Aswath Damodaran - Making Sense of the Market - [Invest Like the Best, EP. 279]

[00:00] I know firsthand how complex the tech stack is for asset managers, and seemingly every new tool and data source makes the problem even worse, adding more complexity, more headcount, and more risk. [00:09] Ridgeline offers a better way forward, one unified platform that automates away all that complexity across portfolio accounting, reconciliation, reporting, trading, compliance, and more. [00:18] all at scale. [00:20] Ridgeline is revolutionizing investment management, helping ambitious firms scale faster, operate smarter, and stay ahead of the curve. [00:26] See what Ridgeline can unlock for your firm. Schedule a demo at ridgelineapps.com. [00:56] update models instantly, and incorporate the highest quality fundamental data into any workflow. If you're a professional equity investor and haven't talked to Catalyst recently, you should give them a shout. Learn more and try Catalyst for yourself at Catalyst.com slash Patrick. That's C-A-N-A-L-Y-S-T dot com slash Patrick. Stay tuned after the episode for my conversation with Catalyst customer Giuseppe Coco of LK Advisors. We talk about how Giuseppe has built Catalyst into his process as an international investor and much more. [01:26] is sponsored by Brex, the integrated financial platform trusted by the world's most innovative entrepreneurs and fastest growing companies. With Brex, you can move money fast for instant impact with high limit corporate cards, payments, venture debt, and spend management software all in one place. Ready to accelerate your business? Learn more at brex.com slash best. That's B-R-E-X.com slash best. Hello and welcome everyone. I'm Patrick O'Shaughnessy,

[01:56] This show is an open-ended exploration of markets, ideas, stories, and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts, and you can access all our podcasts, including edited transcripts, show notes, and other resources to keep learning at joincolossus.com. [02:19] Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. [02:26] solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast. My guest today is Aswath Damodaran, a professor of finance at NYU's Stern School of Business. Aswath is one of the clearest teachers [02:56] open sourced his wisdom for decades. This conversation is a masterclass of key investing concepts. We discuss inflation, narratives, disruption, the evolution of alpha and edge, and his thoughts on ESG. Please enjoy this great conversation with Aswath Demodaran. [03:14] Aswath, I've wanted to do this with you for, I don't know, I guess more than a decade since I started reading your work on valuation and markets and narrative and numbers, so many different things. [03:23] I think because we have the opportunity to talk about so many different topics today, it's important that we start with the most important one in today's markets in late May 2022, which is inflation.

[03:33] Inflation is something that, [03:35] almost no modern investors below a certain age have ever had to deal with as professionals. And all of a sudden, it's been thrust in their face. I'd love you to just do a deep dive for us on how you, as an investor, ultimately focused, I think, on valuing companies. [03:51] think about inflation as a now dominant force in markets. [03:56] I think it's interesting when you said most investors below a certain age haven't dealt with it. That's true for investors in the U.S., perhaps in Europe. The reality is there are countries outside which have had inflation, [04:08] Sometimes, you know, astronomically high inflation, Turkey, for instance, I mean, they've had to deal with inflation now for a decade. [04:14] I think that [04:15] Sometimes talking to people outside your geographies can give you some sense of what you need to be scared about. [04:23] And I think that's one thing that I found early in this discussion when we first started talking about inflation in 2021. [04:30] I found it disconcerting that people were so quick to dismiss inflation. Not only did they buy into the feds and the administration's sales pitch that this was transitory, it was going to go away. [04:41] So what's the big deal? [04:43] And I think only people who've never lived through an inflationary period will ever say, what's the big deal about inflation? Because it takes over the conversation as it does right now. [04:53] It drives everything else out of discussion and it drives the market. And I'm afraid we're in one of those spirals where inflation drives everything we do in markets.

