Podcast Summary
Understanding Expectations Investing in Today's Macro Environment: Michael Mauboussin emphasized the importance of expectations investing, understanding skill vs luck, measuring modes, and decision making in today's unprecedented macroeconomic environment.
Key takeaway from this episode of Acquired is the importance of expectations investing in today's unprecedented macroeconomic environment. Michael Mauboussin, the head of Consilient Research at Counterpoint Global, shared his insights on this topic, drawing from his extensive research and experience. Michael, who has been a hero and favorite investor for many, emphasized the significance of understanding the role of skill and luck, measuring modes, and decision making in expectations investing. He also shared his personal story of discovering Al Rapaport's book "Creating Shoulder Value" in the late 1980s, which had a profound impact on his career. The discussion also highlighted the impressive growth of Statsig, a sponsor of the show, which now processes over 130 billion events per day and serves almost all major AI companies. The episode provided valuable insights for anyone interested in investing and making data-driven decisions.
Understanding business value through cash flow and market expectations: Cash flow is the ultimate driver of business value, and evaluating a company's strategy requires understanding its competitive situation, growth potential, and market expectations. The stock price reflects these expectations, so investors should assess their accuracy to make informed decisions.
That the ultimate driver of business value is cash flow, not accounting earnings. This perspective, emphasized by a financial analysis master, underscores the importance of understanding a business's competitive situation, growth potential, and the market to evaluate its strategy effectively. Moreover, the stock price of a company reflects the market's expectations about its future financial performance. To make informed investment decisions, one should determine whether these expectations are realistic, optimistic, or pessimistic and act accordingly. By considering the market's perspective, investors can reverse-engineer their valuation process and make more informed decisions.
Reverse engineering prices for value understanding: Successful investing requires understanding potential outcomes and their probabilities, focusing on value instead of price, and reverse engineering prices to determine value in today's complex investment landscape with a shift from tangible to intangible assets.
Investing involves understanding the probabilistic nature of expectations and the importance of reverse engineering prices to determine value. John Burr Williams, in his 1938 work on Discounted Cash Flow models, encouraged skeptics to reverse engineer prices instead of projecting values. Today's complex investment landscape, with a shift from tangible to intangible assets, requires a probabilistic approach to understanding expectations. Intangible investments, such as software code, marketing, branding, and employee training, now make up a significant portion of investments. The income statement and balance sheet can be confusing in this context, and accountants attempt to distinguish between necessary expenses and discretionary investments. Buffett and Munger's approach to investing emphasizes inverting assumptions and focusing on value rather than price. Ultimately, successful investing requires a deep understanding of the potential outcomes and their probabilities.
Understanding a Company's True Value Beyond Financial Statements: Focus on cash flows, particularly free cash flow, and a company's ability to invest at high returns, as traditional earnings and financial statements may not fully reflect a software-based business's value.
The traditional way of evaluating businesses through earnings and financial statements is becoming less relevant as more companies, particularly software-based ones, invest heavily in intangible assets. These investments often don't show up on the income statement, making the numbers less insightful for understanding a business's true value. Venture capitalists, who have long understood intangibles as investments, are now seeing this perspective adopted by the broader investment community. Many public companies today are losing money in the sense that they're making productive investments rather than just having costs exceed revenues. The focus should be on understanding a company's cash flows, particularly free cash flow, and its ability to invest at high returns. The increasing global reach and faster growth of software-based companies also means that successes and failures can have more extreme consequences than in the past.
Understanding OpEx in Software Companies: Michael Moritz's academic approach to stock analysis emphasizes the importance of considering OpEx and understanding markets, competitive strategy, and decision making when analyzing software companies.
When analyzing software companies, it's essential to consider their operating expenses (OpEx) and understand that their financial performance cannot be fully understood by looking at one number, such as operating cash flow. Michael Moritz, who taught Ben Graham's legendary security analysis course at Columbia Business School, emphasizes this concept in his four-part course structure. The first part is about markets and their efficiency or inefficiency. The second part is competitive strategy. The third part is on decision making, which differentiates good to great investors. Moritz started teaching this course in 1993, having been inspired by Charlie Wolf, who was the first PC analyst at First Boston and a tenured professor at Columbia Business School. Moritz's academic approach to stock analysis caught Wolf's attention, leading him to suggest Moritz teach the course. Moritz's experience began in 1992 when he joined Credit Suisse as a food industry analyst. He found himself drawn to the technology sector and its "cool guys" working on innovative projects. This anecdote illustrates the importance of understanding markets, competitive strategy, and decision making when analyzing companies, particularly in the software industry.
