Guest User

February 13, 2025

Episode 344 - Michael Mauboussin: The One Job of an Equity Investor

Guest User

February 13, 2025

Michael J. Mauboussin is Head of Consilient Research at Counterpoint Global, Morgan Stanley Investment Management. Previously, he was Director of Research at BlueMountain Capital, Head of Global Financial Strategies at Credit Suisse, and Chief Investment Strategist at Legg Mason Capital Management. He is also the author of three books, including More Than You Know: Finding Financial Wisdom in Unconventional Places, named in the The 100 Best Business Books of All Time by 800-CEO-Read. Michael has been an adjunct professor of finance at Columbia Business School since 1993, and received the Dean's Award for Teaching Excellence in 2009 and 2016. He is also chairman emeritus of the board of trustees of the Santa Fe Institute, a leading center for multi-disciplinary research in complex systems theory.

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What if the key to successful investing is about understanding how market expectations, intangible assets, and even your own biases shape the outcome? In this episode, Cameron sits down with Michael Mauboussin, a renowned expert in investment strategies and behavioural finance, to explore how the evolving dynamics of investing influence valuation, investor decision-making, and market efficiency. Michael is the head of Consilient Research at Counterpoint Global, part of Morgan Stanley Investment Management, and an adjunct professor at Columbia Business School, where he teaches courses on investing and decision-making. His work focuses on behavioural biases, skill versus luck, complex adaptive systems, and valuation. In our conversation, we discuss the core principles of equity investing, unpack the evolution of intangible assets, and explore how market dynamics are influenced by index funds. You’ll learn about capital allocation strategies, the shifting landscape of private equity, accounting challenges with intangibles, and how traditional investment frameworks are being redefined. Michael also provides insight into the "free dividend" fallacy, the importance of understanding the basic unit of analysis, the paradox of skill in active management, and more. Join us to learn about market and investing fundamentals to improve your strategy with Michael Mauboussin. Tune in now!

Key Points From This Episode:

(0:03:08) What the primary job of an equity investor is and the origin of stock returns.

(0:05:37) Why dividends are less critical to total shareholder return unless fully reinvested.

(0:08:43) Dissect the behaviour of investors in dividend stocks and the "free dividend fallacy."

(0:10:01) Value versus growth classifications and how intangible assets impact valuations.

(0:16:39) Learn about the potential advantages for companies investing in intangible assets.

(0:20:20) How to determine a company's position in the competitive advantage life cycle.

(0:24:42) The phase that offers the highest returns and what to consider about newer industries. (0:26:18) Explore the tradeoffs of intangible-intensive companies and the impact on base rates.

(0:29:22) Pitfalls of valuation multiples and the implications for systematic value investors.

(0:32:25) Relevance of market metrics and how index funds have affected alpha opportunities.

(0:38:14) Effects of rising indexed assets and what to consider about market concentration.

(0:45:01) Discover the historical link between market concentration and future returns.

(0:46:31) How active managers benefit markets and misconceptions about skilled managers.

(0:48:46) The value of active managers and advice for structuring investment portfolios.

(0:52:44) Unpack the shift from public to private equities and why it happened.

(0:55:40) Insights into the benefits of private over public equities for investors.

(0:58:00) Ways intangible assets influenced the rise of private equity.

(0:59:27) What the market says about future returns and using public equity for diversification.

Read The Transcript:

Cameron Passmore: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making. This week, we're hosted by one Canadian, just me, Cameron Passmore, CEO and Portfolio Manager at PWL Capital. Yes, I am flying solo this week. It's actually my second solo, I think, in five years.

Unfortunately, as you heard last week, Ben could not make it this week for an incredible conversation. This week, we interviewed Michael Mauboussin, who I've been a fan of for a long time. I've listened to Michael on many podcasts, including with Barry Ritholtz, Ted Seides, Shane Parrish, Bill Gurley, and many others. So I've been a big fan. I really was looking forward to being with Ben to get a chance to talk to Michael.

This conversation was spectacular. Classic Ben questions that I got a chance to ask Michael. And of course, just absolutely hits it out of the park. You can hear, as he was saying at the end, he's been a professor for 33 years at Columbia Business School. And you can see these years of communicating. These topics are just remarkable clarity, thoughtfulness plus command of the academic evidence. It's a beautiful mix and a great conversation.

Right now, Michael serves as the head of Consilient Research at Counterpoint Global, which is part of Morgan Stanley Investment Management. As I mentioned, he's an adjunct professor at Columbia Business School where he teaches courses on investing and decision-making. The main themes of his work, and you'll hear him talk about this, are behavioural biases, skill versus luck, complex adaptive systems, and valuation. Author of several very influential books, including The Success Equation, More Than You Know, Expectations Investing, which he co-authored with Alfred Rappaport, and also Think Twice. These are four phenomenal books.

It was super fun. Ben, I wish you were here. It's always a lot of fun to do this with you, and I hope you're happy with how this conversation turned out. I know I had a blast. I was excited, as I said, at the end of this, to jump out of bed this morning to get a chance to meet someone who I've long enjoyed listening and learning from. With that episode 344. Here's a great conversation with Michael Mauboussin.

Cameron Passmore: Michael Mauboussin, it is so exciting for me to welcome you to the Rational Reminder Podcast.

Michael Mauboussin: Thanks, Cameron, great to be with you. And I want to say that I'm a big Rational Reminder Podcast fan myself. Thrilled to be part of it.

Cameron Passmore: Well, it blows me away because, as I was saying before we started, Ben and I have been listening to you for years. And I've listened to you so many times on so many podcasts of friends of ours. It's a real thrill to have you here. And these questions that Ben prepared are our greatest hits of questions. It's kind of a rapid fire. So let's just go. I've been looking so forward to these. Off the top, Michael, what's the one job, the one job of an equity investor?

Michael Mauboussin: Well, I think Cameron, if the question is an equity investor trying to generate excess returns, the answer is to try to find some sort of edge, some sort of variant perception. And the way I might distill that is to distinguish between fundamentals and expectations. This is a lesson I learned from my mentor, Al Rappaport, who wrote about this in his book Creating Shareholder Value in the mid-1980s. And Al has been a longtime mentor and collaborator and just a wonderful friend.

Chapter seven of that book was called 'Stock Market Signals to Managers.' It was meant for executives, but it's exactly the same mindset that we can use as investors. And the idea is simply that a stock price or any asset price, but a stock price reflects the set of expectations about future financial performance of a company. Your job is to figure out whether those expectations are too optimistic, too pessimistic, or about right, which is usually probably the right answer.

It's very much like a handicap. It doesn't matter which horse is going to win the race. What matters is which horse or horses are mispriced relative to their prospects. And then when you get down to fundamentals, it's really how much money can the company invest? At what return on investment. That combination of investment and returns gives you a sense of cash flows in the future. And of course, a notion of sustainability means that you can find profitable above-cost capital investments over time. How long can you pull off that trick? And those are some of the ingredients that go into it. If you had to say, "What is the one job?" To me, that would be what I would answer.

Cameron Passmore: And can you link that on a fundamental basis. At the very simplest, most basic level, where do stock returns come from?