[05:04] Maybe you can describe just exactly how that mechanically works. Like, why is inflation so incredibly important, good, bad, and ugly? To understand inflation, I think we've got to break it down into two components. Now, one is what I call expected inflation. Expected inflation is something that we can build into our financial assets. [05:24] So if you're buying a bond, if you expect inflation to be 5%, you set the coupon rate at 7% or 8% to cover inflation. Expected inflation, to me, is the more benign part of inflation. The part of inflation that's deadly is unexpected inflation, which is inflation coming in higher or lower than expected. [05:44] When inflation is unexpected, you've not had a chance to adjust to it. [05:49] Now, if you own financial assets, unexpected inflation can cut both ways. When inflation comes in below expectations, [05:56] As a bondholder, you're happy because you set coupon rates at 7% and inflation is now at 2% or 3%. And that actually spreads across all financial assets. [06:05] where inflation comes in above expectations, [06:08] It's devastating because you never had a chance to build it into prices. You have a mad scramble going on, adjusting prices to reflect the new inflation. [06:17] What does that mean with bonds? You've got to mark down the price of the bond because the coupon rate is not high enough. [06:22] which stalks the same phenomenon plays out in a more subtle way. [06:26] With stocks, at least you get a chance to adjust your cash flows, unlike bonds, so the effect can vary across stocks. [06:32] It's unexpected inflation that is so deadly.

[06:35] I was just finishing up a piece in inflation to kind of follow from what I wrote a couple of weeks ago. [06:41] where actually in each decade, look at both expected actual inflation and the portion of that that's unexpected. [06:48] We talk about the 70s as a high inflation period, and it works. [06:52] The 80s were also a high inflation rate if you look at the average inflation rate. But here's the difference. [06:57] In the 70s, unexpected inflation was always positive, which meant inflation came in [07:03] consistently above expectations. In the 80s, inflation was high, but towards the second half of the decade, inflation came in lower than expectations. [07:12] And if you look at what stocks did in the 70s and the 80s, and what bonds did in the 70s and the 80s, you can see, [07:18] how devastating it is for financial assets when inflation becomes high and volatile. [07:25] My concern with what's been happening in 2021 and 2022 was seeing a pattern that we saw in the 70s. [07:32] which is people's expectations are set by what they've lived through. [07:36] And the reality is most people entering the market, if you look at the investors in the market in 2021, entered the market in the last 10, 15, 20 years. [07:45] And for those people, the only inflation they've known is low and stable inflation. And it takes a while. And this is the behavioral component for people to adjust their expectations. [07:56] So one reason I think we were so slow to adjust to inflation is because we thought this was a passing phase. It's going to go away. We fell back on. Inflation has always been low because that's the only thing we knew.

[08:08] So I think it's the unexpected inflation that I think is so damaging. And what we're seeing in markets right now is markets are trying to adjust to what's the true inflation going to be. I mean, we all agree that the 8%, 9% that we're seeing is probably too high a number, that some of it is supply chain score with the excuses that were given early on. [08:29] But we all also, I think, finally agree that we're not going to go back to 1% or 1.5% inflation. [08:35] which is what we had in the last decade. [08:38] The question of where we fall between the 1.5% and the 8% or 9% is what's driving markets. [08:44] If inflation subsides back, the most benign scenarios goes back to 2%, which is supposedly the Fed's target. That's the most benign scenario. [08:53] But that scenario is becoming a lower and lower probability scenario the further we get into this process. At this point, the question is, will it go to three? Will it go to four? Will it go to five? [09:04] And adjusting from a 2% expectation to a 5% expectation is devastating for all financial assets. It's not just stocks. It's not just bonds in any type of financial asset. [09:16] That's why I think we need to think through this process a little more carefully and adjust our portfolios accordingly. Because we're going to have this go on, I think, for pretty much the rest of the year as we try to find what I call steady state and an expected inflation we can live with. [09:33] Obviously, we have some historical precedent for this. You mentioned the 70s and 80s. What are the big lessons that you take away from those periods of history as it pertains specifically to portfolios? So obviously, cash lost a lot of its value in the 70s. What about everything else?

