Base Rates Book

My notes from a wonderful paper from Michael Mauboussin

Hi.

Reading time: About 8 minutes

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Note : this article is all based on work done by Michael Mauboussin any credit goes to him and if there is a mistake it is from my side

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Base rates are something that we should incorporate into our daily thinking. Incorporating the base rates model in your decision automatically makes you take more informed decisions.

Before we go deep into the conversation of base rates in finance it is important to understand what base rates are.

Base rates are historic averages which help us or give us a guide as to what the expectations should be for the future. For example, base rates tell us that the chances of dying of an animal attack are 1 in 1.5 million whereas the chances of dying in a terrorist attack are 1 in 3.2 million (USA). So if we incorporate base rates into our thinking we would be more wary of areas surrounded by wild animals then by areas where you would think terrorist attacks are likely.

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Coming to Finance now.

Research analysts whether they are sell side or buy side have to forecast the financial statements and key ratios and they have to to figure out if the companies current market capitalisation (market expectation) is higher than or lower than their expectations.

A company like Zomato according to reports from a sell side firm (Motilal Oswal) is expected to grow their sales at 55.5% (CAGR) in the next 3 years. This is for their expectations of a price of 320. The current price is 250. So they are expecting a higher sales growth than the market. Now in the sell side report has come up with these numbers from their own research. They have analysed their competitive strength and what they think the demand for the various businesses that Zomato have will be like in the future and at the same time at what cost they are going to grow. This kind of research is also known as bottom up work.

The numbers are based on their hard work and research. The firm which does this kind of research ends up experiencing overconfidence and optimism. They put value in their own research and don’t look at the story that history tells us.

Analysts tend to have forecasts which are too narrow and this causes them to go wrong a lot.

This begs a question; if you cannot rely on your own bottom up research than what is the alternative?

There is no alternative per se but there is something else which should be factored in to your research. Base rates. Incorporate base rates and you will realise that you are actually quite far off from the average.

So how do we do that?

Michael Mauboussin has done a wonderful job in gathering data for all the US companies and putting them in buckets based on size. For the simplicity factor we will use the data provided by him.

Zomato in 2024 had sales of roughly Rs 121bn if we convert that into USD it becomes roughly $1.4bn. So we can compare Zomato to a company which has sales between $1bn-1.5bn.

Interestingly you can see that only 1.5% of companies have been able to achieve a CAGR of sales above 45%. This table has data of companies dating back two decades. So there are a lot of companies. To be precise 37 out of 2548 companies could achieve the feat of growing more than 45% over a 3 year period.

Now if you knew the average is so low would you still be so confident as to predict such levels of growth?

Maybe. Maybe not.

There is the bottom up research and there is base rates. Both are important. But how do you know which one to give more weight?

To figure that out there is something known as correlation. It measures how consistent a particular line item can be.

“Correlation measures the degree of linear relationship between variables in a pair of distributions.The value of a correlation can fall between -1.0 (the rise in one variable perfectly correlates with the fall of the other)and 1.0 (both variables move in tandem). A zero correlation indicates randomness. We will examine a single variable,sales growth, measured over time and all of the correlations are positive.” - Michael Mauboussin ‘The Base Rate Book – Sales Growth’ 2015

For instance the correlation of sales growth is very low year on year. This means that you cannot easily forecast sales growth. When this is the case for a line item then you should start with base rates and then seek reasons to move away from it.

Base rates are not destiny. But at the same time there are a lot of companies which forecast growth and don’t achieve it.

Warren Buffet and Charlie Munger had some thoughts on management forecasting rapid growth. He wrote this in his letter to shareholders in 2000:

“One further thought while I’m on my soapbox: Charlie [Munger] and I think it is both deceptive and dangerous for CEOs to predict growth rates for their companies. They are, of course, frequently egged on to do so by both analysts and their own investor relations departments. They should resist, however, because too often these predictions lead to trouble.

It’s fine for a CEO to have his own internal goals and, in our view, it’s even appropriate for the CEO to publicly express some hopes about the future, if these expectations are accompanied by sensible caveats. But for a major corporation to predict that its per-share earnings will grow over the long term at, say, 15% annually is to court trouble.

That’s true because a growth rate of that magnitude can only be maintained by a very small percentage of large businesses. Here’s a test: Examine the record of, say, the 200 highestearning companies from 1970 or 1980 and tabulate how many have increased per-share earnings by 15% annually since those dates. You will find that only a handful have. I would wager you a very significant sum that fewer than 10 of the 200 most profitable companiesin 2000 will attain 15% annual growth in earnings-per-share over the next 20 years.

The problem arising from lofty predictions is not just that they spread unwarranted optimism. Even more troublesome is the fact that they corrode CEO behavior. Over the years, Charlie and I have observed many instances in which CEOs engaged in uneconomic operating maneuvers so that they could meet earnings targets they had announced. Worse still, after exhausting all that operating acrobatics would do, they sometimes played a wide variety of accounting games to “make the numbers.” These accounting shenanigans have a way of snowballing: Once a company moves earnings from one period to another, operating shortfalls that occur thereafter require it to engage in further accounting maneuvers that must be even more “heroic.” These can turn fudging into fraud.(More money, it has been noted, has been stolen with the point of a pen than at the point of a gun.)

Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions. A few of these managers will prove prophetic — but others will turn out to be congenital optimists, or even charlatans.Unfortunately, it’s not easy for investors to know in advance which species they are dealing with.”

There are exceptions as I said. Base rates are not destiny.

Take the example of a company like Apple. When I saw the numbers they had I was truly shocked.

To grow the way they have considering their size is something which is truly remarkable. But they have a focus as a company which is not on numbers but the focus is on the things that produce the numbers.

“Y’know, we’re fortunate to have a good year, but maybe the most important answer to that first would be that we don’t believe in such laws as laws of large numbers. This is sort of, uh, old dogma, I think, that was cooked up by somebody and Steve [Jobs] did a lot of things for us for many years, but one of the things he ingrained in us [is] that putting limits on your thinking [is] never good. And so, we’re actually not focused on numbers, we're focused on the things that produce the numbers, right?” - Tim Cook

In the report there is one more very interesting thing that was covered. The concept of reversion to the mean is one which is known by a lot of people but using it is not common.

Mauboussin did a wonderful job not in establishing where the mean is but in measuring how rapid the reversion to the mean would occur. It is a very simple process.

High correlation = Modest reversion to the mean.

Low correlation = Faster reversion to the mean.

These are some key points:

Sales Growth has low correlation year on year and is not persistent. But Sales growth has high correlation with total shareholder return.

Gross Profitability has high correlation and is very persistent but the problem is it does not have a high correlation with total shareholder return.

Earnings Growth also has low correlation year on year. Earnings growth has very high correlation to total shareholder return.

This is the dilemma. The things which matter for a shareholder are not as easy to predict as they are not consistent year on year.

If you want an underlined and highlighted copy of all the Base Rate books please comment down below and I will send you a copy!

Thank you,

Samvit.