Q&A With Michael Mauboussin, Prospector of Wisdom in Unconventional Places

Michael Mauboussin is chief investment strategist at Legg Mason Capital Management and adjunct professor of finance at Columbia. A veteran of Wall Street, Mauboussin is known for bringing unconventional ideas and ways of thinking into new contexts.

Michael wrote More Than You Know: Finding Wisdom in Unconventional Places (NEW: Updated and Expanded 2007 Edition) as a guide to help investors escape the myopia of Wall Street. We thought this unconventional approach to wisdom would be equally stimulating for business managers and executives and so we share our interview with Michael Mauboussin, in which we spoke about innovation, ideas and authors.

Q: Michael, what was the event in your life or the stock in your portfolio that convinced you that a multi-disciplinary approach was the best way to go? After all, most stock market players and business people end up in very narrow fields of expertise.

A: I started on Wall Street twenty years ago with a liberal arts background with no formal training in business. So I was never burdened with the knowledge of how things work. Early in my career I read Al Rappaport's book, Creating Shareholder Value, which made an enormous amount of sense to me. He argued that Wall Street's simplistic focus on earnings and earnings growth was suboptimal. His work encouraged me, from an early stage, to take a different approach.

I also read intensely early on including lots of finance, competitive strategy, and the approaches of great investors. I recognized pretty quickly that what mattered to the market and what great investors did didn't fit very well with most day-to-day activities on Wall Street.

I then went into a phase where I started to read actively outside of investing -- lots of science, including evolutionary theory, complexity theory, and psychology. Around that time I first met Bill Miller, who was (and is) way ahead of me in taking a multi-disciplinary approach. Bill helped shape my curriculum and introduced me to the Santa Fe Institute, which is dedicated to multi-disciplinary research.

By the time Charlie Munger's speeches about mental models came out in Outstanding Investor Digest in the mid-1990s, I was primed. I have always had the feeling that a multi-disciplinary approach has to be the most intelligent way to invest at least given my temperament. Being influenced by brilliant investors like Miller and Munger only added fuel to the fire.

The mental models approach is not easy, because it requires a substantial time investment with uncertain payoff. You may read something in another field that has no relevance to what you're working on in the portfolio, at least no relevance today. But the accumulation of ideas sets the stage to make connections that can be hugely useful in improving decision-making.

Finally, I can't emphasize enough how important psychology is in all of this. I can teach students how to do a cash flow model or conduct a competitive strategy analysis, and they'll be competent. What's much harder to teach is how hard it is to be a successful investor from a psychological perspective. Great investing is very unnatural, and incentives can create a huge barrier to success.

Q: Tell me how you profited from this. Show me the money!

A: Truth be told, I have spent most of my professional career learning and teaching about investment process, first as an analyst and later as a strategist. I have never run money on behalf of others.

I suspect that whether someone benefits from my work has a lot to do with how they approach investing. I can say that many people over the years students, peers, and even competitors have told me that my work has helped them be better investors.

My role at Legg Mason Capital Management is to help assure we have the most robust process possible. I'm hopeful -- my money's riding on it -- we'll deliver superior results over time.

Q: One section of the book looks at innovation and you refer to the number of building blocks for innovation, saying this will lead to more success and more failure for companies. What do you mean by that and what does this imply for CEOs and other managers? No more stability?

A: People sometimes perceive innovation as coming from a brilliant inspiration in the shower. If you break down innovation, it more resembles the recombination of idea building blocks. The Wright brothers combined cable technology, bicycle technology, and Bernoulli's principle to cobble together the first flying machine. No building blocks, no airplane.

If this approach to innovation is correct, the rate of innovation will accelerate as we have more idea building blocks and we can recombine them faster than before. Scientific advancement, storage technology, and computers --fueled by Moore's Law -- pretty much assure the table is set for continued, rapid innovation.

The implication is the period companies can sustain competitive advantage will shorten over time. Researchers have already validated this finding empirically. So yes, change is coming, and it's coming faster than it used to.

Just to balance the comment, however, it's worth noting that there is a spectrum of companies and innovation affects them to varying degrees. Some industries, like waste management or beauty salons, are likely to see much less innovation than other industries, like telephony or nanotechnology.

Q:  The Corporate Strategy Board and Clayton Christensen's work both help us understand that large companies often stall out in growth. What should executives do as a company gets
large? And should investors just flee growth companies after a certain number of years when everything looks great, or is there a smarter approach? (If we look at Microsoft, Cisco, Yahoo, the argument for fleeing looks compelling.)

A: There are two distinct parts to this question. The first is, What executives should do as a company gets large? The ultimate litmus test of a management's quality is capital allocation. Managers should work hard to identify and invest in projects or businesses that can earn above the cost of capital. And such a process requires understanding the process of innovation. But when a company can't find attractive economic opportunities -- and note the standard is value creation, not earnings per share growth -- it should return cash to shareholders. There is no shame in being an extremely well-run company that generates cash consistently.

