Michael Mauboussin Master Class — Moats, Skill, Luck, Decision Making and a Whole Lot More

In this episode of Acquired, hosts Ben Gilbert and David Rosenthal engage with investing expert Michael Mauboussin, Head of Consilient Research at Counterpoint Global, Morgan Stanley. They explore Mauboussin's insights on the evolution of investing, highlighting the shift from tangible to intangible assets and the impact of low discount rates on valuations. Mauboussin emphasizes the importance of understanding base rates and the paradox of skill, where increased uniformity in skill across participants makes luck a more significant factor in outcomes. He also touches on the persistence of performance in venture capital, suggesting that top firms may benefit from preferential attachment, where success breeds success. The discussion also covers the potential for new top companies to emerge, with Mauboussin speculating on the rise of a $10 trillion company and the role of geography and niche markets in finding competitive advantages in investing.

• The hosts express interest in having an animation created for the intro music of their YouTube channel.
• They consider the idea of crowdsourcing the animation work to their listeners.
• The hosts agree that this would be an engaging way to involve their audience.

Yeah, dude. We should see if any listeners want to create some cool, like, animation for the intro music for the YouTube channel.

This quote shows the hosts' desire to engage their audience by inviting them to contribute creative work to the podcast's YouTube channel.

• Ben Gilbert introduces himself as the co-founder and managing director of Pioneer Square Labs and PSL Ventures.
• David Rosenthal introduces himself as an angel investor based in San Francisco.
• They both host the podcast Acquired.
• Michael Mauboussin is introduced as the head of consilient research at Counterpoint Global, part of Morgan Stanley Investment Management.
• Michael Mauboussin is recognized for his extensive and influential work in investment research.

Welcome to this special episode of Acquired, the podcast about great technology companies and the stories and playbooks behind them. I'm Ben Gilbert. And I'm the co founder and managing director of Seattle based Pioneer Square Labs and our venture fund, PSL Ventures.

Ben Gilbert introduces the podcast and himself, setting the stage for the episode's focus on technology companies and investment strategies.

• Pilot is introduced as a sponsor and a company offering accounting, tax, and bookkeeping services for startups and growth companies.
• The hosts discuss the importance of focusing on what makes a company's product unique and outsourcing other tasks, like accounting.
• They emphasize how Pilot can help companies focus on their core competencies by handling their financial operations.
• Pilot's growth and reputation are highlighted, along with its backing by notable investors.

Our next sponsor for this episode is one of our favorite companies and longtime acquired partner pilot for startups and growth companies of all kinds. Pilot is the one team for all of your company's accounting, tax, and bookkeeping needs, and in fact, now is the largest startup focused accounting firm in the.

This quote introduces Pilot as a sponsor and explains the services they offer, emphasizing their value to startups and growth companies.

• The concept of "expectations investing" is introduced, focusing on understanding the expectations reflected in asset prices.
• The approach involves reverse-engineering the market's expectations to decide whether to buy, sell, or hold a stock.
• The discussion highlights the probabilistic nature of investment decisions and the importance of scenario analysis.
• Michael Mauboussin credits Al Rappaport's work as the foundation for his investment philosophy and the revised edition of "Expectations Investing."

The idea is to say a stock price, or it could really be any asset price, a price of an asset. But let's say a stock price reflects a set of expectations about future financial performance. So the first step is to say, what do I have to believe for this to make sense?

This quote explains the central concept of expectations investing, which is to understand the future financial performance expectations embedded in a stock price.

• The discussion addresses the shift from tangible to intangible investments in company valuation.
• The change in accounting practices and the challenge of evaluating intangible assets like software and branding are highlighted.
• The hosts note the increasing number of public companies that appear unprofitable due to intangible investments.
• Michael Mauboussin emphasizes the importance of cash flow over earnings and the strategic investment of capital at high returns, drawing a parallel to Walmart's history of negative free cash flow during growth.

