Looking beyond the fundamentals
Legg Mason's ace strategist Michael J. Mauboussin believes you can make money by spotting situations where investors' expectations don't reflect the underlying value.
by Corey Hajim, FORTUNE Magazine

(FORTUNE Magazine) - Michael J. Mauboussin is chief investment strategist for Legg Mason - the Baltimore investment house run by renowned fund manager Bill Miller - and an adjunct professor at Columbia Business School. His new book, More Than You Know, is an unconventional look at investing that delves into science, history, and psychology. He talked with FORTUNE's Corey Hajim about outsmarting the market, Eddie Lampert, and how to be a better person.

What's the key to successful investing?

The first thing is to focus on your investment process--a good process leads to a good outcome. The second thing is that you want to have some sort of edge - you want to have the odds in your favor.

But the markets are efficient, right? So how can investors improve their odds?

I think the default assumption for most people is the market knows more than they do. And the markets are pretty smart. However, periodically the market does zoom to excesses on either the upside or the downside. That's because when the fundamentals are good, investors want to buy, and when they're bad, investors want to sell. But that can push things to the point where the expectations built into the stock price are either too negative or too positive.

How do you gauge the expectations?

The nutshell is you reverse-engineer. Typically, to determine a valuation you would start with your own inputs - earnings or cash flow or dividends - and you do either a cash-flow model or a dividend discount model or apply some multiple and end up with a price. The expectation approach would go completely backward. You start with price, and then canvass neutral sources - analyst reports, Value Line, S&P - to determine the expectations built into the price.

Give us an example in which the market's expectations are wrong.

We have a 4% to 5% position in homebuilders. The fundamentals for housing, to state the obvious, are not good. But expectations are unduly low. We don't know at what point the stocks will bottom, but we think today's prices reflect the bad news and then some. A number of homebuilders have a fair bit of land on their books. They can, for some time, allocate less capital to buying land, which will free up huge amounts of cash and allow them to purchase stock or pay dividends.

Do you like any stocks that aren't facing such a tough business climate?

Citigroup (Research) has had a lot of challenges - management changes, some reputation issues, and the Fed raised interest rates. But the stock is trading at a low-double-digit multiple with a very attractive yield, return on equity is very high, and the company has repurchased a lot of stock.

Another one that is really interesting, especially for the longer term, is Sears Holdings (Research) . When you talk about someone who makes good investment decisions, [Sears chairman] Eddie Lampert is cast from the same mold as Warren Buffett. So with Sears, we think the valuation is attractive, it has a free-cash-flow yield that is above the market's yield, and you can buy one of the best capital allocators in the markets.

Your book draws on ideas from a wide range of disciplines--from psychology to philosophy to biology. What do they all have to do with investing?

The overarching theme is a celebration of the idea that having a multidisciplinary perspective can make you a better investor. And to take it beyond that, it can make you a better person, a better parent, a better spouse, a better friend, a better executive, a better writer. If you spend time learning about other disciplines, things that are not in your own bailiwick, the information you gather may not be immediately useful - in fact, it may never be useful - but there is some chance you will make connections that can be helpful at some time in the future. Top of page