Michael Mauboussin - Pattern Recognition and Public Markets (EP.370)

24:37So fast forward to January 1st, 2024, For expected equity returns are 8.5 % nominal. You take out the inflation expectations. Your real equity returns are from the mid-sixes, low to mid-sixes. Not great, not compelling, but a heck of a lot better than real 3 % or something like that. And again, going through high-yield spreads and BBB spreads and so on and so forth. So the basic idea is, I think, public markets went from appearing to have very low expected returns, got much higher at the end of 2022 and into early 2023. And obviously we had that rally, pretty substantial rally at the end of 2023 that brought it back down, but it's still a much, much more attractive environment.

25:16And I think we went from really way below expected return averages to something more closer to normal. So then you just take a step back and you say, okay, well, we're all here to try to satisfy future liabilities. So the question is, what expected returns do we need in our portfolios to allow us to do that? The two-year story is that it's a lot easier to do it today than it was 24 months ago. So the structure of public markets is a lot different than it's been over the past. And you wrote this paper on birth, death, and wealth creation in public markets. And I would love to talk through first, what's left after these changes over the last stretch of time?

25:55For some reason, I'm completely fascinated by this topic. And the stories will go back to mid-1970s. There were about 4 ,800 companies. the Wilshire 5000 was launched in 74, I believe. The 5000 was because there were 5000 public companies by the mid 1970s. In 1996, we reached the apex, which is a little over 7 ,300 companies. Today, we don't have the 2023 numbers yet, but it's going to be around 4 ,200. So we're not only way lower than the peak, we're lower than we were in the 1970s. Academics study this, they call it the listing gap. And they say, oh, given how big our economy is and our population is and so forth, that the listing gap is somewhere between 6 ,000 and 12 ,000 companies.

26:35In other words, if we had just continued at that pace, we would have 6 ,000 to 12 ,000 more public companies today than we actually do. So what the heck is going on here? It's basic math, which is companies get added in the listings and companies get pulled out. The main way companies get added are initial public offerings. And what we've seen is IPOs from 76 to 2000 averaged about 280 per year. They're a couple of years way above that. And since 2001, they're about 120. And by the way, the last couple of years have been horrible. 2022, we had 38 IPOs. This is data by Jay Ritter at University of Florida.

27:13Last year, 2023, 54 IPOs. I mean, you're talking about the levels that were great financial crisis, recession type of numbers. So just fewer companies are coming public. So why do companies get delisted? The number one answer is mergers and acquisitions. And notwithstanding that we've had fewer IPOs, M &A marched along. Obviously, it's cyclical, but it marched along. So the companies coming out has been pretty consistent. So that's led to this fewer number of public companies overall. But when you take a step back and say, oh, we went from that apex of 7 ,300 to 4 ,200, it turns out that the vast majority of those, about two-thirds of those, are actually micro cap.

27:51They're crammed into the bottom 2 % of market cap. the whole index. And so they're just not really big or super consequential companies, but it's addition by subtraction. So by getting rid of these super small companies, that means the average and median market cap of those companies that remain today are quite a bit bigger than they used to be. You're exactly right. And it's funny because we talk about historical multiples or historical returns or whatever. Again, it seems like we should be paying some attention to what the underlying companies were in our numbers. We often don't do that, certainly are not overt about it.

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29:18Learn more at srsaquium.com. That's S-R-S-A-C-Q-U-I-O-M.com. And now back to the show. On public companies exiting, you mentioned M &A. Private equity, obviously, there's more and more coming in, how much of a driver of the shrinking public companies has private equity world been? It was very quiet in the 1980s. It got rolling a little bit in the 1990s, but really it's in the 21st century. Since in the last 10 or 15 years, buyouts have been about 20 % of delisting of public companies. So for every 100 public companies that were delisted because of acquisition, a lot of it is strategic one buying the other, but one out of five was through a buyout.

30:05And It's an interesting question to ask, what do we think that's going to be going forward? Especially if these guys can exit some stuff, there's a lot of dry powder around for companies to do deals. As the public markets, I guess you could say, get more concentrated, and we certainly know that from the MAG7, but also this washout of microcaps. What have you seen over the years in how public markets have generated returns? It's interesting because venture capital is almost a completely shrunken time horizon of what happens in public markets. And this is another area I find fascinating. This is all work by Hendrik Bessenbinder at Arizona State University, professor of finance, and he's got these jaw-dropping statistics.

