Wall Street's favorite strategist discusses how to be a better investor

By Joseph Adinolfi

Morgan Stanley's Michael Mauboussin has cultivated a loyal following over his nearly four decades on Wall Street. He joined MarketWatch for a brief interview earlier this week.

Few Wall Street strategists see their research go viral on social media. But Morgan Stanley's (MS) Michael Mauboussin has cultivated such a rabid following that links to his latest reports can be seen pinging across platforms like X practically as soon as they are released to the public.

During a career in finance that has spanned nearly four decades, Mauboussin has published roughly 170 reports - according to a tally maintained by one of his many followers - along with four books. His approach has earned him a loyal audience by fusing elements of behavioral economics and cognitive science with highly technical discussions about how to approach valuing companies, while also offering helpful deep dives that add historical context to contemporary markets.

Recently, Mauboussin has been publishing alongside co-author Dan Callahan at Morgan Stanley Investment Management, where he serves as head of consilient research at Counterpoint Global, which manages a number of equity strategies.

Earlier this week, Mauboussin gave MarketWatch half an hour of his time to chat about several topics that have popped up in his recent research. (The following interview has been edited for clarity and length.)

MarketWatch: Investors seem preoccupied about the level of concentration, especially in large-cap indexes like the S&P 500 SPX and Nasdaq-100 NDX. What makes this bout of extreme concentration different from similar episodes in the past?

Mauboussin: To put it in context, the way we measure it is we measure the top 10 stocks versus the full market. The reading we had is in the low-30s - that is the highest we've seen since 1963.

And to find this at a sustained level, we'd have to go back to the 1930s. If we were to look back over the past century, this is really unusual. But what's really challenging for investors is the rate of the rise. If you were to go back to 2014, concentration has more than doubled. It is that rate of change that has been really unsettling.

MarketWatch: What is one thing investors should keep in mind about the companies behind the biggest stocks in the market that may not have applied in the past?

Mauboussin: It is worth noting that, notwithstanding our current status, the U.S. is the fourth-most diversified of the 12 largest markets around the world, and the U.S. is 60% of the total global market cap. If you look globally, it's not that unusual.

I think one way to answer that question is to ask whether there is fundamental support for these large firms doing as well as they have.Now, we have data in the report that showed these companies were 27% of the market cap in 2023, but they were just under 70% of economic profit. It's important to note that economic profit isn't the same thing as profit as reported on an income statement; it's essentially how much you're adding to the capital you've deployed into your business.Economic profit has been consistently quite a bit higher than market capitalization. That relationship has been true for the past 25 or 30 years.

The second factor that I think we have to consider is the rise of AI and what that has meant for these megacap companies. When you think about artificial intelligence, there are two issues to delve into. First, there is clearly an infrastructure play. Companies are demanding these chips and that has been what's supporting companies such as Nvidia (NVDA).

The second is asking whether AI will be what Clay Christensen called a "sustaining innovation" that will support the companies that are already strong versus a "disruptive innovation," which is when an innovative new technology supports companies that go on to supplant these bigger firms.

So far, the market's judgment seems to be the former. It seems like the market believes AI is going to strengthen the hands of the strongest players.

MarketWatch: You have written about how opportunity is necessary for skilled investors to thrive. Dispersion in the S&P 500 was high in 2023, yet most active managers continued to underperform. Do you see anything that might help to explain this?

Mauboussin: We just looked at the dispersion numbers the other day, and it seems to be average right now the way we measure. So it doesn't seem like we're in a particularly good or bad environment for stock pickers.

But one way concentration can hurt active managers - and there's plenty of research showing this - is when the average market capitalization of the stocks owned by funds is lower than the average market cap of the S&P 500.

As a consequence, when large caps do very well, these funds struggle because they are exposed to smaller-capitalization companies. Data shows that in 2023, 80% of these funds had lower market caps and struggled, while the other 20% actually did quite well. That's the primary issue - this natural exposure to relatively smaller companies versus the S&P 500.

This has been true for decades: If large-cap companies do well, it tends to be a more challenging environment for active management, whereas if small cap does well, it tends to be a better environment for active management.

MarketWatch: What has changed about how investors value stocks since you began your career on Wall Street?

Mauboussin: I think by far the most important topic has been the rise of intangible investments. Let's take one step back. In the late 1970s, for instance, tangible investments were roughly double those of intangible investments - intangible being those that aren't physical. According to the latest reading, it has almost flipped; intangible investments are now double tangible investments.

The reason this is important is that tangible investments are capitalized and depreciated over their useful life. You put the investment right on the balance sheet.

Intangible investments, by contrast, are expensed on the income statement. By the way, the FASB [Financial Accounting Standards Board] had a big decision regarding research and development in the early 1970s and they came to the conclusion that it should be treated this way. So, say you spend $1,000 to acquire a customer that generates $1,500 in cash flows, and the initial investment is an expense.

This is important because it means that earnings and invested capital are understated. To help put this into perspective, we estimate that profits for the S&P 500 are understated by between 10% and 15%.

This means that if you're going to default to using multiples such as enterprise value to Ebitda, you just have to be very careful since it's not apples to apples relative to history, or even between industries. In terms of valuation, core principles haven't changed a bit, but the nature of investing has changed and accounting has changed - and as a result of that, we're getting some distortions that are important for investors to know about.

MarketWatch: What is one common mistake or misconception that investors often make when valuing a stock?

Mauboussin: We wrote a piece about valuation multiples, and the biggest component of that is that earnings multiples often don't tell you about how much investment there is.

Say you have a lemonade stand and you invest $1,000 and your hurdle rate is 10%. In scenario one, you're earning exactly that and so value creation is neutral. In scenario two, you're earning $200 - clearly you're creating a lot of value. And in scenario three, you're earning $50, so you're destroying value.

If you were to look solely at earnings, you'll see that they don't tell you all that much about the underlying return-on-capital profile of the company. But you really need to take this into consideration when you're assigning multiples. And again, you have three scenarios here - the first is value-neutral, the second is creating value and the third is destroying value.

One thing investors need to keep in mind when using earnings multiples is whether the company is A) creating value or not, and B) how does growth amplify that.

In the report, we cited Aswath Damodaran, who said investors price companies, they don't value them. That's really the message we're trying to deliver - it's not that multiples are bad, but that you need to use them very mindfully and thoughtfully to justify your claim here.

MarketWatch: Many Wall Street economists anticipated the U.S. economy would have been in a recession right now, yet none has materialized. Where did these forecasters go wrong?

Mauboussin: I learned a long time ago that it isn't a good idea to be an economic forecaster. I've always been taken by the work of Phil Tetlock at the University of Pennsylvania. He wrote a book in 2005 called "Expert Political Judgment" where he tracked forecasts made by experts in economics and politics. And he found that the forecasts they made really weren't that accurate, they weren't much better than an extrapolation algorithm. When I think about investing, obviously you want to have some sense of what's happening in the world. I always say you want to be macro aware, but macro agnostic. You want to be alert to the wide range of possible outcomes, and think probabilistically. I personally try not to make economic forecasts, but I think having a recession scenario wasn't unreasonable.

One thing we've written about is pattern recognition. The question is, under what circumstances does pattern recognition add value? The point we've made is that pattern recognition works, but that it's very conditional.

The very classic and convenient example would be something like chess, which is very stable and linear, making it conducive to pattern recognition. But when you introduce unstable, nonlinear environments, basically all bets are off.

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06-21-24 0700ET

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