In this podcast, Motley Fool senior analyst Bill Mann interviews Michael Mauboussin in front of a live audience about a range of investing topics, including:
- The approach of "expectations investing" and how to apply it.
- Why a company's base case for growth is so important.
- Peloton's faulty growth predictions.
- Businesses with real option value.
Mauboussin is an adjunct professor of finance at the Columbia Business School and the head of consilient research at Counterpoint Global, Morgan Stanley Investment Management.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
This video was recorded on September 3, 2022.
Michael Mauboussin: There are certain businesses that have option value, an option is the right but not the obligation to do that. If there are market leaders in uncertain markets with smart management teams and access to capital, they may be able to see opportunities as they present themselves and take advantage of it. ...
Chris Hill: I'm Chris Hill and that's Michael Mauboussin. He's an author, a professor of finance at Columbia Business School, Head of Research at Counterpoint Global, a division of Morgan Stanley. But at The Motley Fool, we like to think of Mauboussin as the investors' investor. There are other investors who are more famous, there's certainly other investors who spend more time on television, but if we could grab coffee with any investor, Mauboussin would be the first pick for a lot of us. At our FoolFest Investing Conference last week, Bill Mann interviewed Mauboussin in front of a live audience. They talked about the approach of Expectations Investing, why a company's base case for growth is so important and much more.
Bill Mann: One of your most famous pieces of work is Expectations Investing. It's a wonderful process. I think that one of the great things that you have brought to the table, and a lot of people call you the investors' investor, is the thought of having the market inform you what it is thinking as it values companies. With every single company, the stock price is a piece of information. For our Foolish investors, maybe just give a little bit of thought of where you started from that and how you apply it?
Michael Mauboussin: I actually went to college here at Georgetown. I was a government major, had no business experience whatsoever when I went on to Wall Street. I'm still confused, but I was definitely confused at that time.
Bill Mann: You're confused in the right direction.
Michael Mauboussin: Confused in the right direction. Someone gave me a copy of a book called Creating Shareholder Value, written by Alfred Rappaport, who's my co-author. I read that book and that was the first thing that added some coherence into my thinking. There were three things he talked about. One was, and this is all important for all of us, it's not about accounting numbers, it's about cash and economics. Go beyond the accounting to understand what's really going on. The second, which I think is also really important, is that he argued that competitive strategy analysis, why is this business distinct and unique and good, should be joined at the hip with valuation. We tend to do those things separately, but they should go together. The last thing was the original book is Chapter 7. It's called stock market signals for managers.
The audience was executives, but clearly the relevance was for investors as well. The idea here, Expectations Investing is to say, we have one thing we know for certain, and that is the stock price. What we can then do as reverse engineer what has to happen for that stock price to make sense. Now, we think you should do that with a discounted cash flow model. That can get a little bit fancy, but it doesn't really matter. The core concept is how high is the bar set and how high must my company jump to clear that bar. That idea of always understanding what has to happen for that stock to make sense, I think, is the core idea. Now, we want you guys to use expectations investing to try to make it somewhat accessible.
We have built a website called expectationsinvesting.com that has downloadable Ex-tutorials including Excel spreadsheets. If you think the idea makes sense, you think it fits your philosophy and how you want to approach the world, and you want some tools at your fingertips to be able to do that, we try to provide those. That's the basic setup. By the way, it's true for almost everything in life. What has to happen for this to make sense. I think by the way, we're approaching football season, the way I like to think about it is the over-under for football games. You're not betting on the actual score, which is itself very difficult. But you're saying no, I think they're going to score more than this or less than this. That I think is a cleaner type of bet to make.
Bill Mann: I have a way that I think about investing and then thinking about the stock price in Expectations Investing and that is, your returns will be what the stock price was when you bought, divided by what actually happened. Everything in investing from the moment that you buy. There's asset values and you've written a lot about intangible markets. But essentially everything is based on the discounted cash flow when it comes to investing.
