MW What investors should consider when they're swinging for the fences, according to this award-winning Wall Street researcher

By Steve Goldstein

Babe Ruth was the one of the greatest baseball players of all time, and yet he also was the career leader in strikeouts, a measure of offensive failure, when he retired.

Michael Maoboussin is a veteran Wall Street analyst, previously at Credit Suisse and now at Morgan Stanley Investment Management, who's frequently been named to Institutional Investor's All-America Research Team and just authored an insightful piece about generating returns.

"The Babe Ruth effect highlights that it is not only how often you are right that matters (probability), but how much you make when you are right versus how much you lose when you are wrong (payoffs). Venture capital, as an asset class, loses more frequently than it wins. But the gains are so large they offset the losses in the aggregate," he says.

He has the numbers to bear that out. In public equity investments, 25% lost money over five years, compared to 62% for VC investors. Venture capital as an asset class has the highest dispersion between good and bad returns.

He said there are best practices in setting payoffs and probabilities.

-- Use base rates. That is, find probabilities and payoffs for a specific reference class. He uses the example of the three-year compound annual growth rate of sales for U.S. companies over the past 63 years. "Instead of asking, 'what do I think will happen?' the base rate approach asks, 'what happened when others were in this situation before?'" Granted, finding the appropriate reference class is not an exact science, and past experience doesn't always hold true for the future - for instance, thanks to internally-generated intangible assets, the distribution of sales growth is now more extreme in the past.

-- Sensitivity and simulation. Investors and analysts often use three simple bull, bear and base cases, but there often are a range of payoffs. "The crucial point is that the elasticity of operating profit to changes in sales differs a great deal by industry and company. As a result, analyst earnings forecasts can be very inaccurate, especially in the case of declining sales," he says. Five scenarios might be a worthwhile trade-off between insight and complexity, he says.

-- Margin of safety. Margin of safety was a concept popularized by the investing legend Benjamin Graham, and Maoboussin says it's the difference between value and price. "The point is that you want to have a sufficient gap to improve the odds of generating excess returns as that gap narrows as well as to compensate for 'miscalculations' in analysis or 'worse than average luck.'"

One other point he makes is even the best investments suffer through volatility.

The top 20 S&P 500 components between 2005 and 2024 - companies including Nvidia $(NVDA)$, Netflix $(NFLX)$ and Apple $(AAPL)$- had an average maximum drawdown of 69%. Domino's Pizza $(DPZ)$, which has returned 22% per year, had a drawdown of 93%. "Reaching the peak of total shareholder returns almost always requires going through a valley," he says.

-Steve Goldstein

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February 20, 2025 05:18 ET (10:18 GMT)

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