Tim du Toit is the editor and founder of Eurosharelab. He has more than 20 year of institutional and personal investing experience in emerging and developed markets. He previously published the terrific James Montier Resource page. Tim is based in Hamburg,. Germany. More of his articles can be found at Eurosharelab (www.eurosharelab.com).
Republished here with permission.
I have been an avid reader of Michael Mauboussin’s research since about 2004 when he started working for Legg-Mason.
If you want to learn what successful investing is really about, along with the research to back it up you cannot do better than read Michael’s work.
I have unfortunately not had the pleasure of meeting Michael but it is something I would really like to do.
To get to know his work I have put together this resource page, a listing of all Michael’s articles I could find on the internet along with a short description.
First something on Michael’s background.
Michael Mauboussin Bio
Michael Jacques Mauboussin is the Chief Investment Strategist at Legg-Mason Capital Management Inc. He joined the firm in 2004.
He is also Chief Investment Strategist and Senior Vice President at Legg Mason Funds Management Inc.
Prior to joining Legg-Mason he was a Managing Director and Chief U.S. Investment Strategist at Credit Suisse First Boston (CSFB). He joined CSFB in 1992 as a packaged food industry Analyst.
Michael is the former President of the Consumer Analyst Group of New York and was repeatedly named to Institutional Investor’s All-America Research Team and the Wall Street Journal All-Star survey in the food industry group.
His latest book, Think Twice: Harnessing the Power of Counter intuition was published in the fall of 2009.
He has also written “More Than You Know: Finding Financial Wisdom in Unconventional Places” and was co-author of “Expectations Investing: Reading Stock Prices for Better Returns”.
He has also been an Adjunct Professor of Finance at the Columbia Business School since 1993.
Business Week’s Guide to the Best Business Schools (2001) highlighted Michael Mauboussin as one of the school’s “Outstanding Faculty,” a distinction received by only seven professors.
In 2004, SmartMoney magazine named him as one of its Power 30, a list of “the most influential people on Wall Street”.
Mr. Mauboussin is on the Board of Trustees at the Santa Fe Institute. He holds a B.A. in Government from the Georgetown University.
Now on to Michael’s research
In the article, “The Real Role of Dividends in Building Wealth” dated January 25, 2011, Michael Mauboussin argues that for dividends to be included as a source in accumulating capital, the investor must reinvest dividends. Research has shown that this is unfortunately not the case with the majority of private investors.
In this January 12, 2011 article called “Blaming the Rat” Michael Mauboussin talks about the relationship between incentives and behaviour.
Social scientists often assume that poor behaviour is a result of faulty incentives and that good behaviour reflects well-structured incentives.
Ironically, management literature shows that the relationship between incentives and behaviour is more complex that what these scientists originally thought. In most cases, drive and mindset are more important than the incentive program.
For investors, the objective is to find driven leaders who have good capital allocation skills and have a substantial stake in the company. A good example is Warren Buffett who receives a relatively modest compensation as CEO. Since nearly all of his net worth is invested in Berkshire Hathaway, he has the motivation and incentive to perform well.
In the July 15, 2010 article called, “Untangling Skill and Luck” Michael Mauboussin provides framework on how to differentiate between skill and luck. One of the most difficult things a fund investor has to do. And something you have to test your own performance against all the time. Was the return you generated based on luck or was it skill?
In this article, Michael Mauboussin discusses what comprises a good investment process – finding gaps between expectations and fundamentals and gives guidelines as to the correct sizing of investments.
In a presentation at the CFO Executive Summit titled “It’s all about Managing for Value” dated June 11, 2010, Michael Mauboussin discusses that the primary goal of a corporation is to maximize its long-term shareholder value.
In corporate strategy, the litmus test is whether the strategy will ultimately increase shareholder value.
In this article on “The Colonel Blotto Game” dated May 12, 2010 Michael Mauboussin draws lessons from the Colonel Blotto game on how to compete when you are the underdog.
For a company with fewer resources than its competitor, the best strategy is to compete in a non-traditional way in order to expand the number of battlefields thus changing the basis of competition.
Another lesson from the game is that the “best” team does not necessarily win the game. The winner is usually the one who has effectively played to its strengths and weaknesses.
In “A Surge in the Urge to Merge” Michael Mauboussin writes in January 12, 2010 that a Mergers and Acquisitions (M&A) wave is currently brewing.