Michael Mauboussin: The way I would think about it is, and I'll just repeat what you said, your return is the expectations at point A and the expectations at point B. The question is, what will the world think in the future, say, six or12 months from now? It's super relevant in this environment we're in now with all this uncertainty. The question is, what will the world understand? Obviously what happens in terms of financial performance between A and B's can inform B, but really what you want to do is put yourself into the mindset is what will the world believe and why at some point in the future? It's really revisions and expectations. In a sense it's a trivial statement, but in other ways, it's actually very profound. Profound to think about.
Bill Mann: Are you familiar with the book of lists? Do you remember this from 1980s was Irving Wallace and David Wallechinsky and Amy Wallace. They put together this list, it was bunch of lists. It was like famous people who died in the bathtub and people whose brains weighed more than nine pounds. Do you remember?
Michael Mauboussin: Not really?
Bill Mann: The people's Almac, anyway, great story so far. They put out a second book. This is one of my favorite books in the world, not because it's a good book, because it is a terrible book. [laughs] It's called The Book of Predictions. This is for you.
Michael Mauboussin: Thank you, Bill.
Bill Mann: Really enjoy. Here's the thing about this book that I absolutely love. Look at this, we should have put your book on the other side to keep stacking them up. Here's what I love about this book. They went around to a bunch of futurists in every area and said tell us what is going to happen in this area, in this area, in this area 10, 20, 30 years from now. There are some things that are in here that are prescient, like there was a technologist who said in the year 2010, there will be plenty of jobs servicing electric cars since 1982. They're out there a little bit. You know what only gets mentioned once in this book? A priest, roman catholic priest from Phoenix, Arizona said, by the end of this decade, the Soviet Union will not exist, is the only one, the rest of them, every single one was the Soviet Union is going to do this, they're going to do that. Some said they're going to take over and that we have no chance of winning.
Michael Mauboussin: Why did a priest?
Bill Mann: I wonder [inaudible 00:07:10] .
Michael Mauboussin: That's right.
Bill Mann: [inaudible 00:07:13] may have been talking his book a little bit. I think he may have been wondering why it was that he was being asked, but everybody else at that time in 1982 did not see seven years later that some union would cease to exist. When we're talking about investing and when we're talking about expectations, the future is really, really hard to predict. What are some of the ways in your process that you get out even 2, 3 years and make adequate or roughly accurate predictions about the future?
Michael Mauboussin: The first thing just, to reinforce what you said, for those that are not familiar with it, you should definitely check out the work of Phil Tetlock at the University of Pennsylvania. Phil has done a lot on expert forecasting. He wrote a book probably 15 years ago, it's called Expert Political Judgment, where they actually took hundreds of experts and asked them to make predictions, and these were not Roman Catholic priests, these were people who were actually [laughs] reported experts.
Bill Mann: The thing is everybody else had to be laughing at him.
Michael Mauboussin: Yeah.
Bill Mann: He said something absurd.
Michael Mauboussin: Then Tetlock did something that was unusual, which is actually kept track, and it turns out that they're actually quite poor at forecasting. By the way, they're like the rest of us, they have a whole list of excuses as to why they almost got it right, it was just the timing thing. One of my favorites was my forecast was so significant, it changed the course of world events.
Bill Mann: The world made sure I was incorrect.
Michael Mauboussin: I like to play that card every now and then. [laughs] Tetlock went on to do, which is now famous for participating in a forecasting term and his team and they found that of the thousands of forecasters they had, there were handful people so-called super forecasters that did very well. I would just say if you said one mental model that anybody could give, if I wish I had when I was 20 years old, it would be the concept of base rates. Base rate basically says, let me just take one step back, when we have a problem, and it could be forecasting companies performance or whatever it is, the classic way to do it, and see if it makes sense to you, is you gather a bunch of information, you combine it with your own experience and your own inputs, and then you'll forecast into the future; how long will it take your remodel your kitchen and what will it cost.
Bill Mann: The answer is longer.