If you go back way to Ben Graham and so know they focus a lot on things like book value, which know where the accounting was actually probably a reasonable representation because most of your assets were things that truly showed up on your balance sheet. But as you pointed out correctly, the world has changed a ton and now more of our investments are intangible versus tangible.

This quote discusses the historical focus on tangible assets in company valuation and contrasts it with the current emphasis on intangible investments.

• The hosts refer to Michael Mauboussin's paper "Measuring the Moat" as a key resource for company analysis.
• Mauboussin's course at Columbia Business School is structured around four parts: market efficiency, valuation, competitive strategy, and decision-making.
• The course emphasizes the importance of understanding markets, differentiating oneself as an investor, and the role of decision-making in investment success.
• The discussion touches on the evolution of the investment landscape and the need for new tools to evaluate intangible assets.

Yeah, so the course structured. And we can dwell on the competitive strategy piece, but I usually like to think about it in four parts. The first is just thinking about markets.

This quote outlines the structure of Michael Mauboussin's course at Columbia Business School, highlighting the key components of effective investment strategy and analysis.

• Charlie was a tenured professor at Columbia Business School.
• During a sabbatical year, Charlie decided to pursue equity research.
• He was turned down by every firm except for First Boston in the late 70s/early 80s.
• Charlie chose to follow the personal computer industry, which was not well-regarded at the time.

"And Charlie was actually a tenured professor at Columbia business school who decided he had a sabbatical year, decided he wanted to do equity research, of all things."

The quote explains Charlie's background and his unexpected career shift from academia to equity research, highlighting the context of the personal computer industry's emergence.

• Michael was influenced by Charlie, who was an academic and PC analyst.
• Michael's work was more academic than traditional Wall Street approaches.
• Charlie suggested Michael should teach at Columbia Business School due to his work.
• Michael began teaching in the summer of 1993 and has been doing so for 30 years as of 2022.

"So he comes back the next day, and he goes, yeah, there's not that much about brands in here, but you should teach at Columbia Business School."

The quote captures the moment when Charlie recognized Michael's potential as an educator and recommended him for a teaching position at Columbia Business School.

• Michael's work on "Measuring the Moat" began in 2002.
• It was one of the hardest professional challenges he faced due to the need for synthesis.
• He read works by Michael Porter, Clay Christensen, and Brian Arthur.
• The goal was to create a cohesive method for investors and executives to understand competitive strategy.

"And I'll just say that that was among probably the top three hardest things I've ever done professionally."

This quote reflects on the difficulty of creating the "Measuring the Moat" framework, emphasizing the complexity of synthesizing various strategic concepts.

• Michael struggled with the definition of competitive advantage, which Porter did not explicitly define.
• He proposes that competitive advantage should have two features: an absolute one (returns above cost of capital) and a relative one (being better than competitors).
• The framework includes quantitative measures like returns on invested capital.

"So we argue that a competitive advantage should have two features. One is an absolute one. One is a relative one."

The quote outlines Michael's criteria for defining a competitive advantage, highlighting the necessity for a company to surpass the cost of capital and outperform competitors.

• Michael breaks strategy into three pieces: lay of the land, industry dynamics, and the source of the company's competitive advantage.
• Lay of the land involves understanding industry entry and exit, market share changes, and pricing flexibility.
• Industry dynamics cover Porter's five forces and Christensen's disruptive innovation.
• The source of competitive advantage is typically low cost production or differentiation, linked to return on capital.

"We basically broke the strategy into three pieces. One is, I call it lay of the land, but basically, what am I dealing with here?"

The quote explains the first part of Michael's strategic framework, which assesses the broader industry context to understand the competitive landscape.

• Capital velocity is a key concept, defined as sales divided by invested capital.
• Low cost producers have low margins and high capital velocity, while differentiators have high margins and low capital velocity.
• This helps identify the nature of a company's competitive advantage.

"Sales divided by invested capital. So low margins, high velocity, that means you're turning your capital fast."

The quote clarifies the concept of capital velocity and its importance in categorizing companies as low cost producers or differentiators based on their operational strategies.