While research shows that company making acquisitions in the early part of the cycle deliver the best returns the focus of any investor in evaluating M&A deals is whether the acquiring company adds shareholder value from the acquisition. In economic terms (do the synergies exceed the premium paid) not just looking at accounting based measures.
In this article, “See For Yourself” dated December 2, 2009, Michael Mauboussin stresses the importance to carefully sort through the source of data and verifying the accuracy of claims.
It is important to always check the primary source for any assertion we hear.
The investing world is no different with many misleading beliefs floating around. One example is the notion that higher growth leads to higher valuation. This runs counter to studies that have shown that it is not just growth that creates value but value-creating growth or incremental investments that earn returns above the cost of capital.
Michael Mauboussin, in the article, “What do We Need to Fix?” dated July 16, 2009 lists the causes of the recent financial crisis and suggests what regulatory oversight can best prevent potential failures.
The article lists the following potential failures that need to be fixed:
- Public goods that benefit everyone in a population. Regulation need to make sure that everyone contributes to avoid the problem of free riding.
- An economic transaction that produces costs or benefits to parties not involved in the transaction creates an externality. An example of negative externality is pollution from a factory.
- An incomplete market where there is not enough supply or demand for a product or service. In such cases, the government may need to step up to fill supply and demand.
- Human behaviour that is undesirable – regulation needs to mitigate the costs.
In this September 1, 2009 article titled, “Investment Committees” Michael Mauboussin mentions that few investment committees are structured to make the best investment decisions.
The article mentions key ingredients of a successful investment committee. Among the suggestions is a small team with diverse members with a steadfast focus on their investment process.
In this June 5, 2009 article called “In Defence of Shareholder Value” Michael Mauboussin defends the concept of shareholder value from high profile critics who believed that it was a perpetrator of the recent financial crisis.
Michael argues that the concept of shareholder value is not based on boosting stock prices, but rather sound capital allocation skills that add value to the company. Eventually, these capital allocation decisions will be reflected in higher stock prices.
In this excerpt of the Greenwich Roundtable dated December 11, 2008 called, “Long Term Investing: How I Learned to Stop Worrying and Ignore Volatility” Michael Mauboussin argues that the definition of risk and volatility is dependent on the investor’s time horizon.
If a trader has to pay a bill next month, he would mostly likely focus on the volatility of his investments. Conversely, a long-term investor thinks of risk as permanent loss of capital. He can effectively ignore volatility as long as his purchase price is below his calculated value.
At the end of this article he offers practical advice to investors on how to deal with volatility. It includes deciding to become a long-term investor, betting according to Kelly criteria, working to reduce stress and not dwelling on short-term portfolio moves.
In the November 20, 2008 article called, “What Biology Can Teach You about Today’s Market” Michael Mauboussin interviews scientist Doug Darwin.
The interview looks at similarities between biological systems and complex adaptive system like the stock market. The following are the key takeaways from the interview:
- There are similarities between reproductive and investment strategies: (a) The r-strategy has a number of offspring and is similar to diversification; (b) the K-strategy has fewer offspring but invests much more in each is similar to concentration; (c) anti-z, seeking to build reserves in good times to allow better performance in bad times is similar to insurance.
- Like a biological system, the market is subject to both exogenous and endogenous shocks.
- After an ecosystem has been rebuilt after a crisis, the species that survive may not do well. The key is for participants or species to identify and exploit new niches that develop in the new after the crisis environment.
The article dated November 3, 2008 and called, “Show Me the Money”Michael Mauboussinreiterates the importance of cash flows rather than earnings as a barometer of economic reality.
He points out the shortcomings of earnings as a tool for assessing a company’s economic reality:
- Earnings can be based on alternative but still acceptable accounting methods.
- Earnings exclude incremental capital needs, which include working capital and capital expenditures.
- Earnings do not consider cost of capital, which provides no clue whether growth increase shareholder value.
In this October 29, 2008 article called, “Where from Here?” Michael Mauboussin dissects the financial crisis of 2008.
He describes the crisis as a collateral-based crisis, which requires more than just a liquidity infusion from central banks.
He also discusses the case for attractive long-term returns of asset classes, including equities. Looking at dividends alone, one could argue that equity prices are attractive. The S&P 500 dividend yield is only about 0.8% below the 10-year Treasury rate and 3% higher than the 10 year rate if you add share buybacks.