30:42He studied every public company that's been around since the 1920s. Again, since the CRISP database was established, there have been a little over 28 ,000 companies. And what he found is just under 60 % earned returns less than treasury bills on a monthly basis. So just take a moment to take that in. Of all the companies that have ever been public in the United States since the 1920s, let's call it a century just around it, almost 60 % have failed to earn treasury bill returns. And they destroyed an aggregate of$9 trillion of wealth by his calculation. Okay. So the other 40 % plus have obviously created value and they've created$64 trillion of wealth.

31:21So the aggregate wealth creation, and this is through 2022, we'll have to update for 2023, was$55 trillion. dollars. What's remarkable is if you distill that even one step further, the top 2 % of that 28 ,000 created 50 trillion of the 55 trillion in total. So just 2 % of all these companies are essentially 90 % of the total wealth creation. So again, it's worth taking a moment to let that settle in how profound that is and how extraordinary the skewness is. Now, there's some really good work on venture capital. There's a study of 30 ,000 venture capital deals. What is the distribution of returns?

32:01Hmm. Turns out 60 % of them don't earn their dollar back. And then again, this extraordinary right skew, this right tail that pulls up the returns for the full asset class. We're looking at a century for the public markets. The average holding for a venture capital deal historically has been about five or six years. It's happening in a very shortened universe, but it looks the same, interestingly, just sped up a lot. We associate power laws with venture, but if you let it play out in public markets, it's also the exact same power law. It's a power of compounding is the key insight. It's a completely fascinating thing.

32:40And by the way, not only did Best in Binder document this for the US, and my data I just shared with you is for the US, but in the third quarter of last year, they published a paper in the Financial Analyst Journal going around the world, 64 ,000 public companies developing developed markets, same basic pattern. At this point, I think we can say this seems to be a characteristic of public markets around the world. And if that's a characteristic, essentially, these are some of the rules by which we're going to have to play. The question is, how do we play? What are the implications as you get your head around the distribution of outcomes in public markets for the optimal way to think about participating in public markets?

33:22Boils down to two things, seems to me. One would be just cast a wide net. We said 60 % are going to be bad, 40 % are going to be good, 2 % are going to be spectacular, just index. And if you index, you're going to get the bad, but you're going to get the good and you're going to capture that skew. And that would be, again, if you take the public market equivalent returns for venture capital, it's obviously very, very cyclical, but it's been pretty good over very long periods of time. And this would be essentially saying you're going to own every venture fund. You're going to participate in all the goods and bads, but over time, it's going to do pretty well for you.

33:53So indexing would be answer number one. The second thing to say as a fundamental investor is, might I be able to identify those companies that are likely to do this over time? And it's a probabilistic assessment, but can I find those stars and put them in my portfolio and hope to get much better returns? So that would be the second approach. And so that also automatically then says, all right, well, what are the characteristics of those kinds of companies? Can we identify them? Again, a priori, pattern recognition, right? Going back to pattern recognition, are there things that we should be looking for?

34:23So that would be the second strategy. And I think that's what probably most active managers, fundamental managers are trying to do. The one thing I'll point out though, I guess to state the obvious is if you do find one or two or three of these superstar companies, they appreciate a lot and they get really big in your portfolio. And so you get in these interesting challenges with diversification rules. Berkshire Hathaway has, I think, a$320 billion public equity portfolio. It's obviously every quarter you can see it. Just an ooch under half of that portfolio is in one stock, and that's Apple. So it's very interesting.

34:58Now, obviously, Berkshire is big and diversified. There's lots of stuff going on, but it couldn't be a viable standalone fund because who's going to pay a fee to own half the portfolio in one stock, which happens to be the second largest company in the world and very liquid and so on and so forth. So that's another challenge is even if you can find these things, can you manage them within a portfolio setting that works? So that wealth creation, the 2 % of companies generating substantially all the profits is over multiple decades. If you shorten that to even five or 10 years, how did the dynamics change?

35:33You're making a really important point, and I call these data jaw-dropping, and they are, but I think it becomes much less dramatic if you shorten the time horizon. For example, you think about the leaderboard, the top 20 greatest wealth creators of all times, and it would include some suspects you would guess, which would be Apple and Microsoft and Amazon and Alphabet and so forth. But it also includes things you might not have guessed, which would be General Motors and General Electric and companies that have really struggled for a long time say, well, how the heck they get on that list? And the answer is they delivered spectacular returns in the 50s and 60s and 70s.