Michael Mauboussin: The answer is always longer and more costly than you think. By contrast is a very different way of thinking about the world. Says I'm going to think about my problem as an instance of a larger reference class. In other words, I'm going to ask what happened when other people were in this situation before. Rather than me thinking about I had this conversation with my contractor and he told me this, that, and the other, you say of all the people who have remodeled kitchens, what happens? It's a very different way of thinking about the world and a very informative way of thinking about world. So the answer is appeal to the base rates. By the way, Jason Zweig, the wonderful journalist at The Wall Street Journal, once interviewed Danny and said what's the most important advice you'd give to an investor and he said, what is the base rate? So it turns out that for corporate performance, we have very rich repositories of base rate data.
The big ones not surprisingly for companies are sales growth rates and basically margins. Those are the two big drivers essentially, and sales itself, the most distinct key thing. What you can then say is, I'm going to look at a company and I'm going to say, the market thinks it's going to grow x percent, I'm going to look at the base rates of companies of this size or in this industry and actually look historically what the distribution of growth rates has been. One example I often like to give on this is actually Peloton Interactive, and it's been a rocky road for Peloton.
But in the fall of 2020, roll back basically two years ago, the pandemic was just getting going and of course people were now working at home, and so the demand for Peloton boomed and they had a fabulous fiscal 2020 and they had really excellent prospects. There was an analyst who said, "We believe that they can grow 30 percent compounded annually revenues for the next 10 years. He had a really good model, it was bottom-up, very well thought through and so forth, and you might say that's persuasive. The question you'd ask is how many companies of that size have ever grown by 30 percent compounded annual for 10 years? The answer was about one percent. Then you say to yourself, we've just been through an incredible exogenous shock called the pandemic.
Bill Mann: Yeah, heard of that.
Michael Mauboussin: One percent of companies have ever done this in history, what's the likelihood? Maybe give some probability to it, but it's not going to be your base case. I think to me the long-winded answer to that is to think about what are the base rates. Now the application of base rates is all over the map. Some thinks it's relatively straightforward to do because we have a lot of data and the distributions are well-behaved. Other situations are unusual and the distributions look really funky, and so with the application, but I would just say, broadly speaking, it's a vastly underutilized framework versus a misused framework.
Bill Mann: How do you go about determining the difference between a one percent type company and a company whose valuation is completely off the rails? For example, if I were to come into your Columbia class as a first-year business student and I were to present to you a discounted cash flow for Starbucks and say it's growing at 21 percent per year for 25 years, you didn't kick me out, but that is precisely what happened. When you were talking about edge case companies or what are some of the ways that you separate fact or potential from mutual?
Michael Mauboussin: I think there are two big things to think about, and I'm sure this is what you guys are thinking about when you're looking at businesses as well. The first is what I would call the basic unit of economics, which is try to get down to the basic unit of how that company makes money. For Peloton, for example, it would be subscribers, Connected Fitness subscriber cost how much to acquire that person? How long do they stick around? What do they pay? What are the costs against them? For Starbucks, it might be a store, a four-wall economics. That's the first thing, is to really understand that intimately. Now what we know is as companies invest more, it's often difficult to sustain attractive returns. You want understand there might, as you move geographies, whatever, some sort of fate, but that would be the first thing. I really want to get my arms wrapped around that.
The second is how big is the fancy terms total addressable market? How big is the potential market for this? Just to take a step back and say, and again do this with sober lenses, how big could this potential market be and try to understand that intelligently. We wrote a piece about this and we argued first a bottom-up analysis. We also looked at historical diffusion models to see how and then using base rates. You can triangulate these different techniques to get a sense of it. Now, that might give you the pond in which to fish for the future rapid growth high return businesses, but it's hard to know. Then the other thing I'll just add in there is that we have a chapter about this in Expectations Investing. There are certain businesses that have option value. An option is the right but not the obligation to do that. If there are market leaders in uncertain markets with smart management teams and access to capital, they may be able to see opportunities as they present themselves and take advantage of them. We wrote about in 2001 and end up being lucky more than pressured, but Amazon.com was a great case in point.
Bill Mann: Yeah.
Michael Mauboussin: So at that point, AWS I doubt was even a glimmer in Jeff Bezos' eye, but AWS of course.
Bill Mann: Yeah, no one would have built that in.
