We Study Billionaires - The Investor’s Podcast Network - TIP421: Expectations Investing w/ Michael Mauboussin

Starting point is 00:00:00 You're listening to TIP. On today's show, we have a very special guest, and that is investing legend Michael Mobison. Michael is head of consulate research at Counterpoint Global. Previously, he was Director of Research at Blue Mountain Capital, head of global financial strategies at Credit Suisse, and Chief Investment Strategist at Leg Mason Capital Management. He's the author of three books, as well as an adjunct professor at Columbia Business School, where he's been teaching the security analysis course for 30 years. I hope you're in a comfortable seat because we go on quite a ride with this one.

Starting point is 00:00:33 In this episode, we discussed Michael's early career working under the tutelage of Bill Miller, his introduction to the Santa Fe Institute and how it shaped his investing style, the three steps of what Michael calls expectations investing, the concept of reflexivity, the problem with investing based simply on multiples, the rise of intangibles, what are they, how to look through them, the golden rule of share buybacks and why they are controversial to some, how to calculate a company's competitive moat, how Michael has updated the security analysis course

Starting point is 00:01:01 at Columbia, how to determine your own cost of capital, and so much more. This was immediately one of my most enjoyable discussions I've had to date on this show. I have no doubt that you will get a lot out of this one. So without further ado, please enjoy and learning about expectations investing with Michael Mobison. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-rength. made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to the Investors podcast. I'm your host, Trey Lockerbie, and like I said at the top, I'm here with Michael Mobeson. Welcome to the show. Thanks, Trey. Great to be with you.

Starting point is 00:01:52 It's an honor to have you here. And I want to explore some things that I haven't heard you talk a lot about. I want to dig into your early career just for a minute because your career is obviously punctuated with amazing experiences, but one stood out to me in particular, And that was your time at Leg Mason, where you were chief investment strategist under Bill Miller. Bill's been a guest on our show, and we consider him a legend. And I've even heard you mentioned that he's been a big mentor for you. So I wanted to kind of hear about how you came to work for Bill and what impact he had on your investment style. Yeah.

Starting point is 00:02:23 So this story starts with a sort of, it's kind of a funny beginning. So I'm at first Boston. I'm the package food analyst. So I follow Kellogg and General Mills and all those kinds of companies. and one of our sales guys calls me up, and he says, I've got great news for you. I was like, oh, yeah, by the way, this is all pre-internet. Because I got great news for you. Bill Miller wants the even pages.

Starting point is 00:02:46 I was like, dude, what are you talking about? He goes, well, there's this really smart investor in Baltimore, Maryland, named Bill Miller, and he asked me to do two things. One is to flag every time I see a company with a 10% free cash flow yield, and second is to send good strategic reports about an industry or sector. He goes, you know, I wrote a report about the food industry and I sent it to Bill and I asked my assistant to fax it and only the odd pages went through and he wanted to read the even pages. So that's like a really good sign. So that was my first initiation with Bill was that, you know,

Starting point is 00:03:19 he was reading some of the stuff I had done. And then very quickly from there, I was able to meet with him and his team to talk about, mostly to talk about valuation. And I come from obviously this background of thinking a lot about discounted cash flow and how to apply that. I was actually using Alcar software, Al-Val of Al Rappaport, who ended up being my co-author and also a mentor of mine. And so I went down, and the first time I met Bill with his team, he just sort of sat me down very unceremoniously in a conference room. And he's like, all right, this is a guy who's going to tell us about valuation. So I just talked about valuation. So that was really the first point of connection was that I think we approached the world of thinking about businesses and valuation in very

Starting point is 00:03:57 similar fashion. In the mid-1990s, I think it was 1996 specifically, I was out with him at a baseball game and he's like, you know, you should really get to know the Santa Fe Institute. So I was at the time reading pretty broadly, a lot of biology, a lot in evolution, trying to think about how those things would tie back to economics and investing. So I was kind of prime for that message. And so I went out there in the fall of 1996 for the first time and I completely fell in love. I got to sit next to Bill. And we talked about the various presentations and had coffees between the sessions and so forth. And so from there, it was sort of this, a little bit of a meeting of the minds. And so Bill approached me a couple times to join the team.

Starting point is 00:04:35 But in the early 2000s, really when credit suites at the time was sort of the sell-side business was challenging and so forth, Bill sort of set it up in such a way that it was playing to all my strengths and all the stuff I love to do. So I joined that team in 2004. And it was just a phenomenal thing. And I guess I would just say about Bill, there are a few things that I deeply, you know, you mentioned you sort of like you guys are big fans. I mean, there are a couple things about him that are just amazing. The first is just an ongoing commitment to learning. And, you know, he's an incredible voracious reader and an incredible retention. And it's not

Starting point is 00:05:08 just in the world of business, of course. He's always got wonderful literature and so forth that he's reading. The second thing, he's all about ideas. I always find that very admirable. So in other words, he's not swayed by who's giving him the idea. He's swayed by the virtue of the idea itself and has very good taste and thinking about good ideas. And then the final thing, which I think is really hard to do from an evolutionary point of view, is he's not afraid to sort of do something or think about something new. So if you trace his investment career, he started running value trust in 1982 with Ernie Keeney. And they were very much Graham and Dodd, price to book, sort of very old school. Bill evolved to focusing on return on capital. And he focused on, you know,

Starting point is 00:05:46 the implications of technology and increasing returns. And as you know, the last half dozen years or so, he's gotten involved in cryptocurrencies and so forth. So he's really has evolved his thinking over time, is very open to new ideas and thinking about ways to make money. So anyway, that's a long-winded answer to a really great question, but it was a great organization, and he stands as a huge source of inspiration as a dear friend. Well, yeah, and the reason I brought up Bill is because I believe that success leaves clues, you know, and you talk about the Santa Fe Institute and how much that had an impression on you and how that might have shaped his thinking, so to speak. So I know You've had a number of years working with the Santa Fe Institute, being chair of the board,

Starting point is 00:06:24 etc. Maybe give us a glimpse of, or maybe even an example of a day you walked out of there and said, wow, hmm, that really changed my mind on something. Yeah. So the first, just by way of background, you know, the Institute was found in the mid-80s. And the original founders felt that academia had become very siloed. So the biologists talked to the biologists and the physicists to the physicists and the economists and the economists.

Starting point is 00:06:47 And most of the interesting and truly vexing problems in the world. light at the intersections of disciplines. And, you know, science has made incredible strides through reductionism, breaking things down into their components. But the argument is to go forward, we really need to unify different disciplines in some important way. So that was the mission. And if there's a sort of unifying theme, it's a study of complex adaptive systems, these evolutionary systems. And, you know, the simplest way to think about it is a bunch of different agents, whether they're investors in the stock market or neurons in your brain or ants in an ant colony that interact with one another, and then we examine what emerges from that whole set of processes.