36:08As a consequence of that historical performance, they remain on the list. So one of the tricks here is that Besson Binder is translating these wealth numbers from percentages to dollars. And as you know, Ted, you and I, as investors, we care mostly about percentages, not dollars. Now, if you're CalPERS, you're super big, maybe you have to worry about dollars, but for the most of us, it's percentages. If you buy Apple, I'm going to round the numbers just to make it easy for myself. If you buy Apple, it's a$3 trillion market cap. It goes up 10%. That's$300 billion. But if you buy a$30 billion market cap, it goes up 10 to$3 billion.

36:40As a portfolio manager, the 10 % is 10%. But the wealth creation implications using this framework would be wildly different. So that would be the answer. So in a sense, what you're doing as an active manager is you're trying to find tomorrow's stars today, essentially. That would be, I think, the way to try to think about that. So find those companies with much more modest market caps that can deliver the percentages. And it's probably reasonable to have a three to five-year horizon or something like that. So look for those kinds of things, and I think you'd be fine. Anytime you think about the dollar wealth creation, you get back to the concept of compounding.

37:13Is there anything you looked at in even the multi-decade horizon that would start to indicate compounders, in air quotes, are the things to own as opposed to some value stock or something like that? The one thing I'll say, and we've alluded to this in a few pieces, but not written a ton about it, is since 2000, roughly speaking, it feels like the economics of the biggest companies have been almost economic law defying. By that, I mean two things. One is they've grown faster than what we would expect big companies to do, and they've sustained very high returns on capital that have really not been driven down in a way that's been very difficult to do.

38:00Now, there are lots of interesting theories as to why this could be the case, but the ROICs for the top quintile of public companies has distanced itself from the next quintile and sustained at a very high level. And that is wealth creation versus percentages, but I think that's a distinction that's really an important one to pay attention to. There's a book, it's provocative, I'm not sure it's right, it's called The New Goliaths by a professor named James Besson at Boston University. The premise is that large technology companies have invested substantially in proprietary software that has allowed them to both enjoy scale benefits, but also differentiation with their customers in a way that has not really happened in the past.

38:46So these are intangible investments. Many of these large companies now, they have data and developing software that is not diffusing throughout the economy. So it's not benefiting others. an interesting thesis to explore. Those are the big issues. We talk about Magnificent Seven, and obviously they're very different types of companies. And so throwing them all in one bucket may not be the right thing to do. But when you take a look at the economic profit, so return on capital, less cost capital spread times invested capital, the economic profit of the Magnificent Seven, it's actually larger than their market cap representation.

39:22I'm not justifying anything, but I'm just saying it's not without any foundation. These are really extraordinary businesses with very high returns and generating lots of cash. You touched earlier on the private markets. You're in the public markets. All the people you talk to are multi-asset class investors. Where are you assessing out what's happening in the private markets? The first question I always like to ask is, why have these asset classes historically drawn so much attention and realistically capital? And it goes back to really what we talked about a moment ago with probably the apex being the beginning of 2022 was the return profile public markets really seemed to degrade a lot since the great financial crisis.

40:06The asset class did well, but the prospective returns did quite poorly. And so I think a lot of investors are saying, I need to satisfy my liabilities. I need to generate certain types of returns. And as a consequence, I need to move out on the risk spectrum. Look, buyouts increase risk by adding financial leverage. Venture capital takes on risk by buying nascent companies with fairly high failure rates. So I think that was the main impetus for a lot of this. And the question is whether that has or has not reversed. Now, the other thing is we know buyouts in general, we've had a very gentle pattern of lower rates, which benefits these guys.

40:49benefits them in terms of financing costs, or perhaps important is exit multiples versus entry multiples. And by the way, I don't think there's a single buyout firm that assumes the exit multiples can be higher. They assume that's going to be flat or down, but if it's higher, that's great. So I think that's contributed to the returns. It's conceivable that easy component of it may not be around going forward. That's interesting. So just the return profile. The other thing that's interesting is to think about if you're in venture or buyout, the key is you run a fund and you have to buy, but you have to sell.

41:24And I think the buy part may not be that difficult, but the sell part seems to be a little bit of a bottleneck right now. We just mentioned the low levels of IPOs. Historically, IPOs were a very substantial mechanism, especially for venture, for exit. That's gone away. Now they're doing more strategics. We've seen a really substantial uptick in antitrust focus. Whether or not the Justice Department or FTC wins these cases, it creates friction and makes managers and executives, it creates uncertainty as to whether they want to do these things. The question to ask is, how can we open up these exits?

