Dumb Investors, Smart Markets

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September 1, 2000

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CSFB Strategist's Stock Approach

Builds New Economy Following

By GREG IP

Staff Reporter of THE WALL STREET JOURNAL

Michael Mauboussin recently got an excited phone call from an analyst colleague at Credit Suisse First Boston, Michael Regan. The day before, bad weather delayed Mr. Regan's flight, scheduled to leave Chicago at 4:45 p.m. for Newark, N.J. To kill time, the chief steward offered 1,000 frequent-flier miles to the passenger who most closely guessed when the plane would depart.

Mr. Regan spotted a chance to test a favorite theory of Mr. Mauboussin, the chief investment strategist of CSFB, a unit of Credit Suisse Group, of why the stock market may not be as crazy as some think. He collected the 85 passengers' guesses, which ranged from 6:15 to midnight. But the average, 7:24 p.m., almost nailed the eventual departure time of 7:35 p.m. and was closer than 93% of guesses.

Mr. Mauboussin's response: "Another victory for dumb agents." Mr. Mauboussin believes the influx of millions of poorly informed amateur investors -- "dumb agents" in academic jargon -- during the bull market may have made stocks more, not less, correctly valued.

Proving the forecasting acumen of amateurs is hardly a conventional role for a Wall Street guru, but then the 36-year-old Mr. Mauboussin is one of Wall Street's most unconventional thinkers. He doesn't forecast the Standard & Poor's 500-stock index or pick favorite sectors. He denigrates the importance of earnings growth and price/earnings ratios in valuing stocks while extolling more esoteric measures like "real options" and "return on invested capital," and applies the dynamics of flu epidemics to Internet stocks.

Mr. Mauboussin preaches that conventional earnings analysis is poorly suited to recognizing the value created by New Economy companies. He is hardly the only one who feels that way: Many money-losing Internet companies make the same claim. What sets him apart are the analytical tools he has popularized as alternative ways to value stocks, many of which justify otherwise inexplicable valuations. Companies today, he says, increasingly create value not from physical assets but from intangible assets, such as intellectual property and a self-reinforcing network of users, that offer the potential of far higher returns on investment.

Even if mainstream gurus don't follow this stuff, the market, he claims, does. That is why he likes to demonstrate how the collective decision making of many poorly informed people is often more accurate than a few clever forecasters.

Mr. Mauboussin isn't as publicly known as Goldman Sachs Group's Abby Joseph Cohen and some other Wall Street gurus, but he does have a dedicated fan club among some of the key players in the New Economy, from executives at Amazon.com Inc., who have put a link to Mr. Mauboussin's research on their internal employee Web site, to managers at technology mutual fund kingpin Janus Capital, where he is one of the few Wall Street strategists to draw a crowd.

"He does the most interesting theoretical work of any strategist out there," says William Miller, manager of the Legg Mason Value Trust mutual fund, whose controversial bets on some richly priced tech stocks enabled him to beat S&P 500-stock index nine years in a row. "It would have been much harder to hold onto these things ... if we didn't have the external support his valuation work gives."

But Lise Buyer, a former Internet analyst for CSFB, found Mr. Mauboussin's research academically interesting, but of little practical help in advising clients what Internet stocks were about to do: "It works in a big strategic sense, but it doesn't work when a company misses a quarter."

Read research reports by Michael Mauboussin at http://www.capatcolumbia.com/

Indeed, Mr. Mauboussin eschews predicting where the market is going, believing that investors generally get stock prices right. But then how do you explain the Nasdaq Stock Market's explosive rise between November and March, stunning collapse in April, and subsequent roller-coaster ride?

Part of it, Mr. Mauboussin says, is that in today's fast-changing environment, the value investors attach to any company can change sharply overnight. Each individual may know only a tiny bit about a technology company, but their collective opinion is usually superior to that of any individual expert.

In addition, dumb agents collectively get the market right only when they are acting -- and making mistakes -- independently. When they start copying each other, the result is bubbles and crashes, which wouldn't occur in a truly efficient market. In retrospect, Nasdaq's rocket ride happened because "portfolio managers basically said, 'Gee, if I overweight technology, I'll outperform.' As that basic decision rule was adopted, it created vulnerability in the system when everyone started to think the same way." But he notes Nasdaq remains up sharply from a year ago. That is proof, he says, that even though Nasdaq is off its high, "the underlying shifts in our economy are real."

In person, Mr. Mauboussin comes across more like a professor than a securities analyst, albeit a young one, whose favorite expressions are "Cool!" and "Awesome!" Yet he had little formal training in securities analysis. A liberal-arts major at Georgetown, he earned a "C" in accounting for nonbusiness majors (he was a B-plus student, overall).