Starting point is 00:07:24 So you get the sense of it, right? There are no disciplinary boundaries whatsoever. It's just interesting people pulled together. Let me maybe give two examples of things I think are super cool. One, and I think profoundly important in the world of investing, was Brian Arthur's work on increasing returns. Right. So if you take an economics class, and really this appeals to common sense as well, what you learn is that high returns on capital tend to be competed away, which makes sense. So T-Business is super profitable. I come along and I say, gee, I can do what T-D-Drey does and maybe charge a little bit less than he does. And so you have to match my prices and so on and so forth. And so we sort of migrate our way down to sort of earning our cost to capital. What Brian Arthur

Starting point is 00:08:08 talked about was under certain conditions and circumstances, businesses could actually enjoy increasing returns. In other words, these end up being winner take most or win or take all markets. And again, this is not broad. This is not everywhere you look, but under certain conditions, it could be true. And I think Bill was one of the first people to think about connecting that idea to markets and thinking about businesses and what the implications were. So that's one that was both intellectually interesting, but also could be very lucrative in a market setting. The second bit of work, and this is just sort of a side note, but it is the work on scaling. And this is probably most associated with Jeffrey West. He wrote a wonderful, beautiful book called

Starting point is 00:08:46 Scale for those who are interested in this topic in more detail. And just to set it up, Jeffrey is trained as a theoretical physicist, but he collaborated with Jim Brown, who's a biologist, who Brian Enquist, who was an ecologist, so people from different disciplines. So the simplest description of scale where they started was this idea of, you imagine just an X, Y chart, like one you would know, but the key is that the X axis, in this case, is on a logarithmic scale. So instead of 1, 2, 3, 4, 5, it is 1, 10, 100, 1,000. So the increments are the same percentage differences. So it's a log scale.

Starting point is 00:09:19 And then the y-axis, same thing, also log-scale. So on the x-axis, you put the mass, for example, of a mammal, so how much they weigh. And on the y-axis, you put their metabolic rate, which is basically how much energy they need. So mass and metabolic rate, you plot every mammal from a shrew or mouse to a blue whale. And they all fall on the same line on this log-log scale with a three-quarters exponent. Totally awesome, right? So this has been understood for about 100 years, more than 100 years, probably. I think it's called Clyber's law. This guy, Clyber figured it out. But no one knew why. So like the mystery was the why. And so Jeffrey, along with Jim and Brian, got together and figured out the why this particular scaling law works. And that immediately opened up a huge threat of research about scaling laws in other social systems, including cities and corporations. And so this. This is like really exciting stuff that is really coming out fast and furious. So cities also follow very fascinating scaling properties, as do companies.

Starting point is 00:10:21 We understand the mechanisms now for biological systems. I think the mechanisms for social systems are still being explored, which is super cool. So that has some implications for investing, for example, but maybe not as direct, but just a cool bunch of ideas, right? And that's just, I mean, this is just a tiny tasting. So there are many, many other things that are going on that are exciting and other whole initiative in collective intelligence. Collective intelligence work directly maps over to markets and market efficiency. So there are lots of parallels you can draw, but it's super fun going down the path, right? Because there's so many interesting people. And the last thing I'll say about

Starting point is 00:10:54 SFI is that almost by nature, it draws people or intellectually curious. Most of the scientists we have there have extraordinary street credibility in their own discipline, their core discipline, but they're obviously very interested in lots of other stuff. So that makes it so much fun because everybody walks around, everybody's actively open-minded, and just so every conversation tends to be a blast. So that's a little bit of the, a little bit about SFI. Incredible. Wow, that brings up a lot of ideas. My head is kind of spinning on where to go next, but I just noticed this kind of underpinning connection between what you're saying and a number of other investors we've researched. And as Buffett would explain it, it's almost like zoology. You need to become obsessed with the species of companies.

Starting point is 00:11:39 Do you find a similar thing with the people you're meeting with it and say, for example, at the Santa Fe Institute where there's this obsession with complex adaptive systems, whether it's a human body or the animal kingdom or the stock market? Is that the common thread kind of tying everybody together? I think so. And, you know, the question is, are there universal principles or broader principles that we can apply? And that's the key idea.

Starting point is 00:12:02 And even going back to our concept about scaling and biological systems to crack the code of that problem, they had to think about fractal geometry and energy dissipation and network theory. So there are a bunch of tools and concepts from various disciplines that had to come together. And I think you're exactly right. I think investing is very much the same thing, which is there are lots of pieces to try to click together to gain some insight as to what's going on. So yeah, I think in many ways it's the same thing. And the other thing I'll just say to be completely explicit about it, I think is the stock

Starting point is 00:12:32 market itself is one of the classic examples of a complex adaptist system. investors themselves are the agents in that particular model. They're interacting with one another, right? So we're buying and selling securities in different order of sizes and so on and so forth. And what emerges from that is this thing we call, in quotes, the stock market. But the key to emergent systems like this is that the properties and characteristics of the system, in this case, the stock market itself, are quite distinct from the underlying agents, right? So you can't really learn about an ant colony by studying ants. You can't really learn about the stock market by studying individuals. It's really the collective behavior that is really important to understand. And that leads

Starting point is 00:13:10 us immediately into discussions about the conditions under which markets are efficient, so sort of the wisdom of crowds, and then the conditions under which markets tend to go haywire, which is a madness of crowds. And we know that both of those things are useful ways of thinking about markets. The question is, which regime are we in and how do we think about that? Amazing. Well, I love kind of hearing about those earlier days because you've now become a legend in your own right and had amazing success and have just written some of the best literature on investing that I've ever come across, including expectations investing, which you just re-released as an updated version. And I got to say, I was very happy to read this new version. I'm kind of curious.

Starting point is 00:13:48 The original came out 20 years ago, and you've been an adjunct professor at Columbia for now, about 30 years. Was part of the incentive to update the book just in an effort to keep students engaged in that class with relevant case studies? Yeah, I think so. Trey. Actually, that is a big motivation. You know, the first thing I'll just say is the first version of the book, it had really bad timing. It came out in September 2001 right before 9-11, you know, in the middle of a bare market. So at the time, we sort of contracted to write the book, the world was much better, investment world was much better. And that was difficult. But the second motivation is much more what you just described, which was a few things.

Starting point is 00:14:24 One is clearly the world continued to change, including accounting changes and, you know, the rise of intangibles. And the second thing, as many of the case studies, as you just pointed out, were no longer relevant. Our prime case study before was Gateway. We're like, let's pick a company that'll be around for a long time in Gateway 2000, which ended up going away like two years later. So that was not such a great choice. And so like young students, young people have never heard of it before. So that's not very helpful. And then very much to your point, teaching this, this is part of my course. It's not the whole course, obviously, but teaching this allowed me to understand what works and what doesn't work,

Starting point is 00:15:00 you know, what things I should emphasize or de-emphasize and so forth. So I had a little accumulated experience over the years that I also think was helpful. So it was a combination of those things. Al Rappaport, who's amazing and another just extraordinary mentor of mine, so much fun for me to work with him, for the opportunity to collaborate with him yet again was a real thrill for me. So super fun. And I have to say that the COVID lockdown actually also probably helped. The fact that we knew we couldn't go anywhere and we were sort of sitting around. So let's try to be productive. So it was really a combination of all those things that encouraged us to do it. And for me, the journey of these things is really the payoff. It's so much fun to go back

Starting point is 00:15:39 through the idea, see what stood that test of time, see what didn't. Yeah, so that was the basic motivation. I absolutely love this book because it flips the idea of valuing a stock simply based on its future discounted cash flows essentially on its head by backing. into the price, which is obviously known. This philosophy actually inspired our own TIP finance tool, and we use this exact concept now to determine the intrinsic value of a company. I'd love if you could walk the audience through the three steps of expectation investing and kind of break down each step. Yeah, and T. I'm glad. I'm excited to hear the TIP. You guys are doing this because it makes sense to me, and I hope you feel like it does give you some insight as you go through it.