One way to approach an environment like what we had in 2008 is to step back and take a normalized view of things. Data shows that the market tended to bottom out around zero percent rolling 10-year returns. This happened in 1930’s, 1970’s and in 2008.
Finally, he mentions Warren Buffett’s rare and unsolicited opinions about the market valuation levels. He plotted Buffett’s stock market calls and the following 10-year returns and concluded that these calls very profitable for investors.
In this article called “The Sociology of Markets” dated July 15, 2008Michael Mauboussinmakes a point on how the money flows from financial institutions can change asset prices.
He provides evidence to show how these financial institutions matter. Through the years, the share ownership of individual investors has decreased and they have now delegated investing to institutions.
For example, research studies showed that small cap stocks have outperformed large cap by about 400 basis points from 1926-1979. However, that trend did not continue in 1980s and 1990s when large cap stocks outperformed small-caps. The main reason is the large increase in flows to mutual funds and the money flowed mainly into large cap stocks.
It is important for investors to be aware of the incentives and flow of the money to assets as it creates revaluation and out performance of that asset class.
At the height of the 2008 financial crisis, this article called, “The Failure of Arbitrage” dated May 18, 2008 gives evidence of the failure of arbitrage in periods of financial crisis and that a crisis creates a good hunting ground for attractive future returns.
In this paper called “Fat Tails and Nonlinearity” dated December 20, 2007, Michael Mauboussin reminds investors to be aware of the concepts of diversity breakdowns and non-linearity.
The stock market is one form of a complex adaptive system, and for the system to function efficiently agent diversity should be present. Otherwise, diversity breakdowns happen.
He also suggested that investors should be very aware of fat tail risks, an infrequent and extreme event like the financial crisis in 2008, and the role of non-linearity of price movements.
Investors should understand how a complex adaptive system like the stock market sets its prices. Prices tend to be efficient as long as certain conditions like diversity, aggregation and incentives are met. When one or more of the conditions are violated, prices are no longer an unbiased reflection of value.
This analytical paper called, “Death, Taxes, and Reversion to the Mean” dated December 14, 2007 expands Michael Mauboussin’s previous discussion on financial models.
Investors should be aware of the models that analyst use to predict future performance, notably returns on invested capital. Analysts should incorporate the concept of mean reversion in their model, tempering the optimism inherent in their forecasts.
In this September 7, 2007 article, “Was Harry Potter Inevitable” Michael Mauboussin explains how counter factual thinking can lead to suboptimal behaviour and how research on management success can fall for the halo effect.
According to Michael, counter factual thinking involves looking at the what-if’s investors experience a lot of the time. This happens when we initially fail to take advantage of an attractive investment opportunity and subsequently pass even if the investment opportunity (at a higher price) still represents good value.
Meanwhile, the halo effect is a psychological bias where one’s perception of one trait is influences by the perception of another trait. For example, we tend to judge a good looking person as more intelligent.
While earnings have been the traditional metric to derive the value of a stock, Michael Mauboussin points out that cash flows reflect better economic reality than earnings in the article, “What You See and What You Get” dated July 23, 2007.
In the May 23, 2007 article titled, “Turtles in Omaha” Michael Mauboussin argues that the qualities that make investors great are mainly emotional and psychological.
In explaining this, the article talks about the profile of a Warren Buffett successor, and the story of the Turtle Traders of Richard Dennis and Bill Eckhardt.
The conclusion is that psychological pitfalls can lead to suboptimal investment performance and temperament is better than intelligence.
In this article, “Explaining the Wisdom of Crowds” dated March 20, 2007, Michael Mauboussin explains the wisdom of crowds: the idea that a collective can solve problems better than most experts.
Michael makes the point that certain conditions must be present for the crowd to prevail. These include diversity, aggregations, and incentives.
If these conditions are no longer present, for example diversity breaks down, the problem solving ability disappears. In a complex system like the stock market, this usually results in periods of market inefficiencies and the forming of bubbles.
At the height of mergers and acquisitions spree in January 2007,Michael Mauboussin’s article “Does the M&A Boom Mean Anything for the Market?” dissects whether a merger boom is an indication of peak valuations of market and precursor of poor performance or not.
In this January 16, 2007 article on “The Importance of Diverse Thinking” Michael Mauboussin explains the value of multidisciplinary approach to investing.
This article refers to the concept of Charlie Munger’s use of different mental models to approach investing. The logic of multidisciplinary approach to investing provides investors new tools to solve complex problems.