Creating a Competitive Strategy: Understanding Industry Landscape, Dynamics, and Advantage: To create a successful competitive strategy, analyze industry landscape, dynamics using Porter's Five Forces and disruptive innovation, and identify a company's unique competitive advantage through financial analysis.
Creating a competitive strategy involves synthesizing complex concepts from various sources, making them cohesive, and measurable for investors or executives. A competitive advantage can be defined as having returns above the cost of capital and being better than competitors. The strategy can be broken down into three pieces: understanding the industry landscape, analyzing industry dynamics using Porter's Five Forces and disruptive innovation, and identifying the source of a company's competitive advantage, whether it's through low cost production or differentiation. Measuring the mode helps ensure a systematic approach and can be made more concrete by examining financial statements. The use of a checklist also encourages thorough consideration of all relevant issues.
Early-stage business economics: Complex adaptive systems and real options: Understanding complex adaptive systems and applying real options theory in volatile markets with premium management and access to capital can inform early-stage investment decisions.
Understanding the economics of a business, particularly in the early stages, is crucial for successful investment. This involves considering complex adaptive systems, where the interactions of agents and their learning and adaptation create a system that is greater than the sum of its parts. In such systems, real options theory can be valuable, particularly in volatile markets where management's ability to understand and exercise options is crucial. Real options are valuable when there is volatility, a premium on management, and access to capital. Additionally, it's essential to consider the role of entry and exit in industries, as few people typically spend time on these aspects. This holistic approach to understanding the economics of a business can help investors make informed decisions, even in the face of the uncertainty that comes with early-stage investing.
Investing in early-stage companies as options on industry-disruptors: Early-stage investing involves buying options on potential game-changers, as industries experience a surge in competitors and eventual consolidation, leading to significant returns if a few investments succeed.
Early-stage investing can be seen as buying options on potential industry-disrupting companies, rather than making traditional investments. According to research by Steven Klepper from Carnegie Mellon, industries often experience a surge in competitors during their early stages as the market sorts out what it likes. After this initial upswing, there's a period of consolidation, where the number of companies declines, but the industry continues to grow. This creates an interesting investment opportunity, as a fewer number of companies capture the spoils. In the context of early-stage investing, the potential for extreme outcomes makes it difficult to determine the value of a company at an early stage. However, building a portfolio of such investments and hoping that a few of them hit can lead to significant returns. It's important for investors to recognize the paradigm shift in the nature of the asset they're buying – options on potential game-changers – rather than applying traditional investment frameworks.
Investing goes beyond visible cash flows, consider optionality and reflexivity: Optionality and reflexivity impact a firm's fundamental outlook, enjoy market upside but be aware of risks, diversify portfolio
Investing in businesses, especially during unprecedented times, requires careful analysis and consideration of various factors beyond just visible and predictable cash flows. The example of Tesla illustrates this, as the company's optionality and potential reflexivity can impact its fundamental outlook. Reflexivity is the idea that the observer's actions can influence the value of the firm. This concept has been around for a long time, and it's particularly relevant in mergers and acquisitions. However, most movies don't tend to have good endings. Bill Gurley's advice to enjoy every last minute of the upside and be fully invested may be seen as a different approach to investing, focusing more on market timing rather than buying and holding. Ultimately, it's important to remember that none of us are that clever when it comes to market timing, and a well-diversified portfolio can help mitigate risks.
Using mental models to make informed investment decisions: Great investors use base rates and pre-mortem to expand their thinking, while average investors may be overconfident. Base rates help predict outcomes by considering a problem as an instance of a larger reference class, while pre-mortem explores reasons why an investment might fail to identify potential risks.
Great investors approach decision making with a thoughtful and open-minded perspective, while average investors may be too quick to assume they know the future. Tools like base rates and pre-mortem can help expand one's thinking and make more informed investment decisions. Base rates involve considering a problem as an instance of a larger reference class, allowing one to draw on past experiences to make predictions. Pre-mortem asks investors to imagine an investment has failed and explore reasons why, helping to identify potential risks and mitigate them. Additionally, maintaining an open-ended understanding of how the world might unfold is crucial for successful investing. Great investors understand that they don't have all the answers and are always learning, while average investors may be overconfident in their abilities. By employing these mental models and maintaining a flexible mindset, investors can make more informed decisions and ultimately improve their investment outcomes.