Starting point is 00:16:20 So as you describe, there's three steps of the process. Step number one is to understand the expectations that are baked into today's stock price. And the way we try to do that is to use value drivers. We are driving this from a discounted cash flow model, but the big value drivers are things like sales and margins and investment needs, basically. So CAPEX and working capital and so forth. And to do that, we try to go to different sources, primarily, you know, sort of consensus estimates of these things. You can get these things from different services and analyst reports and so forth. There's art in this part of the process, just to be clear, but the question you're trying to answer is, what does the market believe to get to today's stock price or what does one have to

Starting point is 00:16:59 believe to get to today's stock price? So if I want to, you know, just use a metaphor for that, to sort of like where the bar is set, how high is the bar? And then step two is introducing strategic and financial analysis along with understanding the history of the organization or company or industry and assessing whether that set of expectations is too high, too low, or about right. And what's essential about step two is really scenario analysis. You're trying to now stress these things and say, for example, sales is really important, how good could sales be? So what's the high range of sales growth rates? How bad could sales be? And what is essentially what's priced in. So you're doing if then scenarios. And that's important because that drives these value

Starting point is 00:17:40 outcomes that you need to assign probabilities to. And then once that has that step one and two are done, now you have an expected value and you can take that expected value and compare that to the actual stock price. So you know what's priced in. You have ranges of things that could possibly happen. And it's the difference between the price and the expected value that becomes the determinant of whether you should buy or sell or hold the stock. So that's the basic process. It makes sense. It's a lot of the same tools that people use every day. But like you said, you're using them backward, you're using backward versus forward. There are a couple of nuances in here, I think, are important. One is we dedicate a whole chapter to it is chapter three.

Starting point is 00:18:15 They call the expectations infrastructure, which helps guide a structured way to think about these if-then scenarios. And so often people are not as disciplined as they should be in doing scenario analysis and making sure that you're capturing the impact of things like economies of scale and operating leverage and so forth. And then again, just making sure that you're thinking about things strategically. So you're embedding these assumptions against a backdrop of an industry structure and a competitive set to make sure that what you doing makes a lot of sense. And then the last thing I'll say is, we don't spend a ton of time about it in the book, but it's really important, which is one should appeal to so-called base rates. And base rates are

Starting point is 00:18:53 essentially the history of performance of all other companies to see how your company might work. So, for example, as I'm just make this up, you're looking at a company with $5 billion of revenues and you want to know what the sales growth rate distribution might look like for the next three, five or 10 years. Well, you can obviously do your bottom up forecast. The other way to do that is to look at all companies of $5 billion in history and say, okay, what was the observed distribution of growth rates, and then sort of make sure that what I'm doing makes some sense in that context. It may be different than that, but unlikely to be wildly different. And so it's a really good way to ground what you're doing in a sensible way. So there are a couple little wrinkles I would

Starting point is 00:19:29 add on. They're analytical tricks that can help you be even more robust in the process. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to a lot of, expose human rights abuses and building technology under censorship and authoritarian pressures.

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Starting point is 00:23:45 Another idea or concept in the book is this idea of reflexivity. In the book, you mentioned that investors devote insufficient attention to the idea that a stock's price can actually impact its future performance. Do you have an example that you could provide of this? Yeah, the first thing I'll just say is that certainly if you study finance, there's a sort of premise that the stock price is a reflection of the fundamentals, right? So it's almost like a camera is taking a picture of the fundamentals and trying to express it. And what we know is that there's actually a feedback between these two things. So the stock price itself can shape the fundamentals and then fundamentals and then, okay, so you get the idea there are these feedback loops. I mean,

Starting point is 00:24:24 the idea has been around for a very long time, but George Soros put the label of it called reflexivity. Tray, I think probably the best example we've had in the last half dozen years or so is probably Tesla, which is it became a stock that was very popular with a subset of investors. It drove the value, the stock price up a lot. And, you know, it was a company that even Elon Musk conceded was short on cash in a couple spots, you know, was in sort of difficult spots. But as the stock went up, the company quite wisely took advantage of it. I think the number is in 2020, for instance, they raised something like $12 billion of equity, selling equity. And that, of course, allows them $12,000 a lot of money to build factories and to support the operations and so on and so

Starting point is 00:25:06 forth. So the very fact that the stock went up really helped them get the capital they needed to actually fulfill the objectives they had in the first place. And so there's a good example where had they not had access to that capital because of their stock price, they may not have been able to do the things that they've actually done. So I think that's a really good example. This is not a commentary on Tesla one way or another, but I think when you look back over the last, again, half dozen years or so, This is a pretty good example of something that fits that pattern where the fundamentals and the stock price themselves reinforce one another. Funny enough, that's the exact one that came to mind when I was reading this. So I'm glad you touched on that.

Starting point is 00:25:42 Yeah, it's almost like this self-fulfilling prophecy that's a reaction instead of causation. So very, very interesting. You know, on this show, I've also been exploring the concept of garb investing. It's fairly new for me. And I've been coming to the conclusion that multiples, like the price to earnings, multiple, for example, barely matter in early stage investing, meaning like, say, Tesla's early stage on the stock market, and similarly, other high growth companies. As I was reading your book, I started to question whether any multiple is useful at any stage. So you've often said to your students that you have to earn the right to use a multiple. What do you mean by that exactly? Yeah, so the answer is that a multiple has to capture a lot of stuff that's going on. And the two biggest drivers would be the return on invest in capital of the business and the growth. And why are those two things so important? And this, I think, is quite intuitive. If your returns on capital are well

Starting point is 00:26:41 above the cost of capital, you're creating value and growth is good. And you know Warren's work very well. Warren Buffett calls us the $1 test. So if you invest a dollar in the business, and it's worth more than a dollar in the marketplace, that's a good thing. So that means you're earning above your cost to capital. If you're earning exactly your cost of capital, their growth makes no difference because every dollar that goes in is worth a dollar. So you're getting no lift in value. And then, of course, you're investing a dollar and it earns below the cost of capital. That's bad, right? The more you grow. So the first thing you have to think about is return on invest a capital. And the second thing you have to think about is growth. And the impact of growth is

Starting point is 00:27:14 contingent on the return on invest in capital. So all that stuff that's going on is built into a multiple. So you have to really unpack it. Now, to your point, the reason this is so difficult for young companies, there are a bunch of reasons. One is the range of outcomes is huge. So we don't really know what the returns on of us at capital are. We don't really know what the growth is. And it's compounded by the fact that often young companies have to spend a lot of money on what we call pre-production costs. They basically have to spend money to get up and running. And as a business person yourself, I'm sure you can relate to this concept where you have to spend, you have to invest, essentially to reap the benefits down the road.

Starting point is 00:27:49 And you don't really know how much that's going to be. And the economics don't look. They may be very good, but they can superficially look quite poor at the outset. I was like to say, you open a restaurant, the very first day you're open. You spend a ton of money building the store and putting in the furnishing and hiring people. And you have no revenue, right? So day one, you don't look so good. It may have been a brilliant restaurant, but it takes some time for that to unfold.