Michael Mauboussin: Like any financial assets, the present value of free cash flows, which is the ability to disperse cash back to the owners of the business. I grew up in a small town in Central New York, Ithaca, New York, which is home of Cornell University. My father was a car dealer. I would say relatively unsophisticated in terms of financial stuff, but it was very clear where our family's wealth came from. It was the cash flows from his business. If inventory levels got too high, it was worrisome to him. He tried to obviously pay all the taxes he needed but if there are strategies that he could minimize his taxes — it was really the cash flows. And so that was always in my head. It's the present value of the cash flows, i.e. the cash flows that can be dispersed back to the owners of the business over time. That would be, I think, the fundamental answer to that question.

Cameron Passmore: Let's link the cash from the business to the other question that comes up all the time. How important or perhaps unimportant are dividends to total shareholder return?

Michael Mauboussin: This is such a fascinating question. By the way, I talked about dispersing capital. There are three ways to do that. Dividends, share buybacks, and M&A. Selling your company for cash. I find that people like dividends too much and don't like buybacks enough. There seems a lot of confusion about both those topics. But the answer is if you're thinking about total shareholder returns, essentially the capital accumulation rate, which I think that you and I care about when we're thinking about wealth creation or wealth building, the, I think, counterintuitive answer is dividends are actually not important. We just need to think about how that could be the case. And the answer is, it's for you to earn the total shareholder return. The requirement is you need to reinvest 100% of your dividends without friction back into the stock.

If the stock's at $100 and they pay a $3 dividend, what happens is the stock goes X dividend, of course. The price adjusts back to $97. And then that day, you have a $97 stock and $3 cash. What a TSR requires is you take your $3 and buy more stock with that so you get your capital and quote your capital balance back to $100. Most people don't do that. Most people spend their dividends, which is perfectly fine, and it leads to this idea called the free dividend fallacy, which is Hartzmark and Solomon have written a bunch of stuff on this. They wrote a paper called 'The Dividend Disconnect.' I think it's the Journal of Finance that very much spoke to this.

The answer is, unless you're reinvesting 100% of your dividends without any friction, you're not going to earn the total share of a return, and dividends in and of themselves don't matter. There's one other comment I'll make which is interesting is, if you do that, you reinvest your dividends with no friction, or the company buys back stock, the same amount of stock instead of paying a dividend, and you do nothing, both of those are doing the same thing from a practical point of you, which is increasing your percentage ownership in the company. In the dividend case, you're buying more shares and the share account doesn't change. In the buyback case, you are not selling with a smaller share count. In both cases, you're actually increasing your percentage ownership in the company. That's the answer.

Now, the one you say, "Why would dividends matter?" They might matter for things like signalling effects. They might matter for capital discipline. The company giving the money back to their shareholders rather than doing something dumb with it. There may be ancillary benefits of returning capital to shareholders. I mean, by the way, buybacks might do that just as effectively as dividends. But in terms of people, say, something like 60% of returns in the market come from dividends, that just is not mathematically correct if what you care about is the capital accumulation rate, which is I think what your clients and most of us, we're thinking about retirement or paying for our kids' college education or whatever is that's what we're going to care about.

Cameron Passmore: We've all seen those charts to show the percentage over time that the return is dividends. But it's not like if you didn't get the dividends, the money would have just been incinerated. It would have been retained by the company and used for other purposes. It doesn't just go away.

Michael Mauboussin: Exactly.

Cameron Passmore: Can you comment on the behaviour of investors in dividend stocks?

Michael Mauboussin: I think the evidence on this shows, and by the way, this is true for institutions as well as individuals, is that a very small percentage of investors actually reinvest their dividends. They do not reinvest it. The total shareholder return number, which is the most widely cited number for companies typically, virtually nobody earns the TSR. You could only do it if you had an automatic dividend reinvestment program and a tax-free account. And some people do have that, but it's a small percentage of the total. This is a classic mental accounting. You think of the value of the stock is sort of your capital recount, and then you get sort of free money. That's precisely what these guys, I think, meant by this idea of the free dividends fallacy.

Cameron Passmore: And the passion is for dividend-paying stocks where many people are so high, I think a lot of those people have a preference for dividends. Therefore, they might behave better if there's market volatility in dividend stocks.

Michael Mauboussin: Yeah, that could certainly be true. You could argue that a company buying back stock, you could create a homemade dividend by selling your prorated amount. Now, that's very easy to say and rolls off the tongue from an academic point of view. From a practical point of view, how many people are really willing and able to do that? Probably not many. But again, in theory, there are ways to extract capital from your investments, obviously.

Cameron Passmore: What are the problems with classifying stocks or even managers, I guess, as value or growth based on measures like price-to-book or priced earnings?

Michael Mauboussin: I think Charlie Munger talked about this. I certainly believe this myself. Value investing is absolutely essential. And value investing only means buying something for less than what it's worth. Full stop. I think Munger said, "All intelligent investing is value investing." And to that degree, I think that's true. I teach at the Heilbrunn Center for Graham and Dodd Investing at Columbia Business School. This is sort of the carry of the Ben Graham tradition, which is sort of the whole value investing tradition.

I think what's happened is the notion of value investing has gotten conflated with the value factor, which is saying that you should essentially buy statistically cheap stocks, as you mentioned, multiples of earnings, or cash flows, or price-to-book, and sell the ones that are statistically expensive. The key is that those multiples may be proxies for low or high expectations.

And so low multiple just means low expectations. We talked at the top fundamentals and expectations, that, broadly speaking, those companies are going to be companies with low expectations. And broadly speaking, high multiples are going to be high expectations. But we really do need to take another level to understand it more effectively. Saying it all differently, all things being equal, higher multiple, I guess to state the obvious. But the key is how the company's gonna perform vis-a-vis those expectations.

As I would like to say, expectations investing, the bars are level for the hurdler to clear, and the company's fundamentals are how that hurdler can jump. The bar can be set at a foot. But if the company can only jump a half foot, you've got a problem. And the bar can be set at six feet. But if the company could jump seven feet, it's going to be a fabulous investment. But obviously, high bars are harder to clear than low bars. We just need to take the next step.

I think we just need to distinguish between value investing, which is going to be a sort of an immutable good idea. Buying something for what it’s worth versus the value factor, I think we'll talk about it, might have some other limitations as well in terms of giving us the signal of low expectations.

Cameron Passmore: How is the increasing importance of intangible assets affected the way firms you think should be valued?

Michael Mauboussin: This is a perfect follow-up for the value factor conversation. Just to level set with all the listeners, rough numbers. But in 1975, these are data from the United States, although around the world, you get similar patterns. Maybe not exact ratios, but same patterns. In 1975, tangible investments for US public companies were about double those of intangibles. Tangibles are exactly what you think of, factories, and machines, and things you can touch, feel, and kick. Intangibles, by contrast, are things that are by definition non-tangible. This would be things like software code, or branding, or marketing, or training your employees, and so forth.

Two X tangible to intangible in 1975 are estimates for 2025. It's called 50 years later, that ratio will be flipped. It'll be twice as much intangible to tangible. Interesting. But why do we care in some fundamental way? We don't care. And investment is an outlay today in the anticipation of greater cash flows in the future that compensate you for. That idea is the same whether you're investing intangible or tangible.