Challenging our own thinking and being open to new perspectives: Writing articles, red teaming, journaling, and reviewing decisions can help us avoid biases, understand reasons objectively, and improve decision making skills.
Effective decision making involves challenging our own thinking and being open to new perspectives. This can be achieved through various methods such as independent analysis, red teaming, and journaling. Each of these approaches can help us avoid intellectual baggage and biases, and provide us with valuable feedback. For instance, writing a 200-word article on why an investment turned out badly can help us understand the reasons objectively. Red teaming, or challenging prevailing views, can help us identify vulnerabilities and weaknesses. Lastly, journaling and keeping a decision log can help us review our decisions periodically and give ourselves honest feedback. It's important to remember that giving and receiving feedback is difficult, but it's essential for growth and improvement. Additionally, understanding the concept of base rates and separating skill from luck can help us make more informed decisions. Overall, these practices require discipline but can lead to significant benefits in our personal and professional lives.
Understanding the role of skill and luck: Skill and luck are interconnected and cannot be easily separated. The paradox of skill states that as skill increases, the role of luck becomes more significant.
Skill and luck are interconnected and cannot be easily separated in many aspects of life, including business, sports, and investing. The author's editor initially suggested moving a chapter about the importance of understanding the distinction between skill and luck to the end of the book due to its complexity. However, the author's friends found it to be the most interesting part of the book. The author was inspired by the works of Taleb and Gould and wanted to provide tools to help quantify the impact of randomness. Skill is defined as the ability to apply knowledge readily in execution or performance, while luck is an event that happens to an individual or organization and can be good or bad, with a reasonable expectation that a different outcome could have occurred. The concept of the luck-skill continuum places activities on a spectrum, with chess matches and running races being all skill and no luck on one end, and roulette wheels and lotteries being all luck and no skill on the other. Most activities fall somewhere in between. The paradox of skill states that in activities where both skill and luck contribute to outcomes, as skill increases, the role of luck becomes more significant. This concept challenges our intuition and highlights the importance of recognizing the role of luck in our lives.
Persistence of Performance in Venture Capital: Despite increasing skill parity and market efficiency, venture capital still shows persistence of performance. Successful funds attract more deal flow, making it crucial for startups to identify and approach them.
In various domains, the skill gap between the best and the average has narrowed, making outcomes seem random even for highly skilled individuals. This phenomenon is evident in sports, where global markets have led to increased competition, and in investing, where markets are efficient. However, in venture capital, there is still persistence of performance, indicating ongoing skill. My pet theory is that this persistence may be due to the preferential attachment effect, where successful funds attract more deal flow. But it's essential for great startups to identify and reach out to these funds, creating a symbiotic relationship. Overall, the increasing parity in skills across domains and the efficiency of markets make differentiating oneself a significant challenge.
The role of skill and luck in investment success: Skill and luck contribute to investment success, but extraordinary streaks are challenging to replicate due to increased competition and the power of regression towards the mean.
The success of a venture firm or an investor is influenced by a combination of skill and luck. The "imprimatur" or approval from leading firms can help boost future opportunities, creating a reinforcing mechanism. However, the hypothesis that a partner leaving a leading firm to start their own shop will carry their success is not always the case. Regression towards the mean is a powerful mental model that helps understand the role of base rates and individual analysis. In the world of investing, where returns may happen faster than ever before, it is debated whether someone with a 60-year track record like Warren Buffett will ever be matched. The combination of skill and luck is necessary for any streak, and while the luck piece may remain the same, the increasing competition on the global playing field makes it more difficult for individuals to replicate extraordinary streaks. Examples of such streaks, like Joe DiMaggio's 56-game hitting streak and Bill Miller's 15-year streak of beating the S&P 500, are likely to remain impressive and challenging to surpass.
The paradox of skill in investing: As more knowledge is shared, the performance gap between top investors and the rest narrows, but opportunities for excellence and differentiation still exist.
