Interview With Michael Mauboussin

By Yaser Anwar, CSC of Equity Investment Ideas

Michael J. Mauboussin joined Legg Mason Capital Management as Chief
Investment Strategist in 2004. Prior to joining LMCM, Michael served as
Managing Director and Chief U.S. Investment Strategist at Credit Suisse
First Boston. He was also a member of the firm’s Research Review
Committee. Michael joined CSFB in 1992 as a packaged food industry
analyst. He is the former president of the Consumer Analyst Group of
New York and was repeatedly named to Institutional Investor’s
All-American Research Team and the Wall Street Journal All-Star survey
in the food industry category.

He is the author of More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006) and co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns
(Harvard Business School Press, 2001). Mauboussin has also authored or
co-authored articles for the Harvard Business Review, Journal of
Applied Corporate Finance, Financial Management, and Fortune.

Mauboussin
has also been an adjunct professor of finance at Columbia Graduate
School of Business since 1993. BusinessWeek’s Guide to the Best
Business Schools highlighted Michael in 2001 as one of the school’s
“Outstanding Faculty,” a distinction received by only seven professors.
He is also on the Board of Trustees at the Santa Fe Institute, a
leading center for multi-disciplinary research in complex systems
theory. Michael received a B.A. in government from Georgetown
University.

Y: Thank you for joining us sir.

M: the pleasure is mine.

Y: In your Jan 24th. 2007 column you cited results of a McKinsey study based on two market-derived indexes, which show that current M&A activity is creating much more value than in the prior peak. Until now, Private equity could borrow cheaply because there was high demand for their LBO debt from CDO issuers. Defaults on bonds rated below investment grade reached an all-time low of 1.57% during 2006 vs. an average of 4.90%. Going forward, how long do you expect this buyout boom to last and what catalyst(s) can rattle the buyout mania?

M: The main point of that column was to counter the argument that just because M&A activity is strong, the stock market is likely to fare poorly. By the measures you mentioned—deal value added and the rate of acquirers overpaying—the activity in 2006 was downright healthy, at least in comparison to the past decade and certainly to the prior M&A volume peak in 2000. So we think there’s a good case for continued M&A activity and solid stock market returns in 2007.

A number of factors have been in place to encourage M&A. First, corporate balance sheets are flush and there remains ample debt capacity. Second, while equity valuations are off their lows they remain at reasonable levels—indeed, we’ve seen multiple contraction for the market overall in recent years. Third, debt markets have been accommodating, both in terms of spreads and appetite for new issues. Finally, institutions have continued to allocate capital to private equity, with over $150 billion of inflows in 2006 alone.

Naturally, conditions change and we may see a reversal in some or all of these factors. The issue most weighing on the market today is whether the problems in sub prime mortgage lending will spill into other areas of the bond and stock market. We view the issues there as related more narrowly to lending standards than to the consumer’s ability to pay. But we’re keeping a close eye on the developments.

Given the balance of evidence I would argue M&A activity should continue at a brisk pace, albeit perhaps not at 2006 levels. But it’s always important to recognize that markets are dynamic and the favorable factors may certainly become less favorable.

Y: What computers did to typewriters and ATMs did to tellers; will Quantitative Strategies do the same to Fund Managers?

M: I view this as similar to what’s known as the “red queen effect” in evolution. In Lewis Carroll’s Through the Looking Glass, the Red Queen says, “you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” Evolutionary theorists apply this to the dynamics between predator and prey. Better strategies by predators require improved strategies for the prey, and vice versa. Both must constantly evolve just to stay in place.

The same idea applies to markets. Just as technology has changed vast swaths of the economy, so too has it made markets more and more efficient over the years. So doing what worked a generation or two ago is unlikely to work today: there are too many smart people—including lots of PhDs—harnessing too much data, and deploying too much computing power.

All that said, there will be a role for active managers for the foreseeable future. The reason is human nature, which hasn’t changed much in recent centuries and is unlikely to change any time soon. We know from lots of experience and careful studies in social psychology and sociology that people episodically lose cognitive diversity and start to act in unison. These so-called diversity breakdowns, more commonly known as bouts of fear and greed, lead to market excesses and market opportunities.