What's important is the accounting is different. And there was actually in the United States a very interesting case by the FASB in the 1970s where they decided to expense research and development versus capitalize it. If you go back and look at the history of this, it was actually not like a layup decision. They actually had a lot of discussions about different ways to handle R&D. And they just came to the conclusion that the payoffs were sufficiently uncertain that the most "conservative approach" would be too expensive.

What's happening is these intangible investments are getting expensed on the income statement and selling general administrative as GNA, whereas tangible investments are being capitalized on the balance sheet and then depreciated over time. But let's say you buy a machine that costs $1,000 that lasts five years and it's NPV positive. Let's just say it's got good cash flows, it's a good investment. How do we account for that? We put the machine up. That goes into net property, plant and equipment at $1,000. We then depreciated it over five years, $200 a year. It's done.

Now, let's say you're a customer business, a subscription business, and it costs you $1,000 to acquire a customer. Let's say that customer is going to churn in five years. So we know they're going to go away. They're going to generate the same stream of cash flows as the machine, NPV positive. Well, how would that accounting work? Well, the answer is we're going to expense that full $1,000 and then we're going to get those benefits from that customer over the next five years.

Well, if that's an NPV positive thing, the more of it we do, the more we're actually going to lose money. We're taking the hit up front versus an accrual over some period of time. This is the interesting observation and then the devil's in the details, which is how precisely do we go through the SG&A item of every company and say, "What is maintenance?" Another is, SG&A, we need to keep the business as it is in terms of market share, or revenues, or whatever. And then what is discretionary intangible investment?

This maintenance versus discretionary piece is really the big thing. And by the way, there are multiple threads of academic research on this, which are fascinating. I think most quants now use Peters and Taylor, which is a sort of default assumption. They assume 100% of R&D is intangible, 30 % is intangible. You can refine that. And there are actually some very interesting research papers refining it.

What happens if you do that? Let's just state the obvious. Earnings go up. We're removing an expense. We are adding an amortization, but we're removing an expense. And invest, the capital goes up. Now note that free cash flow, the number we care about, the lifeblood number we talked about before, doesn't change because you're increasing earnings, but you're increasing investment by the same amount. So free cash flow doesn't change. But it gives us a more refined view of the profitability and the invested capital. The question is, should I care about that? And the very first question you asked is, what is the one job of an investor? And if we're trying to understand fundamentals, I think this idea of understanding the magnitude and return on investment becomes extremely central.

Just to give you some guideline on this, these are our estimates, ballpark. But if you capitalize and amortize in tangibles for the S&P 500, for instance, we estimate that earnings would be somewhere around 10% to 15% higher than they are. Again, there's an offset. Investor capital would be higher. But 10% to 15%. If you are relying solely on multiples, you would be overstating the multiples. The multiples may not be quite as onerous. And again, the application of this concept varies widely. Some industries are still primarily tangible. So this is basically not an issue. Whereas other industries are almost solely intangible where this is a huge issue. That is, to me, I think the important point here on thinking about intangibles and how they've risen.

Cameron Passmore: That is so fascinating. How permanent do you think the advantage gained by companies that successfully invest in intangible assets?

Michael Mauboussin: I think it's to be determined. If you ticked off basically sort of how they're different from tangible assets – and there's a wonderful book called Capitalism Without Capital, which I would recommend to all the listeners, by Haskell and Westlake, the marketing guys. They talk about the four S's. Scalability. Scalability means that it's often, for an intangible asset, expensive to create the first version, but relatively cheap to do incremental versions. You think about writing software code or developing a drug. If your product or service is successful, the incremental costs are low. So you can scale really fast. You're going to see that with intangible companies.

The second is sunkenness, which is the opposite, which is if your intangible thing is not valuable or successful, it becomes obsolete. It becomes a sunk cost. Whereas if you, for example, Cameron, started a restaurant and didn't work out, you could still sell your inventory, and your cash register, and your chairs, and tables, and so forth. So there would be value to somebody else.

The third one is spillovers. Spillovers just says it's really hard to protect the intellectual property. And we know that best practices tend to diffuse. And then the last idea is that a lot of innovation, interestingly, is the recombination of building blocks of ideas. And to the degree to which those building blocks are digital, we can find solutions faster than we could before. And I think that's a really interesting question today.

The question you pose, a more important one, is how permanent are these things? I do think it's an open question. I would recommend a book that might shed some light on this by Jim Bessen, he's a professor at Boston University, and the book's called The New Goliaths. Got a lot of interesting factoids in there, but he makes three fundamental points. One is, increasingly, the very large companies, think about the magnificent seven type of companies, are spending large amounts on proprietary software. This is intangibles, but this is proprietary. That dollar amount is about a third of total R&D being spent. It's a big number. The second point he makes is that proprietary software is allowing these companies to enjoy classic economies of scale, just like Adam Smith. But at the same time also differentiate their products or services. This would be customization in a sense they're getting two sorts of competitive advantage, scale advantages and differentiation advantages.

And then the third point he makes is, this has always been true to some degree, companies develop technologies through proprietary efforts and so forth. But what's different is, in the past, it used to diffuse. He's got this really interesting case study of General Motors developing the automatic transmission for cars. And they did that around 1940. They patented and all that stuff. But within about a decade, and by the way, there was a world war in the middle, basically every original equipment manufacturer had some version of the automatic transmission. That diffused. Whereas whatever the secret sauce is at Google or whatever the secret sauce at Amazon, that's not diffusing. Those guys are doing that internally. That may argue that there's a little bit more permanence than some people think.

Here's the last thing I'll mention. This is high-level trivia. Ben Graham, of course, wrote Security Analysis. There are now seven editions. Perhaps the most heralded edition is the second edition, 1940. And in the 1940 edition, Ben Graham has a passage about intangibles, believe it or not. And in that passage, he basically says, these assets may be just as good and just as durable as tangible assets. That's a fun little factoid that Ben Graham, now this is nearly a century ago, had an observation that these assets could have some sustainable value. Anyway, I think the answer is an open question still. And I think there's empirical evidence that it doesn't always go well. But for some companies, it certainly can be a sustainable advantage.

Cameron Passmore: How can investors determine where a company is in this competitive advantage life cycle?

Michael Mauboussin: You're asking me all these such fun questions. I love this one too. Let me start by noting that traditional life cycle analysis typically relates to age. It's a basic story that we could all tell. You're a young company. You invest a lot. You're not making profits yet. And then, over time, you mature. You get economies of scale. Your profitability goes up a lot. You're in your prime of your economic life. And then over time, because of competition, and senescence, and bureaucracy, the returns grind back down to the cost of capital. You get this sort of pattern of up and then fading back down.

I, for years, believed this. I taught it. People talk about this all the time. And I worked with Dan Callahan, my colleague, and I said, "Dan, let's just test this. I'm sure it'll be great. Let's just see what happens to ROIC patterns when IPOs happen. We should expect them to be bad and we expect them to go up." We saw a picture that looked nothing like what that story was at the top. It turns out that ROICs were really high for IPOs, and then they actually went down and they stabilized over some period of time. It was completely baffling to me.

Then I called my friend, Bryant Matthews at Holt Value Associates, and I said, "Bryant, if you run this number," and he runs a version of it, "It's basically the same picture." I'm like, "Okay, we got to go back to square one." Well, it turns out we're really lucky because there was a fascinating paper written in 2011 by Vicki Dickinson at the University of Mississippi. She's a professor of accounting and she did something extremely clever. She combined two really important sets of insights. The first insight was going back to the life cycle work of Steve Klepper and Michael Gort.