The world of investing, especially in the realm of startups, has become much more competitive than it was decades ago. This is evident in the shrinking bell-shaped distribution of excess returns, or alpha, in the investment industry. This phenomenon, known as the paradox of skill, suggests that as more best practices and knowledge are shared, the performance gap between top investors and the rest narrows. This is similar to how the quality of automobiles has improved significantly over the years, making it harder for any one car to stand out. However, there are still opportunities for excellence and differentiation, such as Crusoe's clean compute cloud solution for AI workloads, which offers superior performance and cost savings by utilizing stranded energy. If I were 18 years old today and interested in investing, I would understand that it may not seem easy, but the challenges and competition make the rewards all the more valuable. It's important to stay informed, adapt to new trends, and continuously improve one's skills to succeed in this ever-evolving industry.
The power of great content and effective distribution: Effective distribution and timing can help a talented analyst stand out and attract a loyal following, but it's important to consider which 'game' to play and if you can make a meaningful impact in your chosen field.
Success in investing, or any field, often comes down to a combination of great content and effective distribution. The story of Dan Benton, a talented analyst who launched a newsletter at the same time as his popular one was ending, illustrates this perfectly. He provided valuable content, but his timing and marketing strategy helped him stand out from the crowd and attract a loyal following. However, in the world of investing, it's essential to consider which "game" you want to play. Some niches or markets may offer opportunities to be the smartest person at the table, but scaling up can be a challenge. Ultimately, it's worth asking yourself if there's a significant issue you're passionate about and if you can make a meaningful impact in that area. While finance can be an exciting and rewarding field, it's essential to consider the broader impact you can make on the world.
Identify areas for competitive edge in investing: Focus on under-researched companies, markets, or emerging fields like crypto. Stay informed, adaptable, and bring unique value to succeed.
To be successful in investing, it's essential to identify areas where you believe you can outsmart the competition. This could mean focusing on under-researched companies or markets where due diligence and personal presence can give you an edge. Another area of opportunity is in the rapidly growing field of decentralized finance or crypto. Ethical and profitable opportunities exist, but it's crucial to approach these markets with caution. Additionally, the speakers discussed the incredible growth in market capitalizations over the past 20 years, with only one company, Microsoft, making the top 10 list in both 2001 and 2021. They also highlighted the impact of declining interest rates on valuations and the massive amounts of wealth being created across various asset classes. Ultimately, the key to success in investing is staying informed, being adaptable, and identifying opportunities where you can bring unique value to the table.
The business landscape changes, new companies and industries emerge: In 20 years, only a few of today's leading companies may still be on top, and new companies and industries could emerge, making it important to stay open to new opportunities.
The business landscape can change dramatically over the course of 20 years, and it's possible that only a few of today's leading companies will still be on top in the future. During the discussion, it was mentioned that three of the top ten companies in 2021 were not public in 2001, and two had not been founded yet. Companies like Facebook and Tesla, which are now among the most valuable, were not even in existence at that time. The speakers also noted that expectations for returns in all asset classes should be relatively muted due to current risk-free rates and credit spreads. They questioned whether 20% of the companies on the leaderboard in 20 years would be those that have yet to be founded, and 30% that are yet to be public. The speakers also highlighted the underrepresentation of healthcare as a sector in the list of top companies. The world changes, and new companies and industries emerge, so it's important to stay open to new opportunities. To learn more about these topics, listeners can check out the papers and books written by Michael J. Mauboussin, including his talk at Google in 2012. Michael's email address and Twitter handle are also provided for those who want to get in touch with him. A new announcement is the acquisition job board, which curates exciting job opportunities in the startup ecosystem for those looking for their next career move. Acquired.fm/jobs is the place to go for these opportunities.
Exploring the Investment Industry with Acquire.fm: Acquire.fm is a podcast and learning platform that offers personalized insights and connections within the investment industry, focusing on both crypto and non-crypto topics, and encourages community engagement through Learning Partnerships and one-on-one relationships.
The Acquire.fm community, led by Sandy, provides valuable insights and connections within the investment industry through their podcast and learning platform. This platform goes beyond traditional career search websites and offers a more personalized and engaged experience. With a focus on both crypto and non-crypto topics, Acquire.fm offers a wealth of knowledge through their extensive back catalog and new episodes. They encourage listeners to engage with the community by becoming Learning Partners, sharing episodes with others, and building one-on-one relationships. Overall, Acquire.fm offers a unique and valuable resource for those looking to deepen their understanding of the investment industry.