The vast majority of active managers fail to exploit these opportunities for two reasons. The first is there are massive institutional constraints. Because of agency costs, most money managers are satisfied to, in Keynes’s words, “fail conventionally rather than succeed unconventionally.” Second, going against the crowd is psychologically very uncomfortable and unnatural. Clearing one of these hurdles is difficult; clearly both is extremely rare.

Y: What keeps you up at night and what kind of risk are you most worried about- geopolitical, excessive leverage and/or equity valuations (feel free to add any)?

M: No specific issues keep me up at night but I recognize we live in an uncertain—not a risky, but uncertain—world. I think the distinction between risk and uncertainty, which economist Frank Knight formalized 80 years ago, is important. In a risky situation, we don’t know the outcome but we do know all of the possible outcomes. Think of a roulette wheel or the turn of a card.

In an uncertain situation, we neither know the outcome nor the underlying distribution of outcomes. It certainly appears that world events and markets are uncertain. Unfortunately, most of the tools we use to understand the world around us—especially in markets—are the tools of risk.

Characterizing an uncertain system as risky causes little harm the vast majority of the time, but is disastrous some of the time. This is a point Benoit Mandelbrot first made over 40 years ago and has been recently effectively championed by Nassim Taleb. Taleb emphasizes that it is not just the frequency of events that matter, but the magnitude as well. The crash of 1987, for example, was an event that lied outside anything risk math would allow. But while such moves in markets are rare, their magnitude assures they leave an indelible imprint on returns.

There are lots of issues to pay attention to and worry about. I often review prediction markets, like www.tradesports.com and www.newsfutures.com, to get a sense of market-based probabilities of events like terrorist acts, natural disasters, or the spread of the avian flu. But I am aware that unanticipated, and in many cases very bad, events will occur. My main consolation is the markets have seen many such events over time, and has plodded forward in every case.

Y: Your book, More Than You Know, is unlike typical investing books because it stresses the importance of diverse thinking to profit in constantly changing financial markets. What led you to develop such a thought process and why should investors instill this process into their investing philosophy?

M: To generate excess returns in markets over time, it’s important to have some insight. And if your inputs and thinking are the same as everyone else, it’s unlikely you’ll generate valuable insights.

To explain the value of diversity, I like to use the toolbox metaphor. Imagine moving into a home in need of lots of repair (this represents your problem set). Now consider a couple of alternatives: you can have one power tool or a full, diverse toolbox. It seems intuitive that diversity will be a benefit in this case, even though someone with a power tool will do better with certain repairs. In his new book, The Difference, social scientist Scott Page develops the logic of diversity and uses the toolbox metaphor.

We needn’t rely solely on metaphor to make the case for diversity. There’s excellent empirical evidence to support the view as well. Psychologist Phil Tetlock, in a remarkable piece of scholarship, asked over 300 experts for literally thousands of economic and political predictions over a 15-year span. The results, which he presents in his book Expert Political Judgment, are not encouraging: experts are poor predictors on balance, and fall into many of the same psychological traps as everyone else.

But within the data, Tetlock noticed an interesting feature. The quality of an expert’s prediction had little to do with their social identity or beliefs, but rather was linked to how they thought. He used the Isaiah Berlin distinction between hedgehogs—people who know one big thing well—and foxes—individuals who know a little about a lot. Tetlock found the foxes, the people with more diverse thoughts, were better predictors than the hedgehogs.

So diversity’s value is clear both in theory and in practice. So you might ask why more people don’t pursue diversity. The first answer is it takes a lot of work—lots of reading and thinking. But that doesn’t seem satisfactory, because the payoffs are so high in markets. The incentives are sufficiently high that investors would pursue the path if it were only about working hard.

The more likely answer, in my opinion, relates to beliefs. While most people are happy to input data, very few people are willing to examine their beliefs: where they came from, how they’ve been shaped, what behaviors they lead to. Really good investors work and think hard, and are ultimately intellectually flexible. That’s what diversity is ultimately all about. It’s not only hard, it runs counter to the nature of most people.

