More Than You Know - Michael Maubossin

Summary: Develop and refine your process.
- Calculate your expected value and probabilities. Consider if affect is changing your perception on the probabilities.
- Determine if the investment provides you with high magnitude. Accept you will not always be right (frequency bias).
- Understand what the market 'expects'. Add context to your investment analysis, this is also a Greenblatt principle.
- Low turnover, high concentration.
- Evaluate management, use proxy statement/DEF 14A.
- Behavioral finance: Practice naturalistic decision making, don't accept the first OK option. Be flexible to changing opinion.
- Anticipate change / disruptive innovation, different based on industry.
- Smaller/newer growth companies are more likely to outperform.
- Think of the market on a power law distribution.

This book is split into four sections: (1) Investment philosophy, (2) psychology, (3) innovation and competition, and (4) science and complexity theory.

  1. Investment Philosophy

Process > Outcome.
This section of the book focuses on the difference in process and outcomes. If you are playing blackjack, and you hit on 17 and get the 4, it doesn't mean it was the right thing to do.

Magnitude > Frequency, calculate expected value.
When reviewing a stock, do not assign a single terminal value. Calculate expected value, and assign multiple outcomes with the probability of each; and look for asymmetric bets. Do not look for the best company, look for the best odds to win big and lose small. It is fallacy to think if you make money >50% of the time you will end up making money. One example: Options traders lose 90% of the time, but if the one payoff is 20x, they still come out positive. Human nature prefers being right, with frequency instead of focusing on magnitude.

Risk vs Uncertainty
Understand the difference in risk and uncertainty. Risk is inherent with known outcome distribution. Risk calculated mostly with degrees of belief, propensities, and using historical frequency. Further recommended reading on this topic provided: 'Calculated Risk' book.

Be open minded to changing opinion
Cognitive flexibility is the reason generalists can outperform experts in many areas. The market is a complex system, not linear, and context must be considered.
Market expectations are as important as the fundamentals.
We often use P/E and other multiples to determine value, this is an economical cul-de-sac given. You will have better results if you start with price, and determine what that implies about future cash flows.

Traits that outperform
Investors that outperform funds do so by mimicking lower turnover and higher concentration. Funds that outperform eventually get flooded with inflows, and then return to the mean. Streaks are calculated as skill ^ luck. In other words Steph has a 92% FT%, then he has (.92)^5 chance of hitting 5 in a row. Long streaks generally are secondary to underlying skill and should be recognized as such. Return to the mean is still inevitable here (92% in this case).

Management evaluation
The proxy statement is an important financial document, determine if management incentives align with shareholders. Things to check: Review board members past history, do they hold stock, is the CEO also the chairman, what metrics are used to evaluate management, and fixed/variable compensation. Good capital allocators are rare, and this cannot be delegated from the CEO. Unfortunately they get to this position via success in other ways usually. M&A is usually not beneficial, especially to acquirer.
* I may add further reading on this, vs practice.

2. Psychology

Know yourself, mistakes you are most likely to make and how you can be influenced.

Contrarian to the collective
Understand the market is a collective making decisions. Focus on where the collective is wrong, not individuals. It is impossible to contemplate all possible information. Reverse engineer the market expectations to assist with this.

Another note for being open minded
3 tendencies that prevail throughout investing are commitment and consistency, validation, and scarcity. These principles are why it's hard for many investors to change opinion.

Behavioral finance
Decisions are usually made based on the first OK solution. When you find an investment idea and it looks good, do you compare it with other options. You can beat this by practicing 'naturalistic decision making'. This consists of (1) mental imagery and simulation, (2) pattern matching, and (3) reasoning through analogy. Subconscious has more bandwidth and usually knows first.

Probability theory
Affect plays a role on probabilities in your expected valuation. In general if there is no strong affect, you focus on probabilities. If there is a strong affect, you focus on outcome. Example: Lottery – people consider the outcome but not the probabilities because of the strong affect. If you like an idea you usually assign less risk also.

3. Innovation and Competitive Strategy

Anticipate change
Realizing there are always challengers to the current status quo; he uses the analogy of the young lion challenging to be pack leader. His second analogy of the brain development with lots of synapses forming, then being pruned down. Newer companies outperform, particularly in the first 5 years.

Change is different by industry/fitness landscapes.
- Stable, DCF analysis
- Course, DCF and also strategic options for change.
- Roiling, more emphasis on the strategic options for future.

Change, Mgmt Focus
Being adaptable and realizing short term pain/change for medium term benefit; ie Tiger Woods swing. Don't focus only long term however as there are too many variables to predict.

P/E Ratios
Past PE is using non-stationary data, don't use it. It is effected by inflation, taxes, and equity risk premium at the time. Intangible businesses also require higher ROIC (less assets), thus they are not comparable.

Growth and the Cost of Capital
Acknowledge you can grow to bankruptcy if ROIC < cost of capital. If ROIC > cost of capital, ask for how long (consumer or production basis). Keep in mind more than a good business you are looking for a company with incorrect expectations. He uses CFROI comparison w cost of capital for this historic review. Usually fate determined quickly when below cost of capital (acquired or bankruptcy). ROIC: Advantage based on consumer or producer? Does this advantage have longevity?

4. Science and complexity theory

We tend to think of investments on a Bell curve, and use mean, std dev, etc. This does not correctly represent the market, or stocks. Markets and investments follow 'power law' principles, with frequent small events and infrequent large events.

Do not look for 1:1 cause and effect in the market, because information/sources so vast you will be creating a correlation that does not exist. Diverse opinions help make better decisions on expected value.

Looking into the past does not regularly work, as when growth stalls inevitably companies typically lose 50% of their value.

Pyramid of numbers
There will inherently be many small companies and fewer large companies; he uses the analogy of animal sizes – typically the larger the animal the fewer found in nature (ie more ants than elephants). Focus on smaller capitalizations where it will be easier to find growth.

Sentiment swings are powerful in the market; don't get caught in the cycle but also recognize its role.

Paul Weaver

Charlotte, NC