[09:49] What is the lesson that you think might be portable from other periods of high inflation in the West or around the world to today's market? If you think of cash as invested in Peebles, which is what cash has become now, increasing in, it actually did very well because it kept up with inflation. [10:05] What was more dangerous if you invest in longer duration financial assets, bonds, stocks, because their unexpected inflation meant you had to readjust the price for whatever the new inflation came in. That said, though, there are some subgroups of stocks that will do better than other subgroups. In the 70s, for instance, you found low PE stocks, small cap stocks did much better than [10:28] higher PE stocks. So in a sense, if you think about this as a very lazy categorization of value versus growth and the small cap premium, much of the small cap premium that people keep talking about in valuation was earned in the 1970s. It was the decade where the small cap premium was strongest. [10:46] So for whatever reason, small cap companies had more flexibility to adjust to inflation [10:52] And there's a reason why the more established you're as a company, the more your business model has already been sent, the more adjustments involved when inflation hits you. Because you've got to change the way you do business. [11:03] And I think that the lesson from the 70s and the 80s is there's really no safe spot. [11:09] among financial assets. [11:11] But among financial assets, there are relatively less damage versus more damaged assets. [11:16] If we think about something really naive, which would be that equities might be a safe place because they might have pricing power in aggregate, and they can sort of pass the inflation onto their customers. Why is it necessary then that

[11:29] equities as a financial asset. [11:31] are in bad shape in a high inflationary environment like what is happening inside of companies that make that the case [11:37] That's where the contrast between expected and unexpected inflation comes in. You're right. Companies can adjust to expected inflation. I tell people, look, if you tell me inflation is going to be 10%, you can guarantee me it's going to be 10% forever. [11:51] We'll all learn to live with. We'll all write our compensation contracts with a 10% clause in there. We'll adjust for prices consistently. [11:59] The problem is when inflation becomes high, it also becomes volatile. [12:04] which means that when inflation is 10%, it's far more likely to be swinging from 4% to 16% than inflation is 2%. [12:11] What kills companies is the uncertainty about inflation. And here's why. [12:16] Let's say you're a company with long-term investments. You've got to make a decision on a 30-year project. [12:20] I mean, go through the basics of capital budgeting in a company. You sit down, you make projections about how much you can raise prices in the future and what your cash flows will be, and you're building it based on expectations. [12:32] But now that expected inflation could be 4 or 16, [12:36] you're going to be far less likely to take that long term investment. So here's the first area of disparity. [12:42] Companies that have to make longer-term investments will be far more hurt by high inflation than companies that can live with short-term and flexible investments. [12:52] Inflation kills infrastructure companies. It kills companies which make long-term investments because those investments now [12:59] will either be delayed or not taken when inflation becomes uncertain.

[13:04] If you look at outside the US at countries which have had hyperinflation, not just talking about 5, 7, I'm talking about 50, 100 or 5,000% inflation. Every company in that country becomes a financial service company because they discover it's easier to run a bank on the side and lend money out short term than it is to build factories or toll roads. [13:28] So you need pricing car in the sense of not just setting prices, but being able to adjust prices quickly. [13:34] And very few companies have that degree of pricing power because that requires that your product be incredibly non-discretionary, that people buy it no matter what the price you charge. [13:44] that the competition, [13:46] behaves the way you do because you can't unilaterally disadjust prices if you're in a competitive environment. [13:51] And third, that the regulatory framework you work with [13:55] actually is quick. [13:57] I mean, I'll give you the example. Your 30s, [13:59] should be relatively protected against inflation. [14:02] The reason is that there are regulatory commissions that should allow you to set prices that incorporate inflation because you're supposed to earn a return equity roughly equal to your cost of equity. [14:13] The problem is regulatory commissions are composed of people appointed by politicians. So inflation is 12%. You know the right thing to do is pass on that 12%. [14:24] When we said it at 4% or 6%, people can't afford the 12%. So during high inflationary periods, even though in theory your prices should keep up with inflation as a regulated company, in practice, they don't.

[14:39] It's one reason. I mean, real estate was one of the few bright spots in the 1970s. And people say, should I go into real estate now, especially if it's rental real estate? [14:49] because you should be able to raise rent when inflation is unexpectedly high. Well, that's true if you don't live in a rent-controlled or you don't own property in a rent-controlled city. [14:59] I can almost guarantee you that even if inflation is 12%, rents in New York City are not going to go up 12% because I've seen that rental committee get into meetings and decide on what to do. And they've had a tough time putting in a 2% increase when inflation is 2%. And you think they're going to increase rents by 12% if inflation is 12%? I don't think so. [15:21] So I think the problem is, well, in theory, we can talk about how companies can be insulated against inflation. [15:28] In practice, they cannot. And there's one more thing. Our tax laws are all built around... [15:34] book value, what you actually invest in. [15:37] So things like depreciation actually become less valuable when inflation goes up because you get the same dollar depreciation. [15:45] that you used to with 2% inflation when inflation is 12%, and all of those benefits become less valuable. [15:52] What have you learned about goods versus services and that mix in all of this as it pertains to inflation? [15:58] I think it's not so much goods versus services, discretionary versus non-discretionary. [16:04] I think that [16:06] If your good or service that you provide is something that people can live without, they can delay buying, they can defer buying, you're far more exposed to inflation than if you're not. A grocery store chain will do far better.