• Michael endorses the use of checklists to ensure a systematic approach to evaluating companies.
• Checklists help investors consider all relevant issues, even if not all apply to each company.
• This methodical approach is crucial for understanding the economics of a business before investing.

"And I was very specific about putting a checklist at the end. And I think checklists are interesting just because they force you to think about all the different issues."

The quote underscores the value of checklists in Michael's framework, emphasizing their role in comprehensive analysis and decision-making.

• Valuing early stage companies is challenging due to the complexity and adaptability of the market.
• Michael uses the analogy of options to describe investment in early stage companies, highlighting volatility, management's ability to exercise options, and access to capital.
• He references the work of Steven Klepper on industry entry and exit patterns, suggesting this knowledge is crucial for early stage investment decisions.

"When I think of complex adaptive systems, I think about certain features. I mean, to break that term down, complex just means the interactions of lots of agents, right?"

The quote introduces the concept of complex adaptive systems, setting the stage for the discussion on the unique challenges and considerations when investing in early stage companies.

• Industries typically experience an initial surge in competitors followed by consolidation.
• Understanding where an industry is in this cycle can be valuable for investment decisions.
• The pattern of industry evolution is consistent across various sectors.

"So that's another really interesting thing to think about when you're looking at early stage stuff, which is say, all right, where are we in this whole cycle?"

The quote emphasizes the importance of recognizing the evolutionary stage of an industry, which can inform investment strategies and the potential for returns.

• Early stage investments are likened to buying options on potential future success.
• Michael discusses the importance of building a portfolio to manage risk and capitalize on potential high-value outcomes.
• He touches on the differences in return profiles between venture deals, buyouts, and public companies.

"I think that's right, Ben. And I think the other interesting thing know, we wrote a big piece on public to private equity probably a year, a little over a year ago."

The quote connects to the earlier discussion of early stage investments as options, emphasizing the strategic approach to managing a diverse investment portfolio.

• The concept of reflexivity suggests that investors' actions can influence the value of the firm they're observing.
• This interaction can be particularly impactful in cases like Tesla, where stock performance enables capital raising and influences the company's trajectory.
• Reflexivity can work both positively and negatively, affecting the long-term outcomes of companies.

"And that reflexivity basically says the very act of bidding up a stock changes the fundamental outlook for that company and so on and so forth."

The quote introduces the idea of reflexivity, explaining how market perceptions and investor behavior can materially affect a company's fundamentals and future prospects.

• Michael contrasts the difficulty of market timing with the importance of staying invested to capture upside potential.
• He acknowledges that while many speculative investments do not end well, it's challenging to predict market turns.
• The discussion includes Bill Gurley's perspective on investment timing and the importance of being fully invested.

"But I think Bill's attitude was, Bill's take is a bit more to me, like this idea of market timing."

The quote reflects on the challenges of market timing and the rationale behind staying invested, as advised by Bill Gurley, to potentially benefit from market growth despite high valuations.

• The stimulus packages during the pandemic provided people with extra money.
• With no sports to bet on, people turned to stock trading as a form of entertainment and potential income.
• The influx of new traders may have sparked a change in investment behavior.

"They had nothing to do. They had no sports to bet on. We put a little extra money in their pocket through stimulus and they're like, all right, here's something we can do to keep ourselves entertained and in some cases make some money."

The quote explains how the stimulus money and lack of usual entertainment options led people to engage in stock trading, potentially altering the investment landscape.

• Statsig is a feature management and experimentation platform.
• It was founded by VJ, a former Facebook executive responsible for their mobile app ad product.
• Statsig enables product teams to ship features faster, automate A/B testing, and measure impact on business metrics.

"Statsig is a feature management and experimentation platform that helps product teams ship faster, automate a b testing, and see the impact every feature is having on the core business metrics."

This quote describes the purpose and capabilities of Statsig, highlighting its role in assisting product teams in efficient feature deployment and evaluation.