42:02Because before we can keep going, we have to get some of these exits done. So you're seeing things like continuation funds. And by the way, obviously the number one technique for buyouts to exit was selling to other buyout firms. Is that a musical chairs type of thing? So how long does that go on? So I think these are established, very thoughtful people in these. I think they're here to stay. The question is, when you think about what you need to do as an investor to satisfy objectives, how much do you need to do this? The last thing I'll mention, Ted, I think that you and I have talked about this as well.

42:33Often it's the case that investors are worse enemies themselves. and its inability to stay the course in particular things. And because venture and buyouts have essentially longer time horizons, whether people like it or not, they have to sit in their seats for a while. And that's actually, I think, probably been to their benefit versus their detriment. That's the other thing that's interesting is the time horizon component of all this is you don't need to do that. Maybe you could do that in public markets as well, but it instills a constraint that actually may ultimately be to the benefit of the beneficiaries.

43:08So to put color on that in the public markets, what does it take to own some of these, say, 2 % winners for the long term? Bessenbinder wrote a series of papers, and I would recommend people go check them out. If you go to SSRN, you'll find these papers, and they're accessible for the public to download. And he found a couple of things. One of the things that's not shocking to people would be they performed well. So they had good sales growth and profits and cash flows and so forth. So all the fundamental stuff was fine. The other thing he pointed out, technology companies, they're not overrepresented actually.

43:41And so this is something we forget about this a lot in life, but everything's a distribution. And so even if a right tail is fat, it doesn't mean the left tail isn't fat as well. So a lot of technology companies do well, but a lot of them fail. Same, we were talking about biotechnology, same thing. So you have to look at the fullness of the distribution. But I think the one that was most striking was that he documented that almost every one of these great compounders had massive drawdowns at some point. And it was common to have drawdowns at 75 % or more, but some were 80%, 85 % drawdowns. And to state the obvious, it shakes out all but the very hardiest of shareholders.

44:18You buy XYZ, you think it's great, you think it's going to be a compounder, and it goes down for a whole series of reasons. could be market generator, some specific stuff, goes down to 80%. That's just a hard one to overcome that and sit tight. And by the way, you're questioning yourself, your clients are questioning you, everybody thinks you're nuts and so on and so forth. So part of that is staying the course. Obviously, Apple, again, is a good example, a very valuable company. But if you follow and went public in the early 1980s, I mean, this thing was teetering on bankruptcy. The stock had done very poorly for a long time.

44:50People forget about where it came from to get to where it is today. It was great at the outset, and then it had a really, really dark period, and then this wealth creation phase since Steve Jobs 2.0. It's an amazing story. It's worth understanding the full history of Apple to understand this basic concept. Curious what else is tickling your research interests? A couple things. One is we are working a lot on a concept called increasing returns. If you're an investor, and again, this is macro or micro, you've heard of increasing returns. I mean, just to define a decreasing returns, what we learn in microeconomics, which is incremental unit of capital earns a lower return.

45:30So if Ted Lemonade Stand does really well, Michael Lemonade Stand comes and competes, and eventually we drive the returns down toward the cost of capital. By the way, that's the basic default. But we know that there are instances of increasing returns where returns on capital actually go up, market shares actually go up. They're sort of these winner take all markets. We're sitting down and just going through, there are actually multiple different flavors of increasing returns. Classic economies of scale, which you do learn. Alfred Marshall talked about this 150 years ago. Learning by doing. International trade is another area.

46:00Paul Krugman is now probably known as a New York Times pundit, but he won the Nobel Prize for his work on international trade. Path dependence and lock-in and network effects. This is the most common one in the investor world. And then finally, Paul Romer won the Nobel Prize in 2018 for his work on endogenous growth theory. So basically this idea, how do ideas contribute to a better world? How we can recombine physical assets. So increasing returns. The other one, Ted, that we're working on, I'm going to call 09 to 2021, the period of easy money. Central banks around the world, relatively low, Fed funds rate close to zero.

46:36And so people talk about easy money. The question is, what did public companies do in the face of easy money? And so you say, what would the predictions be? Well, the predictions be like, oh, we're going to take on leverage. Hey, we're going to invest more because we have a pecking order of projects. And so now the cost of capital is down so we can do more stuff and so on and so forth. What did companies actually do? None of that stuff. They actually didn't invest more. And so what capital structures got more conservative cash balances built up on balance sheets is excluding financial services companies like what the heck is going on?