Y: The Fed seems to be quite relaxed about the sub-prime troubles and don’t expect the trouble to spill-over into other parts of the economy. What do you think?

M: I’m not sure the Fed is relaxed about the sub-prime issues. The key issues shaping Fed policy, quite appropriately, appear to be economic growth and inflation. Growth, while slower, remains acceptable but there are concerns about investment spending and the housing market. The sub-prime issue, of course, is an important part of this growth equation. Inflation, too, seems to have cooled. All this added together has dictated the Fed’s neutral course.

The main question is whether the sub-prime issues have broader implications. The core problem appears to be related to lending practices, especially over the past 18 months. That other parts of the sub-prime spectrum, including credit cards and auto loans, are holding up suggests the problems may be contained. But if we start to see evidence of additional consumer stress or an across-the-board increase in lending standards, challenges may ensue. The Fed is tuned into the right issues and would likely ease if these concerns mounted.

Y: Sarbanes-Oxley. Hank Paulson thinks its bad for business, especially small to mid-size companies, but the SEC thinks it benefits the investor community as a whole. What is your opinion, do you prefer an updated version of Sarbux or you think it shouldn’t be there altogether?

M: Sarbanes-Oxley was a government remedy for a market problem. It served its purpose well, and I believe the markets and companies were better off with it than without it, notwithstanding the substantial accumulated cost.

That said, legislation that’s passed in reaction to a problem is unlikely to be perfect, and that too is true for Sarbanes-Oxley. So I’d be in favor of a careful review of the act, with an eye toward preserving the favorable dimensions while encouraging changes that reduce the costs—especially for small companies.

I’d add that I believe Sarbanes-Oxley played a partial role in the financial strength we’re seeing today in corporate America. In a short period, we witnessed a bear market, a weak economy, and a terrorist act. Also at this time were corporate scandals and Sarbanes-Oxley, which shined a bright light on financial statements. Companies naturally turned inward and focused on maximizing the resources they had at hand. The result was limited hiring—this recent expansion has not seen the job growth typically associated with recoveries—rapid productivity gains, and very strong cash flows. So atoning for the sins of the market has left Corporate America in a remarkably strong financial position.

Y: In your analyst days, you were rated as one of the top analysts by WSJ and Institutional Investor, can you tell us how you analyzed and (and to this day analyze) projected EPS quarter after quarter with high accuracy?

M: In my long-ago days as an analyst, I was guided by the same principles that guide me today. First, I focused much more on cash flow than on earnings. While tracking companies closely allowed for competent earnings forecasts, I dwelled on cash. Second, I emphasized competitive strategy analysis—and in fact viewed that analysis as vital for my valuation work. Which companies had improving positions? Which ones were losing out? Why? These were the questions than interested me.

Finally, I tried to understand the expectations for financial performance that the stock prices implied. I first learned of this approach reading Al Rappaport’s book, Creating Shareholder Value, in the late 1980s. Al and I later co-authored a book, Expectations Investing, which developed the ideas in even more detail. I still believe today the single biggest error in the investment business is a failure to distinguish between fundamentals and expectations. These are two different things.

So earnings forecasts were a by-product of my core analysis.

Y: Sell-side research has become commoditized and lost its luster ever since the tech bubble burst. As someone who made the transition from sell-side to buy-side, how can institutional investors extract alpha from the sell-side?

M: I’m not sure the buy-side can extract alpha from the sell-side, nor has it ever been able to. But the sell-side can help active managers in their investment process in a couple of ways.

First, sell-side analysts are often very focused on a sector and have groomed relationships with management teams. As a result, they tend to have good industry data and access to managements. So for a buy-side investor seeking to get up to speed, or even attempting to stay current, the sell-side can be a useful resource. I would note, though, that focus and specialization has both a good side and a bad side. The good side is the accrued depth of knowledge. The bad side is an inability to compare across the market and a tendency to poorly prioritize issues.

Second, the sell-side can be a useful source to understand market expectations. Much of the news flow—both from companies to investors and from investors about companies—tends to come through the sell-side. So a thoughtful analyst can provide a good read on market expectations.

