IIC 2021: Drivers of Disruption by Michael J. Mauboussin

The session titled “Drivers of Disruption” with Mr. Michael Mauboussin started with Mr. Raamdeo Agrawal introducing him as one of the big ‘Gurus’ of stock markets. Mr. Agrawal mentioned that he has been following Mr. Mauboussin’s work closely for the last twenty-five years and has particularly benefited from his insights from the book “Expectations Investing” as it introduced a completely different way of analysing investments. “Keep your ears and brains open during the session”, Mr. Agrawal advised the audience.

Mr. Mauboussin started his talk by giving some insights into the process of innovation.

“There is a really intriguing link between neural development of children and process of innovation. The number of neurons in your brain do not change much throughout your life but the number of synaptic connections have this incredible upswing from the time you’re born, to the time you’re about two or three years old.

“But then there is this significant pruning process because of which in early childhood, we lose 20 billion synaptic connections a day. So the connections you use get reinforced and the ones you don’t use are pruned away. This overproduction and pruning process does a really good job of learning about the environment.”

The process of innovation in businesses is very similar to this process of development through proliferation and pruning.

An MIT professor – James Utterback has described that process of innovation in businesses goes through three phases:

• Fluid – This phase involves a great deal of experimentation, akin to the increase in the synaptic connections of humans
• Transitional – The second place involves the selection of the dominant by the market just like synaptic connections that are used are reinforced and others wither away.
• Specific – The third phase is where things sort of settle down, changes are modest. Similar to when we become adults and our minds become more settled.

Mr. Mauboussin explained this with the example of what happened in the automobile industry. Ransom E. Olds – a pioneer of the American automotive industry – founded the Olds Motor Vehicle Co. in 1897. He was working on as many as 11 prototypes of automobile engine which included those based on steam, gasoline and electric. In 1901, there was a fire at the factory and 10 out of 11 prototypes of engines were destroyed and the one that survived was the internal combustion engine. Around that time, there were around 1500 cars in the United States – a third each were based on steam, gasoline and electric.

This example shows how there was a lot of experimentation in the initial phase with proliferation of various types of technologies and various manufacturers but then over the years, the technology, the number of models and the number of players went through major pruning.

Mr. Mauboussin explained the same phenomenon by giving the example of the Personal Computers industry where again the number of firms proliferated in the initial stages – to over 100 in the 1980s. But then the number got ‘pruned down to single digits by the end of 1990s. During the same time, the revenues of these surviving firms kept climbing up, as the spoils were enjoyed by fewer and fewer as ‘pruning’ went on.

This process of pruning is the main factor why we see the emergence of few ‘compounders’ in various industries to the detriment of other players who fall by the wayside.

But all this is not something which has happened only in the past. Mr. Mauboussin also gave a live instance of how the EV industry is now going through a new experimentation phase and the number of electric vehicle companies is proliferating as more and more existing players and newcomers are trying to experiment. In the next 10-15 years, the pattern will play out again, with the pruning process taking over in a few years, leaving a few survivors who will enjoy the spoils. That makes EVs a very fertile area for disruption as well as investment opportunities.

After that, Mr. Mauboussin moved on to the next hot topic of discussion in current times – Tangible vs Intangible Investments.

Mr. Mauboussin started with an interesting trivia on Walmart – “For the first fifteen years after its listing, Walmart as a business had net negative free cash flows.” Mr. Mauboussin wanted to drive home the point that “this net negative free cash flow was wildly beneficial to shareholders as the investments being made in the business were widely profitable as they delivered high return on capital.”

“The nature of business has shifted from that reliant on the balance sheet, to much more reliant on the income statement – from tangibles to intangibles. As a consequence, the GAAP accounting is giving a much more distorted picture.”

Over the years, the percentage of companies with net negative incomes in the USA has increased and now stands at almost 50%. Mr. Mauboussin emphasised that investors today differentiate between companies losing money for the right reasons and those losing money for the wrong reasons. The former of the two are those businesses that are investing very heavily in ventures that will have outsized payoffs in the future. 