[16:21] than your specialty retailer. [16:23] As you've noticed in the last week, we've seen Walmart and Target, the big retailers all come out and tell the world how badly they're being hit by unexpected inflation. I don't think you're going to see Kroger's do the same thing because you can't delay buying groceries. People are going to pay the higher price. They'll complain about it. [16:43] But what choice do you have? [16:45] So I think that it's discretionary versus non-discretionary. But the big challenge for us is, [16:50] The money we spend now is on things we didn't have 40 or 50 years ago. We don't know how discretionary or non-discretionary your Netflix subscription is. [17:01] We're going to find out very quickly, right? And so this is going to be the real test is so much of our market cap comes from companies that provide products and services that weren't around. [17:12] 30 or 40 years ago, we're going to find out how inflation plays out on those decisions. [17:17] Are you far less likely to upgrade your iPhone if the prices are going up 15% or 20% a year? [17:24] Then if they're going up 5% a year, we're going to find those things out if inflation is here to stay. [17:30] What about broader economic implications? The idea of income inequality, which is already a big issue, comes to mind. Obviously, this kind of inflation can especially hit the lower end of the income spectrum. How do you think about its impact beyond just companies, just on the overall economy and on people? [17:46] That, I think, is the human side of inflation. I mean, inflation is described as the tax on the least well-off among us, the least powerful among us, because they're the ones who don't have

[17:59] the capacity to hedge it. I mean, it's not as if they're portfolios, they can move around. They're dependent on their income stream keeping up with inflation. [18:08] If you had concerns about income inequality coming into this process, you'd have to be [18:12] it's going to get exacerbated by [18:15] whatever inflation does, at least at the lowest end of the wage spectrum. [18:19] there's another hidden cost, which is we know that to break the back of inflation, [18:25] There's only one path, and it's a painful one, which is you've got to put your economy into a deep and long recession. [18:32] I call this the Volcker scenario. [18:34] And most of the time, people don't have the stomach to sit through that, which is one reason why a lot of countries start on the fight for inflation, but very quickly give up. [18:43] Because an election is coming up and you don't want this to... [18:46] get in the way. But I think the reality is, [18:50] If inflation turns out to be higher than expected, [18:53] And we don't like [18:55] the results of high inflation. [18:57] The only way you get out of it is through a recession that's deep and painful. And guess who's hurt by that? Exactly the same. So in a sense, you're between a rock and a hard place here. There is no easy pathway out. [19:11] Which is one reason early last year, I argued that even if you believe that inflation was transitory, [19:18] The thing to do was to act as if it was not and act quickly. [19:22] I've described inflation as the genie in a bottle. As long as it's in the bottle, you can look at it, you can laugh about it, but you let it out of the bottle, getting it back in.

[19:31] is really difficult to do. [19:34] Do you think that the... [19:35] policy environment. [19:37] And again, I'm focused very much on the United States because it's what I know, but I'm interested, I guess, around the world. It seems as though the language out of the Fed is that they take this extremely seriously now after not taking it seriously at the beginning, and that they don't want to be known as the Fed that let inflation get out of hand, given that unemployment's at effectively all-time lows, things like this. Is your sense of the policy response constructive, good, bad? [20:03] I fully understand that Jerome Powell doesn't want to be viewed as the next Arthur Banks. Arthur Banks, of course, was the central banker. [20:11] in the mid-70s who ended up being tarred as responsible, even though there's a whole series of actions that led up to it. [20:17] So I think the Fed is serious about inflation now, but I don't. [20:22] Don't know whether it has the stomach to carry through what that seriousness requires. [20:28] The Fed has only limited power, and that's the other thing to recognize. The only power the Fed has is to make things so painful that the economy, in a sense, shuts down. [20:37] That's the power it has. It's not got the power to change inflation rates or change interest rates even. [20:43] And I think that the scenario that is terrifying is if, in fact, the Fed does push the economy to recession, [20:50] But inflation doesn't come down quickly. [20:53] Because then you're caught with this combination of a bad economy and high inflation, which is the late 70s kind of playing out again. [21:01] And that's the danger of having led inflation run ahead

