Ask the expert: Investment strategy

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Michael Mauboussin has emerged as one of the influential thinkers in markets on investment strategy. The chief investment strategist at Legg Mason has developed a strong following for his insights on how to invest.

Michael Mauboussin answers your questions on investment strategy and how understanding investor behaviour can enhance investment strategy and returns. Read more on his background.

I love the parimutual wager in thoroughbred racing. It keeps me sharp. I do my homework and cut into the track take by 1/2. It is small in comparison to the risk in financial markets on a dollar basis to me. Have you analysed the habits of professional gamblers in comparison to professional investors and if you have, have you identified the similarities and differences?
Paul Benequista Avon, Connecticut

Michael Mauboussin: I am a student of gambling and other participants in probabilistic fields. I recently had the opportunity to spend time with Steven Crist, Chairman of the Daily Racing Form, and it was terrific!

I wrote a piece on exactly this topic. I call it the “T” theory. That is, the behaviors of leading participants in probabilitic fields--gambling, sports team management, investing--have more in common with one another (the top of the “T”) than they do with the average participant in their field (the vertical line in the “T”). Warren Buffett and a great poker player have more in common than Buffett does with the average investor. Common features of successful participants include: always try to have the odds in your favor, a focus on process versus outcome, and an understanding of the role of time. So I believe there is much for an investor to learn by paying attention to these other areas.

I am interested in your 1997 Competitive Advantage Period (CAP) analysis that you did at CSFB. Based on CAP, how many years is Google, Yahoo, Amazon, and Microsoft expected to generate excess returns to justify the current valuations? And which companies are currently underpriced and overpriced based on CAP.
Rajiv, UK

Michael Mauboussin: I am not in a position to discuss the analysis of those companies directly, or to provide specific investment recommendations. However, I believe you can work out those answers with some effort. Here’s a tutorial to guide the process. The objective would be to take consensus value driver assumptions (combine analysts reports along with services like Value Line) and plug them in to the model. The spreadsheet within the tutorial will generate a market-implied CAP.

I’ve just come into some inheritance and am thinking of investing it in the US equity market. Where’s the smart money going these days in your view?
Darren Barber, New York, US

Michael Mauboussin: I don’t have any specific advice but I would try to identify the more attractive parts of the market. I would note that investors are notorious for having bad timing; that is, they want to invest in what has done well. So the first bit of advice is look where performance has been poor and where the expectations appear low.

One area that seems to fit that description is large capitalisation US stocks. Since early 2000, the peak of the market, large cap stocks are down on average while their earnings growth has been strong. As a result, today the valuations look attractive, and the companies have strong balance sheets, returns on capital, and cash flows. Much of the 1990s excess have been wrung out. One way to partcipate in the large cap names cost effectively is simply an index fund. Such funds have low fees and have outperformed a large percentage of active money managers over the years.

I’d love to hear more about the parallels between mate selection in guppies and stock market booms.
Jack Palmer, Cirencester, UK

Michael Mauboussin: The core idea here is the wisdom of crowds (I highly recommend Jim Surowiecki’s book, “The Wisdom of Crowds”). The core idea is that crowds are very good at solving problems when certain conditions are in place, including diversity, an aggregation mechanism, and incentives. When one or more of these conditions are violated, the wisdom of the crowds quickly turns into the whims of the crowd.

That’s where the guppies come into the picture. It turns out that guppy females are attracted to bright-coloured males. But when researchers contrived a situation where certain females observed other females selecting dull-colored males, the observing females bucked their innate preference and selected the dull-colored males as well. So imitation is not a uniquely human (or primate) phenomenon, it’s observable throughout the animal world.

The leap to humans, and hence to markets, is pretty easy. Humans are inherently social and imitative. Imitation confers all sorts of advantages in day-to-day life. But if imitation is taken to an extreme in markets, you get large-scale inefficiency (madness of crowds) and ofetn investment opportunities.

You advocate valuing growth opportunities based on assessing the spread between the return on capital and the cost of capital, the magnitude of investment and the length of time that a company can deploy capital at positive spreads. How do high-PE internet-based companies fit into this model given most are not likely to be particularly capital intensive and are therefore unable to invest significant amount of capital at high rates of return?
Craig Collins, Edinburgh, Scotland

Michael Mauboussin: At the end of the day, the value of a financial asset is the present value of future cash flows. Cash flows, simplistically, represent the cash in versus cash out. One challenge we face in the investment industry is the nature of investment has changed. A few generations ago, investments were things we could touch (and kick), like factories, equipment, or inventory. Increasingly, our investments today are knowledge-based: R&D, training, and marketing. As an example, Microsoft spend $1.8bn on capital expenditures and $6.9bn on R&D in fiscal 2006. Microsoft is investing actively, it’s just that much of their investment is not showing up on the balance sheet. These investments inherently more difficult to measure and manage, but are subject to the same principles.

