Michael Mauboussin is my favourite investing guru because he gives the market its due.
Most investing gurus think they’re great. They point out all the ways the market is stupid and irrational.
Mauboussin’s book Expectations Investing looks at investing through the other end of the telescope. The premise is that you start with the market price, and work out what assumptions are needed to justify it. If the assumptions aren’t right, you should maybe buy.
It’s a good approach because it implicitly respects market prices. And it’s good because it forces you to think very clearly about where stock prices come from.
That’s the other good thing about Mauboussin: he’s one of these highly logical people who think clearly about complicated things.
One of my favourite chapters in the book is his idea about the option value of an investment. It makes sense of some of the weird anomalies you see in today’s markets.
One anomaly is Tesla: a car company valued a little over a year ago at $1.3 trillion, once the sixth-most valuable company in the world, once worth more than all other car companies combined, down 70 per cent in 13 months.
Another anomaly is Berkshire Hathaway. Berkshire is a highly successful conglomerate that outright owns dozens of companies and has shares in dozens more. This is not meant to work: conglomerates went out of fashion in the 1980s. Companies, these days, are meant to do one thing and do it well.
Another anomaly might be the shocking performance of the technology industry in the last year and a half. The median company in Cathie Woods’ ARKK portfolio was down 83 per cent from its peak in mid-December. Shopify is a good example of technology’s fall from grace — it has dropped 78 per cent in 13 months, a drop of $150 billion in market cap.
Decisions and options
What Mauboussin says is that a discounted cash flow (DCF) model can be used to describe almost everything that’s going on in stock prices. But not everything.
A DCF can be used to make sense of a company’s fundamentals, the market it operates in, the risks it faces, and its growth path. It can accurately value a company based on all these factors.
But what it doesn’t capture is the value of a company’s investment decisions. Companies make investments, just like stock pickers. They put money into projects of uncertain value. They’re constantly making decisions about how much, and whether, to invest.
A startup might invest in marketing and infrastructure. Established companies might invest in R&D and branding and expansion into new geographies.
When a company invests — say in a new technology, or a new distribution centre — it opens the door for further investment in future. It opens the door for another decision to be made.
Mauboussin’s point is that companies have the option to invest in future ifthings work out well. That option is, in itself, valuable. And the option value should be reflected in the stock price. You can put a price on a decision.
Take Tesla. Tesla has built a giant battery factory in Nevada. Thanks to that investment, it now knows how to build and operate giant battery factories. It can build more of them if the demand for batteries grows. And if demand for batteries doesn’t grow, it doesn’t have to build more of them. Tesla has an option on battery factories.
Tesla’s option on building battery factories is just like a financial option, which gives the holder the right but not the obligation to buy a stock at a specific price. Those options are valued using something called the Black-Scholes formula. The formula, says Mauboussin, can be adapted to value companies’ investment options.
The formula has five inputs: the present value of the battery factory’s cash flows (as calculated by a DCF); the cost of building the factory; the length of time before the opportunity to build the factory has passed; the risk-free rate, and the volatility of the industry.
Volatility is important. It’s a measure of how unpredictable the future is. For some industries, like groceries, you can be pretty sure where demand is going to be in two years. In technology or biotech, it’s much harder to judge. The more volatile the industry is, the less predictable the future is, and the more the option will be worth.
This tells part of the story of Tesla’s collapsing share price. Last year Tesla was in a strong position. It had the lead in lots of electric car technologies, and it had built factories all over the world. It was well-positioned to make further investments and consolidate its position. But when Musk took a sledgehammer to the Tesla brand by taking over Twitter, the value of all those options collapsed.
It’s the same with a lot of these technology companies. Shopify for example had made huge investments in logistics, with the goal of competing with Amazon among e-commerce companies. The investments opened up the opportunity for further investments and expansion. But because of the slowdown, the value of those options got written down.
What about Berkshire Hathaway? Buffett says a big part of its success is its diffuse nature. It gives him more options. If there’s a great investment opportunity in one business, he can easily move capital into it from the rest of the group. Without the conglomerate structure, he’d have to pay taxes as he moved capital out of one business and into another.
Obviously, Buffett and Charlie Munger are two all-time great investors. That makes them a perfect complement for a business with lots of options.
They can defer an investment if needed. They can cancel an investment plan that goes bad. And they can double down if it comes good. For skilled decision-makers, that’s a valuable place to be.