But it’s crucial to recognize that the incentives for the sell-side and the buy-side are different. What’s important to each group and how they allocate their time will necessarily also be different.

So I wouldn’t look to the sell-side for which stocks to buy or how to weight them in a portfolio, but might use the sell-side to provide information and a sense of expectations.

Y: What publications are a must read for you in-terms of finding investment ideas?

M: I’m not responsible for idea generation at LMCM. But I believe that good ideas generally come from three sources. The first is broad reading. Here I would include traditional business periodicals (e.g., The Wall Street Journal, Fortune, The Economist) as well as periodicals most investors don’t read (e.g., Nature, Scientific American). Books of all sorts are also very helpful. These sources often provide important context, idea sparks, and possible signals.

The second source would be what other great investors are doing. Find a list of investors you deeply respect, investors who operate with a similar philosophy and time horizon, and pay attention to their actions. Here, too, some good ideas can surface.

Finally, I’d speak to a limited group of investors. This is a two-edged sword—discussing stocks all day with other investors is a bad idea because it severely impedes your ability to think independently. By the same token, bouncing ideas off a respected business friend or colleague can provide a good opportunity for feedback and constructive criticism.

Y: Given the success of your books, More Than You Know: Finding Financial Wisdom in Unconventional Places and Expectations Investing: Reading Stock Prices for Better Returns, what can we expect from Michael Mauboussin, the author, going forward?

M: I have no current plans for a new book. But a topic that interests me is how and why markets are generally efficient and periodically inefficient. The core idea surrounds collective problem solving, or more formally, a view of the stock market as a complex adaptive system. This line of thinking intrigues me because it allows us to at least partially dismiss the current finance dogma, offers conditions under which markets are likely to be efficient and inefficient, ties to what we see in many other natural systems, better fits the empirical data, and shows the limitations of experts.

If these ideas become accepted more widely, a number of core ideas will be overturned including our understanding, conceptualization, and modeling of risk. Or should I say uncertainty.

Y: Thank you for your time sir.

http://www.equityinvestmentideas.blogspot.com/

By Yaser Anwar, CSC of Equity Investment Ideas

Michael J. Mauboussin joined Legg Mason Capital Management as ChiefInvestment Strategist in 2004. Prior to joining LMCM, Michael served asManaging Director and Chief U.S. Investment Strategist at Credit SuisseFirst Boston. He was also a member of the firm’s Research ReviewCommittee. Michael joined CSFB in 1992 as a packaged food industryanalyst. He is the former president of the Consumer Analyst Group ofNew York and was repeatedly named to Institutional Investor’sAll-American Research Team and the Wall Street Journal All-Star surveyin the food industry category.

He is the author of More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006) and co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns(Harvard Business School Press, 2001). Mauboussin has also authored orco-authored articles for the Harvard Business Review, Journal ofApplied Corporate Finance, Financial Management, and Fortune.

Mauboussinhas also been an adjunct professor of finance at Columbia GraduateSchool of Business since 1993. BusinessWeek’s Guide to the BestBusiness Schools highlighted Michael in 2001 as one of the school’s“Outstanding Faculty,” a distinction received by only seven professors.He is also on the Board of Trustees at the Santa Fe Institute, aleading center for multi-disciplinary research in complex systemstheory. Michael received a B.A. in government from GeorgetownUniversity.

Y: Thank you for joining us sir.

M: the pleasure is mine.

Y: In your Jan 24th. 2007 column you cited results of a McKinsey study based on two market-derived indexes, which show that current M&A activity is creating much more value than in the prior peak. Until now, Private equity could borrow cheaply because there was high demand for their LBO debt from CDO issuers. Defaults on bonds rated below investment grade reached an all-time low of 1.57% during 2006 vs. an average of 4.90%. Going forward, how long do you expect this buyout boom to last and what catalyst(s) can rattle the buyout mania?

M: The main point of that column was to counter the argument that just because M&A activity is strong, the stock market is likely to fare poorly. By the measures you mentioned—deal value added and the rate of acquirers overpaying—the activity in 2006 was downright healthy, at least in comparison to the past decade and certainly to the prior M&A volume peak in 2000. So we think there’s a good case for continued M&A activity and solid stock market returns in 2007.