Starting point is 00:28:11 So that's why I think your observation that it's tougher to do for young companies. You know, you could still run through scenarios. You can think about things, but that becomes more difficult. It turns out it probably gets easier as you go on. And we always like to say the Grim Reaper of multiples is basically the, we call it the commodity multiple. It's just the inverse of the cost of capital. So pretend the cost of capital is 8% and you earn a dollar. That means the Grim Reaper multiples 12 and a half times.

Starting point is 00:28:38 One over 8% equals 12 and a half. And eventually if all companies earn the cost of capital because of maturation or competition or whatever, that is the multiple toward which they will migrate. So eventually, Bruce Greenwald, my colleague at Columbia Business School has got this great line. He says, eventually everything's a toaster. What he means is like, eventually it all becomes a commodity, right? And you get back to that commodity multiple. So earning the right of using a multiple means that you understand the underlying drivers that support that multiple. And I'll just mention one other thing, Trey, not to go too long on this topic, but I think it's important. Recently started

Starting point is 00:29:15 my 30th year teaching Columbia Business School, and we're going to be talking about this exact topic in a couple of weeks. So there are sort of the two most popular ways to value businesses are the price earnings multiple, right? So the stock price divided by earnings, usually some sort of forward-looking earnings. And the second is enterprise value to EBITDAs. Enterprise value, most simplistically is the market value of the debt plus the market value of the equity, and EBITDA earnings before interest, taxes, depreciation, and investigations, or it's sort of a gross cash flow number. Well, here's an interesting thing I point out to my students. By the way, the correlation between those two is about 0.7.

Starting point is 00:29:45 So high PEs and high EBDA multiples usually go together. Low, okay. But what I show my students are instances where two companies have the same PE but radically different EVD EBDA multiples or the same EVD EBDA multiple and radically different PEs. Now, what's up with that? So these are the two most popular metrics. Which one do I pick and why? And so immediately when I point that out, you're going to say, well, I need to know more.

Starting point is 00:30:11 Exactly. You need to know more. And then we're going to go right back to where we were before, which is, I need to understand, you know, how the accounting works and how the cash flows work and how the returns like capital work and so on and so forth. So the key is earning the right of the multiple just means that you sort of understand the underlying drivers of businesses. You understand the return on capital characteristics. And then you're using a heuristic based on all this information you have embedded. And by the way, I use multiples myself as a backdrop. There's nothing wrong with them. But I just think this idea of walking around saying that's 15 times. That's 27 times. Without understanding what the implications are, it's probably not a great way to go. So going back to your restaurant example, it just came to mind a very tangible business, right? You know, real estate and book values and things like that. But you mentioned earlier this rise of intangible. So also keeping on the theme of earnings that actually don't create value necessarily, I love to break down the idea of intangibles for the audience. Let's first walk through what constitutes and intangible and how it's,

Starting point is 00:31:11 expensed and then maybe how it could actually even distort a company's earnings. So a tangible asset, a physical asset, it's very much what it sounds like, right? Something you can touch and feel, move. So think about factories or machines, inventory, stuff like that. An intangible asset is by definition non-physical. So what should conjure up is brand building, training, software code is considered to be an intangible. So these are, in quotes, softer things. But, of course, as you know, important for building value. Now, what's happened is our global economy has transitioned from a reliance on tangible assets. So think back to the year 1900 and, you know, sort of the dominant organization would be something like U.S. steel. So you have these big furnaces and you're moving steel around and so forth. That's very tangible. And then if you think today of the most dominant companies, you're thinking mostly companies that have intellectual capital. So you're going to think about the Googles of the world or big pharmaceuticals.

Starting point is 00:32:08 pharmaceutical companies or something where the primary thing that drives the value are recipes or ideas or algorithms or software, basically. So that's how the world's changed. And to put a finer point on it in the 1970s, tangible investment exceeded intangible investment by a factor of about two to one. And today, that relationship is completely flipped. So intangible investment is twice as big as tangible investment, right? So that's the first thing. As a level set is, our global economy has transitioned. By the way, if you think about it, it makes sense. We've gone through other transitions before. Now, the second interesting question is how this is accounted for.

Starting point is 00:32:45 So a physical asset, and let's just say like a restaurant might be a good example, or a factory, you have to spend the money today to build it. And the accountants would say, hmm, this is going to deliver value for some period of time. Let's just make it up, say it's 10 years. There's something in accounting called the matching principle. What we want to do is it match the expense over that full period of time. So you'd spend $1,000 on your factory. and then we depreciate that factory over 10 years, so $100 a year for 10 years.

Starting point is 00:33:12 And that depreciation shows up as an expense, but that's it, just one-tenth of it per year over time. Intangibles investments, by contrast, as accounts are like, hmm, we're not sure about the payback. We're not sure about the useful life. And to be conservative, what we're going to do is expensive. So it's all an expense day one. So even if you spend a lot of money on R&D or a branding campaign and you're completely

Starting point is 00:33:35 persuaded that there's a multi-year payoff, accounts are going to say too uncertain, so we're going to expense it all. So again, the same investment in a tangible investment will go on the balance sheet and be depreciated, whereas the intangible will go on the income statement and be expensed. Okay, so let's try to make one more concrete example. Let's say, Trey, that you have a subscription business, right? And you want to get people to buy your subscription, and on average, when they buy your subscription, they stick around for five years. Well, the way to break it down is, there's going to be some cost to acquire those customers, right? Whether it's your marketing, spending or whatever it is. And then you're going to get some stream of cash flows, again,

Starting point is 00:34:12 contractually for the next five years. And let's say that's a great investment. In other words, the cash flows you're going to get over five years is worth a lot more than the cost to get those customers. So it's an economically really attractive proposition for you as a business person to do this. What's going to happen to the accounting? It's going to look horrible, right? Because the faster you grow, the more of these upfront expenses you're going to be shouldering, your earnings are going to look horrible, even though you're building value every single day. Now, the parallel back in the traditional world, the tangible world, was Walmart. You know, Walmart, for the first 15 years, it was public, had negative free cash flow.

Starting point is 00:34:47 So they earned money, but their investments were bigger than their earnings. So they spent more than they made. Right. And by the way, when you're negative free cash flow, it means you have to raise capital. That means you have to raise equity or debt or whatever it is. And Walmart did that for the first 15 years. Was negative free cash flow problem? No, it's fantastic.

Starting point is 00:35:03 because the stores they were building were wonderful, great returns on capital. And so the faster they grow, the more wealth they would create. Again, negative free cash flow, but really good economic propositions. So this is what's happening in the world today is that as we've transitioned from one tangible world to an intangible world, even good unit economics, good businesses, they're going to appear very different than they did in generation or two before. And as a consequence, you have to be careful about relying solely on earnings. The report we wrote about this was called one job. And the argument was the one job of an investor is to understand the basic unit of analysis of the business. Is it a store? Is it a customer? And that really should be guiding how you

Starting point is 00:35:48 think about how the company invests and what that means for valuation. So I hope that was clear enough, but that's the basic distinction. And I think it's very exciting because by the way, how do you, if you want to sort of deal with it, one of the ways to deal with it is to capitalize those intangible investments. So basically what you're saying is we're going to treat brand spending or training or whatever it is or R&D just like a factory investment. We're going to put it on the balance sheet and then amortize it over some period of time. And so when you do that, again, you change the picture quite dramatically. The cash flow stay the same at the bottom line, but the path to get their changes quite dramatically. So it's a really exciting area. I tell my

