Mauboussin: Good Underpinning for Continued Recovery

Ryan Leggio: I guess a competing outside view which I think some investors are struggling with is looking at Shiller's cyclically adjusted P/E ratio. And James Montier, who is now at GMO, has done some work showing that predictably lower valuations lead to higher returns over the next decade; whereas higher valuations would lead to lower returns. Unfortunately, right now some investors are looking at that number right now around 20 which is near the higher valuation spectrum. What do you think that investors should be taking into account when they look at this other type of outside view...

Michael Mauboussin: Right.

Leggio: ...and come to maybe a different conclusion?

Mauboussin: Well let me first say that the basic concept has to be right. Which is high expectations tends to lead to disappointing outcomes and low expectations tends to be favorable outcomes and that is pretty much true not only for investing but for life. If you keep your expectations down, things tend to work out all right. That said, a lot of valuation work is somewhat circumstantial, so you just have to be very sensitive to the context. To me when I look at our current outlook, you say interest rates at least for now are relatively low, both real and nominal.

Equity risk premiums that had spiked...risk premiums across the spectrum had spiked in 2008 have now settled back down. The VIX, a year ago was roughly 40, this morning I looked at it and it was 17. So that has really come down fairly dramatically.

Then you say, "What is a reasonable earnings number for the market?" You go back to guys like Jeremy Siegel who will say the trend line earnings for the market is probably in the $80 range. I think that the consensus now is in the mid-$70s. So that gives you a multiple of about 15 times, which is somewhat lower than the 20 that you just mentioned.

But, the other thing that is really important about valuation, which I think often gets glossed over. I know you guys pay a lot of attention to it and we talked a lot about it over the years is, "What is the return on invested capital?"

So all things being equal, higher returns on invested capital for the same growth rate suggests and justify higher valuations.

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You look at the top 20 or 25 companies in the S&P 500. These are the guys that really have done nothing in a decade. A lot of them stock price wise, and many of them are down. However, they have increased their earnings, their balance sheets remain very strong, and in many cases they have improved their return on capital.

So I would argue there is actually a fairly good underpinning for, especially these large guys, to do reasonably well for the foreseeable future, which can be a good tailwind.

Now there are things to worry about, things to worry about is, if the government stimulus comes off too quickly does that slow us down? Do we think the housing market has found its footing? Or it is going to find its footing in the next six or nine months? If that doesn't happen, that would be a worry.

Taxes certainly would be something you would have to worry about. So it is certainly not a risk-free scenario, but on balance we think it tends to be more constructive.

Leggio: I know you have done a lot of research and that you bring a lot of this research to the table to the Legg Mason portfolio managers and the investment policy committee. What research items from your books and the articles that you put out really could have maybe changed some of the results for the funds, if any? Have you guys thought about tweaking the process at all based upon some of your research?

Mauboussin: Yeah, there are two things that I would mention. The first is I think and Bill Miller has talked a fair bit about this. I think when we saw the financial crisis we categorized it more as a liquidity crisis, than the collateral crisis that it was. And historically that had not been the wrong call, but in this case it was the wrong call. So the collateral crisis would be something along the lines of, you buy an asset, you use some leverage to do it, it makes asset go up and when you reverse the process the asset price goes down, which means margin call, which means you sell asset, right?

So it creates almost a violence on the way out and a violence on the way down. And in this case the asset that we were talking about is called the U.S. housing market, which at its peak was something like a $22 trillion asset. It's a much bigger asset than...the S&P 500 now is around $10 trillion, so it's a much bigger asset. When that collateral crisis happens with that large an asset class that is going to tend to have much more repercussion.

So that would be one thing, is how do we think about these crises in the future. The second thing I ought to say is we do try to think about the world probabilistically which means we try to come up with potential outcomes, and we try to attach probabilities to those.

I think perhaps we could have been quicker in updating some of those things so for example, the GSE is a good example, Fannie and Freddie, where we had scenarios that they would be for example, basically nationalized, so it wasn't a surprise.

But in those winds that were blowing in August of 2008 we maybe could have been faster in shifting our probabilities, which maybe would have helped us. So those are some of the things.

Now all that said, I also want to emphasize that one of the other struggles is, if you have had a process that has worked for many years, in this case over a quarter of a century, we know our business has a component of luck or randomness in it so we also want to be mindful that we don't want to radically change everything we are doing because what we have done has served us well for so long.

And the basic principal goes back to the same idea is buying stocks for cents on the dollar and holding those things for the long haul. And that tends to be a good way to go, notwithstanding stretches of good or bad periods.