Q: Ok sure, Michael, but rare is the CEO humble enough to admit the best option is to hand back the money. It is perverse logic, but many CEOs would consider this a shaming defeat. Your thoughts?

A: There's no doubt many executives feel this way. But the CEO is the ultimate steward of capital. The executive should make every effort to find attractive projects on behalf of the owners. However, when those opportunities are exhausted, returning capital is the right thing to do.
Over many generations, more executives have been guilty of overinvesting than of underinvesting.

The investor's standpoint is somewhat different. The key for an investor is to find stocks where the expectations for the company's future financial performance are unduly low. Following a period of extended growth, investor expectations tend to overshoot what is realistic for the business. But large, slow growth companies can be attractive provided the expectations reflected in the price are sufficiently modest. Indeed, a lot of large capitalization companies in the U.S. reasonably fit this description today.

Q: What is the best piece of advice that you have for finding wisdom in unconventional places?

A: If you're involved in financial markets, there is basically no end to your learning. There's always another facet of your game you can improve, whether it's learning about more companies or industries, better understanding psychology, or freshening up on the latest academic theories.

My advice is very simple. Identify some important topics, for example evolution, psychology, complexity theory, figure out the books in the field that will provide you with a good understanding of the topic, and delve in. Allocate time to reading, and read actively -- pay attention to your thoughts and try to make connections. Not every topic will offer an idea spark immediately. But over time and with some diligence, you will invariably start thinking about problems in a richer way.

Next, I'd recommend Amazon.com as an incredible resource. The recommendations they provide and threads you can follow are very impressive. I frequently spend time exploring books on Amazon.com, and have found many gems that way.

Finally, I make a point of asking smart people what they are reading. I'm always happy to leverage the knowledge and insights of people I respect. Often people not only give you good recommendations, they'll give you a quick summary so you can judge quickly whether you want to delve in yourself.

Q: Bill Miller, CEO of Legg Mason Capital Management, is arguably one of the best investors on the planet with an exceptional 15-year record of beating the market. What have you learned from him about business?

A: Bill embodies the mental models approach. His interests and ability to learn are seemingly boundless. And he constantly relates what he learns back to markets, back to portfolios. He's shown me that basically everything you learn can be applied to being a better investor.

He's also an example of why temperament is so important. He's very even-keeled and focused. He's also very rational, and doesn't suffer from loss aversion in ways most people do. I'd argue a large part of his temperament is innate; but he's also created an environment that supports his approach.

Ideas are Bill's currency. He's constantly on the lookout for ideas that can help him gain insight. That pursuit of good ideas is certainly something I've tried to learn from him, irrespective of their source.

Q: Michael, I enjoyed our chat. Thanks very much. By the way what are you reading these days?

A: I've enjoyed a number of books recently. The first is Donald MacKenzie's An Engine, Not A Camera. An economic sociologist, MacKenzie suggests that while we perceive economic models as describing economics (a camera), the models themselves help shape economics (an engine). The best real-world example is the Black-Scholes options pricing model, which changed options-pricing overnight.

David Warsh's Knowledge and the Wealth of Nations is a also a great read. Warsh traces our understanding of increasing returns from Adam Smith to the work of the book's main protagonist, Paul Romer. The Origin of Wealth, from Eric Beinhocker, is another noteworthy title. At 500 pages, this books is not light reading. But it's probably the most detailed description of non-equilibrium economics out there. Eric was very inspired by the Santa fe Institute, and that shines through.

Two psychology books have also caught my attention. The first is Daniel Gilbert's Stumbling On Happiness. While ostensibly about happiness, Gilbert entertainingly explains how our minds recreate the past, partially create the present, and project the future. In every case, the mind takes shortcuts and uses tricks, all of which are very relevant to understand as a decision maker. Finally, I's mention Judith Rich Harris's No Two Alike. Harris is a controversial figure in psychology, but she lays out an interesting theory to explain individual personality differences.

** Other Resources **

Author podcasts, reviews and book excerpts of More Than You Know.

Mental Models Investing: Focus Investing explores Charlie Munger's approach to Mental Models in this 22-page report.

Mauboussin on Strategy: Legg Mason's strategy page includes a sign-up for the Mauboussin on Strategy newsletter and an archive of recent issues.

Video: How do you compare? Mauboussin explores the elements of comparative decision-making in this short video for Legg Mason.

Charlie Munger's articles, speeches, audio interview and other resources and Poor Charlie's Almanack, a collected book of Munger's musings.

The Disruption Group lists the results from disruption, including new revenue streams and sustainable, high return on equity.  The website also has a CEO Guide to the Benefits of Disruption (pdf)