Starting point is 00:36:27 students, I'd be fired up about this because we don't really know how to do this, right? Like, all this stuff is happening pretty fast and pretty new and there really aren't established standards to do this consistently. In fact, obviously, the accounting standards haven't changed at all or not much. So it's a pretty exciting time because if you're just one little step ahead of everybody else, you might be able to do okay. I think the idea of intangibles is pretty easy to understand, especially when you bring up a company like Google, let's say. But I'd like to cover another case study from your book, which is this other high-flying tech stock. And it's really interesting because you wouldn't necessarily think it's an intangible investment, so to speak,

Starting point is 00:37:04 but it seems to have been a tangible that's evolved. And it might surprise the audience a little bit to know that I'm referring to Domino's Pizza. And interestingly enough, the stock price today is quite close to the stock price analyzed in the book, which I found interesting. So it's really applicable. I encourage everyone to go look into that. Anyways, talk to us about the idea of even a company evolving into this and where else you know you might be seeing that happen? Is it just inevitable because of the internet? Are there other companies that are actively making this change? Yeah, super interesting. And Trey, I'll just say, you know, I'll sort of state the obvious. I think everybody would agree with this is that all businesses have some mix of tangible and

Starting point is 00:37:42 intangible, right? So there's what I'm just saying is a pendulum swinging a little bit, but all companies have components of it. And by the way, I should mention Walmart, which I sort of put into the tangible bucket, but one of the things that distinguished Walmart in the 1970s was really their use of technology. So in a sense, they were ahead of the curve and the intangibles may have been the secret sauce that really allowed them to do so well. Domino's, most people know Domino's pizza is basically a franchise business. They own some stores mostly for R&D purposes and so forth. So the vast majority of their stores are owned by franchisees. So the economics of the business are pretty

Starting point is 00:38:11 good because they're essentially taking a percentage of revenues. But the key for them is the health of their franchisees. They want their franchisees to do really well, make a lot of money, to grow, because of course that helps the parent. So there are two ways in which Domino's is really a big and tangible business. The first is that they work a lot on technology that allows their franchisees to be effective. So this is from how they lay out the stores to ordering systems, to labor management systems, and so forth. There are ways to ultimately help the franchisees anticipate demand and so forth. And so that's all very technology-laden. And that's something where they can add a lot of value. And they have a lot of consistency through the franchise system that

Starting point is 00:38:50 allows them to be very effective and sort of ahead of the curve on that. By the way, they're one of the first companies to be mostly digital, and that really helps too in terms of information gathering. And then the second big function, which happens mostly at the parent level, is just advertising. So obviously, you see these ads on TV all the time or wherever you are, and that's something where they can do this in a fairly centralized and efficient fashion with a national footprint. And again, advertising is sort of the classic and tangible investment. It plays on the air, and it goes away. They spend the money. And that's it. So, of course, it drives the business. It drives the brand value, drives the perceptual.

Starting point is 00:39:23 It drives a perception of trust and so on and so forth. But the accounts will say, you know, you spent a lot of money on December 31st of the year and next day it's worth nothing, which just doesn't seem to make any sense. So, yeah, I think it's a good example of a business that's relied on technology and advertising and intangibles in particular to distinguish itself. We picked it is because it's a stable business, but it's a great business. It's really done very well over a long period of time, generates a lot of cash and it seems to be very well managed.

Starting point is 00:39:50 Yeah, and just leave this out there, but the PE is 40, right? now, which just raises a lot of questions to dig into more. So shifting gears a little bit here, I'd like to talk about the chapter in this book on share buybacks. It might surprise some of our listeners to hear how controversial share buybacks can be. So for example, Charlie Munger has said that spending $1 over the intrinsic value of a stock using a buyback is basically deeply immoral or unethical, whatever word he used. But now I think we can agree as being a bit cheeky here because obviously we can't know the intrinsic value of a company down to the dollar. But there are a number of ways that buybacks would be very controversial.

Starting point is 00:40:29 What is, as you put in the book, the golden rule of share buybacks? Trey, I just say, I don't get this. Why is controversial? And I find it to be, it doesn't make any sense that people are so against these things or they don't seem to understand them and so on and so forth. So it's very frustrating. The golden rule of buybacks that we lay out is a company should repurchase its shares only when the shares are below expected value. And you mentioned intrinsic value, but you might think

Starting point is 00:40:53 about those terms loosely interchangeably. And there are no better investment opportunities out there. And so the first part of that is buying back below expected value. That's sort of the munger point. Now, maybe I can build on that a little bit because we also have a chart in the book or a table in the book where we talk about this. And I like to call it the value conservation principle. So just to parse a couple different ideas, let's say you're a company and you're worth a thousand dollars. It's say it's all cash, right? Just to make it easy. And then you say, we're going to buy back $200 worth. So you're going to go from $1,000, you're going to give $200 back, and then you're going to be worth $800. So the value of conservation principle says, it doesn't matter if you buy back

Starting point is 00:41:31 stock with the $200 or pay a dividend with the $200 or burn the $200 in the parking lot. Right? The value of the firm's going to go from $1,800, full stop, because that money is no longer in the house. It's now out of the house. Where the munger point becomes important is this idea of your relationship with expected value or intrinsic value. So if you're buying back overvalued stock, what happens is the sellers are benefiting at the expense of the ongoing shareholders. So the value conservation, there's a group that wins, which is the sellers, and there's a group that loses, which is the ongoing holders. The value of the firm itself, it would have said it doesn't matter. The second scenario is if you buy back undervalued stock, which is what we ultimately want

Starting point is 00:42:11 companies to do and what the Golden Rule talks about, in which case, the selling shareholders lose and the ongoing shareholders win. And that's really the pivotal idea. Now, I agree with monger in the sense that an executive should understand a little bit of where their stock is and what the expectations are. In fact, the whole inspiration for expectations investing the book was Chapter 7 from Al Rappaport's original book called Creating Shareholder Value and Chapter 7 was called Stock Market Signals to Managers and basically said implored managers to use the expectations approach to understand. So Al was talking about this. This is back in the 1980s, and he was talking about it even before that. So most executives just sort of knee-jerk think their stock's undervalued,

Starting point is 00:42:53 but you can do a much better job to understand that more effectively. So, you know, that's the value conservation principle. And then the other thing is no better opportunities exist, which is, you know, ideally we'd love to see companies invest in their operations. So capital expenditures or working capital or other things that would build value within the organization, typically you know what's going on in your own company best, and so you have good information and so forth. There may be opportunistic mergers and acquisitions. It's hard to create a lot of value with M&A, but it can be done. So that might be a better use of capital.

Starting point is 00:43:23 But absent those things, if your stock's undervalued, buying back stock makes you enormous amount of sense. Now, the last thing I'll say is under very, very strict conditions, including assumptions about taxes and timing and so and so forth. Buybacks and dividends are essentially equivalent to one another. But what's interesting is no one thinks about them that way. executives don't think about them that way at all. They think of dividends as like a quasi-contract, deep commitment. And so when they pay a dividend, they're low to ever cut it and they want to raise it and

Starting point is 00:43:49 so forth. And buybacks, they think of this kind of discretionary, you know, like, hey, you know, we had a pretty good year. We paid all our bills. We got a little bit of money sitting around. Like, what do we do? Let's buyback stock. There can be very much of a different mindset. And that's borne out by the numbers and the variance of buyback activities a lot higher than the variance of dividend payments, not surprisingly consistent with that, even though on paper they should be essentially the same thing. So those are some thoughts. And like you said, Munger was probably being a little bit cheeky, but the point is buying back overvalued stock or buying stock for the wrong motivations can be detrimental to ongoing shareholders for sure.