Klepper and Gort, these are the sort of famous guys on this, and they described five stages of life cycle; introduction, growth, maturity, shake out and decline. Pretty much what you would expect. But then Dickinson did something super cool. She said, "How do we figure out which stage the company's in?" And she said, "Well, let's go to the statement of cash flows."

Now, she just mentioned, by the way, statement of cash flows, at least in the United States, is a relatively newcomer to financial statements. It really wasn't mandated until the late 1980s. And if you read a finance or even accounting textbooks, it's kind of a third fiddle. People talk about income statements and balance sheets, and most of financial statement analysis focus on those two things. Anyway, it's a statement cash flow. And she said there are three parts to it. There's operating cash flows, there's investing cash flows, and there's financing cash flows. All of them could be either inflows or outflows. We have two to the third possibilities, eight possibilities. And then she intelligently placed based on those pluses and minuses where a company would be in and which stage it would be in its life cycle.

The Dickinson stuff in and of itself was fabulous. We actually came along and made three additional adjustments to it. One is we took stock-based compensation out of operating. They're stopped right now. SBC is an add-back to operating cash flow. We think it should be a financing thing. So we put it into financing. It's a capital raise. The second thing is the intangible adjustment we just talked about. We essentially increase earnings and we increase investments. And then the third thing, we remove purchase and sales of marketable securities from investing. That was back in the day when this was established. It wasn't a big deal, but now some of these companies have huge cash balances. And so that can be distorted.

We did that. We applied the Dickinson thing. It's a site to behold. It was beautiful. We covered that pattern perfectly. The ROICs followed perfectly. And it turned out the ages roughly followed it, interestingly. Just to give you a level set, about 75%, 80%-ish are in the growth maturity phases. That's still the most popular phase. Or those two stages are the most popular stages. But the important thing for us is it allowed us now or allows companies to move from one age to another. You're not always just getting older, like the rest of us. We wish we could go back to our youth. But if you're an older company and you find a fountain of youth in terms of a new line of business or some investment opportunity, you can actually go back and go from, for example, maturity to growth and vice versa. It's a really cool, powerful framework. And then we obviously can do transition matrices. And then we can figure out shareholder returns based on where companies are in various stages. All super, super cool stuff.

Cameron Passmore: Which stage has the highest returns for investors?

Michael Mauboussin: Well, it turns out that it looks like maturity has the highest return. But I would just qualify that to say that it's almost always the case that transitioning into maturity or growth in maturity are going to be the best. We wrote a report called 'Trading Stages'. So people should go back and look at that transition matrix and they can see all that stuff for themselves. Maturity and growth is really the sweet spot.

Introduction tends to be challenging. Because, again, you're just investing a lot with sort of uncertain prospects. Decline tends to be not so good because, to state the obvious, you're declining. The transition matrix, I think, is sort of the magic. And going back to growth maturity seemed to be the most profitable areas.

Cameron Passmore: Does this suggest anything about investing in newer or more exciting type industries or companies?

Michael Mauboussin: To state the obvious, it's challenging. One of the things that I would recommend people do as well as they possibly can is to understand the basic unit of analysis, which is understand, "Does this company make money?" Going back to our machine and customer acquisition, that's a good example of it. By the way, CapEx tends to be a value-creating investment. When companies do that, that tends to be a good thing. Customer acquisition tends to be less clear. But you can see, for instance, if a company has good customer economics and they accelerate their growth, that should be a good thing because the fundamental unit economics are good. That to me would be the main thing is, does the basic economic activity make sense? And if it does, you obviously sometimes have to project and have a little bit of growth in the maturity of the business and so forth. But that to me would be the way to think about that.

Cameron Passmore: How does intangible intensiveness change the base rates for differences of expected stock returns? That's a classic Ben question?

Michael Mauboussin: You get a lot of nerd stars for asking that question as well.

Cameron Passmore: Well, we'll give them all to Ben. That's not a star to me.

Michael Mauboussin: Let's back up and say, "What are we talking about with base rates?" And so the idea here is that when analysts or investors model the performance of companies, the sort of classic way they do that is they gather a bunch of information, they talk to management, they listen to earnings guidance, they listen to the analysts and so forth, and then they build a model. They have some sort of sense of what the growth is going to be.

Another way to think about growth rates or performance would be this idea of base rates. What a base rate is essentially is appealing to a reference class rather than saying, "What do I think is going to happen?" What you do is you say, "What happened when other companies were in this situation before?"

I'm modeling a company with $2 billion revenue and I want to think about the five-year sales growth rates. Rather than me forecasting it based on all this stuff I've gathered, I say, "Let's look at the distribution of growth rates for all $2 billion companies over five years." Many people don't know those numbers off the top of their heads, but it's an accessible number, obviously.

You have this base rate, and that can help temper, by the way. Introduces some sobriety in some cases. We tend to find egregious examples, but you can see analysts projecting these really rapid growth rates. And then when you look at the base case, the reference class is that basically it's 1% of all companies are doing it. So you're making a bet that seems to be quite extreme.

Okay, so let's tie this back to intangibles. We talked about the characteristics of intangibles. One thing we talked about was sunkiness. And that's this idea that things can become very obsolete, where if you write some software and it's really hot, it can sell a lot. And that's huge economies of scale and do really well. If it's a flop, it basically is worth nothing. It becomes obsolete very quickly.

The key thing with base rates is they're not static distributions that are handed down on high-on-stone tablets. These are living, breathing distributions that change over time. So they're there to guide us. They're not the ultimate answers to anything. What we found was when we examined intangible-intensive industries, they have similar means and median, by the way, growth rates. But they had both faster growers, more on the right tail, and then much slower growth rates. Whereas the population may look like this, a skinny bell-shaped distribution with intangibles, the bell-shaped distribution gets fatter, wider. That means more chance of doing really well. And at the same time, more chance of being obsolete.

And we could probably think of lots of examples. Usually, people pick on BlackBerry or Nokia as companies that went from being on top of the world to being obsolete quite quickly. There's a long list of companies in recent years, the Magnificent Seven would be a good example, that have been able to scale at sort of extraordinary rates.

By the way, you think about the growth rates that are being achieved by companies like Microsoft, Amazon, Google, there's very little precedent for anything like this in the past. Companies have just not been able to do that. I think the intangible component of it is an important ingredient in that story.

Cameron Passmore: What mistakes can using valuation multiples alone to value firms lead to?

Michael Mauboussin: A bunch of them. I always say to my students that multiples are not a valuation. Multiples are a shorthand for the valuation process. And one should never confuse those two things. What's good about shorthands? They save us time. What's bad about shorthands? They can have blind spots. What are those blind spots?

Well, number one, Cameron, just to acknowledge this, a multiple, an enumerator is basically a number, a value that represents the present value of cash flows from here to eternity. And the denominator is a snapshot. What's going to be earnings or book value this year, or next year, or maybe the last 12 months or whatever it is. You're comparing eternity to a snapshot that, in and of itself, you could see could be problematic.