For example, in analyzing a company like Amazon, the multidisciplinary investor does not treat the company as a plain vanilla retailer but a network with different hubs. In network theory, the value of the network increases as more people use of it. Thus, Amazon’s valuation multiple should less comparable to those brick and mortar retailers.
Here’s a transcript of Michael Mauboussin’s September 2006 interview with economist and strategist, W. Brian Arthur. In this interview, Brian shares his views on the competitive position of the United States.
Brian argues that the emergence of China on the manufacturing scene is a positive net gain for the United States.
He believes that the United States is basically a service economy and is forced to specialize in advanced technologies like airlines, telecommunications equipment, genetic engineering and intellectual property. As long as the United States maintains its strong position in science and innovation, its competitive position is not much of a concern.
In this August 9, 2006 article called, “How Do You Compare” Michael Mauboussin offers practical advice on making comparisons.
Michael discusses different levels of comparisons, which includes highlighting issues and considerations, addressing psychological traps in comparing and providing checklists for investors to improve the quality of their thinking.
In this excerpt of the Greenwich Roundtable, “Interdisciplinary Perspective on Risk” dated August 15, 2006 Michael Mauboussin underscores three key concepts on risks:
- While risk and uncertainty are used interchangeably, the main difference is that uncertainty is not knowing how the underlying distribution of outcomes.
- The mechanism of risk and uncertainty involves both endogenous and exogenous sources of risk in a complex adaptive system.
- The outcomes of complex adaptive system have a power law distribution: larger events happen infrequently and small events happen frequently.
Michael also notes that humans are still not good at dealing with risk and uncertainty. We still think in linear terms, assess probabilities poorly and we find the need to link cause and effect.
On May 18, 2006, Michael Mauboussin wrote an article called, “Long Term Investing in a Short Term World.” where he lists factors affecting the short-term mindset of both companies and investors.
He suggests use of time arbitrage to take advantage of this short term mentality.
In an article dated March 16, 2006 and titled, “Common Errors in DCF Models” Michael Mauboussin lists down the common errors in discounted cash flow modelling.
He also offers practical advice on how to correct them.
In this February 1, 2006 article titled, “Size Matters” Michael Mauboussin emphasizes the importance of position sizing in investing.
To earn substantial returns in the long run, an investor should find situations where they possess an analytical edge over the market and allocate capital using the Kelly criterion discussed in the article.
The aftermath of three-year bear market that started in 2000, various corporate scandals, heightened geo-political risk and terrorism have led to corporate America to focus on balance sheet health.
Michael Mauboussin, in the article, “Clear Thinking about Share Repurchase” dated January 10, 2006 addresses the issue of capital allocation.
Commenting on the prevailing idea that share buyback are better than dividends he mentions that not all buybacks are created equal. As a general rule, a company should only repurchase its shares when they are trading below expected value and when no other better investment opportunities are available.
In the article, “Are you an Expert?” dated October 28, 2005, Michael Mauboussin discusses the value of experts in various domains.
The value of experts declines as domain outcomes are probabilistic, like in fields such as economic forecasting and the stock market. This domain tends to favour the collectives over experts. (i.e., market experts do not add value).
In the article, “Aver and Aversion” dated August 9, 2005, Michael Mauboussin draws on the experiments of psychologist Solomon Asch, Daniel Kahneman and Amos Tversky to provide insights to investors on psychological and behavioural impediments.
The Solomon Asch experiment found that the price performance tempt most investors to follow the majority.
Meanwhile, the Daniel Kahneman and Amos Tversky study discusses loss aversion that leads to suboptimal investment decisions.
Michael Mauboussin concluded that these studies provide investors with awareness of our behavioural pitfalls and the value of finding ways to ensure that one’s personality and investment approach are compatible.
In an article titled, “Ecosystem Edge” dated July 27, 2005, Michael Mauboussin introduces the concept of keystone companies as an expansion of the earlier article on network economics.
Michael believes that keystone companies – businesses at the centre of healthy economic ecosystem – tend to deliver sustainable value creation.
Furthermore, keystone companies have two core parts: value creation and value sharing.
A keystone company creates a viable platform for its ecosystem members, as well as capturing only a portion of value of the ecosystem they help create.
Michael also provides a brief analysis on three keystone companies: eBay, Google, and Amazon.com.
