Interview with Michael Mauboussin, Director of Research, BlueMountain Capital Management

OutlookIndia

Michael Mauboussin wears multiple hats – that of an analyst and fund manager, a writer and a teacher. Now director of research at BlueMountain Capital Management, he was the head of global financial strategies at Credit Suisse and the chief investment strategist at Legg Mason Capital Management earlier. Among the many books to his credit, three stand out — The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing; Think Twice: Harnessing the Power of Counterintuition; and More Than You Know: Finding Financial Wisdom in Unconventional Places. He has been an adjunct professor of finance at Columbia Business School since 1993 and continues to be on the faculty of The Heilbrunn Center for Graham and Dodd Investing. His distinction is defined by not just the fact that he received the Dean’s Award for Teaching Excellence in 2009 and 2016, but by the progress of his students, a great example of which is none other than Todd Combs, one of the two portfolio managers handpicked by Warren Buffett. He is an authoritative voice in the world of value investing, with great work around behavioural aspects and moats to his credit.  #MichaelMauboussin #BlueMountainCapitalManagement #Business #OutlookBusiness #OutlookMagazine #OutlookGroup

Transcript

00:00 [MUSIC]

00:06 Investors make a lot of behavioral mistakes, but

00:08 I'll mention three I think are particularly prominent.

00:11 The first is this notion of overconfident.

00:13 People tend to be overconfident in understanding the future.

00:16 And the way that manifests for

00:17 investors is they tend to project ranges of outcomes that are vastly too narrow.

00:22 So investors really need to try to calibrate themselves to appropriate

00:25 distributions of outcomes to offset that overconfidence.

00:30 The second really big one is called confirmation bias.

00:33 That basically says once you've made up your mind, made an investment,

00:35 you tend to seek information that confirms your point of view and

00:38 dismiss or disavow information that doesn't confirm it.

00:42 One of the essential tasks of an investor is really to

00:45 understand new information as it comes in and to revise your views appropriately.

00:48 The third big one is a failure to use base rates.

00:54 So base rates are essentially a record of what's happened in the past to

00:58 companies in similar situations.

01:01 And understanding base rates in terms of sales growth rates or

01:04 earnings growth rates or return on capital patterns can allow investors to have

01:08 a much better understanding about how the future may unfold for

01:11 a particular company or an industry.

01:13 [MUSIC]

01:17 The role of psychology is essential in investing.

01:20 One way to think about that is the notion of the wisdom of crowds.

01:24 So crowds tend to be really smart when three conditions are in place.

01:28 Diverse thinking, a properly functioning aggregation mechanism, and

01:33 appropriate incentives.

01:34 And crowds go from wise to mad when one or more of those conditions are violated.

01:40 By far the most likely condition to be violated is diversity.

01:44 Rather than us thinking independently, we correlate our views.

01:48 Humans are inherently social, and investing is an inherently social exercise.

01:54 So under normal conditions, people may come up with different points of view about

01:57 an industry or a company.

01:59 But from time to time, we tend to correlate our opinions.

02:02 And there's a really rich literature in the world of social psychology about how

02:05 that happens.

02:07 Essentially, we lose our conformity because the power of the crowd overwhelms

02:11 our own independent judgments.

02:14 Now we've seen some epic examples of this historically.

02:17 Of course, the dot com boom in the late 1990s and

02:21 subsequent crash in the early 2000s is a great example.

02:25 And much more recently, in late 2017 with Bitcoin, where a lot of people got into

02:30 that Bitcoin, into the craze, a collapse of diversity of views, and

02:35 a huge run up led by a crash.

02:38 So again, the notion of psychology and understanding how we think about the world

02:42 and how that translates into market efficiency is an extraordinarily important

02:46 dimension to understand.

02:48 And all great investors have really good psychological makeups.

02:51 [MUSIC]

02:56 The first thing I would emphasize on valuation is that people tend to use

02:59 multiples like price to earnings or enterprise value EBITDA.

03:03 And multiples are really not valuation.

03:06 Multiples are shorthand for the valuation process.

03:09 At the end of the day, valuation comes back to the basics,

03:13 which is what is the present value of future free cash flow.

03:16 Now when you think about valuation,

03:18 how that core principle ties back to things like multiples,

03:22 there are a couple dimensions that become really essential.

03:25 The first is return on incremental capital.

03:29 The second is growth.

03:30 And the lesson is quite clear.

03:32 If returns on capital are equal to the cost of capital, growth has no bearing,

03:36 and the valuation for the business should be what we call the commodity multiple.

03:40 By contrast, if returns on capital are high, growth is a positive amplifier.