• Statsig provides visualizations and a stats engine for real-time product observability.
• It allows companies to connect new features to business metrics and understand their impact.
• Notable customers include Notion, Brex, OpenAI, Flipkart, Figma, Microsoft, and Cruise automation.

"The tool gives visualizations backed by a powerful stats engine, unlocking real time product observability."

The quote emphasizes Statsig's ability to provide immediate insights into how new product features affect user behavior and business outcomes.

• Quality and temperament of decision-making distinguish great investors from average ones.
• Michael Mauboussin emphasizes the importance of scenario analysis and recognizing the unpredictability of the future.
• He suggests using base rates, pre-mortems, red teaming, and journaling to improve decision-making.

"The idea is to maintain sort of an open-ended understanding of how things might unfold."

The quote underlines the need for investors to remain open-minded about future possibilities, avoiding overconfidence in predicting outcomes.

• Base rates involve considering historical outcomes in similar situations.
• Pre-mortems involve envisioning a future where an investment fails and identifying potential reasons.
• Red teaming is about challenging prevailing views and assumptions.
• Journaling involves keeping a decision log for self-feedback and improving future decisions.

"Most of them are about opening up your mind, and one of them is about feedback."

This quote summarizes the purpose of the tools Michael Mauboussin mentions, which are designed to broaden perspectives and provide self-assessment.

• Base rates require setting aside personal views and information to consider historical precedents.
• They are counterintuitive but have been proven to be a robust component of decision-making.
• Kahneman and Tversky's work highlights the importance of considering base rates over intuitive judgments.

"Base rates are actually a very different exercise, which is it says, hey, let's think about this problem as an instance of a larger reference class."

The quote explains the concept of base rates, which involves looking at a current problem in the context of similar past situations to inform decisions.

• Michael Mauboussin wrote a book on untangling skill and luck in various domains.
• He was inspired by the analytical approach to player evaluation in "Moneyball."
• The book "Think Twice" deals with decision-making and introduced the concept of luck and skill.

"So, look, I just think that one of the most fascinating topics out there is this idea of untangling skill and luck."

The quote introduces the discussion on the interplay between skill and luck in determining outcomes in business, sports, and investing.

• Skill is the ability to apply knowledge effectively in execution or performance.
• Luck is random and can be good or bad, with the possibility of different outcomes under similar circumstances.
• The luck-skill continuum places activities between extremes of pure skill or pure luck.

"Luck is much more difficult to define... it's reasonable to expect a different outcome could have occurred."

This quote defines luck and contrasts it with skill, setting the stage for understanding their relationship in various activities.

• As overall skill level increases, luck becomes a more significant factor in outcomes.
• Absolute skill has increased across domains, but relative skill gaps have narrowed.
• The paradox of skill explains why highly skilled individuals may have outcomes that appear random due to equal skill levels.

"In activities where both skill and luck contribute to outcomes, as skill increases, luck becomes more important."

The quote encapsulates the paradox of skill, noting that in fields where both factors play a role, increased skill levels make luck a more decisive factor.

• Persistence of performance indicates skill, with venture capital showing significant persistence.
• Public equity markets show limited persistence, indicating a closer alignment with average performance.
• Michael Mauboussin's pet theory on venture capital success involves preferential attachment and network effects.

"If you can get access to one of those funds and invest with them, you tend to do very well."

The quote suggests that investing with top-performing venture capital funds can lead to better outcomes due to the persistence of their performance.

• Regression toward the mean occurs at a rate that can be predicted based on where an activity falls on the luck-skill continuum.
• In pure skill activities, there is no regression, while in pure luck activities, outcomes regress completely.
• Understanding regression helps in setting realistic expectations for performance in various fields.

"You can actually figure out, not just, we all know that regression toward the mean happens, but you can actually figure out the rate at which it happens."

The quote points out that the concept of regression toward the mean is not only observable but also quantifiable, depending on the balance of skill and luck in an activity.