So with the Internet stocks, the goal is still to get a sense of their ability to generate cash. How much are they investing, and in what form? What will the return on that investment be? How long can they sustain competitive advantage? These questions remain central.

One last thought is it may make sense using some real options techniques in valuing Internet companies. Real options analysis applies when you have a smart management team, a market-leading business, and considerable variability in outcomes. I’m not advocating scrapping the DCF approach, but rather recognising there may be some useful analytical techniques that are not widely understood or applied.

Where are US rates headed from here?
l. Crosbie, London, UK

Michael Mauboussin: We don’t have strong views about the direction of rates. We do pay attention to a multitude of sources, including the Fed, leading economists, and dedicated bond investment firms (including our sister firm, Western Asset Management). But forecasting rates is not a source of competitive advantage for us.

I am a Master of Science in International Finance at CERAM in Nice, France. I am going to write a master thesis soon, and I am interested in investment strategy and the effect oil prices have on many areas such as investment financing and risk management. Do you have any advice on a topic concerning this, an interesting new areas to do some research in?
Elisabeth, Nice, France

Michael Mauboussin: I don’t have good advice in this area. An interesting area of exploration is our understanding of risk and uncertainty. We know that price distributions are not normal - they are fat-tailed. However, we don’t understand the causal mechanisms well and are still working on devising effective ways to manange that uncertainty effectively. I believe much of this work will be interdisciplinary, and will include physicists and sociologists as well as economists. We have much to learn. Good luck!

I have recently been asked as part of a project to produce an investment strategy to maximise capital growth over the next 20 years. I have found your work very interesting and was wondering if you could share some of your views on this subject. Any help at all would be greatly appreciated.
Ronan Byrne, Ireland

Michael Mauboussin: There is no easy answer to this question (I wish there were!). One important discussion relates to how you should go about this task. A substantial debate in economics, finance and investing is whether you should follow the principle of geometric mean maximization or mean/variance. I wrote about this earlier this year . Many mainstream economists frown on geometric mean maximization, because it doesn’t assure long-term results (only the best probability of such results), investors need to be in for the long run for the principle to work, and you have to have a good understanding of payoffs to apply the concept.

I would argue that mean/variance is not the best way to think about maximizing long-term wealth if you are reinvesting your investment proceeds. If you face a one-time financial decision, you want to maximize your arithmetic mean. But with repeated favorable opportunities - either through time or diversification - chances are you will do better in the long term by maximizing geometric mean. Mean/variance may be deeply embedded in the investment industry’s lexicon, but it doesn’t do as good a job at building wealth as a Kelly-type system.

Do you think we have seen the end of the recent commodity bull run (now that the GSCI is showing a negative return for the current year to date) and following on from that, will investment banks need to look towards structured products in commodities to facilitate client demands for exposure to alternative assets?
Gareth Evans, London, UK

Michael Mauboussin: The recent commodity run followed a very classic pattern. Supply and demand imbalances triggered fundamentally-justified moves in commodity prices. But only up to a point. It appears a substantial part of the price move, culminating this spring, was the result of financial speculation and asset allocation shifts. History in commodity markets suggests that higher prices spur supply to meet demand, ultimately resulting in commodity price moderation. This cycle appears to be no different.

William Bernstein recently wrote a short essay that effectively captures the current picture.

Over the last 45 years, a theoretical investment in commodity futures appears to have delivered returns better than the S&P 500 with a zero correlation with the stock market (in fact, the correlation is actually negative over some time periods). The key to these returns is a futures market in backwardation - that is, future prices are below spot prices. In many commodity markets today, thanks to speculators, backwardation has yielded to contango, where future prices are higher than spot prices. Since today's circumstances are different than those assumed in the historical calculations, it is not a good idea to extrapolate past returns into the future.

I have no strong view on structured products. My sense is that investment banks will work hard to create products to satiate demand. If the trend toward higher weights in alternative assets continues, you can be sure products will follow.

