The Most Powerful Investing Tool You Aren’t Using | Four Lessons from Michael Mauboussin

Key Concepts

• Base Rates: The natural tendency to think about the world by gathering information and combining it with personal experience, versus using base rates which involves viewing a current problem as an instance of a larger reference class and asking what happened in similar past situations.
• Expectations Investing: A three-step investment framework:
  1. Reverse Engineer Price: Use a discounted cash flow (DCF) model to determine what must happen for the current stock price to be justified.
  2. Analyze Expectations: Assess whether the company is likely to meet, exceed, or fall short of these implied expectations using historical, strategic, and financial analysis. This is a probabilistic exercise involving multiple scenarios.
  3. Act: Make buy, sell, or hold decisions based on the analysis.
• Multiples are Not Valuation: Multiples (like P/E ratios) are a shorthand for the valuation process, not the valuation itself. Understanding the underlying economic assumptions that justify a multiple is crucial.
• Paradox of Skill: As absolute skill in a field increases, relative skill (the difference between the best and average) decreases, leading to a greater role for luck in outcomes.
• Reference Class: The group of similar situations or entities used to establish a base rate. Choosing the correct reference class is critical for accurate base rate analysis.
• Earn the Right to Multiples: Before using valuation multiples, one must demonstrate an understanding of the underlying economic assumptions and drivers that justify them.

Book Project and Substack

The podcast hosts are collaborating on a book titled "The Most Important Investing Lesson: What the World's Best Investors Would Teach You." The book aims to compile the best lessons from interviews with approximately 200 investors. To facilitate public feedback and revision, they have launched a Substack at excessreturns pod.substack.com. This platform will host draft chapters of the book, old episodes, transcripts, and original content. They encourage audience engagement and feedback to improve the book before its eventual publication, aiming for a chapter release every one to two weeks over the next year.

Lesson 1: Base Rates

Michael Mauboussin emphasizes the importance of base rates in thinking about the world, not just for investing but for business and life.

• Definition: Instead of relying solely on personal information and experience to project into the future, base rate thinking involves identifying a current situation as an instance of a larger reference class and examining what has happened in similar past situations.
• Unnatural Process: This approach is unnatural because it requires setting aside personal information and experience, which individuals tend to overvalue. It also necessitates effort to find and appeal to relevant base rates, which are often not readily available.
• Reshaping Perspective: Once found, base rates can significantly reshape one's thinking, leading to a more grounded understanding of likely outcomes.
• Application in Forecasting: Base rates are particularly useful in forecasting, such as predicting market movements. Acknowledging a standard deviation around a forecast (e.g., 10% with some standard deviation) is a base-rate-informed approach.
• Complementary Tool: Base rates are a tool to supplement analysis, not a replacement for it. The "Mag Seven" companies, for example, defied initial base rate expectations due to unique company-specific factors.
• Reconciliation: The ability to zoom out to a wide-angle view (base rates, outside view) and then zoom in to a narrow, ground-level view (specific company analysis, inside view) and reconcile the two is a powerful analytical hack.
• Real-World Examples:
  • Company Growth: When analyzing a company growing earnings at 50% annually, one should not only assess its business prospects but also examine how many other companies that grew at 50% historically sustained that growth.
  • Small Business: The odds of success for a new small business can be estimated by looking at the base rates for similar businesses in that category. For instance, opening a bar or restaurant might have low base rates of success.
  • Financial Planning: When considering financial goals like paying for college or a mortgage, base rates can inform decisions by looking at the experiences of others with similar capabilities and circumstances, assessing their happiness and outcomes.

Lesson 2: Expectations Investing

Michael Mauboussin's Expectations Investing framework offers a structured approach to valuation.

• Three Steps:
  1. Reverse Engineer Price: The only known certainty is the current stock price. Using a discounted cash flow (DCF) model, one must determine the future cash flows and growth rates (drivers of value like sales growth, margins, capital intensity) that are implicitly priced into the current stock. The goal is to be agnostic and understand what needs to happen for the price to make sense. This is akin to knowing the height of the bar in a high jump competition.
  2. Analyze Expectations: This step involves using historical, strategic, and financial analysis to judge whether the company is likely to meet, exceed, or fall short of the expectations identified in Step 1. This is a probabilistic exercise, leading to multiple scenarios with attached probabilities, and thinking in terms of expected value. This step also highlights that low multiples don't necessarily mean low expectations; it's about performance relative to what's priced in.
  3. Act: Based on the analysis from Steps 1 and 2, make a buy, sell, or hold decision.
• Flipping the Traditional Approach: This framework inverts the common approach of determining intrinsic value and comparing it to the stock price. Instead, it starts with the stock price and works backward to understand the embedded expectations.
• Probabilistic Thinking: The importance of considering multiple scenarios and assigning probabilities is stressed, as opposed to relying on a single predicted outcome. This acknowledges the inherent uncertainty and overconfidence biases.
• Real-World Example (Mag Seven): An investor using this framework might have initially seen high expectations priced into "Mag Seven" stocks. However, some investors correctly identified that the reality would far exceed those expectations, leading to significant gains. This highlights that while base rates exist, unique company factors can lead to outcomes that defy them.
• Amazon Web Services (AWS) Example: Early analysis of Amazon's potential, even when the company seemed large and richly valued, involved sum-of-the-parts analysis to estimate the value of emerging segments like AWS. This demonstrated the need to look beyond current valuations and consider unknown growth engines.
• Value Investing Connection: For value investors, the bet is often that expectations for cheap companies are too low, and reality will be slightly better. This is about "genuinely awful becoming less bad," whereas growth investing is about "good becoming great."

Lesson 3: Multiples are Not Valuation

This lesson emphasizes the misuse and misunderstanding of valuation multiples.