Michael Mauboussin: Right. What we did say, we did say this is a company that is positioned to have options. Ideally, by the way from an investor's point of view, you want to have that potential for option value without paying for it. We see it in retrospect, but that was an example, if you said it feels a little bit expensive and a little bit rich, the option value would have been one way to think about how to bridge those two points.
Bill Mann: Your first job in the industry was a food analyst at Credit Squeeze?
Michael Mauboussin: Not really true.
Bill Mann: No.
Michael Mauboussin: No. My first job was to be training program to be a financial advisor. This is important to say.
Bill Mann: Okay.
Michael Mauboussin: I was a miserable failure at that job. I was fired. I was basically fired.
Bill Mann: I feel you on a molecular level right now.
Michael Mauboussin: I was fired. People like to look at my Craig, I'm like, no you don't understand, my first job I was an abject failure.
Bill Mann: Okay. Got it out of the way.
Michael Mauboussin: Exactly, I got it out of the way. Here's what is important, the training program actually, the virtue of it, was we went through 20 different departments at the firm, Drexel Burnham. It's called skill matching, I was able to figure out what I felt I could do reasonably well, one was equity research. I ended up being food analyst.
Bill Mann: Okay.
Michael Mauboussin: That wasn't in my experience there, but after being a failure.
Bill Mann: All right. I hate being wrong.
Michael Mauboussin: [inaudible 00:16:33] .
Bill Mann: What was your process? What access to information did you have at that time? I always think it's interesting to go back, and think that. When I first started investing, it involved a phone call to the company, to their IR, to send information. What was your process like in that time?
Michael Mauboussin: I mean, obviously this is pre-Internet and all that. By the way, if I wanted to 10-K, or 10- Q, I'd had to request it from the corporate library, our firm's library, and then they'll send it down in your office memo, or whatever, but I did the standard stuff. Now this is also pre-Sarbanes-Oxley, you could have conversations with companies were a little bit more open.
Bill Mann: Sarbanes-Oxley for people who don't know, was a law that was passed that caused companies to have information go to everyone at the same time.
Michael Mauboussin: Uniformly closures. That is 20 years ago. that's been for a long time. It wasn't like I was doing anything nefarious where that but that was helpful, but I built models ground-up from basic financials, did talk to management, and I applaud a lot of stuff we talked about. I applied completed strategy frameworks, I did a lot of work on returns, did a lot of work on cash flows. It was it was pretty standard, some stuff I teach my course to some degree.
Bill Mann: I have ten times the amount of information that you had at the time.
Michael Mauboussin: Way more than ten times.
Bill Mann: Way more than ten times. Why does it seem that outcomes, and decision-making has not improved across the board with access to information that when you started, you would've said that's the next best thing to perfect information.
Michael Mauboussin: I'm not sure it hasn't actually, on some level. If you think about, I mean, needs to be questions about marketing efficiency and stuff like that, and have markets become more efficient. Now you have these pockets, and Zany stuff happening with meme stocks, or whatever it is. But for the most part, markets are really hard to beat, it's hard for you to sit there, and say, I'm smarter than the market, I know something now.
Bill Mann: It's easy to say actually, it's just hard to actually.
Michael Mauboussin: It's an overt thing, but with expert investing, what we're saying is you buy something when the expected value is higher than the current price. You're saying there's scenarios under what you're wrong. It's acknowledging that it's still a probabilistic situation, but I don't know if the market isn't smarter, and better than what it used to be. Now that said, it's like we're subject to the same vagaries, you think about even if we had met here five years ago, and I told you there's going to be a global pandemic. There's going to be, all these things when the Fed policy, and all. I mean, inflation is going to rear its head in a way we haven't seen for 40, or 50 years. I mean, it would have been difficult, you know, how do you factor all that stuff in? These are the things under your control, and things out of your control. Those out of your control don't change, and people tend to be bad at understanding them.