A number of factors have been in place to encourage M&A. First, corporate balance sheets are flush and there remains ample debt capacity. Second, while equity valuations are off their lows they remain at reasonable levels—indeed, we’ve seen multiple contraction for the market overall in recent years. Third, debt markets have been accommodating, both in terms of spreads and appetite for new issues. Finally, institutions have continued to allocate capital to private equity, with over $150 billion of inflows in 2006 alone.

Naturally, conditions change and we may see a reversal in some or all of these factors. The issue most weighing on the market today is whether the problems in sub prime mortgage lending will spill into other areas of the bond and stock market. We view the issues there as related more narrowly to lending standards than to the consumer’s ability to pay. But we’re keeping a close eye on the developments.

Given the balance of evidence I would argue M&A activity should continue at a brisk pace, albeit perhaps not at 2006 levels. But it’s always important to recognize that markets are dynamic and the favorable factors may certainly become less favorable.

Y: What computers did to typewriters and ATMs did to tellers; will Quantitative Strategies do the same to Fund Managers?

M: I view this as similar to what’s known as the “red queen effect” in evolution. In Lewis Carroll’s Through the Looking Glass, the Red Queen says, “you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” Evolutionary theorists apply this to the dynamics between predator and prey. Better strategies by predators require improved strategies for the prey, and vice versa. Both must constantly evolve just to stay in place.

The same idea applies to markets. Just as technology has changed vast swaths of the economy, so too has it made markets more and more efficient over the years. So doing what worked a generation or two ago is unlikely to work today: there are too many smart people—including lots of PhDs—harnessing too much data, and deploying too much computing power.

All that said, there will be a role for active managers for the foreseeable future. The reason is human nature, which hasn’t changed much in recent centuries and is unlikely to change any time soon. We know from lots of experience and careful studies in social psychology and sociology that people episodically lose cognitive diversity and start to act in unison. These so-called diversity breakdowns, more commonly known as bouts of fear and greed, lead to market excesses and market opportunities.

The vast majority of active managers fail to exploit these opportunities for two reasons. The first is there are massive institutional constraints. Because of agency costs, most money managers are satisfied to, in Keynes’s words, “fail conventionally rather than succeed unconventionally.” Second, going against the crowd is psychologically very uncomfortable and unnatural. Clearing one of these hurdles is difficult; clearly both is extremely rare.

Y: What keeps you up at night and what kind of risk are you most worried about- geopolitical, excessive leverage and/or equity valuations (feel free to add any)?

M: No specific issues keep me up at night but I recognize we live in an uncertain—not a risky, but uncertain—world. I think the distinction between risk and uncertainty, which economist Frank Knight formalized 80 years ago, is important. In a risky situation, we don’t know the outcome but we do know all of the possible outcomes. Think of a roulette wheel or the turn of a card.

In an uncertain situation, we neither know the outcome nor the underlying distribution of outcomes. It certainly appears that world events and markets are uncertain. Unfortunately, most of the tools we use to understand the world around us—especially in markets—are the tools of risk.

Characterizing an uncertain system as risky causes little harm the vast majority of the time, but is disastrous some of the time. This is a point Benoit Mandelbrot first made over 40 years ago and has been recently effectively championed by Nassim Taleb. Taleb emphasizes that it is not just the frequency of events that matter, but the magnitude as well. The crash of 1987, for example, was an event that lied outside anything risk math would allow. But while such moves in markets are rare, their magnitude assures they leave an indelible imprint on returns.

There are lots of issues to pay attention to and worry about. I often review prediction markets, like www.tradesports.com and www.newsfutures.com, to get a sense of market-based probabilities of events like terrorist acts, natural disasters, or the spread of the avian flu. But I am aware that unanticipated, and in many cases very bad, events will occur. My main consolation is the markets have seen many such events over time, and has plodded forward in every case.

Y: Your book, More Than You Know, is unlike typical investing books because it stresses the importance of diverse thinking to profit in constantly changing financial markets. What led you to develop such a thought process and why should investors instill this process into their investing philosophy?