Starting point is 00:44:24 Yeah, one of those reasons being, you know, just boosting the earnings per share. That would be definitely qualify, I think. But there's an interesting thought here also around the idea that if a company, their insiders, start selling the stock for a certain reason. And you can call it insider trading. But if they're buying the company back, you know, based on the perfect information, as you've put it, that they have, essentially, it's looked at as only a benefit. I just find that kind of interesting. Yeah, I mean, the thing is that, and I'm not fully versed on the insider literature,

Starting point is 00:44:52 but I think there's a much weaker signal with selling stock than there is for executives than buying stock. So if you're an executive, you own a lot of stock, they usually have these program where they're selling a certain amount of stock all the time and so on so forth. you know, because it's a tricky thing to do legally and so forth. So I think there's usually not much of a signal there. There is a big signal when they're buying back stock, the company's buying back stock. So I might separate those two things a little bit, but you're exactly right. People have very different reactions to these various things for whatever reason.

Starting point is 00:45:18 I'm also interested in it because a big part of my thesis for continuing to hold Berkshire as long as I have is the idea that once Charlie and Warren pass on, there will inevitably be more buybacks that occur. I would just imagine because you'd no longer have these allocators at the helm. You've got Ted and Todd, and you definitely got a cohort of talented people that are going to take the reins and a jeet, etc. But there are, sometimes that can trigger the end of a company. GE comes to mind, you know, when they started doing lots of buybacks. And it's sort of the beginning of the end or the decline. If that is the case for Berkshire, would you analyze it any deeper than that? Or do you think it's, I'm not even sure if you agree with my thesis, but it's something

Starting point is 00:45:57 that is a big part of it. And I'm curious if you look at it the same way. Yeah, no, I don't disagree at all. By the way, I should mention that Todd Combs was in my class, 2002. These are one of my students many years ago, 20 years ago, and just a wonderful guy, very, very thoughtful. So look, I think that the answers to all these questions are conditional, but by and large, what we know is that older companies, more mature companies, often are profitable and have fewer investment opportunities. And as a consequence, if you're, you know, it's basic math, if your returns are high and your growth is relatively modest, you're going to generate excess cash. And that is excess cash that should be returned ultimately to the owners of the business. And so

Starting point is 00:46:34 things like buybacks and dividends are going to make a lot of sense. And so Berkshire now is obviously very big. Some of the businesses in there are reasonably mature. And like you said, the game has played extraordinarily effectively, is that you have probably the world's greatest capital allocator sitting at the helm for 50 years. And some point that ends, there will be others that can allocate capital effectively. But it's just given the side, and by the way, they're buying back stock now, obviously, right? So given their size and profitability and prospects, I think that does make a lot of sense. Now, the key question then becomes, what is the intrinsic value of Berkshire Hathaway? Are they doing it appropriately? Now, if you know that Warren and Charlie are buying back the stock, you can probably be

Starting point is 00:47:11 pretty comfortable that they are very sure that the stock price is worth more than where it is today or the intrinsic value is higher than what it is today. And I think they've said it on record many times that they would not buy it if they didn't think that was the case. So yeah, it's hard to argue with any part of that thesis, you know, being very big, it's hard to grow fast when you're big to state the obvious. So it's hard to just to deploy a lot of capital when you're really, really big. And so if you're profitable and you're big and you're in relatively mature markets, giving money back to the shareholders is a natural thing. I mentioned Walmart having negative free cash flow in their first 15 years. Walmart now is a fairly mature business, hugely cash generative. It's where it should be

Starting point is 00:47:46 in its life cycle. So they're going to do all this. And Microsoft, even Apple, they're growing pretty fast. You know, big companies very profitable. And so these guys have a lot of resources to return capital shareholders. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up. And customers now expect proof of security just to do business. That's why VANTA is a game changer.

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Starting point is 00:51:12 fundrise.com slash income. This is a paid advertisement. All right, back to the show. One interesting discussion point right there was reminding me of this idea of comparing a return from an investor to their assets under management or even adjusting in that way because Buffett has actually underperformed the S&P for quite some time. But if you look at it on a percentage basis, you could say that that makes sense. But if you compare it to the size that you just mentioned, He's pulling out incredible amounts of cash and not necessarily comparing him to the S&P might be the best comparison. But if you look at other investors, is there a way that we should be measuring their returns

Starting point is 00:51:52 differently based on the actual cash they're pulling out rather than just comparing a percentage? Yeah, Trey, I think this is a really fascinating question. And I think the answer is yes, by the way. And the model for that is a model that was originally developed by Jonathan Burke and Richard Green's paper. It's probably 15 or 20-year-old paper. And they lay out an idea, I'm going to call it gross value added, but the idea is pretty intuitive, which is what they argue you should look at is the gross returns of the fund, when I say gross, I mean pre-fee, minus the benchmark return. So you're going to do a little risk adjustment and before fees. So there's going to be some spread. And that spread times assets under management. So what you're doing is translating these percentages into dollars, exactly to your point. And so as an illustration in one of their papers, they give this example that, in the first five years that Peter Lynch was running Magellan, he had these insanely high

Starting point is 00:52:45 excess returns, but he was running very little amount of money. So the dollar extraction was actually quite modest. And you might think about that as equivalent as being like a great poker player playing at a small stakes table, right? You're going to clean up, but there's just not a lot of money to make because the stakes are so small. By contrast, in his last five years, his alpha, his excess returns are still positive, but they're vastly smaller as a percentage. But he was managing a gargantuan amount of money. So his actual dollar value extraction was vastly higher. So, I mean, there's some argument that that's the way to think about the world. And by the way, if you run a big pension fund, it doesn't matter for us as individuals, you and I, but you're running some

Starting point is 00:53:26 big pension fund or endowment or whatever it is, you know, you have to focus on making dollars, not percentages. I mean, they often go together, but you need to make dollars. And so I think that gross value added the Burke and Green model is a very useful way to think about it. And in fact, they've extended that research into thinking about how to identify a skill and argue that this measure is probably a better indicator skill. And by the way, we actually calculated this GVA gross value added back to the 1970s for all mutual funds in the United States. And what we found is the aggregate number is positive, like $1.6 trillion or something like that. But it turns out that that is all pre-fee. It turns out that's roughly equivalent to the fees over the same period. So the active

Starting point is 00:54:04 management community has basically earned the market rate of return. It earned better before fees and then charged fees and basically came out to something neutral. So that might be one way to think about that. And that's why you say things like, you know, Berkshire Hathaway owning a large stake in Apple is meaningful, right? Because it's a big company. So when that thing goes up, it moves the needle for Berkshire Hathaway versus owning a stake, even a meaningful stake in a relatively modest-sized company, even if it does really well. It just isn't many dollars in terms of moving the needle. So sticking on that investment, you know, Buffett's appeal or the appeal of Apple to Buffett was obviously its competitive moat. He did it very qualitatively, I think, as he would

Starting point is 00:54:43 put it going around asking people if they could live without their phones. Everyone said no, right? So it's easy as that. But you've written this unbelievable paper on how to actually calculate the competitiveness of a company, essentially the moat. And can you provide an overview? I mean, it's a long paper, but maybe you just hit the high notes here on how you would go about calculating the competitiveness of a company. Maybe Apple's a good example. So there's a, I mean, there's obviously a qualitative aspect to this, but it's also at the end of day quantitative. So this is not just, you know, academic. The end goal is earning a return above your cost of capital, right? So we mentioned before a return on investa capital. That's

Starting point is 00:55:18 precisely what we're after. So we want high returns on investa capital. And I would even say further, the definition of a competitive advantage is high return on investic capital relative to capital. So that's the absolute bogey. And then the relative bogeys, you're better than your competitors. Measuring the mo, we put into three different parts. The first part is we call it the lay of land, which is trying to understand what's going on. So there are a set of tools that you would pull out for that, including what we call an industry map. So basically laying out all the players and the competitors and understanding where your firm fits into that whole schema. Second would be things like a market share test. So does market share move around a lot in this industry?

