During his recent interview with Tobias, Michael Mauboussin, the Director of Research at Blue Mountain Capital Management, discusses the three most powerful ideas from Expectations Investing. Here’s an excerpt from the interview:
Tobias Carlisle: So much the better for chatting with you right now. I can’t tell you how much I’ve been looking forward to this conversation. You may be able to see in my bookshelf back there, many of your books are on prominent display. I thought we’d start with the book that you first cowrote with Alfred Rappaport, Expectations Investing. I think the story about how you came to write that is quite interesting, so would you let us know, how did that come about?
Michael Mauboussin: I’ll first say that I was a liberal arts major in college. I studied government. I’d never taken a business class. Well I take that back, I took accounting for non-business majors when I was a senior and got a C plus in the course, out of the gracious heart of the professor. So I really had no business experience, and so I came onto Wall Street in the mid-1980s having no idea what was going on, and really there were so many old wives’ tales and rules of thumb. I guess to some degree we still have those, but that was certainly the main thing I confronted.
Michael Mauboussin: Then in the late 1980s one of my trainee classmates actually handed me a copy of Alfred Rappaport’s first book called Creating Shareholder Value. That was published originally in 1986. For me that was my epiphany. The light bulb went off. There were three things in particular he talked about in that book that have really become the centerpiece of my thinking all along in my professional career. The first is something, Toby, you’ve written a lot about and you know a lot about, is that it’s not accounting numbers, but it’s cash that ultimately drives the number of businesses, and so how do we think about that as value investors in general.
Michael Mauboussin: Second is, and I still we do a poor job of this, he argued that competitive strategy and valuation really shouldn’t be separate, they should be joined at the hip. Which is to say, the litmus test of a good strategy is that it creates value, and that you can’t really do a thoughtful valuation without understanding the economics of a business and the industry.
Michael Mauboussin: Then the third and final thing of this chapter, a chapter that is aimed at corporate executives, but it was called Stock Market Signals to Managers, and the argument was, “Hey CEO, what is crucial is what’s priced into your stock in terms of expectations, and for you to deliver excess returns in the stock market, it has to be consistent with a revision in expectations. So this idea of the markets being expectations machines.
Michael Mauboussin: So I immediately started writing about this very enthusiastically as an analyst. By the way, then it was a little bit out there. It was a little bit quasi-academic, but I had a couple of key executives in particular, and investors, who were supportive. One I would mention, by the way, is Bill Stiritz, who was the CEO at the time of Ralston Purina. He’s prominently featured in Will Thorndike’s book, The Outsiders. And getting the sort of imprimatur from someone like Stiritz really was an attaboy for a guy like me who was young at the time.
Michael Mauboussin: Then I collaborated, just I would talk to Rappaport from time to time, and then in the late 1990s he sat down and said, “A lot of these ideas do make sense for investors. Would you like to collaborate on a book where we take those core principles and apply them specifically to investors?” We wrote that in 1999. By the way, it actually launched on September 10th, just think about this, September 10th, 2001. So the day before a national tragedy in the middle of a three-year bear market.
Michael Mauboussin: So the timing on the release was not ideal, but it was just an awesome project. And just being able to work with someone who’s your mentor, and someone for whom I have such deep respect, and now Rappaport, I still … He’s in San Diego, he’s not so far from you, and I still talk to him frequently. And just such a thrill, and just been such a huge influence in my life, not only professionally and even personally. That’s the Expectations Investing story.
Tobias Carlisle: One of the really powerful ideas in Expectations Investing, and it’s built right into the title there, is the idea that you can see implied from the market price the expectations for a business. So we’ve got historical data on earnings and cash flow and growth rates, and then you can take a forward look at what the market price employs, and then your job as an analyst is to determine whether that is a fair expectation or not. I think that one of the nice things about it is, it does a really good job of tying together, that Buffett would never allow them to be separated but they are often separated, the growth and value for investors. So can you just talk a little bit about that process, how you come up with the expectation and the mechanics of that undertaking?
Michael Mauboussin: Yeah. 100%. There are a lot of people who have negative things about discounted, I think everyone agrees that discounted cashflow is intellectually the correct way to value all financial assets, so you get very little pushback on that, but people get the devils in the details about how models can lead to whatever values, assuming whatever assumptions you make.
Michael Mauboussin: So the first beautiful thing about expectations investing is, it actually reverse engineers the process. One thing we know for sure is the price, and then you basically are asking a simple question: what has to happen for this price to make sense? So mechanically what you would do is, can I do a good job, or a reasonable job, of trying to understand the consensus expectations that are built into this price, and value drivers. So sales growth rates, operating profit margins, capital intensity, and understanding what has to happen for that price to make sense. So now you’re making an over-under judgment rather than saying, “I have a laser precision as to what I think the thing is worth.”
Michael Mauboussin: You bring up this value versus growth thing. This is really essential, because the key insight in all this is, we want our businesses in general to create value, so their returns are in excess of their opportunity cost to capital, which is finance 101, or economics 101. So what we know is, if you’re earning excess returns, growth is a wonderful thing, and the faster you grow, the more wealth you will create. You can show that mathematically in a very trivial way. Of course if you’re earning below your cost to capital, growth is bad, because the faster you grow, the more wealth you’ll destroy. So this notion of value and growth, I think, has always been a false dichotomy. In the factor worked usually you’re talking about sort of proxies for these things. But ultimately they have to be connected to one another, and value creation’s the key principle.
Michael Mauboussin: That leads to some very interesting simple heuristics. If you have a very high return on capital, high growth expectation business, very very modest tweaks downward in the growth rate will lead to very sharp declines in the value of the stock, mathematically appropriately so. Likewise, values stocks, which I think is why they’ve done well over long periods of time, tend to be low expectations stocks, so that’s why they tend to do well.
Michael Mauboussin: So to me, and I teach at, as you mentioned the Columbia Business School connection, I teach at the Heilbrunn Center for Graham and Dodd Investing, so very much in this tradition. But I think the name was chosen very carefully, to not be just pure Graham, cigar-butt type of thinking. It’s really, if Graham were around today, how would he think about value investing. I think he would embrace many of these same ideas. So sometimes cheap stocks are cheap for a good reason, and sometimes they’re cheap because the expectations are unduly low, so it’s distinguishing between those things that really seems to be the crucial things.
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