M: To generate excess returns in markets over time, it’s important to have some insight. And if your inputs and thinking are the same as everyone else, it’s unlikely you’ll generate valuable insights.

To explain the value of diversity, I like to use the toolbox metaphor. Imagine moving into a home in need of lots of repair (this represents your problem set). Now consider a couple of alternatives: you can have one power tool or a full, diverse toolbox. It seems intuitive that diversity will be a benefit in this case, even though someone with a power tool will do better with certain repairs. In his new book, The Difference, social scientist Scott Page develops the logic of diversity and uses the toolbox metaphor.

We needn’t rely solely on metaphor to make the case for diversity. There’s excellent empirical evidence to support the view as well. Psychologist Phil Tetlock, in a remarkable piece of scholarship, asked over 300 experts for literally thousands of economic and political predictions over a 15-year span. The results, which he presents in his book Expert Political Judgment, are not encouraging: experts are poor predictors on balance, and fall into many of the same psychological traps as everyone else.

But within the data, Tetlock noticed an interesting feature. The quality of an expert’s prediction had little to do with their social identity or beliefs, but rather was linked to how they thought. He used the Isaiah Berlin distinction between hedgehogs—people who know one big thing well—and foxes—individuals who know a little about a lot. Tetlock found the foxes, the people with more diverse thoughts, were better predictors than the hedgehogs.

So diversity’s value is clear both in theory and in practice. So you might ask why more people don’t pursue diversity. The first answer is it takes a lot of work—lots of reading and thinking. But that doesn’t seem satisfactory, because the payoffs are so high in markets. The incentives are sufficiently high that investors would pursue the path if it were only about working hard.

The more likely answer, in my opinion, relates to beliefs. While most people are happy to input data, very few people are willing to examine their beliefs: where they came from, how they’ve been shaped, what behaviors they lead to. Really good investors work and think hard, and are ultimately intellectually flexible. That’s what diversity is ultimately all about. It’s not only hard, it runs counter to the nature of most people.

Y: The Fed seems to be quite relaxed about the sub-prime troubles and don’t expect the trouble to spill-over into other parts of the economy. What do you think?

M: I’m not sure the Fed is relaxed about the sub-prime issues. The key issues shaping Fed policy, quite appropriately, appear to be economic growth and inflation. Growth, while slower, remains acceptable but there are concerns about investment spending and the housing market. The sub-prime issue, of course, is an important part of this growth equation. Inflation, too, seems to have cooled. All this added together has dictated the Fed’s neutral course.

The main question is whether the sub-prime issues have broader implications. The core problem appears to be related to lending practices, especially over the past 18 months. That other parts of the sub-prime spectrum, including credit cards and auto loans, are holding up suggests the problems may be contained. But if we start to see evidence of additional consumer stress or an across-the-board increase in lending standards, challenges may ensue. The Fed is tuned into the right issues and would likely ease if these concerns mounted.

Y: Sarbanes-Oxley. Hank Paulson thinks its bad for business, especially small to mid-size companies, but the SEC thinks it benefits the investor community as a whole. What is your opinion, do you prefer an updated version of Sarbux or you think it shouldn’t be there altogether?

M: Sarbanes-Oxley was a government remedy for a market problem. It served its purpose well, and I believe the markets and companies were better off with it than without it, notwithstanding the substantial accumulated cost.

That said, legislation that’s passed in reaction to a problem is unlikely to be perfect, and that too is true for Sarbanes-Oxley. So I’d be in favor of a careful review of the act, with an eye toward preserving the favorable dimensions while encouraging changes that reduce the costs—especially for small companies.

I’d add that I believe Sarbanes-Oxley played a partial role in the financial strength we’re seeing today in corporate America. In a short period, we witnessed a bear market, a weak economy, and a terrorist act. Also at this time were corporate scandals and Sarbanes-Oxley, which shined a bright light on financial statements. Companies naturally turned inward and focused on maximizing the resources they had at hand. The result was limited hiring—this recent expansion has not seen the job growth typically associated with recoveries—rapid productivity gains, and very strong cash flows. So atoning for the sins of the market has left Corporate America in a remarkably strong financial position.