How does one objectively estimate the future cash flow of a company when one’s view of the future is so influenced by the prevailing market sentiment? Consider technology stocks in 2000, energy stocks last year and even Chinese banking stocks today. Is objectivity even possible in valuation?
Clement Loh, Toronto, Canada

Michael Mauboussin: The key to investing is understanding the expectations built into the asset price. So for stocks, the idea is to reverse-engineer the financial expectations built into the share price - items like sales growth, margins, and capital needs. Al Rappaport and I describe this process in detail in a book we wrote a few years ago. There are three steps to the process. First, understand the future financial performance implied by the stock. During this step, you want to be agnostic: simply figure out what the price implies. In the second step you apply financial and strategic analysis to determine whether the market-implied expectations are too high, too low, or about right. This step gets more to the heart of your question. Step three is then to make a buy, sell, or hold decision.

Your question addresses a very fundamental aspect of investing that the valuation textbooks don’t discuss: psychology. I’d recommend (re)reading chapter 12, “The State of Long-Term Expectation”, in Keynes’s General Theory of Employment. Keynes suggests that most people fall back on “convention” - basically the current situation, modified if warranted. What we now know from social psychology and sociology is periodically, investors coordinate their behaviour and become nearly universally bullish or bearish.

So my recommendation is twofold. First, do you best to observe market sentiment and gather a sense of whether investors are all standing on one side of the ship. Second, if you perceive excesses, apply the expectations approach to see if the future performance is achievable. This combination of activities should help insert objectivity into your valuation process.

One school of thought holds that we haven’t seen a real US stock market crash yet in this decade, but before that, we need to see mass euphoria propelling the market to much greater heights that easily eclipse the dotcom boom. What’s your view on this?
Terence Choy, US

Michael Mauboussin: Booms and crashes are notoriously difficult to anticipate. In fact, we can generally only identify them after the fact. Even if you comb through financial history including all markets, it appears there have been less than three dozen full fledged booms and crashes. So while they occur, I see no reason to anticipate one in particular.

One obvious point, made by Didier Sornette in his book “Why Stock Markets Crash”, is that crashes only follow substantial price runups. We have not seen a large run-up in the market in general, and valuations remain reasonable - especially when considered in the context of current interest rates and returns on capital. Specifically, large capitalisation US stocks appear attractive.

What connection do you see between Tiger Woods’ golf swing and markets?
Tony Tassell, London, UK

Michael Mauboussin: I describe this connection in my book, More Than You Know. I suggest that a concept from evolutionary biology, fitness landscapes, is a good metaphor for what Tiger Woods went through retooling his swing. Briefly, imagine a mountain range with mountains of different heights (fitness landscape). As a species moves up a mountain, it gains fitness - basically an ability to reproduce. Now imagine reaching a peak (a local optimum) and seeing a higher peak elsewhere. To get there, you have to go down into the valley (losing fitness) and climb to the higher peak. That’s what Woods did in 1998-2000.

The link to the markets is some companies go through a similar process. They have to give up some short-term success in order to attain greater long-term success.

What are the benefits for investors in overlooking the short-term noise to focus on the long-term?
Chris Brown-Humes, London, UK

Michael Mauboussin: Any probabalistic system, including the stock market, is going to be a combination of noise and signal. Think of signal as the long-term fundamental underpinnings. For a company, that might include sales growth, profitabililty and returns on capital. Noise are the fluctuations that occur around the signal.

Opportunity arises when the market extrapolates noise as if it’s the signal. Here’s a simple anology. Say you have a fair coin. You know that the signal is a 50-50 ratio of heads and tails. Now say you flipped 10 times and saw 7 heads and 3 tails. If the market were to extrapolate that noise and assume the coin were biases toward heads, that would represent an opportunity for time arbitrage.

The same mindset applies to companies. If the market takes short-term data (noise) and extrapolates it to reflect the long term fundmanentals (signal), you can arbitrage the opportunity. Of course, your assessment of the signal must be correct, and the signal must reveal itself and be recognised by the market. I wrote a piece earlier this year covering this topic.


Mr Mauboussin recently published a book More Than You Know - Finding Financial Wisdom in Unconventional Places. While drawing on the wisdom of investors like Warren Buffett, Mauboussin’s books also find insights into fields ranging from casino gambling to evolutionary biology. Mr Mauboussin analyses the strategies of poker experts and finds a parallel between mate selection in guppies and stock market booms. He also takes a look at lessons for investors from ant colonies, Tupperware parties, slime mould and Tiger Woods’ golf swing.

A recent strategy note looked at how investors can take advantage of a long-term approach in a short-term world where “noise” distorts the efficient pricing of assets. Another looked at how investors make comparisons in judging investments. Read his recent research.

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