Michael Mauboussin is on the Mount Rushmore of investment thinkers. The world of professional investing is better because of the work he has published over the decades. Below are quotes pulled from an interview Michael Mauboussin and Tom Digenan did for Graham & Doddsville. The quotes are in italics. My response will be below each quote.

Discussing what he learned from Creating Shareholder Value “The first was value is not about accounting numbers; it’s about cash. This is a lesson that we relearn from time to time. The analysts always focus on cash. The second thing was about that competitive strategy and valuation should be joined at the hip…The finance guys say ‘well, it’s good to have a competitive advantage,’ but don’t quantify it…The argument was that your stock price reflects an expectation about how you’re going to perform as a company. You, as an executive need to understand what the market expects, and exceeding those expectations will make your stock go up.”

    The first part about cash and earnings is pretty straight forward. Following the cash and how it is spent is extremely important. Also, when doing valuation, earnings can be manipulated. Cash is not perfect but it’s probably to best way to value the company and what the company’s strategy is. The second part, valuation and strategy are very relevant to where I am right now. I have spent a lot of time learning about valuation. I have been learning about the different valuation methodologies, how its constructed, the thought behind different assumptions. But it’s now time to move beyond valuation and figure out how a company can establish a competitive advantage. Valuation will be partially determined by a company’s ability to execute its strategy and how the market responds to it. The final part is all Expectations Investing by Mauboussin.

Clients would be curious about his valuation process “Tell us more about your valuation approach.”

    This is a question I am not sure analysts ask themselves much. We go through our own valuation process without thinking about the different biases that might have slipped into our assumptions. We don’t step back and examine our methodology. There is a tremendous amount of pressure to get to an answer quickly. And speed is important, but if the process used to reach that answer is flawed, then the answer is irrelevant. Why are we using a P/E multiple for valuation? Do we understand the assumptions behind the EV/EBITDA multiple being used? Are we calculating the cost of capital correctly? But we also have to ask ourselves if we understand the company’s strategy, both its strengths and weaknesses. It is this type of self-examination that will make us better investors.

“Cognitive dissonance impairs out ability to immediately incorporate evidence refuting your current hypothesis. In addition, there is a value trap element in play where you can justify maintaining the position by saying, “but it’s really cheap now.”

    Incorporating these sign posts should be part of our decision process when we make stock recommendations. We should list and disclose to everyone what these sign posts are what we should do if they come to fruition. This will help us in future buy/sell decisions. It will also help fight the anchoring bias.

“People get set in their ways. I don’t think most organizations have an actual process that pushes you towards continuous improvement and it’s something that you’ve got to be adamant about because it’s not comfortable.”

    Inertia is an underrated force in organizations, especially where success is prevalent. The world is inevitable going to change. An organization is going to face challenges internally. If that organization is not constantly looking where to improve and doesn’t make that mindset a primary part of its culture, the success it enjoyed might not last. Amazon’s journey is a great way to see the benefits of this mindset.  

“…knowing the mechanics of valuation, or know how to do the strategy analysis is almost the ante to the game. If you can’t do that, you’re not even in the game.”

This is where OSAM will begin to gain an advantage over other quant shops and fundamental investors. From the topics Patrick has discussed on Twitter, his podcast, and papers it’s obvious he is spending a lot of time learning and thinking about strategy. The next step is to figure how to quantify that strategy and where evidence can be found in the numbers. I am sure they are already doing this. This is the advantage fundamental analysts have had over quants, but that might be disappearing. Fundamental analysts need to get better at their analytical edge in response.

“When I think about investing, it’s really about trying to bring both of those things to bear (knowledge and execution). Are there tools that we can provide people with to make them even more effective at what they do? The second part is we make sure people are very methodical in their decision making.”

On top of improving ourselves as investors, we need to find way to analyze and understand information faster and more efficiently. Then we need to understand what to do with this data. This goes back to Michael Reece talking about data alone is worthless. If you have access to all of the inputs to Apple’s business, that data would be worthless if you didn’t understand how Apple operates and what its strategy is.

About the investment process, “One is to have a clearly stated thesis and some sort of identifiable edge when entering a position.” 

This goes back to separating fundamentals from expectations. This is something I am just beginning to understand and implement. It’s embarrassing that I haven’t been doing this all along because it seems so intuitive. But if I am disciplined in implementing this in every investment decision, it will improve my process. This is also about understanding your edge. It could be analytical (the market over/under estimates the power of a company’s competitive advantage or doesn’t understand it at all), behavioral (difficult to measure against the market unless extreme reactions are current state), informational, or technical. 