Second is it doesn't really capture the magnitude of investment and the return on invested capital. You can have two companies with very similar growth rates, but they deserve very, very different multiples as a consequence of their capital intensity and returns. The intangible investment we've already talked about. Two businesses are very similar. One's intangible intensive, one's not. The non-one will have a much lower multiple than the one that's got intangibles, even though their economics may be very similar.

And then the last thing that's interesting is you can get very mixed signals. We wrote a piece called valuation multiples, one of my favourite charts was actually a plot where the X axis is price-earnings the Y axis is EV/EBITDA multiples, the most popular two multiples. And of course, there's a really high correlation, not surprisingly. But you find instances where two companies have very similar PEs and very different EV/EBITDAs or very similar EV/EBITDAs and very different PEs. And so you get different signals. And so the question is why are those signals so different?

What we featured in our report was, at the time we did the report, Apple and Walmart had the same PE multiple effectively, but they quite different EV/EBITDA multiple. Unpacking why the PE was the same while the EV/EBITDA multiple was very different. It was a very fun exercise. And again, illuminating, looking underneath the hood to understand why these things were different.

Cameron Passmore: And what are the implications for systematic value investors?

Michael Mauboussin: I think that most systematic investors are on this. There's a fair bit of academic research already showing how introducing intangibles, even simplistic ways of introducing intangibles into earnings and book value improve the quality of the value signal. I think they're on it to some degree already. I think it refines it. We have these yawning gaps between the value and growth. And Cliff asked us at AQR. He's talked a bit about this. I still have a lingering suspicion that part of that is a measurement issue. I'm sure it's a combination of things. But it's not just a stretch valuation and maybe also a measurement issue in there as well.

Cameron Passmore: There's another Ben question for you, Michael. How does your thinking on intangibles and valuation extend to the relevance of market-wide metrics like CAPE for saying that the market is overvalued?

Michael Mauboussin: The intangible thing's not an insignificant piece of that. CAPE was developed by Bob Shiller. And one of Bob Shiller's good friends is Jeremy Siegel at Wharton. And Siegel wrote a piece about the limitations of CAPE. You can modify it and I think you get a little bit better signal. But for example, it's reported earnings. There's asymmetry. You can have write-downs, which will impede earnings, which make multiples look higher, but you don't have write-ups. There are some issues like that. It's also, as you know, been a very bad timing. I don't think it was ever meant to be a timing signal, but it's been a very bad timing signals for probably now 20 years, probably. It's not that I'm being complacent about the market. There are a lot of things to worry about. I'm just not sure that this is a crystal-clear bell ringing for all those reasons.

Cameron Passmore: Let's shift to your thoughts on index funds. How do you think the rise of index funds has affected alpha opportunities for all the active managers?

Michael Mauboussin: This is a really hard one. And I know you guys have been talking a lot about this with various folks. I might start at the top with a concept that's not my idea, but I called it the paradox of skill. And the paradox of skill says in activities where both skill and luck contribute to outcomes, which of course that's true for investing, as skill improves, luck becomes more important.

And the key insight there is to think about skill on two dimensions. One is absolute and the other is relative. And so I think we'd agree, absolute skill has never been higher, certainly in professional investment management. We have access to information, and computers, and lots of smart people. Other way to think about this is if I gave you the tools at your fingertips, Cameron, today and put you back in the 1960s, you could run circles around your competition.

Cameron Passmore: Can you imagine?

Michael Mauboussin: It would be awesome.

Cameron Passmore: If you ever think about that, that alone is mind-blowing.

Michael Mauboussin: It is. Even when I started in this industry, it's a funny thing. This is the mid-1980s. I was in a training program and there was a rotation. And so we rotated through equity research. It wasn't me, but one of my trainee colleagues worked for an analyst, this is 1980s, who did not use a computer. He did all of his earnings models on a literal spreadsheet. Write it out. And so, if he wanted to change the gross margin, he would erase it and write in a new number and recalculate everything. That was in my investing career. This is obviously pre-internet, pre-all that. We got the point on that.

Now the key is the second dimension, which is the relative skill. I learned this lesson, by the way, from Stephen Jay Gould, the biologist. He was talking about baseball. Ted Williams in particular. Last player to hit over 400 Major League Baseball in 1941. And the argument he ends up making is that excellence has become more uniform. The gap between the very best and the average is less today than it was in generations past. And as a consequence, you and I, whether we're great tennis players or bad tennis players, we're perfectly matched. We're identical players. The answer is who wins the match will be a coin toss. It'll look like it's luck. Even if we're super skillful, it'll look like it's luck. That's the first of the paradox of skill. And I think that is operative. And that's true for anything, by the way. Professional sports, as the athletes become better, there's going to be more parity in the league. It's less true for superstar-driven sports than it is for non-superstar-driven sports, but that grind toward parity is pretty uniform.

Second thing is, interestingly, of course, alpha is what we're striving for. Alpha is a measure of excess returns relative to the benchmark adjusted for risk. But for there to be positive alpha, someone has to have negative alpha, right? Because by definition, alpha is a Y-intercept on a regression. It has to be zero by definition. For someone to have positive alpha, someone has to have an equivalent amount of negative alpha. And this is all before fees.

And so here's the question I would pose. And I think this is the case, but I think it's open to some debate. Is it the case that the players who have left the market as indexing has risen and active management has declined in terms of flows, might it be the case that the people who left the party first were the weaker players? If my job is to be the smart person at the poker table, but now the weak players have left the table, I'm left playing with the other sharks, my life got a lot harder, not a lot easier. And I think that's a fair assessment of what's happened as well, that I think a lot of the players that have left the party are not good. There was more alpha opportunity.

The third thing I'll say, Cameron, is we track this in some way, which is we look at the standard deviation of alpha. Literally, we look at every US mutual fund. We usually do large-cap and then we plot the distribution of alpha. It's not exactly a normal distribution, but it's close enough. And then we can measure the standard deviation. And so if the paradox of skill is correct, what you'd expect to see is that that would narrow over time. And that was precisely the argument Stephen Jay Gould, by the way, batting averages in baseball, the average batting average has been about the same. It moves around a little bit, but about the same. But what's happened is the standard deviation of batting average has gone down a lot. That's why there are no 400-hitters anymore. It's not because the players aren't spectacularly good, they are. It's because the standard deviation of batting average has gone down. And so statistically get over 400, if the average player is 260, it's going to happen maybe at some point, but it's a real statistical anomaly.

We've seen that standard deviation of alpha come down, which would suggest to me that, just on the ground, that's happening. We know that active managers – I mean, this is just the arithmetic of active management from Sharpe. We know that active managers, broadly speaking, after fees are going to underperform the market. But the standard deviation of alpha is actually really important as a second way of thinking about this because, for me, to succeed, someone else has to fail. If the people who are not smart have left the game, life becomes harder.

Cameron Passmore: Can you talk about what you think the effects are of the increasing weight of indexed assets? What effects do you think they're having on the overall markets?

Michael Mauboussin: I just don't know on this. I listened to your discussion with Randy Cohen and Mike Green with great interest. I know you guys got a lot of feedback from your listeners. There are people who are strongly on one side or the other. I find most people are not strongly on one. And I'm certainly somewhat agnostic and open to this. One exercise I did over the holidays, basically, is I went to NotebookLM. This is one of these great uses of these AI products. I fed it about 15 academic papers, including many of the guests you've had on the podcast who wrote those papers. I just basically said, "NotebookLM, tell me what's going on. What does this mean for price discovery? What does this mean for liquidity? What does this mean for all these things?" And I would just say that it came back and it was equivocal.

