Michael Mauboussin seems perfectly suited to a career in Hollywood — he’s tall, fair and drop-dead good looking. Instead, the 48-year-old chose to teach at Columbia Business School, write bestselling behavioural finance tomes and make apparently intelligent people swoon, not necessarily in that order. Mauboussin started his career as a packaged food sector analyst and was until recently the chief investment strategist at Legg Mason, the firm made famous by Bill Miller’s 15-year S&P 500 beating streak. For this interview, he agrees to come down to New York from Connecticut where he lives. And what better quintessentially New York place for a free-wheeling conversation than the 843-acre Central Park? We locate a convenient bench overlooking a baseball diamond and Mauboussin shares his thoughts about the stock market. He also expounds on the role of skill and luck in sports, investing and life — the subject matter of his latest book, The Success Equation.
A little crystal-ball gazing into the future: how do you think investing is going to evolve over the next few years? After all, it is increasingly becoming difficult for active fund managers to beat the market…
There are two parts to investing. One part doesn’t change at all over time and that is the essential objective of buying assets at much less than they are worth. The value of assets are dictated by the present value of their cash flows. So there are certain principles that are going to be immutable and consistent over time.
But coming to your point that active managers find it difficult to deliver excess returns, I talk about this in The Success Equation and it is an idea I call “the paradox of skill”. It says that as skill increases in an activity, luck actually becomes more important. We see this in sports. As training methods and coaching techniques become uniform, the performance of athletes becomes uniform too.
From an investing point of view, it means a couple of things. One is that there should be recognition of that basic reality. We have seen the standard deviation of excess returns in the US mutual fund industry decline fairly steadily since 1960. So this has been borne out. The second thing is that where you can really get an edge as an active manager is in asset classes where there is more diversity of skill. There are certain pockets where that is true. So there are areas where active managers will continue to do well. So there is an immutable part to investing, and a changing part.
You mentioned there could be pockets where active investing could do well. What pockets would that be?
There have been some classic studies. One case that continues to be true in the US is spinoffs. Large corporations have multiple businesses and when they decide to spin off a troublesome business, it becomes almost an orphan that no one wants to own. It turns out, buying those spinoffs has been a very lucrative strategy. Buying stocks where expectations are quite low is a good strategy because that is when valuations are cheap. We have data now for 90 years that shows value investing tends to work quite well. So the simplest way to say it is to repeat a Warren Buffett quote: “Be fearful when others are greedy and greedy when others are fearful.”
Active fund managers don’t deliver but they keep getting assets to manage. Why? Is it simply greed, or that the fund sales guys are doing a great job of lying?
In the aggregate if you say active fund managers roughly approximate the market and they charge fees, just by definition they can’t deliver excess returns. According to the US mutual fund data, over the last 50 years active fund managers have outperformed by an average of 40%. To state it differently, 40% of active fund managers have beaten the benchmark in an average year. But that has a standard deviation of 17%, which is a very wide range. In some years only very few do it; in other years a majority will do it. So the key is it is difficult to beat the market. But there are a couple of factors why index investing is not sustainable.
One is that while indexing and passive fund management makes a lot of sense for people, there is a logical limit to doing this because passive managers are piggybacking on the research and trading of active managers. They are leveraging the information that has been reflected in prices. There is a very famous paper by Joseph Stiglitz and Sanford Grossman that says you need active fund managers who go out, seek information and reflect that in prices, and they will be compensated by way of excess returns in order to do that. Markets aren’t miraculously informationally efficient without somebody doing the work. That is the first point.
Second, there is no way to outperform the market without active management; otherwise you have to reconcile to market returns. Third, most individuals don’t have the time or capability to delve directly in stocks so, for them, it’s about “can we pick managers who have a better chance of making a greater return over time?”. Certainly, hope springs eternal. That is why people do this.
Conventional wisdom tells us that less is more in investing, so churn less. But hedge fund managers like Jim Simons of Renaissance have been able to produce consistent results with a trading-oriented strategy. How?
Yes, I wrote a piece saying that too much turnover was bad. Specifically, the strategy of moving from one manager to another manager within an asset class or firing a poor performing manager and hiring a good performing manager while moving from one asset class to another has proven to be mostly ineffectual. It eats into returns. But when you look at an asset class in particular, there are many ways to fail but there are many ways to succeed too, from trading strategies that are very short-term oriented to the Buffett approach of buy and hold it forever. The key is to have your process in line with your trading behaviour. When I look at Renaissance, they do trade an enormous amount, but the key to their success is that they have geared their process towards doing that specifically. So there is nothing inconsistent about those two things. Where I think we run into problems is when people claim to be long-term oriented but behave as if they are short-term oriented. That disconnect can be very costly.
Particularly to pick up your point about why less is more, there is a very natural tendency for investors to buy what has done well and to avoid what has done poorly. A very powerful influence in the markets is reversion to the mean, whether it is asset class return or anything else. Let me give you the most depressing statistics in investing, which is that in over 20 years the S&P 500 has returned about 9%, the average mutual fund about 7% or 7.5%. But the average investor has only got returns of 5.5-6%. So they have fared worse in terms of returns than the mutual funds in which they invest. How could that be? The answer is bad timing. They are pouring in money at the top of the market and pulling out money from the bottom. So their dollar-weighted returns are actually quite poor. Sometimes being too active when things are good or bad tend to be to people’s detriment.