47:08So it turns out it's really interesting that companies, they calculate their cost of capital, they know it, but they don't use it. For almost everything they do, they use a hurdle rate. And that hurdle rate's roughly 15%. So whether the cost of capital goes to six or eight or 10, doesn't make any difference, they're using 15%. Why do companies not do in quotes what they're supposed to do in theory? So that's another fun area. What a fascinating world we live in. Always something to work on, always something to think about. Great. Well, Michael, I want to ask you a couple of closing questions that I haven't asked you previously.

47:38And the first is in all your travels and talking to money managers, I'd love to hear some of your favorite lessons that you've learned from other people. The thing that almost always strikes me about the best managers that I know is I guess two aspects of it. One is they're always curious about the world and want to learn about the world. And so anytime you find someone in investing, who's not curious, you should ask the question as to what's going on. And then the second thing is, which is also, I think, extremely difficult to do is people are willing to see the world as it is. It's called epistemic rationality.

48:14So when new information comes in, they're able to update their views. And some of the investors I admire the most are people who are really good at that. And I think it's incredibly difficult because it requires a lot of mental nimbleness and a lot of mental energy, candidly. So those would be some of the lessons. I wrote a piece a number of years ago about the attributes of great investors. Those things certainly come out. What's one fact that most people don't know about you? Probably that I had a misspent youth playing sports and I played lacrosse in college. At the time I graduated, I was the leading goal scorer in the history of the school, which is a long, long time ago.

48:56That record's been broken many times since, but I don't think people think about me as a sports guy. They think about me as this propeller head guy, but that might be one. What's your biggest investment pet peeve? We live in a world where we have to simplify things to be able to understand the world, but simplification only works when you understand what's going on underneath the hood. I think Aswap the Motor's got this phrase where he says, people price companies and they don't value companies. And by that, I think he means you say this multiple used to be this, go back to this. This used to be 15 times EBITDA or 25 times earnings or whatever it is.

49:31So I always tell my students, you have to earn the right to use a multiple. In other words, you can demonstrate that you understand what the economic implications are. That always bothers me that people are very comfortable throwing around heuristics or multiples, for instance, without really understanding what it implies about the performance of the business. Which two people had the biggest impact on your professional life? One stands above all others, and that's Al Rappaport. I read his book in 1987. I can say confidently that was a complete world changer for me. Many things he talked about in that book remain at the core of what I do today.

50:10Al's in his 90s. He lives in San Diego. He's amazing. And I talked to him a couple times this week. I talked to him frequently. He just submitted another academic paper with some co-authors, which is a very cool paper. I hope it gets published. It's extraordinary. Just think about someone that age doing that high caliber work. It's great. So he would be one. Maybe the second one I would mention, and I say that I'm leaving off tons of people who have been really helpful along the way. But the other one I probably mentioned is Charlie Munger. I actually had the benefit of having lunch with him in June.

50:41So really feel fortunate to have seen him shortly before he died. But it was less like my personal interaction, but much more about his way of thinking about the world and this idea of mental models. I've been involved with the Santa Fe Institute for many years. I think that's been very reinforcing. But this idea that learning about the world, learning about different disciplines can help you be a more effective investor. It can help you be a more effective parent, partner, professional. I mean, it's just not just investor, but anything you're doing. And it's my natural inclination to think that way.

51:13But I think that whole reinforcing of that lesson has been very powerful. Michael, last one. What's the best advice you've ever received? It's funny. maybe can I flip that and say, what is the worst advice I ever got? Because this is something my mother told me and she was very dismayed when I told her I thought it was completely wrong. My mother always complained that I focused too much on what I was good at and didn't do enough of what I was bad at. And she said, you should work on your weaknesses versus continuing to build on your strengths. Now, on some level, what she's saying is correct.

51:46In other words, you have to be able to do certain things to get around life. But what I firmly believe today is that identifying people's strengths and letting them do what they're good at is much, much more value creating than having them work on their weaknesses. But even sports coaches for teams or managers of people, your job essentially is to make the people who you work with as effective as they possibly can be. So you're putting them in situations where they can win. And that's almost always going to be figuring out what they're good at and letting them do more of what they're good at and figuring out what they're bad at and having them do less of what they're bad at.

52:22Good advice would be to figure out what you're good at because you're more likely to be able to add value doing something you're good at. Michael, thanks so much for joining me again. Always so much fun. Thanks, Ted. My pleasure. Thanks for listening to the show. To learn more, hop on our website at capitalallocators.com where you can join our mailing list, access past shows, learn about our gatherings, and sign up for premium content, including podcast transcripts, my investment portfolio, and a lot more. Have a good one, and see you next time.