VALUE: After Hours (S07 E35): The One Habit That Separates Great Investors From Everyone Else

During their recent episode, Taylor and Carlisle were joined by Justin Carbonneau, Jack Forehand, and Matt Zeigler. They discussed: The One Habit That Separates Great Investors From Everyone Else.

Jack: Yeah, sure. This is actually the one we– We did a draft chapter of the book, because if we don’t start doing something, we’re just never going to do this thing, so we put this up on our Substack. But the one we did was Michael Mauboussin and the idea of base rates. So, just put simply, it’s just the idea of looking at the past and seeing what happened under similar circumstances. He would call it the outside view. It’s the opposite of what most people do, because most people analyze the situation. They’ll look at all the details now and they’ll say, “All right, here’s my conclusion as to what might happen.”

So, if I’m looking at say a growth company that’s growing 25% a year, I might look at what’s going on at the company and its prospects and everything like that, and say, “What are the odds that growth can continue at 25% for the next decade,” or something like that. If I’m doing it, if I’m using base rates, what I might say is, “Let’s look at every company in the past that grew earnings at 25% a year. How many of them were able to sustain that rate over the next decade?” And the answer to that would be, not that many.

And so, I don’t think it’s one of those things where it has to be the only thing you do, but I think it’s a thing where a lot of people don’t use it at all. So, a lot of people say, “Here’s my inside view.” They don’t even look at the base rates to say, “Does this make any sense based on history?” So, that was one of mine.

Tobias: Do you think that the hyperscalers, or Mag-7 or whatever we’re calling them now have broken that model?

Jack: Yeah, to some degree, absolutely. But that goes back to what I was saying. Definitely, if you looked at the growth rates, they were able to sustain at their size. If you had looked at base rates before, you would have said, “No, they can’t do that.” But I think that gets back to the whole idea of marrying the two things together, which is, I’m not qualified. I’m a value guy. I thought there was no chance they were going to sustain any of that, whether I did the inside view, the outside view or any other view. But there were people who looked at those businesses and said like, “Something is different about these businesses,” and they may be able to sustain these growth rates for longer. And so, I think it’s an issue of marrying them both.

I think when people look at Mauboussin’s stuff, sometimes they think like just use the base rates. You can’t just use the base rates, because the world changes. Things are different sometimes, but I think it at least can inform what you’re doing.

Tobias: What do you think, JT? You know that base rate stuff better than I do. What notable breaches in it have there been?

Jake: Well, certainly, the size of the companies. If you had looked at 2015, and you look backwards at base rates, and the starting revenue size of the business and then can they sustain that clip of a CAGR, you are definitely betting against the base rate if you– And yet, they did it. There’s good reasons for it. Brian Arthur’s returns to scale, those network effect type of businesses, they might be a different breed, which is to say that from a Bayesian reference class mentality, you didn’t have the right reference class by just assuming that whatever, like an oil and gas company from 1980, which would be in the dataset, which is creating the base rate, was maybe an apples to oranges comparison by the time you got to Google in 2015. So, you just need to be mindful of how you’re applying them.

But I agree what Jack said that no one really looks all that hard at those for the most part and so they end up– Instead what ends up happening often, is that you remember very loud data points about something like Amazon. I should have bought Amazon way back when, but it’s defied all kinds of different base rates over the years.

Of course, you almost have to have something that defies the base rate in a big way for it to turn into a huge outcome. And so, it’s easy to remember those that you didn’t do, but maybe there’s 1,000 other ones that look very similar from the same reference class that were zeros and therefore, it actually wasn’t that good of a bet. So, anyway, it’s just Jack had it right.

Tobias: It’s still a good approach. I wrote it in this new book that I have coming out, Soldier of Fortune coming out in a few weeks. I had this line in there that said– [chuckles] We remember events by this spectacle, so everybody’s afraid of getting eaten by a shark, but you forget the stuff that’s much more likely to kill you, which is just overeating a little bit every meal, ultimately that catches up to you. That’s more dangerous than shark attacks, clearly.

Matt: You’re making me hungry. Come on, let’s get a sandwich.

Justin: I look at a lot of 13F filings for advisors and funds. It’s these large cap tech stocks that are at the top of everyone’s list. And so, they’ve defied the base rates, and everyone and their brother has been buying them. So, as investors in the last 10 years, it’s worked for the most part and so there’s this maybe bias to your point like you’re not saying seeing all the stuff that doesn’t work, because in most people’s portfolios is a lot of the stuff that worked. And so, you get tricked a little bit maybe.

Tobias: Matt, you want to give us your first one?

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