Starting point is 00:55:53 If it doesn't, that tends to be an indicator of stability and has potential competitive advantage. If market share moves around a lot, it's hard to stick in one place. We look at things called profit pools. So we look at the economic gains for each of the participants. Who's making the money? Who's not making the money? I mean, Apple's an interesting example in the smartphone market. They're not that big a share of the smartphones, but they're very high share of the profits, right? So their profit pool is very rich. And then we look at entry exit. So are there companies trying to come in or out? And that's also an indicator. Barriers to entry are really important for competitive energy. The second phase, then, is the industry. And the classic

Starting point is 00:56:27 way, I think, to do that still today is Michael Porter's Five Forces, very powerful. I would just mention there's a wonderful book by Joan McGrata called Understanding Michael Porter. So Michael Porter is not that easy for fun to read. Joan McGrata does a beautiful job of summarizing his work. So McRae. And then we also like the Clay Christensen work on disruptive innovations. That might be part of the industry piece. And then the third and final component is the firm specific source of advantage.

Starting point is 00:56:54 And the generic ways to think about that would be the differentiation, which is typically a high margin, low capital velocity, and then the other was low cost producers. And by the way, at the end of measuring the mode, the report, we have a checklist and that checklist is really meant to guide you through this process. The first time, a first couple times you do it for an industry, or a company, it's a little bit of work, but you sort of get better at it over time, like you train. And then the checklist allows you to sort of think about the stuff that's relevant for what you're looking at. And that's a really good way to go at it. Now, I'll just say, as a side note, that measuring the moat was one of the top three hardest things I've ever done.

Starting point is 00:57:27 And it's not because there are any original ideas because there aren't, but it's really, it was like an extraordinary task for me of synthesis. So how do we pull these various things together, put them in one sort of flow process that allows people to do that type of analysis effectively? We'll make sure to have a link to all those resources, including your paper and the show notes. I want to talk about the security analysis course originally developed by Ben Graham, David Dodd, and it's what drove Buffett to Columbia many years ago. you've been teaching it, as you said, going on 30 years now. I recently had Morgan Housel on the show,

Starting point is 00:58:02 and in his book he discusses how Ben Graham, apparently on his deathbed, said he would essentially not be using the same concepts he wrote about in his book. Essentially, they had just become too outdated. So I'd love to kind of hear how you've approached security analysis since the days of Ben Graham and iterated upon it and give us an idea of what the course looks like, especially for those like me who will not have the privilege to attend. Yeah, exactly. I do think, you know, I started teaching the course, this is the end of January. I started teaching the course very recently.

Starting point is 00:58:34 And I told the students on the very opening day that I approached the course with the thought of Ben Graham sitting in the front seat and hopefully thinking approvingly that we've evolved the thinking in a way that would be sensible to him. So like you said, the tools, the world he lived in and the tools he used are not the world we live in today are the tools that we would use. But there's sort of a psychological approach that's really the same. By the way, the one thing, there are some constants. There are things that I think are fairly immutable. The two lessons we always talk about from Graham are the idea of the Mr. Market metaphor, this idea that Mark itself goes from manic to depressed and back and forth

Starting point is 00:59:13 and that we should be in a position to take advantage of those opportunities as they arise. That's as true today as it was when he wrote those words. And then the second is the concept of margin of safety, right? And that really means buying things for less than what they're worth to accommodate the idea that we could be wrong. We have bad analysis or bad luck. The other thing, of course, that's also immutable is that we're buying, if you're an investor as opposed to a speculator, and there's no, I'm not making a moral judgment about speculation, but if you're an investor, you're buying stakes in businesses. So this idea that being a business analyst is really important. So how is it different today? One is, I think that Graham's comments were that he was

Starting point is 00:59:50 mostly buying into the efficient market hypothesis. This is 1976, I think he said that. And, you know, I think that the introduction and filling out with understanding markets as complex systems would be something that is very resonant with the idea of the Mr. Market metaphor. In fact, I gave a talk at the Columbia Investment Conference a number of years ago called animating Mr. Market. And I try to bring together the idea of complex adaptive systems to Mr. Market. And I think he would very much appreciate that. I think he would find that to be resonant. The second is that we really are trying to focus on cash flows, right? We know those to be the lifeblood of the business. Back in the day, accounting numbers tended to do an okay job of that. That's less true today. So I'd like to think

Starting point is 01:00:29 that he would be amenable to thinking about things like intangibles and how those things might play out. So that would be another dimension. I think he would probably like the strategy work to understand to distinguish between businesses that are good versus businesses that are not as good in terms of their ultimate prospects. And then the last thing I will say, too, is a good chunk of the course. one of our four modules is on decision-making. So this is the introduction of a lot of the things we've learned in psychology, but we'll call it behavioral financial, behavioral economics, whatever you want. And more importantly, not just the kinds of mistakes that we're likely to make, that we do make, but how we can specifically manage or mitigate those mistakes. So I would just like to think that

Starting point is 01:01:05 if he were sitting in that seat, he would say kind of not along approvingly that what we were doing made a lot of sense. By the way, he first taught that course his version of it in 1927, and it was Columbia Extension School. It was actually not part of the business school until 1950. And it was in the spring of 51 is when Buffett took his class, actually. So you think about that. That was 71 years ago. It's completely amazing. So yeah, and I also tell the students, we have this extraordinary legacy of thinking about and teaching and trying to be at the forefront of many of these ideas. And so we have, you know, we have big shoes to fill. We have to try to fulfill that legacy and perpetuate that legacy to the best of our abilities. You know, Joel Greenblatt's also been teaching at Columbia for quite a long time. And when he was on our show, he mentioned that his Casa Capital essentially, that he looks, the yield he's going for is a 6% flat rate. And I've been noodling on that ever since. I just, I missed the opportunity to ask him why. And I'm kind of curious if you have a similar take, if there's some benchmark number that you also look for. You throw out 8% as a, let's just pull it out of thin air, Casa Capital earlier. I'm wondering if it's in that range. And if so, why? Below that now. And I used 8% because I could then divide that by one without hurting myself. So that was the main reason I used 8%.

Starting point is 01:02:19 Probably should use 10% would be even easier for me. But it's a good question. I would break that into two parts, though. The first is what is a sensible estimate of the opportunity cost to capital. For my source, I like to go to Aswath Demotrin, who's a professor at New York University, who every month posts an estimate of his market risk premium. And I think it's pretty sensible. So you can update that every month.