• Shorthand, Not Valuation: Multiples (e.g., Price-to-Earnings, Enterprise Value-to-EBITDA) are a shorthand for the valuation process, not the valuation itself. The true valuation process involves calculating the present value of future cash flows.
• Understanding Economic Implications: While multiples are useful shortcuts for saving time and communicating, it's crucial to understand the economic implications behind them. Asking "What do I have to believe for this multiple to make sense?" is key.
• Earning the Right: Investors must "earn the right" to use multiples by demonstrating an understanding of the underlying economic assumptions embedded within them. This involves bridging the gap between how multiples are commonly used and the economic realities they represent.
• Implicit vs. Explicit Assumptions: Multiples contain implicit assumptions about future value creation, investment needs, etc. In contrast, DCF models make these assumptions explicit, allowing for debate and clarity. Explicit assumptions are vastly more attractive.
• Growth and Value Creation: Growth in and of itself does not automatically create value. Growth adds value only when a company is earning above its cost of capital. The spread between return on capital and cost of capital is paramount, and growth amplifies this spread. Negative spreads are exacerbated by growth.
• Real-World Application: Many analysts (reportedly nine out of ten) rely predominantly on multiples. This highlights the need for investors to understand the underlying assumptions to avoid falling into an "economic cul-de-sac."
• Analogy to Skill: The analogy of learning tennis is used. One can learn shortcuts to win against average players, but to compete at a higher level, one must understand the fundamentals and earn the right to use advanced techniques. Similarly, understanding the economic drivers behind multiples is essential.
• The Danger of Shortcuts: Shortcuts, including multiples, can become bad habits if not properly understood. They can lead to improper use and prevent learning. This is particularly relevant with the rise of AI tools like LLMs, which can easily outsource thinking if not used critically.

Lesson 4: The Paradox of Skill

This lesson, derived from Steven Pinker's work, explains why increasing absolute skill can paradoxically make relative skill less important and luck more significant.

• Two Levels of Skill:
  • Absolute Skill: The overall level of skill in a field. This has generally increased across various domains (investing, business, sports) due to better training, technology, and information access.
  • Relative Skill: The difference between the very best and the average participants.
• The Core Idea: As absolute skill rises and becomes more uniform, the gap between the best and the average shrinks. This means that even highly skilled individuals are closely matched, and outcomes are increasingly determined by luck rather than skill.
• Baseball Example: Since Ted Williams hit over .400 in 1941, no one has achieved this feat. While players are absolutely more skilled today, the standard deviation of batting average has decreased. This means that a top performer today might be a "three standard deviation event" historically, but the overall skill level is so uniform that breaching the .400 mark is incredibly difficult.
• Investing Application: In investing, the absolute skill level of participants is very high. However, this high and uniform skill is reflected in prices, making it harder to consistently outperform. The idea that reducing the number of active managers makes outperformance easier is refuted; the remaining active managers are highly skilled and tightly bunched.
• Luck vs. Skill Continuum: Understanding where a domain falls on the skill-luck continuum is crucial.
  • High Skill, Low Luck: When competing against significantly less skilled individuals (e.g., a pro tennis player vs. an amateur), skill is paramount.
  • High Skill, High Luck: When highly skilled individuals compete against each other (e.g., two professional tennis players), luck plays a larger role in determining the outcome due to the increased probability of errors or fortunate plays.
• Degenerate Tendencies and Moral Hazard: When skill is neutralized or its impact diminished, it can incentivize bad actors and lead to moral hazard. This can occur in areas where money flows rapidly, encouraging risky behavior that may lead to significant losses when tides turn.
• Practical Implications:
  • Focus: Understanding the skill-luck continuum helps determine where to focus efforts.
  • Humility: It fosters humility by acknowledging the role of luck.
  • Challenging Assumptions: It encourages questioning assumptions, such as the belief that simply reducing competition automatically leads to easier outperformance.
• Self-Assessment Questions: The chapter includes questions to help individuals assess their own application of these lessons, such as:
  • "Are we willing to start with base rates that might contradict our optimism?" (Humility)
  • "Do we have the right reference class?" (Choosing similar situations for base rate analysis)
  • "What are the base rates of our own judgment?" (Assessing the reliability of one's own decision-making)

The Importance of Journaling and Self-Reflection

The discussion highlights the critical role of journaling and self-reflection in understanding one's own judgment and decision-making processes.

• Tracking Decisions: Keeping a trade journal, as advocated by Brett Donnelly, is essential for cataloging experiences, data points, emotions, and the framework used when making decisions. This allows for reflection and study.
• Misremembering Thoughts: Humans tend to misremember their past thoughts and reasoning when making decisions. Writing things down provides an objective record.
• LLMs as Tools: Large Language Models (LLMs) can assist in this process by evaluating judgment over time, providing unbiased assessments, and cataloging thought processes. Asking LLMs to rank past decisions or compare them against reference examples can offer valuable insights into growth or stagnation.
• Earning the Right to Shortcuts: Similar to understanding multiples, one must "earn the right" to use shortcuts by deeply understanding the underlying principles. This prevents shortcuts from becoming detrimental habits.
• The "Torpedo Bat" Analogy: The rapid rise and fall of the "torpedo bat" in baseball illustrates how trends and tools can offer temporary advantages but may fade as others adapt or the underlying effectiveness is questioned. It underscores the need to understand why a tool or trend works, not just that it exists.

Conclusion and Call to Action

The podcast hosts aim to create a book that they themselves would have found invaluable years ago. They encourage listeners to engage with the draft chapters on their Substack (excessreturns pod.substack.com), provide feedback, and suggest future guests or topics. The goal is to collaboratively build a resource that offers practical, insightful lessons for investors and individuals navigating the complexities of life and decision-making.