Mr. Mauboussin said that since the 1970s (when most of the accounting rules were formulated) the percentage of Tangible investments (by corporates) to Private GDP has kept on decreasing whereas percentage of Intangible investments has kept on increasing, so much so that the relationship between the two has flipped and now Intangibles at around 15% are 1.5x of tangibles, which are around 10%.

During the same time, the percentage of SG&A (Selling, general and administrative) expenses businesses spend, which can be classified as Investment Main SG&A has more than quadrupled to more than 30%. In 2019, the amount of SG&A spent by corporates in America that could be classified as Investment Main SG&A was USD 1.8 trillion – twice the amount classified as Capital Expenditure. This is significant as a large proportion of this expenditure is in the form of long term capital expenditure but is being shown as an expense in the P&L account. One has to keep this in mind while analysing capital allocation decisions of today’ organisations.

He explained this via a live example of Microsoft which was discussed recently in a class he teaches at Columbia Business School. If one were to adjust Microsoft’s reported numbers by allocating a part of SG&A as Intangible Investments, its’ Adjusted NOPAT goes up by as much as 15% (from USD 48 bn to USD 56 bn) and investments during the same period went up by 70% (from USD 10 bn to USD 17 bn). This means for companies investing in intangibles and expensing it off as SG&A, both earnings and capital expenditure are grossly understated. He suggested that for smaller and younger companies, these numbers should be even more significant.

Mr. Mauboussin then went on to explain the characteristics of Intangibles

• Scalability – High upfront cost but low incremental costs. Network effects
• Sunkenness – No or less resale value compared to tangibles
• Spillovers – Intangibles are easily imitated but copyrights offer some protections
• Synergies – Innovations arises from combining technologies that already exist

Summing it all up, Mr. Mauboussin discussed the implications all this has for investors.

As declared earnings do not show the true picture, while the relevance of earnings data has declined for all businesses over the years, it has declined substantially more for businesses spending heavily on intangibles. These are mostly new age businesses which are spending heavily on brand building, R&D etc.

Simple value measures like Price to Earnings and Price to Book Value now fail to capture real value. Since the 1980s, the traditional value measures/factors have been underperforming augmented value factors (adjusted for intangibles). 

In the Q&A session, Mr. Raamdeo Agarwal asked Mr. Mauboussin his thoughts on various burning and hot topics of investment management today

On evolution and disruption of Valuation Techniques leading to disruption in businesses themselves

Value Investing is not about buying statistically cheap stocks. It is about buying something for less than it’s worth. The measures used for estimating this worth have to be forward-looking. The factor contributing to this disruption in traditional valuation metrics is the lowest ever discount rates. With treasury yields at 1% and Equity Risk Premium at 4.7%, the expected return in US equities is 5.7%. If you consider all this, the baseline PE ratio for the market should be in the high teens and if there is any value creation at all by any business, it should be valued higher than that. While the fundamentals have not changed, the traditional metrics built in a different era are no longer relevant now.

On valuing the growth and exponential potential of some businesses

Because of discount rates being low, the value of ‘growth’ is definitely high in the current environment. And it is only a handful of companies that outperform treasury bill sort of returns. On top of that, certain dominant businesses which are global franchises now have access to large markets. Some of these businesses have benefited twice in 2020 – firstly, because of low-interest rates and secondly, because of high volatility (and hence the high value of optionality). All this makes valuing the growth component – which now depends to a large extent on intangibles – much more important than before.

On the role of active investing

Active managers contribute to price discovery and liquidity in markets. Passive has gained popularity and rightly so as markets have become more efficient because now there are lots of smart people and institutions. But markets will continue to be ‘efficiently inefficient’ and price discovery still requires human judgment. Hence, there will always be a place for active investment management. We will reach some sort of equilibrium eventually.

On upswing in price creating value

George Soros’s theory of reflexivity explains that there is a feedback loop between price and value in a way that if the price of a stock goes up, it allows the company to use that high price to get cheap financing and reinforce the fundamentals (which then makes the stock go up, so on so forth). The theory certainly seems to be playing put in the case of businesses like Tesla. But one should remember that it is a double-edged sword and can have the opposite effect as well.

Mr. Mauboussin ended the session on a high note with some apt advice to young CFA charterholders and aspirants:

“Continue to focus on learning and while investing, think about participating in a market where you have some sort of an edge.”