03:46 And the faster a high return on capital business grows, the more valuable it will

03:50 be, and that will be reflected in a very high multiple of price to earnings,

03:53 price to sales, or enterprise value EBITDA.

03:55 Finally, if returns on incremental capital are below the cost of capital,

04:00 growth is actually bad.

04:02 And the faster a company grows, indeed, the more wealth it will destroy.

04:06 And you see that last example specifically in worlds like M&A,

04:10 where deals are announced that are accretive to earnings per share, so

04:13 they grow earnings, are actually value destructive.

04:17 So the key idea in valuation is always go back to first principles.

04:20 What is the free cash flow?

04:22 And tie that specifically to growth and return on incremental capital.

04:26 [MUSIC]

04:30 The first thing to understand is valuing technology companies is the same as

04:33 valuing any other business.

04:35 Ultimately, it boils down to the present value of future free cash flows.

04:39 But there are some interesting dimensions about the economics of information that

04:43 are worth considering when thinking about valuing tech companies.

04:46 There are three things I would mention in particular.

04:49 The first is the idea of network effects, where the value of a good or

04:52 service increases as more people use that good or service.

04:56 As a consequence, you get this notion of increasing returns and

04:59 ultimately dominant markets.

05:01 People call them winner take all markets.

05:03 So it's not uncommon in technology for

05:05 companies to have market shares of 80 or 90%,

05:07 which is vastly higher than what we're traditionally used to.

05:11 Now those franchises are incredibly strong, but on the other hand,

05:14 they may not be as strong or persistent as other types of franchises.

05:18 The second idea is a broader one, which is investments in our global economy are

05:22 shifting from those based on the balance sheet.

05:24 So think about new factories or

05:26 inventory to those that are based on the income statement.

05:29 Think about marketing spending or customer acquisition costs.

05:32 As a consequence, earnings tend to look worse when investments are expensed.

05:37 But as an investor, as an analyst,

05:39 the key is to still understand how much money is being invested and

05:42 what kinds of return on capital will be generated by those investments.

05:46 The third thing I'll say is a lot of technology companies can be in doubt or

05:49 call real options.

05:51 These are options to extend businesses in different directions.

05:55 The canonical example of that is Amazon.com 20 years ago.

05:58 Plus they started as a book retailer, but they eventually moved into music and

06:03 then eventually into other markets.

06:05 Again, in each case, exercising options to extend their franchise.

06:09 And it turns out because of the volatility inherent in those kinds of

06:12 businesses, real options tend to be more valuable in technology companies in

06:15 general.

06:16 So again, the core principle is the valuation approaches and

06:20 the principles are all the same.

06:22 But the economics information suggests that we should be thinking about them in

06:25 a little richer setting.

06:26 [MUSIC]

06:31 >> I've been blessed by a number of great mentors over the years.

06:35 The first one I'd mention is Al Rappaport.

06:37 In 1986, he wrote a book called Creating Shoulder Value,

06:40 which really became my guide for how to think about investing.

06:44 He made up a number of points in that book which remain very core to what I

06:47 believe.

06:48 The first is value is not about accounting numbers, but

06:51 rather about cash flows.

06:53 Second is competitive strategy and

06:54 valuation should be connected to one another.

06:57 And finally, stock prices reflect expectations.

07:00 Rappaport and I collaborated on a book called Expectations Investing about 20

07:04 years ago, and he remains a very, very close associate, teacher, and guide.

07:09 The second person I'll mention is Bill Miller.

07:12 I worked with Bill for about nine years at Lake Mason Capital Management.

07:15 Bill has obviously been an extraordinary investor over his career.

07:18 But as much as I admire him for his track record as an investor,

07:21 I really admire how he approaches his task.

07:24 He really is incredibly thoughtful about the world of finance,

07:27 about strategy.

07:28 He has an incredible temperament for investing and insatiable curiosity.

07:34 He's a wide reader and really tries to take the best ideas from

07:38 different disciplines and fold them back into the world of investing.

07:42 The last person I would mention, who I've only met briefly,

07:46 is Charlie Munger, Warren Buffett's partner at Berkshire Hathaway.

07:50 And Munger's advocated for this idea of mental models,

07:52 sort of frameworks for thinking about the world.

07:54 And the argument is if you build your mental models,

07:56 you have lots of tools in your toolbox, so

07:59 you can solve problems as you meet them in the world.

08:02 I think Munger, above all else, has been an extraordinary advocate for

08:05 this approach, and obviously a very successful practitioner.

08:08 So these are just three people who I found to be incredibly influential

08:12 in guiding my journey as I thought about investing.

08:14 [MUSIC]

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