Michael Mauboussin – The Four Sources of Alpha

**Patrick O'Shaughnessy** (0:04)
Hello, and welcome everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. You can learn more and stay up to date at investorfieldguide.com.

**SPEAKER_1** (0:24)
Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions.
Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast.

**Patrick O'Shaughnessy** (0:49)
My guest this week for the third time is Michael Mauboussin. If there's a major question about markets and investing, Michael has usually written one of the best pieces of research on that topic. Today's conversation is a mix of several of his research pieces, but focuses on the sources of alpha. The framing of the conversation is the brilliant question, who is on the other side of a given trade? If you're buying, who is selling and why? Knowing the answer to this question is one of the keys to understanding where excess return comes from.
As is usual with Michael, we explore tons of other interesting ideas that will serve as food for thought. Please enjoy.
Michael, maybe a fun place to start this time because we were talking about it before we hit record is for you not to go into each vertical, but give the rough syllabus for the class that you teach because these chunks, I think, represent a great way for people to think about building out their own sort of market education. And then we're going to spend a lot of time talking about the sources of alpha today and valuation measures. But as framing, I think that the outline of the course would actually be a great place to start.

**Michael Mauboussin** (1:48)
This is a course I've been, this is my 27th year teaching this class and it really has evolved over the years, but it basically is broken into four chunks. And by the way, if you see most of the work I do, you'll see it fall into one of these buckets. And the first is, you know, markets and markets, I call it capital markets, markets, market inefficiency and sort of the big questions I try to pose there are, what does the market care about?
And should we be focusing more on cash flows, earnings, how do we think about economic value? And the second component really is market inefficiency. So why, if you're an active manager, why do you think you can do better than a benchmark? The second big block is just on valuation, and this is translating prices into value and value into prices. And there I spend a lot of the time on talking about traditional metrics, price earnings being the most prevalent, EV to EBITDA, enterprise to EBITDA, and what's good about those things, but what their limitations are. So as I would say, students, you have to earn the right to use a multiple. Like you have to understand what's behind it. And we also spend a lot of time on return measures like return on equity, return on assets, return on invested capital and so forth. And there we actually tuck in some stuff on capital allocation. So here again, as an investor evaluating a company, how do we think about how they allocate capital?
The third building block is competitive strategy. What are the economics of this industry? What are the economics of the company that I'm studying? And the key is if I think this business is a particularly good business, what underlies that advantage? Is it some sort of consumer advantage, some sort of production advantage? What are the factors behind that?
And then the fourth one is one that I did not have at all when I started this course many years ago, but is actually probably now, I think, perhaps the most important component is decision making and really organizing yourself to think about the world probabilistically, organizing yourself to think about how you're going to be effective at integrating new information, which I think we all struggle to do, and thinking a lot about things like base rates. So as a quant, this is something that's very natural to you and sort of in your DNA.
But I think for a lot of discretionary investors and a lot of people just walking around in life, they don't understand or think enough about base rates and how those base rates can be incorporated into their day-to-day decision making to improve the quality of their thinking in general. So those are the four sort of building blocks, and again, you'll see the most of the stuff I do can fit into one of those areas pretty well, and there are a lot of little sub-components to those, but those are the big four.