Starting point is 01:02:39 I think his most recent reading is something. the low sixes, called between six and six and a half percent. That's nominal, by the way, so that does not take into consideration of inflation. So if you take out inflation expectations, which is probably something closer to three and a half to four percent. That's well below historical standards, by the way, but I think that's consistent with everything else we see in terms of interest rates, broadly speaking, and credit spreads and so on and so forth. That is what we do. Now, the other thing, we've tried to test that. So we went back, Aswath has published some sorts of these types of numbers back to 1961. So we have 60 years of data on this. And we

Starting point is 01:03:10 simply took his estimate for a particular year, and then we correlated that with the total shareholder returns for SP 500 in the subsequent 10 years, so like a long term. And the correlation was about 0.7, which is not perfect, but it's pretty good. So it's better than a flat 6% or 10% or whatever the number is. Okay, so that's the first thing. That's how we would do it. That's how I'd recommend doing. I think it's sensible. You can go and Aswell actually shares the spreadsheet with you. So if you want to quibble with any of his assumptions, you can tweak them and so forth and come up with your own estimates. The second thing, though, and I think this goes back to maybe what Joel is thinking about and what others have talked about is when you invest,

Starting point is 01:03:43 you may have your own cost of capital, right? Your own rate of return you want to own. So the typical way we get that is buying something for less than what it's worth, right? If you're buying it for less worth it's worth and eventually goes to the price you think it's worth, you're going to get some sort of return above the cost of equity capital, presumably. So that's the other way to accommodate that is just to put it into your discount to intrinsic value or discount to expected value. And those will get you the same types of answers. Very interesting. So I'm curious, I'm assuming then going to that last point with finding your own, if you're seeing inflation rise, whether it's transitory or not, it goes up to 7.12 percent,

Starting point is 01:04:17 how would you think about adjusting your cost of capital, including that? What would be the premium risk, I guess you would put on top of the interest? Oh, yeah. Well, here's the key. So you can think about interest rates specifically as having two components, the real component and the other is the inflation component. So if you look at the 10-year treasurer, no yield is 1.8. The real yield, because inflation expectations are a little over 2%, so the real yield is something like minus 0.5 or something like that. So the key question is what's happening with real rates and what's happening with inflation expectations. So the main thing to bear in mind is if real rates go up, all assets, the discounted value of all assets go down. If nominal interest

Starting point is 01:04:59 rates go up and the main driver is inflation, you have to now introduce a new way of thinking, which is, does my company have pricing power? In other words, can it price its good or service to keep up with the rate of inflation? Some companies can do that. Many can't. So that's a really important analytical consideration. So when you face with environments as we are today, A, disentangle the reel versus the nominal rate, because if real's going up, that's affect everything. But if it's nominal, then you have to think about the notion of pricing power. So again, if ASWA's numbers are to be to believed, then I think that's not an unreasonable thing, something like six to six and a half nominal, three and a half to four percent real. By the way,

Starting point is 01:05:35 historically, the equity markets in the states have generated returns between six and seven percent real. So it's much more modest. Fantastic. Well, you've already shared an amazing number of incredible resources, but I'm kind of curious to know if you are, say, sitting around like the Thanksgiving dinner table and you've got a nephew across, he's like, hey, Uncle Mike, I want to learn about investing. Where would you direct him to start? You know, again, a lot of this reflects my own biases. I do think the letters of Berkshire Hathaway, Warren Buffett would be a great place to start. Those have been assembled. I mean, Berkshire, you can get them off the Berkshire Hathaway, but they've been assembled in other places that are really good. I do think that Robert

Starting point is 01:06:13 Hagstrom has written many of his Warren Buffett books are really wonderful and do a very good job of summarizing a lot of key ideas and making those things very accessible. I love, and as a teacher in terms of pedagogy, I think it's really important. I love the work of Peter Bernstein. He was amazing. And he wrote a couple books that I would recommend every young person. I ask my own children to read at least one of these books. The first one's called Against the Gods, the remarkable story of risk. And what I love about that is it traces our human understanding of risk. And just sort of see these numbers where they come from and how people thought them up and so forth. It's super cool. And then he wrote a book called Capital Ideas, which really traces the evolution

Starting point is 01:06:52 of what we know in finance today. So when we talk about things like efficient market hypothesis and so forth, where did those ideas come from? what made them happen. And what did the original thinkers believe and not believe about those kinds of concepts? So those would be some things. By the way, Bert Malackel's random walk down Wall Street, wonderful book. Can't miss with that. And then if you want to get a little bit nerdier and more serious, McKinsey is called Valuation. It's a textbook, so it's not like a beach read or something like that. But the McKinsey book has among the best resources for thinking about all facets of valuation. And then I already mentioned Aswat the Motor. And he actually wrote a book

Starting point is 01:07:28 called the Little Book Evaluation, which is a short little book, very nice. But Aswath, all the stuff he does is really good and rich. I mean, I'm just ticking off a bunch of things. There's more, but those would be some things I would point to immediately. I'm going to add to the list, expectations investing. I truly love this book. Thank you so much for coming on and talking. I'm glad you revised it. It's much more approachable for me, especially selfishly. And I really enjoyed reading it. I recommend it to all of our listeners. Where can people follow along with your work and any other resources you want to share. Thanks, Trey. So Twitter, I'm on Twitter and my handle is M-J-Mobison. So it's M-J-M-A-U-B-O-U-S-S-I-N.

Starting point is 01:08:11 My website is Michael Mobbison.com. That's not updated that much, but you can see the other books and some summaries of those things. And then finally, for the book itself, Expectations Investing, has its own website called Expectationsinvesting.com. And I think that's really worth for people to take a look at if they're serious about the ideas, in particular, we We have a section called Online Tutorials. And so if you go to that, you click on it, not only do we have tutorials explaining some of the key ideas in the book, but we also have downloadable Excel spreadsheets. So, for instance, we talked about Domino's before and the market expectations for Domino's,

Starting point is 01:08:43 and you'll open the book and see the numbers in the book. But if you want to bring them to life and see where they came from, you can actually go into the tutorial, click on it, get the Excel spreadsheet and play around with it, and actually move the assumptions around as you see fit and so forth. So it's meant to be a living, breathing way to really make the ideas very concrete and usable. Well, Michael, this has quickly become one of my favorite conversations I've ever had on the show.

Starting point is 01:09:05 I mean, this was so enjoyable for me. I can't even tell you. And I'm truly honored that you came on the show and shared all of this amazing knowledge and wisdom with everybody. I really truly hope we can do it again sometime soon. Thank you so much. Love to do that, Trey. Thank you very much for your time and hospitality.

Starting point is 01:09:19 Have a great day. All right, everybody. That's all we had for you this week. if you're loving the show, don't forget to follow us on your favorite podcast app. And if you want to explore expectations investing, definitely check out TIP Finance. Our TIP finance tool uses the expectations investing calculation to determine intrinsic value. I always love feedback, so definitely find me on Twitter at Trey Lockerbie. And with that, we will see you again next time. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the

Starting point is 01:09:51 Investors Podcast Network and learn how to you. to achieve financial independence. To access our show notes, transcripts or courses, go to The Investorspodcast.com. This show is for entertainment purposes only, before making any decision consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP421: Expectations Investing w/ Michael Mauboussin

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