You have mentioned the ill effects of the recency bias — how do you stay clear of this?
There is a powerful concept that I opened the book Think Twice with, which was developed by economist Amos Tversky 40 years ago — the inside versus outside view. The idea is that when most of us face problems, the natural way is to gather information about it, combine your own inputs and project into the future. So naturally, what has happened recently often tends to be a large component of that. In contrast, the outside view is viewing your problem as an instance of a larger reference class, which is to ask the question what happened when other people were in this situation.
One of the main ways to offset recency bias is to consider a larger sample set and a larger reference class and ask what you should expect. For example, I asked a friend, who is a baseball executive, who his favourite professional team is. His reply: often, if a player is playing particularly well, people start saying that this guy is more valuable than he really is. Whereas, if you step back and say what is right or wrong with his long history, what are other players like and how have they done, that is a far better indicator of his true underlying skill. So the inside-outside view helps meaningfully address the recency bias. But you have to be very explicit about it. It is not easy to do.
Just to stretch that point, would you also say that if you are looking at a stock you would go talk more to the competition than the management itself…
I don’t know if I would necessarily say that. But if I am looking at a stock it goes back to how difficult it is to predict earnings, cash flow, etc. If I am looking at a rapidly growing company that has done very well, the kind of questions I would want to ask is firstly, what is priced in? At today’s price what has to happen to justify that price, in terms of growth rates, returns on capital and all those metrics? The second question I want to ask is that if I look at all those companies that were in that same position, of that same size and that were growing at that same rate, how did they do? I would like to look at that distribution array and say what is priced in versus what the distribution looks like. If that price is very optimistic, then I would be much more cautious about it. If that price looks relatively pessimistic it would be much more interesting. It will not always give you the right answer but it is another way to check your enthusiasm or pessimism.
In general, what is the right way to value a technology company? The pillars that value investing emphasises, which is assets or earnings, these companies either do not have them or have poor visibility. So you have this bunch of companies that give supersize returns, but if you took the traditional route to estimating their value, you may not meet with any success at all.
There are a couple of things to that. One is that value has a fairly immutable definition, which is the present value of cash flows. But technology is challenging for a few reasons. The challenges are that it is very difficult to achieve and sustain competitive advantage. Buffett likes to talk about this economic moat around the business that allows you to generate high and sustainable returns on invested capital. In technology, that is very difficult to achieve, primarily because cycles are very short. What we do in valuation is estimate the value for an explicit forecast period and then the residual value beyond that period.
Now, that’s a fair point; in certain technology companies there is no residual value at all. Think of a great piece of software that becomes popular but once something else comes along, it becomes obsolete. That said, there have been certain software companies that have been able to achieve and sustain competitive advantage. Certainly the easy one to think in retrospect would be a company like Microsoft. Often there are specific drivers behind that and the most prominent probably in technology is network effects: when the value of a good or service increases as more people use that good or service. For example, for Microsoft that was a very powerful driver. I would say businesses like Amazon probably have better competitive advantage where they are able to deliver goods or services profitably. In many technology companies you have to think about option value as well — this is the option to do things that could add on to the business or get into new areas.
How do you estimate margin of safety for tech firms?
It’s pretty much the same way we do for other company — you forecast the range of possible outcomes for the value of the company using value driver assumptions for sales growth, margins and capital intensity. Now, to me, the margin of safety would say something like I would like the price to be at the very low end of what the value could be or should be. So that is a very good bargain. That is why very few technology companies truly have substantial margins of safety.
You have said in the past that one shouldn’t rely much on intuition. But most successful investors emphasise the role of intuition in their decision making. Does intuition become more useful after are successful?
I do think there is a role for intuition in decision making. But what I have said, and I repeat, is that people rely vastly too much on intuition. People draw on much more than they should. Intuition works very well in environments that are stable and linear where you learn about the environment. Sports is a very good example — so if you are learning to play tennis, it is a stable and linear environment. As you play, you get better and better and then your intuition will be very good. Chess is another great example. The grandmasters of chess have enormous intuition, they are analytical but they also have a lot of intuition. Where intuition tends to fail are situations exactly opposite of that — situations that are non-linear and unstable. There you can’t really train yourself, you can’t get feedback. To the degree that the markets and companies operate in a non-linear and unstable environment, it is very difficult to apply intuition.
Now, the point you raised about successful people talking about the role of intuition. The reason is that they forget about their failures. So you always hear the story that Fred Smith was in the shower one day and came up with this brilliant idea of Fedex and he built this multi-billion dollar, wildly successful company. What you don’t hear about is that Smith’s neighbour was also in the shower and also had a brilliant idea, he pursued that and it failed. So there is a massive selection bias. By definition, we only see the successful investors. I do not mean to say intuition does not work, but you need to be thoughtful about when it will work and when it does not.
Do you believe chance plays an equally important role in business as in investing?
I think there is probably more skill in running a business than in investing, in part because there are parts of business that are pure skill. That said, as you move up the organisation and move towards things that are more related to strategy, luck will play a bigger role. Investing again is a paradox of skill, which is that because everybody is so good and all the information is reflected in the markets, luck becomes more important.