The Ten Attributes of Great Fundamental Investors – Michael J. Mauboussin

One of my favorite resources for sage advise on investing strategy is Michael J. Mauboussin.

Mauboussin is the Head of Global Financial Strategies at Credit Suisse. Prior to rejoining CS in 2013, he was Chief Investment Strategist at Legg Mason Capital Management.

Mauboussin is also the author of The Success Equation: Untangling Skill and Luck in Business, Sports and Investing, and Think Twice: Harnessing the Power of Counterintuition and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded.

More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns.

Mauboussin has been an adjunct professor of finance at Columbia Business School since 1993, and received the Dean’s Award for Teaching Excellence in 2009.

Earlier this year Mauboussin released his latest paper titled, Thirty Years – Reflections on the Ten Attributes of Great Investors, it’s a must read for all investors.

Let’s take a look…

This is an excerpt from Mauboussin’s paper. You can read the full paper here, Thirty Years – Reflections on the Ten Attributes of Great Investors.

He starts by saying:

“Perhaps the single greatest error in the investment business is a failure to distinguish between the knowledge of a company’s fundamentals and the expectations implied by the market price.”

The world of investing and business has seen a great deal of change in the past 30 years
This report shares thoughts on the ten attributes of great fundamental investors
Accounting is the language of business and you need to understand it to appreciate economic value and to assess competitive positioning
Investors face a slew of psychological challenges. Perhaps the most difficult is updating beliefs when new information arrives
Position sizing and portfolio construction still do not get the attention they warrant
The substantial shift from active to passive management has profound implications for the investment industry

Mauboussin’s Ten Attributes of Great Fundamental Investors are:

1. Be numerate (and understand accounting)

2. Understand value (the present value of free cash flow)

3. Properly assess strategy (or how a business makes money)

4. Compare effectively (expectations versus fundamentals)

5. Think probabilistically (there are few sure things)

6. Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected)

7. Beware of behavioral biases (minimizing constraints to good thinking)

8. Know the difference between information and influence

9. Position sizing (maximizing the payoff from edge)

10. Read (and keep an open mind)

Mauboussin finishes by adding:

What Next?

It is harder than ever to generate excess returns in the investment management business. The main explanation for the rising difficulty is an idea we call the “paradox of skill.” The paradox says that in some activities, as skill increases luck becomes more important in determining outcomes.

The key insight is differentiating between absolute and relative skill. Absolute skill in investing, which includes bright investors working hard using vast amounts of data and incorporating ideas from the latest research, has never been higher. Relative skill, on the other hand, appears to be narrowing.

The difference between the best and the average is less today than it was a generation or two ago. We see this clearly when we examine the standard deviation of excess returns for mutual funds, which has declined steadily for a half century.

The massive shift in asset allocation away from active investing toward passive investing exacerbates this effect. Thirty years ago, index funds were less than one percent of assets under management, and today they (along with other passive vehicles such as exchange-traded funds) are about one-third.

Think of it this way: For you to have positive alpha, the industry’s term for risk-adjusted excess return, someone has to have negative alpha of the same amount. By definition, alpha for the market must equal zero (before fees). So you want to compete against less-skilled investors because they are your source of alpha.

It is disadvantageous for you if the weak players flee the market (selling their stocks and buying index funds), or if the least capable professional investors lose assets to passive funds, because it means that only the smartest investors remain in the active game.

The truth is that weak players, whom the strong players require to generate excess returns, are fleeing at a record pace. Still, here are a couple of suggestions for active managers to contemplate. The first is to consider carefully where your skill will be most valuable.

More than 25 years ago, Richard Grinold spelled out the “fundamental law of active management.” The non-technical interpretation says that excess returns equal skill times opportunity. All the skill in the world is for naught unless you have an opportunity to apply it. Before figuring out how you will win the game, figure out which game to play.

Second, there is a still a lot of upside in properly building an investment firm. In the past 30 years, we have learned a substantial amount about how our minds work, the value of diversity, and the role of training. Take a look at exhibit 2 [below], which considers the factors that contribute to peak performance as an investor.

The box on the left starts with selecting the right people to be analysts and portfolio managers. The next pair of boxes place emphasis on proper training through deliberate practice and the thoughtful application of technology. Then the organization has to manage cognitive bias. Only then can an individual in a firm reach peak performance.