After college Mr. Mauboussin joined Drexel Burnham Lambert in 1986 as a stockbroker trainee. A mediocre stock broker by his own admission, his attention turned to collecting books and articles about investment gurus such as Warren Buffett, Ben Graham, Mario Gabelli and Alfred Rappaport (author of the influential business book "Creating Shareholder Value"). What he learned was a deep respect for return on capital, cash flow and competitive advantage -- and a low regard for earnings.

His favorite valuation measure is the cash a company generates for each dollar of capital lenders and shareholders have sunk into it. Many companies expand profit, he argues, only through costly investments that destroy shareholder value. Consider two companies, an Old Economy company with a 10% return on invested capital, and a New Economy company with a 50% return, and both earning $1 million. To boost earnings 20%, or $200,000, the Old Economy company must invest an additional $2 million, but the new company need only invest an additional $400,000. Because the new company can grow more cheaply, investors reward it with a higher valuation, even though its earnings growth is the same.

Mr. Mauboussin attributes the extraordinary valuations of many companies to their return on capital far exceeding the 15% to 20% typical of blue chips 30 years ago. Though Dell Computer Corp. has seen its growth rate flag this year, it still trades at about 60 times earnings, because, says Mr. Mauboussin, it boasts return on invested capital of 223% this year.

A report by Mr. Mauboussin on the link between return on invested capital and valuation found its way to Jeffrey Skilling, president and chief operating officer of Enron Corp., the Houston energy and utility giant, two years ago. Mr. Skilling scrawled "I don't get it," across the report and sent it back. Eventually Mr. Mauboussin arranged to meet him, and Mr. Skilling, who is turning Enron into a New Economy market maker for spare electricity, natural gas and telecommunications capacity, became a fan.

But the tools that have won Mr. Mauboussin so many plaudits from outsiders spark skepticism among some fellow analysts. Michael Kwatinetz, who headed CSFB's technology research team until April and is now at a venture-capital firm, says Mr. Mauboussin's tools may work, but he didn't find they added much in explaining the technology stocks he followed, an irony considering tech-stock valuations are what Mr. Mauboussin most seeks to explain.

Many of his concepts are drawn from academic research. For example, Mr. Mauboussin has popularized the idea of "real options" on Wall Street. A stock option gives its owner the right, but not the obligation, to buy or sell a stock at a certain price. Likewise, a "real option" -- originally developed, he says, to value companies such as resource producers -- is an activity a company can undertake but doesn't have to. Cisco System Inc.'s astronomical value, he says, is owed in part to the fact that in a world where technology is changing rapidly, it has the dominant technology, which it can use to extend itself into many new product lines. This potential is a valuable "real option."

Mr. Mauboussin often turns to biology or real life to prove his views. The Academy Awards pool he holds each year among his business students at Columbia University is aimed at repudiating the "lead steer" theory of how stock prices are established. This theory holds that one need ask just the lead steer, not every steer, to know where a herd of cattle is going; similarly, adherents to this theory believe, stock prices are set on the margin by smart investors, and the average investor's opinion counts for little. Mr. Mauboussin champions a competing view: that the stock market is a "complex adaptive system," which, like an ant colony or flock of birds, is a highly organized system with no leader.

At a class last March, he demonstrated the power of such a system by showing the students their Oscar pool results. Asked to pick a winner in 12 categories, students on average got a dismal five right. The best got nine. But the consensus -- the most popular answer in each category -- got 10 out of 12 right, even in such obscure categories as film editing and original dramatic score. One lesson, he says: "Markets are very hard to beat. Over time, 75% of all [money] managers underperform the indexes." Another lesson: "You don't need smart people for markets to work."

If the market gets it right, it raises the question of whether investors need Wall Street to pick stocks for them. Mr. Mauboussin says complex-systems theory isn't a great forecasting tool. However, Didier Sornette, a geophysicist specializing in earthquakes at the University of California at Los Angeles, and colleagues have used it to explain the 1929 and 1987 stock-market crashes in the U.S., the 1997 crash in Hong Kong and to predict the Japanese market's recovery in 1999.

But more to the point, Mr. Regan, the CSFB analyst, notes that even on his plane, 7% of the passengers beat the consensus on when the flight would leave on a "blind guess," so there is still room for a good analyst to create value.

Further, Mr. Mauboussin says influential people can affect stock prices, but not over time: "There's not enough lead steers to go around." But when he gives his class its Oscar pool results, one of Mr. Mauboussin's students challenges him: If smart people don't affect stock prices, why did Nasdaq tumble that very day, after Goldman's Ms. Cohen recommended reducing holdings of tech stocks?

Mr. Mauboussin grins. Ms. Cohen was Drexel's strategist when he started on Wall Street, and he remains a big admirer: "She's a lead steer."

Write to Greg Ip at gregory.ip@wsj.com

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