If you wanted to find an argument that efficiency hasn't been changed, you could find that. If you want to find one that there was an effect on efficiency, you could find that. And so it just seems to me unclear at this point. Now, look, to state the obvious, we could never go to a world of 100% indexing. This is just basically a Grossman-Stiglitz type of argument that we need to have people out there making sure the mail gets delivered and the trains run on time. The question is what is that proper number? So I just don't know. I'm watching this area with a lot of interest. I think that one of the things that's been a little frustrating for me is that the people that worry a lot about the rise of indexing. We should write down the four or five specific things that we expect to happen as a consequence of this and just monitor those things. I'm not sure we've been as clear-cut about anytime you want to make a prediction. It has to be falsifiable in some way, and I'm not sure we've gotten to the point where we've got the falsifiable arguments laid down. It definitely feels different.

I will tell you that in the investment management industry, many people I talk to or especially people who've been around for a long time definitely feel like it's different now. I'm sure everybody from every era says something along the same lines, but it's something very much that we're monitoring and watching closely. I wrote about this in 2017, I think, and I'm not sure we're going to come back to it anytime soon. But I think it's a really fascinating topic.

Cameron Passmore: How concerned should index investors be with the current levels of market concentration in the US market?

Michael Mauboussin: I could argue this both ways, I believe. By the way, here’s a fun little fact to it. Again, I'm using the US market as a benchmark. But since 1950, only 18 companies have ever been in one of the top three slots at year end. It was from '17 to '18 to '24 because NVIDIA became the 18th. In that period, there've been probably 20,000, maybe 25,000 public companies at some point, so it's a very rarefied company.

The work that we did on this revealed a couple of things that might be of interest. One is, whereas we are at very high levels, we saw levels like this in the 1960s. It's high. It's certainly highest in a couple of generations, but it's by no means unprecedented. By the way, if you go back to the 1930s, it was consistently higher than it is today. This is not outside the realm of what history has suggested could be possible.

The second thing is, Cameron, I just wanted to ask the question, if you had a clean sheet of paper and you knew nothing about what the weights would look like for companies in the S&P 500 or whatever it is, how would you go about figuring that out? One way you might do that is to say, what do the fundamentals look like, the differential fundamentals?

We use a very simple proxy of economic profit. Economic profit is return on invested capital, less cost of capital spread, so how much you're earning above your cost of capital, times invested capital. The first piece is capturing value creation. The second piece is capturing how much money has been invested. It turns out that for 2023, so this is now more than a year ago, the top companies were 27% of the way, but they are 69% of the economic profit.

When the dust settles for 2024, I'm going to make a guess that, well, I think the weighting is 32%, so it went up 500 basis points. But that the economic profit is still going to be over 50%. Interestingly, the economic profit is greater than the weighting in the marketplace. Now, again, I'm not justifying anything. We know there's regression to our linear return on capital and so on and so forth, so let's not get crazy. But this is not completely without some sort of substantiation.

The last thing I'll say, and I think index investors should think a lot about this, and it's very common sense, is that when large cap is doing well, concentration goes up because it's the big companies that are pulling the weight, and the market tends to do well if you own a market-cap weighted index. The large cap doing well means index does well. It means markets do well. When concentration comes down, it usually is because large cap is not doing as well as small and mid-cap, and returns for the market tend to be below the average. Rising concentration, above average market returns. Declining concentration, below average market returns.

That's something just to think about as a trade-off. That, by the way, I think is just mathematical or something, brilliant insight with that but just to acknowledge that. We show those numbers back to 1950. If you said, "Oh, I'm really worried about this," if you think that that means the regime of large-cap doing well is going to pass, you could either brace yourself for lower returns or position yourself into smaller mid-cap stocks. You could find an index of those as well, of course. Then that would give you a better chance.

By the way, that was really – if you think about the period from 2000s to the financial crisis, call this eight or nine years, a tremendously bad time for large-cap stocks, horrible. But if you own SMID-cap, small-cap, mid-cap, your life was perfectly fine. By the way, 1970s, horrible for large-cap. 1970s, not bad for small and mid-cap. There are long eras where small and mid-cap do okay.

Cameron Passmore: Do you think the acceleration of popularity of market cap indexing is accelerating the market concentration or increasing the market concentration? Like there's a feedback loop going on there?

Michael Mauboussin: My hunch on this is the answer is no. Owen Lamont has done some great pieces on this. You have companies ranking based on market cap. Then you put $1,000 in it. It's going to buy exactly what the market cap rank is now. That in and of itself is not going to change it. That's my first inclination. Now, the counter argument or the argument against that would be sort of an elasticity argument that if you put money into it, the larger cap stocks is going to drive their prices up. There could be an intellectual case behind that. I just don't find it overly persuasive. Chalk me down as I don't know once again. Again, it's a really interesting thing to think about, so monitoring.

Cameron Passmore: You alluded to the early part of the 2000s where small and mids did better. Has market concentration historically been related to future returns, like there's a linkage there?

Michael Mauboussin: Yes, exactly. Just to repeat what I said a moment ago, when concentration is going up, it tends to be – I think over the period we looked at, market returns were like 11% geometric, something like that. The basic idea is when concentration was going up, you earn returns above 11%. When concentration is going down, you earn returns below that. I think it's a fairly trivial observation. Countries going up, large-caps going up, and market cap weighted. That means index market's going to do well, and small-caps doing well. Concentrate is going to come down, but it's going to be because they're smaller voice. It's going to be less important.

Even if you're an index investor and you're thinking about this whole situation, the bet you'd be thinking about is, do I think the small and mid-cap are going to do better versus large-cap? One of the things we examined was just return on capital patterns for large-cap versus small-cap. I want to say we did Russell 3000, top 1000, bottom 2000, so basically Russell 1000 versus Russell 2000. What we found was returns on capital were pretty good for small-cap relative to large-cap in the 1990s. But really around 2000, we saw this reversal, and that was saying the large-cap stocks did not do well. Their economic returns got much better. We've seen a growing gap in ROIC between large-cap and small-cap or large-cap going up relative to small-cap.

By the way, we see the same gap in the US versus Europe, for instance, as well. Usually, as I like to say, when I point out a trend like this, it's right when it's about to reverse, so that might be the case. But the rise of these large caps relative to small caps is not completely without some sort of economic justification.

Cameron Passmore: How do active managers benefit markets?

Michael Mauboussin: There are two things that active managers do that create, by the way, huge positive externalities, and we're indexers or freeriders, and that is price discovery, basically market efficiency and liquidity. Those are both things we need to worry about. You already posed this question in this context. Market efficiency basically says if things get mispriced, the active managers are there to step in and buy what's cheap and sell what's dear and bring those things back into line. Then liquidity says if you and I need to buy or sell, we have a counterparty that's ready and willing to participate. Those are very important.

Even Jack Bogle, who I knew and I loved being around him, but Jack acknowledged that indexing is a free writing activity. We need active managers around to make sure that these things are happening. There may be ways to measure the value of that positive externality, but it's a very large number. It's a huge thing. Well-functioning capital markets are incredibly important for a capitalistic system. That's what active managers do.

