What I Learned After Reading Michael Mauboussin’s Base Rate Book
I recently finished reading the Base Rate. It was authored by Michael Mauboussin while he was at Credit Suisse. Anyone can read it in its PDF format here. While the book is written for investors, one of its core points is also about something that impacts us all: social media, news feeds, echo chambers, and fake news. The only way to solve for these modern 21st century noise problems is to find a base rate for everything to compare and contrast what you read and learn.
A quote from a legendary behavioral psychologist is the cornerstone of the entire book:
“People who have information about an individual case rarely feel the need to know the statistics of the class to which the case belongs.” — Daniel Kahneman
One of the opening lines explains the meaning behind the book’s title:
“Executives and investors commonly rely on their own experience and information in making forecasts (the “inside view”) and don’t place sufficient weight on the rates of past occurrences (the “outside view”).”
On how to find a base rate and what it might look like:
“Choose an appropriate reference class. The goal is to find a reference class that is large enough to be statistically useful but sufficiently narrow to be applicable to the decision you face.”
This is an investing book and Mauboussin’s definition of active investing is far different than what most people might think:
“The odds provide the probability that a horse will win (implied performance) and the running of the race determines the outcome (actual performance). The goal is not to pick the winner of the race but rather the horse that has odds that are mispriced relative to its likelihood of winning.”
As you read, one theme becomes very apparent — overconfidence is rampant in the investing world:
“The executives at the companies that are merging will dwell on the strategic strength of the combined entities and the synergies they expect. The uniqueness of the combined businesses is front and center in the minds of the dealmakers, who almost always feel genuinely good about the deal… Historically, about 60% of deals (mergers and acquisitions) have failed to create value for the acquiring company.”
Overconfidence is so rampant. Part 2:
For example, notwithstanding that only about 50 percent of new businesses survive five or more years, a survey of thousands of entrepreneurs found that more than 8 of 10 of them rated their odds of success at 70% or higher, and fully one-third did not allow for any probability of failure at all. The bottom line on optimism: “People frequently believe that their preferred outcomes are more likely than is merited.”
How do you spot or manage overconfidence? Look to the S-curve:
One common analytical mistake is to extrapolate high growth in the middle of an S-curve. One famous example is the production of color television sets, which were launched in the late 1950s and reached a sales peak in 1968. The industry grew rapidly in the 1960s, which encouraged manufacturers to add capacity. But they extrapolated the sharp growth and failed to recognize the top of the S-curve. The result was manufacturing capacity in the later 1960s of 14 million units and peak unit sales of 6 million units.
Even Warren Buffett has warned against overconfidence and especially when it comes to earnings guidance. What you’re about to read is a test Buffett once wagered in one of his annual shareholder letters. Mauboussin tested it:
“We started by identifying the 200 companies with the highest net income in 1990. By 2000, only 162 of those companies were still around. Of those, less than 9% (14 of 162) grew net income at a rate of 15% or more from 1990–1999. None of those 14 companies grew at higher than a 15% rate for the decade ended in 2009.”
You cannot rely on one metric to guide your investing decisions. Ideally, you’re decision making is diversified with a system, screen, or combination of multiple metrics. Amazon is a great example on why this matters:
“Take Amazon.com as a case. The stock had a trailing P/E multiple of roughly 540 at year-end 2015 based on a price of $676 on December 31 and full-year reported earnings per share of $1.25. For context, the P/E multiple was 20 for the S&P 500 at the same time. Based purely on its P/E multiple, the valuation of Amazon.com appeared high. The company’s gross profitability told a different story. For 2015, Amazon.com’s gross profitability was 0.54 (gross profit of $35 billion and total assets of $65 billion). According to Novy-Marx, gross profitability of 0.33 or higher is generally attractive.”
The media and groups of casual investors tend to focus on cash. You may have seen headlines before about Apple’s massive cash pile. But focusing on one metric, like the Amazon example above, can be detrimental. There’s generally more to the story — in this case there’s a reason for all that cash:
“Over the past 30 years, the ratio of cash to assets has risen in the United States from 7 percent in 1980 to about 16 percent today. This shift is consistent with the rise in companies that spend a lot of money on research and development (R&D). As R&D expense is a fixed or quasi-fixed cost, this trend reflects the efforts by executives to manage overall risk by using a cash buffer to dampen the impact of operating leverage.”
Executives place most of their importance on quarterly earnings. Perhaps because that is the number the greater population always sees. But if you ask an analyst or Wall Street professional, they tend to put far more weight on cash flow:
“Executives and investors perceive that earnings are the best indicator of corporate results. In a survey of financial executives, nearly two-thirds said that earnings are the most important measure that they report to outsiders and gave it a vastly higher rating than other financial metrics such as revenue growth and cash flow from operations.”
Why is cash flow so important? It is the money that can be given back to shareholders, which, at the end of the day, is why you invest:
“Operating profit is the number from which you subtract cash taxes in order to calculate a company’s net operating profit after tax (NOPAT). NOPAT is a central figure in valuation. NOPAT is the number from which you subtract investments to calculate a company’s free cash flow (FCF). FCF is the cash that is distributable to a company’s debtors and equity holders, and hence is the lifeblood of corporate value.”
The analysis of cash is evolving and here’s a relatively new way to view cash flow:
“Cash Flow Return on Investment (CFROI) reflects a company’s economic return on capital deployed by considering a company’s inflation-adjusted cash flow and operating assets. CFROI aims to remove the vagaries of accounting figures in order to provide a metric that allows for comparison of corporate performance across a portfolio, a market, or a universe (cross sectional) as well as over time (longitudinal).”
Having a checklist can make decision-making quicker and easier:
“You can think of your emotional state and the ability to make good decisions as sitting on opposite sides of a seesaw. If your state of emotional arousal is high, your capacity to decide well is low. A checklist helps take out the emotion and moves you toward a proper choice. It also keeps you from succumbing to decision paralysis. A psychologist studying emergency checklists in aviation said the goal is to “minimize the need for a lot of effortful analysis when time may be limited and workload is high.”
Toward the end of the book there’s two actionable investing and trading concepts. They are the “Man Overboard” and “Celebrating The Summit” moments. This slide, which looks at the Man Overboard moment (a stock drops 10% or more) might be the greatest buy the f’in dip (BTFD) slide you’ll ever see:
A perfect anecdote to end a book on and something I may reference for the rest of my life:
“A big winner can create what we call a “celebrating the summit” moment. The idea comes from Laurence Gonzales, an author and expert on survival in extreme situations, who warns against excessive congratulation after reaching a goal. He points out that mountain climbers commonly celebrate too much at the peak. This causes them to let their guard down just as they are approaching the part of the expedition that may be the most challenging. Gonzales points out that descent is technically more difficult than ascent and that most mountaineering accidents occur on the way down.”
Make sure you’re also following me on Twitter.
