. Tangible assets typically appear on a balance sheet and are depreciated over time. Today, companies are increasingly investing in intangible assets (software, rights, etc.) that are expensed on the income statement and show up on the balance sheet only after a merger. This inconsistent accounting distorts both the income statement and the balance sheet.
Microsoft illustrates this point. Reclassifying intangibles as an investment doesn’t change free cash flow but reallocates the mix between profits and investments.
Is there a downside to using a multidisciplinary approach?
It takes time. A commitment to constant learning outside the immediate scope of one’s work means less time to attend to the here and now. And what’s being gleaned today may not always have an instant application.
Operationally, how can institutions adopt this approach?
First, management would need to embrace this kind of learning environment. Look at the characteristics of what makes for a good investor. One thing is being open-minded, to entertain and actually seek various points of views. The second quality: curiosity. Organizations have to find individuals who desire to understand how things work. Management would then need to ensure psychological safety for employees to think openly and to encourage open debate and the idea of learning as a team. At Counterpoint Global, we have a book club that promotes open thinking and discourse. One recent read was Range by David Epstein, which contrasts specialists and generalists, with a nod toward the latter.
This makes me wonder what you think about Malcolm Gladwell.
I find reading Gladwell wonderful. I think it’s fair to say he sometimes puts the storytelling ahead of the science. Jim Collins (Good to Great) is a really positive force. But like Gladwell, the science behind his famous work is not super rigorous.
Any special quotes or thoughts reflect the way you think about things?
I have a motto for the course I teach at Columbia Business School: “Take nobody’s word for it” (a Latin line that serves as the motto of the Royal Society — Nullius in verba). This means: Do not defer to authority; investigate primary sources, think for yourself. The second line I like is from the German mathematician Carl Gauss: “What we need are notions, not notations.” I share this idea with my students because we have a lot of concepts in finance that are captured by equations, such as the capital asset pricing model. But at its essence, CAPM is trying to reflect a notion, with the equation informing this idea.
You bring a flair to you writing that makes your arguments more accessible and compelling. Where did that come from?
I like to read a lot and it’s one of the best ways to develop an ear for communicating. My approach was very much influenced by Steven Pinker’s book, The Sense of Style, where he advocates for the reader to be thought of as a peer, with the writer and reader sharing the experience. In turn, the reader is expected to put some thought into understanding the arguments being made.
I also credit Laurence Gonzales. Laurence is a very talented teacher and writer. His most famous book is probably Deep Survival: Who Lives, Who Dies, and Why. Laurence did an amazing job line editing my book, Think Twice, and along the way taught me a lot about how to become a better writer.
Let me answer the question another way. There are two ways to describe the world: statistically and through storytelling. People are moved much more by narratives. So I like to use stories to help explain statistical points. Jim Surowiecki does a great job striking a balance between narrative and science, especially in his book, The Wisdom of Crowds.
So, you brought this approach to the new version of Expectations Investing?
Yes. I rewrote a lot of the original work, which was published 20 years ago, in an effort to improve its presentation.
You believe thinking and evaluation are ever-evolving processes. Tell me more.
We have a team at Counterpoint Global dedicated to identifying and understanding disruption. This helps us map out where the opportunities and landmines might be. Then there are the analytical tools: how do I recast financial statements to better reflect reality? How do I think about the value of optionality? These and other issues will help put one in the best position to find good investments.
Can you explain how index investing and automated flows into specific stocks may collide with your analysis of corporate and stock performance?
The investment management world used to be exclusively actively managed. Now we have a substantial portion of investing that’s indexed or rules-based. Active managers do two things that are essential. First, they ensure information is properly reflected in prices. Second, they provide liquidity.
I’m not persuaded we’re near the tipping point where indexing permanently determines stock prices. We still have plenty of active management to ensure market efficiency. Anecdotally, the Covid-induced selloff in 2020 confirms this as the stocks you would’ve expected to rise, rose; stocks that were likely to suffer, did — all while pensions and retirement accounts were channeling lots of money into index funds.
Here’s another reason to feel optimistic about the market’s independence. The Grossman-Stiglitz model says markets cannot be perfectly efficient because there’s a cost to gathering information and reflecting it in prices. Given that cost, there has to be a requisite benefit in the form of excess return. As far as I see, lots of institutional money and asset managers still believe they can realize this benefit.
Is there a tipping point where the flows into index funds may materially distort stock valuations?
Yes. But I don’t think we’re near that. Narrowly focused exchange-traded funds could be most susceptible if they grab too much market cap. But I don’t think that’s playing out, yet.
Do you favor buybacks to dividends?
All things being equal, I lean toward buybacks, when done properly as a more tax-efficient way to help build value per share. A company should repurchase its shares only when a stock is trading below its expected value and no better investment opportunity is available. Aggregate data shows companies are pretty good at buying back shares.
Investors may get confused thinking buybacks in themselves create value. They do no such thing. The prospects of a business remain the same. The value transfer occurs between buying and selling shareholders. When a company buys back its stock on the cheap, selling shareholders lose and ongoing shareholders win. The opposite is true when a company overpays for its shares.
Is there a healthy discipline imposed on corporations when they commit to a dividend payout ratio?
Yes, because companies view dividends as a quasi-contract. (Buybacks on the other hand are viewed as a residual.) Companies and their investors deem capital expenditures, research and development, and dividends very important so they tend to be very steady during normal times. By contrast, things like M&A, divestitures, and buybacks are discretionary and therefore are far more volatile.
Where do you see economies and markets going for the rest of the year and early into 2022?
Same question about inflation, tapering and interest rates?
What are some key metrics and events we should be watching for?
Beyond the obvious, there’s nothing I can add.