[21:05] for such a long period. [21:07] that getting it back under control might take not just three months or six months, but maybe a couple of years. [21:13] I started in markets in 1980, and I remember what the world looked like in 1980. It wasn't a place where you could easily find a job or you could find places to invest. [21:24] The benefit of hindsight, we've pushed it back [21:27] so that we don't think about it. It's not something that I want to live through again, but I don't think I might have a choice in this matter. [21:36] If you go look at the long-term chart of price to earnings ratios, however you want to calculate them, [21:41] significantly adjusted or not. Look at that early 1980s and you're going to see a very gnarly looking tail when markets traded at single digit PEs, which is a far cry from what we've experienced. [21:51] Two more categorical questions on inflation. One is what the behavior of companies can and should be. And then also I want to close on portfolio too. What do you think the smartest, shrewdest companies are doing in the face of this regime change, we'll call it, assuming it continues? Is there going to be a premium on adaptability? You mentioned infrastructure as one example, like longer investment companies have a harder time here. But if you could generalize, what do you think the smartest companies are doing already in the face of this? [22:21] Whenever I think about any issue related to valuation, I go back to my value drivers. In a sense, think about what can companies do if inflation is the bogeyman that they're worried about. [22:30] The first thing they'd like to do is make the products less discretionary. How the heck am I going to do that?

[22:36] I mean, think of Microsoft. I mean, 10, 15 years ago, the way it made revenues was by you upgrading your Windows, whatever, to your Windows, whatever next. [22:45] In the last decade, increasingly, Microsoft has shifted away from an upgrade, software upgrade business, [22:52] to a subscription business. [22:54] Subscription businesses, by their very nature, tend to be less discretionary. For whatever reason, people are far less likely to [23:01] to cancel a subscription than they are to not upgrade. [23:05] So I think about companies pushing towards platform businesses and subscription businesses. I think this gives a very good reason why you might see more of a push happening on that front. [23:16] The second dimension, of course, is your cost structure. If you have companies with large companies, [23:21] costs which are rigid are more effective by inflation. So you're looking for ways to make your cost structure more flexible. [23:29] So when you're negotiating with your unions, your unionized company, you might actually accept higher wages in return for flexibility on those wages, which is rather than set a 7% guaranteed or a 5% guaranteed increase every year for the next five years. [23:45] When it tied to inflation, [23:47] So the more you can tie your cost to inflation and your revenues, the less you're affected by inflation. [23:54] It's easier for some businesses to do this than others. But I think that you're going to see this disparity play out. [24:01] in companies. [24:02] In my portfolio, the first time I have five of the six FANGAM stocks, everything but Netflix.

[24:07] And one of the reasons for that is when I look at those companies, I see the capacity to get their products and services up. They've actually done a very good job of making their products and services up. [24:19] less discretionary. They have cost structures that are incredibly flexible. [24:24] Their investments tend to be short-term and [24:27] I'm not sure. [24:29] And in terms of risk, they're low debt. [24:32] and very little failure risk, things that you worry about with inflation. [24:36] Because if you're a heavily indebted company and there's big failure risk, swings and inflation can very quickly put you under. [24:44] When I look for my list of, hey, these are the things I want in a company, I'm going [24:48] I find them more in technology companies than I do in old-time brand name consumer product companies. It's kind of a shift away from what you might have seen in the early 80s as to where do I go for marketing? [25:02] companies that are best protected against inflation. [25:05] And I think the places you go now are very different than 40 years ago. [25:09] How do you think about something like return on invested capital with emphasis on invested capital as a key thing you care about in companies now? [25:18] I know it's become this magic bullet that people focus on. Every year, I actually compute the return on investment capital for every company on the face of the earth, 46,000 companies. [25:28] So I'm intimately aware of what accountants can do to screw up that number. I mean, I'll give you a classic example. Forget about using the return capital, computing the return and invested capital for a company that grows through acquisitions.