Bill Mann: You had mentioned last year that you felt that the market was dominated by speculators, that speculation was ramping, that investors were really in the minority in the market at that time. I'm reminded there was an article that came out from the Wall Street Journal last year, and it had a graph of five electric vehicle companies that come public through SPACs. They didn't have to do an S1, they did an S4, and all of them had projected that they would have $10 billion in revenue within five years. We just skip to the end part, but also to me, it seems like the information would have come back rather quickly, and have been have been consumed. That there's only been one company ever that has generated $10 billion in revenue in its first five-years, and that's [Alphabet's] Google. To have five EV companies, it was something that, I don't know if the level of information that's out there is crowding out those base rights.
Michael Mauboussin: That's an interesting. I mean, the way I would think about that is to say, that this is the wisdom of crowds. The market tends to be efficient when you have diverse agents, diverse investors, so that different points of view, you aggregate it effectively, and their proper incentives [inaudible 00:20:59] right. When you have those things, we can do this in the classroom. It's easy to show the markets and be smart about, even with people who have pieces of information. Markets tend to go haywire when you lose that diversity, so people instead of being heterogeneous, become homogenous, in their views. By the way, since the beginning of markets, people talk about
boards, so on. Since the beginning of markets, this has been the case.
Bill Mann: Under the buttonwood tree, they're saying.
Michael Mauboussin: There's nothing new, the tools may be different. By the way, taking away friction, and trading costs, there are tools that have had an effect on it. I think that when you talked about the EV thing, when you talk about meme stocks, whatever, these are pockets of these market inefficiencies that, and by the way, the other thing is important to understand about markets, and marketing efficiency is the fancy term for its arbitrage costs. But the answer is, if something gets out of whack, how do you correct it? If there's a large cost to correcting it, it may not be worth correcting, and the consequences, weird stuff can go on for a while. If the cost of borrow stock makes it prohibitive to short it, then even the sophisticated people might say it's not worth my time, and get these unusual outcomes for some period of time. I mean, I think that is something I'll make a prediction with a high degree confidence that we will continue to have those episodes of craziness happening in different markets at different times, in different corners. That that's part, and parcel [inaudible 00:22:29].
Bill Mann: I love the fact that you frame it up as homogeneity versus diversity because my own impression as a practitioner for several decades is that, during periods of extreme greed extreme fear, you get homogeneity even if you've got the same number of participants. Where do you feel like we are now after 18 months of, let's backup, 36 months of a pretty wild market straight up, and then really it's been bruising over the last period.
Michael Mauboussin: Look, I think the fact is it's been extremely difficult, both for executives, and for investors, and executives. You think about companies like Walmart, and Target, these are world-class companies, extremely smart management teams that have really struggled, it doesn't get much better than that. I think COVID has been a very big managerial challenge, as a consequence, it's been difficult, if companies don't know what they're doing, or what they're seeing, that it's hard for investors to get a sense of what's going on. Then for investors, of course, I think people got overly enthusiastic about the stay at home, COVID related stuff, and then the pendulum swings back, and forth. If you see this, things like travel stocks, and so on, so forth. Then of course, all of this, even things like supply chain, and monetary policy, reintroduced inflation, which we hadn't seen, so now that has to get tamped down. I mean, there are all very difficult moving pieces, and all that stuff, so am not sure about how the market has been, you know. Again, in retrospect, it's easy to say these moves seem to be extreme both directions. But at any particular time it's hard to know. I certainly wouldn't have been pressured on about what was going to happen.
Bill Mann: I think maybe my final question is, in a group of individual investors, what is one key piece of advice that you can give so that people, as they're looking at the stocks, and they're looking at the markets, and looking for opportunities. What's the way for people to remain as realistic as possible in terms of what companies can do, or what the market may do.
Michael Mauboussin: I mean, there are two things, one is it goes back to expectations, and say, what do I have to believe for this stock to make sense? Then use the building blocks of sales, profits, and the basic unit of analysis. The second thing which I'm sure everybody knows, but it's so important to keep your eye on the horizon, and maintain a long-term point of view. It becomes very difficult in the short run, especially if you've enjoyed lots of gains, or losses, you start to move, your emotional seesaw starts to tilt one direction or another, and you have to really force yourself to keep yourself on balance. Whether it's been good, or a recent experience is good, or bad, you make sure that you keep it at a level in terms of your decision.
Bill Mann: Wonderful.
Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.
