Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).

Visit his site at: michaelmauboussin.com/

Michael Mauboussin - The Base Rate Book

Michael Mauboussin: The Base Rate Book – Integrating The Past To Better Anticipate The Future

“People who have information about an individual case rarely feel the need to know the statistics of the class to which the case belongs.” — Daniel Kahneman

  • Successful active investing requires a forecast that is different than what the market is discounting.
  • Executives and investors commonly rely on their own experience and information in making forecasts (the “inside view”) and don’t place sufficient weight on the rates of past occurrences (the “outside view”).
  • This book is the first comprehensive repository for base rates of corporate results. It examines sales growth, gross profitability, operating leverage, operating profit margin, earnings growth, and cash flow return on investment. It also examines stocks that have declined or risen sharply and their subsequent price performance.
  • We show how to thoughtfully combine the inside and outside views.
  • The analysis provides insight into the rate of regression toward the mean and the mean to which results regress.

Michael Mauboussin - The Base Rate Book

Executive Summary

  • The objective of a fundamental investor is to find a gap between the financial performance implied by an asset price and the results that will ultimately be revealed. As a result, investing requires a clear sense of what’s priced in today and possible future results.
  • The natural and intuitive way to create forecasts is to focus on an issue, gather information, search for evidence based on our experience, and extrapolate with some adjustment. This is what psychologists call the “inside view.” It is common for the inside view to lead to a forecast that is too optimistic.
  • Another way to make a forecast is to consider the outcomes of a relevant reference class. This is called the “outside view.” Rather than emphasizing differences, as the inside view does, the outside view relies on similarity. Using the outside view can be unnatural because you have to set aside your own information and experience as well as find and appeal to an appropriate reference class, or base rate.
  • Most executives and investors rely on their memory of prior instances as a basis for comparison. For example, they may deem this private equity deal similar to that prior deal, and hence assume the return on investment will be similar. An appropriate reference class is one that has a sample size that is sufficient to be robust but is similar enough to the class you are examining to be relevant.
  • Research in psychology shows that the most accurate forecasts are a thoughtful blend of the inside and the outside views. Here’s a helpful guide: If skill determines the outcome, you can rely more on the inside view. If luck plays a large role, you should place more weight on the outside view.
  • Regression toward the mean is a tricky concept that most investors believe in but few fully understand. The concept says that outcomes that are far from average will be followed by outcomes with an expected value closer to the average. Examining correlations allows us to not only acknowledge the role of regression toward the mean, but also to understand its pace. The data in this book not only offer a basis for an assessment of the rate of regression toward the mean, but also document the mean, or average, to which results regress.
  • This book provides the base rates of corporate performance for sales growth, gross profitability (gross profits/assets), operating leverage, operating profit margin, earnings growth, and cash flow return on investment (CFROI®). In most cases, the data go back to 1950 and include dead companies. It also examines stocks that have declined or risen sharply, and shows the subsequent price performance based on how the stocks screen on momentum, valuation, and quality.
  • Integrating the outside view allows an executive or investor to improve the quality of his or her forecast. It also serves as a valuable reality check on the claims of others.
  • This report is the result of a deep collaboration with our HOLT team. HOLT® aims to remove the vagaries of accounting in order to allow comparison of corporate performance across a portfolio, a market, or a universe (cross sectional) as well as over time (longitudinal).

Introduction

The objective of a fundamental investor is to find a gap between the financial performance implied by an asset price and the results that will ultimately be revealed. A useful analogy is pari-mutuel betting in horse racing. The odds provide the probability that a horse will win (implied performance) and the running of the race determines the outcome (actual performance). The goal is not to pick the winner of the race but rather the horse that has odds that are mispriced relative to its likelihood of winning.

As a result, investing requires a clear sense of what’s priced in today and possible future results. Today’s stock price, for example, combines a company’s past financial performance with expectations of how the company will perform in the future. Market psychology also comes into play. The fundamental analyst has to have a sense of a company’s future performance to invest intelligently.

There is a natural and intuitive approach to creating a forecast of any kind. We focus on an issue, gather information, search for evidence based on our experience, and extrapolate with some adjustment. Psychologists call this approach the “inside view.”

An important feature of the inside view is that we dwell on what is unique about the situation.2 Indeed, Daniel Gilbert, a psychologist at Harvard University, suggests that “we tend to think of people as more different from one another than they actually are.”3 Likewise, we think of the things we are trying to forecast as being more unique than they are. The inside view commonly leads to a forecast that is too optimistic, whether it’s the likely success of a new business venture, the cost and time it will take to build a bridge, or when a term paper will be ready to be submitted.

The “outside view” considers a specific forecast in the context of a larger reference class. Rather than emphasizing differences, as the inside view does, the outside view relies on similarity. The outside view asks, “What happened when others were in this situation?” This approach is also called “reference class forecasting.” Psychologists have shown that our forecasts improve when we thoughtfully incorporate the outside view.4

Analysis of mergers and acquisitions (M&A) provides a good example of these contrasting approaches. The executives at

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