[25:41] is a nightmare. [25:43] Why? Because acquisitions create debris, goodwill. What do you do about that? What do you do if you pay with stock instead of cash? I can make a really bad company have a high return on capital if you give me enough accounting discretion to play that game. [25:57] So I compute the return on investment capital. I say, it's a metric. It's a useful metric, at least at some broader level of law of large numbers level. [26:06] But it's not a metric I want to tie my investment strategy around. [26:10] Because I can see things that can go wrong. [26:14] So I think it's one of many metrics you should look at. [26:17] And the parameter return invested capital is a metric it's designed for mature or declining companies. [26:23] You can be a great growth company. [26:24] Its return invested capital will be either meaningless, [26:28] The return of investment capital, if you take Apple, is negative. Why? Because the cash actually exceeds the book value of equity and debt. [26:34] If you take that to mean, hey, the ROI, that Apple takes terrible projects, you're completely misreading the number. It's the denominator that's negative, not the numerator. [26:44] For young companies, the ROIC becomes almost meaningless. It's not the kind of metric you want to focus on. [26:50] So if you have an investment strategy built around ROIC, and I know there are people, value investors, who buy into this. [26:57] Remember, this is going to leave you with a portfolio of older and declining firms, and some of them will be value traps. [27:05] Because what you're capturing with the return on investment capital is your past year. [27:09] that this company used to have great investments, Kraft Heinz.

[27:13] there's a great return to invested capital. [27:15] It's not because of the new projects it's taking. It's because that 57 varieties of ketchup, [27:20] are paying off in terms of what they did for you 10 years ago, 20 years ago, 30 years ago. ROIC is a backward-looking accounting number. [27:30] to kind of keep that in perspective. [27:32] when your investment strategy is driven entirely by ROIC. [27:36] I mean, I remember in the 1990s, this outfit called Stern Stewart, this measure called EVA. Half of the S&P 500 bought into it. [27:44] It's a measure built almost entirely on return invested capital. And the consequences were incredibly predictable, which is companies gamed it, which is they figured out what showed up in invested capital. [27:58] So in those days, if you lease something rather than bought, it didn't show up as part of invested capital. So they would switch. [28:05] So I know companies play games with ROIC. So I'm not saying don't measure it, don't use it. I'm saying make it part of a portfolio of things you look at. [28:14] and be aware of where it's going to lead you in terms of investing bias. [28:17] What do you think about thinking about the company management, CEOs, CFOs specifically, the importance of the capital allocation toolkit? I'm thinking about debt, raising debt, paying down debt, buying back shares, dividends, these sorts of things, which really haven't so much defined the last decade as tech has dominated and it's been product. I feel like it's been product that really has dominated not so much this kind of capital allocation, the cashflow from financing type of capital allocation. What do you think about the importance of that skillset for leaders?

[28:47] It tells me that you're growing old as a company. [28:50] If you're a young company and your projects make 35%, who cares what your cost of capital is [28:55] In a sense, you're not playing games. The very fact that you see companies playing games with that number tells me that your best days are behind you. [29:02] So Coca-Cola or Kraft Dance, of course they're going to do it. So investment banks will come in and they'll do the dance. And the reality is the cost to cap for a mature company. [29:11] No matter how many games you play, it's tough to move. [29:14] It moves by 20 basis points, 30 basis points. [29:18] When inflation could be 3% or 9%. This is like moving the chairs around in the Titanic while you're heading for the iceberg. [29:25] So when you see a focus on capital structure, you're already conceding that your best days are behind you. Nothing wrong with that. It's good to act your age and say, look, [29:33] Our returns used to be 30. They've come down to 18. They're dropping every day. I want to move my cost of capital 10% to 9%. [29:41] I understand that that's where you're focused, but you're not going to be the 10 bagger in my portfolio. [29:47] You're going to be the company that creates that middle of my portfolio. You might do better than expected. [29:52] But no, I've got to build my portfolio with a mix of companies. And if every company in my portfolio is playing capital structure games, I've overdone it with mature and declining companies. [30:03] You mentioned going to portfolio, some of those stocks that you now have more than you have in the past. What do you think about the other lessons from history and how portfolio positioning should work? You mentioned T-bills already that that did okay if you just held those through the 70s. I'm even curious about things like gold that I'm sure will become popular topics again. Gold did incredibly well in the 1970s. Yeah. Tell me a bit about what you're doing as a person very interested with your own portfolio.