Cameron Passmore: Why don't skilled active managers consistently beat the market?

Michael Mauboussin: I think they do actually. Even if you read Fama and French writing about this, the studies do show that some percent of managers beat the market. The challenge here is not that they don't exist. The challenge is this ex-post, ex-ante problem. They're easy to identify after the fact. They're very difficult to identify in advance.

I think you had Jonathan Berk as a guest at one point. I think you guys talk a lot about the Berk and Green model. There have been variations of the Berk and Green model where they have been able to detect a little bit more persistence, and persistence is what we're looking for. Persistence means what you did in the last period is going to carry over to the next period. There may be ways to shade the odds in our favour, but I think the fundamental issue here is this idea of post-ex-ante.

Now, the other important insight, I'm telling you something you already know for sure about Berk and Green is the notion that skillful managers will take in more assets, and this economy of scale will kick in. You basically take as many assets under management as you can to get your alpha to zero, which benefits you personally but of course the aggregate degrades alpha.

Cameron Passmore: Under what conditions does active management still make sense today?

Michael Mauboussin: I take my cues on this from a really interesting talk by David Swensen, who was the Chief Investment Officer, of course, for many years at Yale Endowment. Swensen said, "We want exposure to an asset class, and we're trying to figure out whether we want active or passive. What we do is we look at the difference between first and third quartile returns." So they look at a dispersion measure. If the dispersion is sufficiently high, he said, “We would go active,” which is an indication that the premise being this Yale could find the skillful people and so on and so forth and get access to the funds and so forth.

This goes back to Grinold and Kahn, really. I think it’s the fundamental law of active management, so information ratio, so measure of excess returns equals information coefficient times the square root of breadth. In plain English, it says excess returns are function of your skill times your opportunity set. I think another way of asking this question is what is the opportunity set required. An opportunity set or breadth is basically how many independent excess return opportunities do you have over some period of time.

One of the best ways to think about that is actually dispersion. You could imagine one asset class where the returns are very clustered, and you could be a super skillful person. But you just can't distinguish yourself because there's just not that much excess return available. By contrast, you have a lot of dispersion, and that performs the underlying assets, and you're skillful. Then you're going to find the ones that do well, and you're going to avoid the ones to do poorly, and you're going to be able to express your skill. Being skillful is only part of the game. Finding the right game to play, i.e. a lot of dispersion, is the second thing.

Part of the answer is where is active good? The answer is where there's dispersion. One of the things you can see quickly is that where dispersion is very high is venture capital or dispersion’s high is buyouts. Those are areas where there's really no indexing to speak of anyway, but that's where active management, of course, dominates.

Cameron Passmore: How do you think the average investor in thinking about their portfolio should think about the mix between active and passive?

Michael Mauboussin: What we just talked about might be a good way to guide on that. I think for most people who are not really interested in markets that much, a thoughtful, diversified index portfolio makes enormous sense for those folks. Get on with your life, and don't worry about it, and minimize your fees and so forth. But that said, if you're interested in wandering off into things that are a little bit more adventurous or different, you might want to go active again in those high-dispersion areas. That might include things like some emerging markets and just where there's dispersion.

Cameron Passmore: How much does that change for sophisticated investors?

Michael Mauboussin: Well, I think it's changed quite a bit. Endowments, for sure, have gone headlong into private. That includes buyouts and venture. While behind them, the pension funds are also sort of that trend is the same trend in place. But I'm not sure I could do better than that's once an advice on that. First of all, figure out what you're trying to do and then pick your spots. The challenge in the aggregate is at the end of the day, for example, even in hedge funds, a very high percent of the returns just go in the form of fees. That's not to say there aren't good hedge funds or hedge funds that don't make sense for particular investors. But by the same token, you have to think about this trade-off between dispersion opportunities, what you pay for, and what you're trying to do.

Cameron Passmore: We're going to get to private. But first, I have to ask you. What's your opinion on smart beta, factor investing? Do you think it's kind of a middle ground between active and passive?

Michael Mauboussin: Yes. I don't have a problem with it. I teach a course in fundamental active management. That's what I've always been involved with, but I have a lot of sympathy for the quants and definitely have this sort of quantitative mindset to some degree. One of the keys that we talked about is this also is not a static world. We already talked about, for example, the limitations of the value factor and how that could be enhanced. But it is a middle ground to some degree. Thinking about even factor timing, Cliff's got a good paper on this. Don't do it except for a little bit or something like that.

Cameron Passmore: Send a little, yes.

Michael Mauboussin: Send a little. Yes, I'm sympathetic to that.

Cameron Passmore: How significant has the shift been from public towards private over the recent couple of decades?

Michael Mauboussin: Yes, it's huge. I mean, the flows have been traumatic. I don't have the latest numbers. Probably the last 15 or 20 years, it's been north of two trillion out of active management. But I just level set with all the listeners, and I think these numbers are going to be roughly right. Our calculation, and this is for the US again, that active public equity managers run about $38 trillion. This is going to get people to lay the land, $38 trillion. The overall market is like $63 trillion, and about 60% is run by funds, and 40 % is held personally or whatever, $38 trillion call it roughly.

Buyouts, our estimate, is the assets under management are about $2.7 trillion. For venture capital, about $1.3 trillion. Let's repeat that; $38 trillion, $2.7 trillion, and $1.3 trillion. Now, it was standing that there's been a big push into privates. Just to be clear that the order of magnitude is vastly larger for publics. One little fun datum on this is that NVIDIA's market cap went up two trillion dollars last year. NVIDIA's market cap went up more than the AUM for the total venture capital industry. Just to put that in a little bit into perspective, the shift away from public equity has been most pronounced with endowments and then pension funds. I think it's not obviously been for a bunch of reasons, including regulatory reasons. Huge for normal investors, but it's been a very significant shift.

Cameron Passmore: And the main cause as being?

Michael Mauboussin: One is we obviously were going through this very low interest rate environment. When you run a pension fund or an endowment, you have beneficiaries you have to serve. As a consequence, you need to get returns. One way to get returns is to go out on the risk spectrum. Venture does that through buying young companies with uncertain prospects. Buyouts do that through leverage. Buying companies are more stable but with leverage.

Second is there has certainly been a rise of sophisticated investors, so just the sophistication of the industry has increased quite a bit. The third thing is there have been very substantial regulatory changes, in particular some regulation changes in 1996, which allowed more people, more investor classes to access privates. Then finally, the last thing is, and this is more muting the flow into public markets, there's just more access to capital for private companies.

Cameron, as you know, in the United States, the number of public companies is sharply lower today than it was 30 years ago. In part, it's because companies are staying private longer, and the reason they're staying private longer is because they can. They're getting access to capital in a way that was really not practical a generation or two before. Those are some of the reasons. The question is to what degree do these things reverse. If interest rates are much higher, you can satisfy a lot of your future liabilities through credit or more plain vanilla equities. That would be interesting.

Cameron Passmore: How do you articulate the benefit that private equities offer investors over public?

Michael Mauboussin: Maybe two or three things I would talk about. One is the managers have much more control over the businesses that they own. They're not just agents. They can bid to some degree principal. So if you're a buyout fund, you own the company. You can make changes, change management, change strategy. Activists can do that in public markets, but it's obviously a much more onerous process. Venture, of course, same thing with control. I mean, you own a stake, but you can work with an entrepreneur, or you can introduce him or her to various folks.