“The second thing that is extremely relevant is ‘signposts,’ which is, if my thesis unfolds as I anticipate it is going to unfold, here’s what we should see happen. If it doesn’t, this gets to one of the most difficult things we to do as investors, which is to update your view.”

    This goes back to the earlier discussion about sign posts, but adds the fact that we have to be a “good Bayesian”, to steal a phrase from his “Who is on the Other Side” paper. 

“One is gaining and edge, and the second is how much you bet, given the edge you have. We spend a lot of time thinking about this. Many people spent almost no time thinking about this. I’ve talked to a lot of portfolio managers and a lot of different organizations that are very heuristic based in their portfolio construction.”

    This goes back to Michael’s discussion about Strength and Weight when looking at data. Weight is the sample size and strength is the degree of to which the conclusions of the data are not random and/or beyond average.  It is rare that both the strength and weight of evidence is high and is not already priced into the market. So, we have to understand the data we are looking at the make good probabilistic assumptions about what it means about the future. A future area to explore is the difference in mindset and approach to an investment between a portfolio manager and an anlyst.

“To me, I would translate value investing into an expectations model, so that what you’re trying to do is buy low expectations. Everything else follows from that. Value investing to me is just buying low expectations.”

    This agrees with the comment made by another portfolio manager to not constrain yourself. In a world where alpha is becoming more difficult to deliver on a consistent basis, constraining yourself to value, growth, quality, etc., will only limit your opportunities. Now, if your knowledge base is consumer staples, venturing into bio-technology might be a difficult transition. But don’t limit yourself to factors, and don’t think that just because you invest in consumer staples that investing in bio-technology isn’t possible. It will just take time and effort.

“I think one of the biggest mistakes you see in the investment business is people fail to distinguish between what’s priced in and what going to happen fundamentally…Everybody has the same person doing both of those things

[fundamental analysis and market expectations]

, but they are very different. The great investors always separate those in their head. Just because things are going well doesn’t mean the stock is good. Just because things are badly doesn’t mean the stock is not attractive.”

    Again, Michael is talking about Expectations Investing. This shows you a) how important this mindset is and b) there is still an edge to be gained by implementing this mindset. This book has been out since 2001.

“If you look at the standard deviation of excess returns from mutual funds on an alpha basis, you see that alpha used to have a big, fat distribution. There was lots of positive alpha and lots of negative alpha. Smart guys win, dumb guys lose. Today, that distribution has shrunk. Very little positive alpha, very little alpha.”

    While this is discussed in the context of the lack of volatility in the market and the effect the rise of passive investing has had on the market, it is also about the paradox of skill.

“Opportunities are a big deal. Think about steeping back and saying, ‘If I want to generate excess returns, where is that likely to happen?’ Being the 500th large-cap U.S. manager is probably a tough way to distinguish yourself. However, there might be other markets where that could be the case.”

    The final quote might be the most important because it summarizes the current state of the asset management business and the mindset every good investor must have. First on the current state of asset management. While this is probably difficult to confirm, I would venture to say that never before has there been so much money controlled by professional investors with so little alpha to be had. It’s becoming increasingly difficult to not just beat the market, but also differentiate yourself in a way that generates excess returns. Part of this is the paradox of skill, part of this is career risk (better to fail conventionally than succeed unconventionally mindset), and part is desire for large capital allocators (pension funds, endowments, insurance companies, etc.) to be able to fit every manager they invest with in a clearly defined box. The paradox of skill a part of the market now; you can’t do anything to change that. But career risk and embracing the difficulties of being different are something we control as investors. There are two factors you will be fighting. The first is that to fight the career risk mentality, you will have to go against the heard. An endeavor most humans are comfortable with initially. The second is that it will be more difficult to raise money from potential clients if they can’t fit you into a defined box. But you might end up finding the “right” clients that will be with you during the boom and doom times. 

    The mindset every investor has to have is curiosity. If you aren’t curious, you won’t ask “why” and you won’t go digging down rabbit holes to find the answer or find something new. It also means looking where no one else is to find opportunities. This is of course risky, but that is the only way to outperform. An example of this is Geoffrey Blatt investing in Iraqi equities. But it’s even better summarized by Patrick O’Shaughnessy when describing the common traits of his best guests. 

“The third common trait is risk management. It is tempting to view uncertainty as a sort of risk, but I think that is a large mistake. All the good stuff is found in places that haven’t been mapped already. In fact, to take the idea of original experience a step further, what is common across the best people I’ve met is not just having the experiences, but then bringing some sort of order to the chaos they found in uncertainty. This isn’t risk, in my opinion. If anything, not seeking out chaos is what’s risky.”

The easy game is where there are few players and little efficiency. Seek chaos.

The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.