Y: In your analyst days, you were rated as one of the top analysts by WSJ and Institutional Investor, can you tell us how you analyzed and (and to this day analyze) projected EPS quarter after quarter with high accuracy?

M: In my long-ago days as an analyst, I was guided by the same principles that guide me today. First, I focused much more on cash flow than on earnings. While tracking companies closely allowed for competent earnings forecasts, I dwelled on cash. Second, I emphasized competitive strategy analysis—and in fact viewed that analysis as vital for my valuation work. Which companies had improving positions? Which ones were losing out? Why? These were the questions than interested me.

Finally, I tried to understand the expectations for financial performance that the stock prices implied. I first learned of this approach reading Al Rappaport’s book, Creating Shareholder Value, in the late 1980s. Al and I later co-authored a book, Expectations Investing, which developed the ideas in even more detail. I still believe today the single biggest error in the investment business is a failure to distinguish between fundamentals and expectations. These are two different things.

So earnings forecasts were a by-product of my core analysis.

Y: Sell-side research has become commoditized and lost its luster ever since the tech bubble burst. As someone who made the transition from sell-side to buy-side, how can institutional investors extract alpha from the sell-side?

M: I’m not sure the buy-side can extract alpha from the sell-side, nor has it ever been able to. But the sell-side can help active managers in their investment process in a couple of ways.

First, sell-side analysts are often very focused on a sector and have groomed relationships with management teams. As a result, they tend to have good industry data and access to managements. So for a buy-side investor seeking to get up to speed, or even attempting to stay current, the sell-side can be a useful resource. I would note, though, that focus and specialization has both a good side and a bad side. The good side is the accrued depth of knowledge. The bad side is an inability to compare across the market and a tendency to poorly prioritize issues.

Second, the sell-side can be a useful source to understand market expectations. Much of the news flow—both from companies to investors and from investors about companies—tends to come through the sell-side. So a thoughtful analyst can provide a good read on market expectations.

But it’s crucial to recognize that the incentives for the sell-side and the buy-side are different. What’s important to each group and how they allocate their time will necessarily also be different.

So I wouldn’t look to the sell-side for which stocks to buy or how to weight them in a portfolio, but might use the sell-side to provide information and a sense of expectations.

Y: What publications are a must read for you in-terms of finding investment ideas?

M: I’m not responsible for idea generation at LMCM. But I believe that good ideas generally come from three sources. The first is broad reading. Here I would include traditional business periodicals (e.g., The Wall Street Journal, Fortune, The Economist) as well as periodicals most investors don’t read (e.g., Nature, Scientific American). Books of all sorts are also very helpful. These sources often provide important context, idea sparks, and possible signals.

The second source would be what other great investors are doing. Find a list of investors you deeply respect, investors who operate with a similar philosophy and time horizon, and pay attention to their actions. Here, too, some good ideas can surface.

Finally, I’d speak to a limited group of investors. This is a two-edged sword—discussing stocks all day with other investors is a bad idea because it severely impedes your ability to think independently. By the same token, bouncing ideas off a respected business friend or colleague can provide a good opportunity for feedback and constructive criticism.

Y: Given the success of your books, More Than You Know: Finding Financial Wisdom in Unconventional Places and Expectations Investing: Reading Stock Prices for Better Returns, what can we expect from Michael Mauboussin, the author, going forward?

M: I have no current plans for a new book. But a topic that interests me is how and why markets are generally efficient and periodically inefficient. The core idea surrounds collective problem solving, or more formally, a view of the stock market as a complex adaptive system. This line of thinking intrigues me because it allows us to at least partially dismiss the current finance dogma, offers conditions under which markets are likely to be efficient and inefficient, ties to what we see in many other natural systems, better fits the empirical data, and shows the limitations of experts.

If these ideas become accepted more widely, a number of core ideas will be overturned including our understanding, conceptualization, and modeling of risk. Or should I say uncertainty.

Y: Thank you for your time sir.

http://www.equityinvestmentideas.blogspot.com/