The control thing, I think, is a big part of that. By the way, there's almost always a reasonable trade-off between control and ownership. If you have a small ownership, it's hard to have control. If you have lots of ownership, you have more control. That would be one. Second is what we already talked about, lots of dispersion. If you are skillful and you can find the right companies, you have a lot of opportunity there. Interestingly, the persistence, we talked about a moment ago. But persistence is an idea. Again, if you performed well in a prior period, what's likely you'll perform in a subsequent period, there's very low persistence in mutual funds, for instance. There's relatively low persistence in buyouts.

But one area where there remains a lot of persistence is the one asset class with tons of dispersion, and that’s venture. If you can get access to the leading venture firms, which is very difficult to do, but if you can get access to those folks, that dispersion and those high returns are going to be winning you sales. Then maybe the last one I mentioned is a little bit more controversial, but it’s a little bit of keeping you from yourself. A lot of people call this volatility laundering, the idea that to some degree you could make your marks to some sort of model or something like that. The volatility appears less than it probably is if you had to monetize all these things from one moment to the next.

Then lockups. As a consequence, the limited partners that people invest with these general partner, buyouts or venture, it just doesn't feel as such a dramatic roller coaster ride as it probably is in reality. The fact that you have a lockup means you have to sit on your hands, whether you like it or not. Those things keep people in place, and a lot of them ride out the storms with a little bit of a psychological benefit. Pretend that the volatility isn't what it really is. Those are some of the factors, I think. It is kind of a benefit because it gives people that stay in their seats.

Cameron Passmore: I think that was another Cliff-ism, wasn't it, volatility laundering?

Michael Mauboussin: It is. Exactly. He's good at all that stuff.

Cameron Passmore: He's exceptional. Here's another great Ben question. What role have intangible assets played in the rise of private equity?

Michael Mauboussin: I'm not that close to this. When I started in this industry in the 1980s, that was sort of the first buyout wave. You remember RJR Nabisco and Beatrice, and there were some of these famous deals. The earmarks of those deals that they were big companies with good cash flows, invisible assets, and a lot of the strategy was to break them up and sell off the pieces and so forth. Tangible assets or things that you could touch and feel were a really important thing.

I don't know the exact numbers now, but I want to say something like 20 to 25 percent of all buyout deals now are in software. If you had told me that was going to be the case in the 1980s or even early 1990s, I would have told you I didn't believe you. It's a little bit for the reason we talked about before because if it doesn't work out, what's the asset value? If your industrial company doesn't work out, you've got assets, and at least there's some salvage value, and you can get some recovery on the bonds or whatever it is.

That said, in the case that there is distress in buyouts for a tangible versus a tangible business, what does that mean for recovery of the bonds? So the equity is gone, but what does it mean for the recovery of bonds? If my memory is correct on the academic work on this, and there are only one or two papers on this, is that the actual recoveries were not that dissimilar. It was a belief of mine that got updated that perhaps there is more recovery value. That's another thing. I just put a tab and keep an eye on that. That's an interesting development. If, in fact, the recovery values are the same for tangible versus intangible businesses, that changes essentially the nature of the buyout business.

Cameron Passmore: What do current private market valuations say about expected future returns?

Michael Mauboussin: We put in our report, Dan Rasmussen of Verdad has talked a lot about this. There was a chart, and I think I got it from Steve Kaplan, University of Chicago, which basically showed the EBITDA multiple paid for a business and the PME, public market equivalent return. Higher is better. Lower is worse. With that chart, if you can imagine it, is as the multiple went up, the PME went down. The regression line goes from the upper left-hand corner, high PME, low multiples, to bottom right-hand corner, which is low PME, high multiples. It seemed like the magic number was 10 times multiple.

That said, if I saw this correctly, multiples are now in buyouts running into the mid-teens and completely uncharted waters from that point of view. So I guess the best answer to that is time's going to tell, but I just don't know.

Cameron Passmore: You said companies are staying private longer than just fewer public companies. Can we extrapolate from that, that investors need to have some private equity now to keep up diversification, keep up expected return characteristics?

Michael Mauboussin: When you look at the population decline in public equities, about two-thirds of the companies that went away were effectively very small or microcap. It's like the bottom two percent of market caps. They're really not that really investable, certainly for an institution. Then the second thing is to say, if Delta Airlines acquires Northwest Airlines, the number of public companies goes down by one. It's cut in half.

But the assets are still out there. It's just a bigger company. The effect is much less dramatic if you look at the aggregate invested capital than if you look at the number of companies. In other words, saying this differently, the companies that are around are bigger than they used to be. How that speaks to diversification may be a slightly different question. But I think that even with however many companies we have now; 3,800 or 3,900, there's ample opportunity.

Now, the other thing to say is these are interesting points. Who are the big unicorn companies these days? SpaceX got a $350 billion market valuation, Databricks at $62 billion, Stripe at $70 billion. They would be decent-sized public companies. You could make the argument that that first set of tens of maybe hundreds of billions of dollars were in the private market. Again, you and I as regular investors couldn't get access to that, so it's almost like a fairness question. Should we have gotten access to that?

First is you'll get something like an Amazon.com, which went public in 1997. Inflation adjusted is probably like $300 million market cap. The market cap today is north of two trillion dollars. Essentially, 100% of the wealth has been created in the public market. You could have participated from day one and gotten all the upside in that. It does seem like there's some movement toward making private markets more accessible to more people. The question is whether there's a degree of sophistication that is useful or maybe even necessary to participate in these things versus just buy what everybody thinks is hot.

Cameron Passmore: I could ask you questions all day long, Michael. We have one left for you. It's our regular final question. How do you define success in your life?

Michael Mauboussin: Yes, Cameron. I love this question. I'll answer it on two different levels. The first is personal. At the end of the day, when you're on your deathbed, this is probably what matters the most, and that's really about family. I've been married to a wonderful woman for more than 34 years. We have five children who are all doing really well, and they all get along with one another, which is really great. As a family, we went on vacation to Vietnam over the holiday, and everybody was together. It’s just really nothing better than that and certainly feel a glow from that. That would be, to me, a very important point of success.

Professionally, I sort of think about that on two levels. One is being able to do what I love to do every single day. I wake up every morning very excited about getting into work and doing my job, and that's a real measure of success. Then the other one is school. In 2025 will be my 33rd year of teaching at Columbia Business School. That's a lot of students over the years. It's just so wonderful first to be with young people and extraordinarily gratifying when they come back and say that there was something useful, whether it was something they learned or maybe even more profoundly like an attitude about life, curiosity, constant learning, thinking about cross disciplines, those kinds of values.

Success would be personal. It would be the family stuff. Professional, it would be getting to do what you love and hopefully working with young people and passing it along.

Cameron Passmore: That's an amazing, amazing answer, Michael. Thank you. I can tell you, I jumped out of bed this morning knowing I was going to have a chance to meet you and ask you these questions. Unfortunately, Ben couldn't be here. It’s a blast to do this with Ben, but I'm so happy that we got to have this conversation. Thank you so much.

Michael Mauboussin: Thank you, Cam. It’s my pleasure.

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