Michael suggests that the theory of efficient market is similar to how complex adaptive system works. A complex adaptive system needs to have heterogeneity to function efficiently. Like the stock market, heterogeneous investors create efficient market. When heterogeneity breaks down and everybody acts in unison, this leads to either excessive optimism or pessimism.
For an investor to earn excess returns, he or she must buy securities that have gaps between likely fundamental outcomes versus the market’s collective forecast.
While abrupt diversity breakdowns in the stock market can offer opportunities, the investor can only take advantage of the opportunities at a psychological cost. The best bet for a long-term investor for delivering superior results is to seek ideas that need special expertise and judgment to evaluate, in contrast to those that are straightforward and obvious.
Michael explains that a contrarian investor should focus on the following:
- How market sentiment produces gap between fundamental knowledge and expectations
- Viewing the stock market as complex adaptive system: markets are efficient – but not always.
- Acknowledging the psychological and institutional constraints of contrarian investing.
On January 14, 2005, Michael Mauboussin published an article titled, “M&M on Valuation” which discusses how to interpret Price-Earnings Ratio according to a 1961 seminal paper of Merton Miller and Franco Modigliani.
According to Merton Miller and Franco Modigliani, the value of a firm is equal to steady state value and future value creation. Using this formula, an investor can split a Price-Earnings multiple into a commodity component and a franchise value component.
Michael notes that investors can use this formula to assess expectations revisions: Low multiples generally reflect low expectations. Conversely, higher multiples often reflect higher expectations.
For example, if a company trades above the commodity component, the market is expecting higher returns on capital and growth. The key is for investors is to determine whether the market is correctly pricing these expectations.
In an article The Economics of Customer Businesses dated December 9, 2004, Michael Mauboussin advised investors that analyzing customer value is a key component of assessing the shareholder value for customer-oriented businesses.
Michael defines customer value as present value of customer cash flows less the cost of acquiring the customer.
Noteworthy is his discussion on customer loyalty and lower churn rates as a determinant for higher revenues and cost savings.
The goal of any investor is to find stocks that will likely have positive revisions in expectations. For long-term oriented shareholders, the expectations that matter surround the present value of a company’s free cash flows.
For customer-centric businesses, a good understanding of customer economics will increase an investors’ chance of anticipating positive revisions in expectations.
In the October 11, 2004 article on Exploring Network Economics, Michael Mauboussin discusses the dynamics of information technology based network businesses.
The business model of an information-technology based network business is different from its traditional counterparts. These types of business typically demonstrate success after reaching a critical mass in terms of demand, rather than supply.
Successful network business exhibit high returns on capital and margins.
At the end Michael Mauboussin lists a number of success factors to look for to identify possible winners in network businesses.
In the article “Employee Stock Options” dated September 7, 2004, Michael Mauboussin discusses corporate governance challenges and compensation philosophy.
Michael equated good management to good capital allocation, noting that incentives should be aligned with value creation to ensure shareholders are enriched.
One of the tools of management compensation is to grant employee stock options. Investors should consider these stock options in their valuations as there are studies that have shown that the market takes stock options into consideration when pricing stocks.
He believes that investors should treat outstanding stock options as a contingent claim.
A detailed step-by-step explanation, together with spreadsheets is available at this website: http://expectationsinvesting.com/tutorial6.shtml
In the article The Life of Game – Sports, Stats, and the Lessons they Teach Us – written on 8 August 2004 Michael Mauboussin shows that statistics provide a way to understand a game or situation that our intuition may not capture.
He also says that by and large, intuition and tradition have played a larger role than statistics in shaping sports measurement, management, and play and that the same is true in business and investing.
An interesting finding of the article is that teams are stronger or weaker across a range of performance variables, or dimensions. And because teams have different strengths across these dimensions, you can’t really say there is one best team. The problem looks like a game of rock, paper, and scissors.
He makes the point that many sports and business organizations are too short-term oriented, and inappropriately focused on outcome versus process.
In this May 24, 2004 article titled Decision-Making for Investors – Theory, Practice, and Pitfalls – Michael Mauboussin discusses and shows that individuals who achieve the most satisfactory long-term results across various probabilistic fields tend to have more in common with one another than they do with the average participant in their own field.
He also makes very good arguments for the following:
- That the distinguishing features of probabilistic players include a focus on process versus outcome, a constant search for favourable odds, and an understanding of the role of time
- That success in a probabilistic field requires weighing probabilities and outcomes—that is, an expected value mindset, and
- The one key to success is a high degree of awareness of the factors that distort judgment.
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