• The global playing field for investing has become highly competitive.
• It is more difficult to achieve the type of returns Warren Buffett did, especially with large capital.
• The "paradox of skill" suggests that as everyone becomes more skilled, the difference between competitors shrinks, making it harder to outperform.

"Everyone is competing on this global playing field now. And so it's so much harder to get the type of returns, especially at the amount of capital that Warren was."

The quote by Ben Gilbert reflects on the increased difficulty in achieving high returns in the current global investment landscape, as compared to the past successes of investors like Warren Buffett.

• Extraordinary streaks are a mix of skill and luck.
• Luck has remained consistent, but skill levels have become more uniform, making it difficult to replicate past success streaks.
• Historical streaks like Joe DiMaggio's and Bill Miller's are unlikely to be surpassed due to the increased uniformity of skill.

"Extraordinary streaks are a combination of skill and luck... And then I think if we're arguing that skill has become more uniform, then it would say that it would be very difficult for people to replicate that."

Michael Mauboussin explains that both skill and luck are necessary for long-term success streaks, and with skill becoming more uniform, it's harder to stand out and achieve exceptional streaks.

• Active managers aim for a wide distribution of excess returns (positive alpha).
• The distribution of returns has become narrower, indicating a more uniform level of skill.
• This narrowing is consistent with the paradox of skill and mirrors trends in other industries like automobile quality and athletic performance.

"One of the ways we can measure that is to look at the standard deviation of excess returns... So if you're an active manager, what you want is a big, fat, bell-shaped distribution... And then what has happened consistently is the bell shape distribution has gotten skinnier and skinnier and skinnier."

Michael Mauboussin describes how the measurement of the standard deviation of excess returns demonstrates the increasing uniformity of skill among active managers, leading to less variability and fewer standout performers.

• The skill level among venture capitalists has significantly increased over time.
• The venture capital industry has become extremely competitive, reflecting the broader trend of skill uniformity.

"In venture, when we do our sort of classic episodes, we talk about what things were like. The level of skill among venture capitalists like back in the day was laughable. And today it is extremely competitive."

David Rosenthal comments on the evolution of the venture capital industry, highlighting the stark difference in skill levels from the past to the highly competitive present.

• Crusoe is a cloud provider for AI workloads that partners with Nvidia.
• It operates data centers powered by wasted, stranded, or clean energy, offering better performance per dollar than traditional providers.
• Crusoe's environmental strategy includes using excess energy from sources like oil flares and wind farms, reducing reliance on the energy grid and costs.

"Crusoe's data centers are nothing but racks and racks of AI... Because Crusoe's cloud is purpose-built for AI and run on wasted, stranded, or clean energy, they can provide significantly better performance per dollar than traditional cloud providers."

Ben Gilbert introduces Crusoe as a company that leverages otherwise wasted energy to power data centers for AI workloads, providing cost-effective and environmentally friendly solutions.

• The world of investing today requires more effort to be the best due to increased competition.
• Finding "easy games" or niches in the market can provide opportunities to excel.
• Young investors should consider where their skills can make the most impact, possibly in underrepresented sectors or emerging markets.

"So part of it is thinking about who's going to play the game... So part of it is thinking a lot about the game that you're playing."

Michael Mauboussin advises aspiring investors to consider the competitive landscape and seek areas where they can have an advantage, akin to choosing a poker game with less skilled players to increase chances of winning.

• Declining interest rates have had a significant impact on company valuations.
• The top companies by market capitalization change over time, with few maintaining their position after decades.
• Future $10 trillion market cap companies are likely, though the timeline is uncertain and dependent on various economic factors.

"I think the first one is easier to answer than the second one. At some point, that seems very likely... The other interesting question is, if the next 20 years are like the past 20 years, is it conceivable that only one of the companies we see today as our leaders is going to be on the leaderboard in 20 years?"

Michael Mauboussin contemplates the likelihood of seeing a $10 trillion market cap company in the future, acknowledging the possibility given historical trends and the impact of economic conditions such as interest rates on valuations.