[30:29] Real assets generally hold up to inflation better than financial assets. I mean, that's why real estate did really well in the 70s. [30:37] The only problem is we screwed up real estate. [30:39] as a physical asset by securitizing it. [30:42] What's happened as we've secured as real estate is it started to behave more like stocks and bonds. If you look at the last 20 years, look at a year in which your stocks went up as an individual, [30:52] Those are the years your house probably also increased in price. These stocks go down, your house also drops. So we've screwed up at least the segment of real estate as an inflation hedge. [31:03] But I think more traditional real estate where you buy a rental property and you collect the rental income can still hold its value. [31:10] So I don't own any rental properties, but I am actively looking because I would like to move some of my portfolio into physical assets where I have some control over my cash flows. [31:22] rather than be dependent on companies being. But I think in a more general sense, I've always been leery about those people who argue for concentrated portfolios. [31:33] And I've heard some old-time value investors say, it's an admission of failure if you have more than five or six or seven stocks in your portfolio, that if you have conviction, and I hate that word, conviction. [31:43] Because conviction goes with arrogance. If you have conviction, you should be able to find companies and put all your money in five companies. [31:50] Maybe that was true 50 years ago. [31:53] You're asking for trouble in this market environment, [31:57] to load up your bets on five companies.

[31:59] I would say spread your bets, spread your bets across asset classes, spread your bets across different types of companies, spread your bets across geographies. European stocks might not have done as well as US stocks in the last decade. [32:13] But they might be the place to be if inflation is coming back more in the US than in Europe. [32:18] So I think that there's a lesson that you learn from the 1970s or any period of market confusion. [32:26] It's to be diversified, to be spread your bets. Doesn't mean you've got to own an index fund. If that's what makes you sleep at night, go out and buy an index fund, buy a bunch of index funds. [32:35] But I think even if you're an active investor, owning only five stocks in this market is almost an invitation. [32:43] for disaster. [32:45] So I would say spread your bets. And I'm glad you brought up gold because [32:48] Again, there are ways you can invest in gold. I'm not a gold bud. I'm not going to put 50% of my portfolio in gold because that's a loser long term. [32:57] I've never owned gold in my portfolio. It might be something I consider, because I've never had a portfolio to begin in inflationary period. [33:05] But let's give gold credit for what it's due. It's a collectible that's held its value for thousands of years. [33:12] And I think when I see gold wannabes, which is where I put cryptos and NFTs, they've got a lot of proving to do before they can be millennial gold. [33:23] which is how I've described them. Some people hold them saying, this is where people are going to go if inflation is coming back.

[33:30] Gold has a 3,000-year lead on them. And it'll be interesting to see how these wannabe golds [33:37] make it through this. This will be the ultimate test. [33:40] When it comes to equity specifically, [33:43] The idea that you are more concentrated in those big technology companies is a great excuse to ask you about Amazon specifically, because I know, I think you've valued Amazon every single year since it IPO'd. So you have an incredibly interesting, long experience with the company. I'm just interested in everything you've learned doing that exercise. That's such a cool exercise to think about just in general, but also as it pertains to today's world. So just talk me through what you've learned doing that every single year between late 90s and now. [34:12] I valued Amazon for the first time in 97. I valued it every year since. Now, when I first valued Amazon, it was an online book retailer. [34:19] telling a story. [34:21] I still have that letter that Jeff Bezos sent to shareholders, I think 97, 98. If you get a chance, read the letter. [34:28] It's amazing in terms of the story it tells. In fact, the way I described Amazon when I first started valuing it, I called it my field of dreams company. [34:38] In the movie, Kevin Costner builds a baseball field in the middle of Iowa. The farmer shows up and says, why are you building the field here? And he says... [34:45] If we build it, they will come. That has been the Amazon team. That was the Amazon team in 97. If we build it, they will come. If we build revenues, the profits will eventually come. [34:56] And they kept that story as their base story and acted consistently with that story for 25 years.

[35:04] And I described Amazon as a company with patients built into its DNA. [35:09] Now, I'll give you an example. [35:10] Amazon Prime was introduced, I think, 2003, maybe 2004. For the first seven years of its existence, it did nothing. [35:19] They had a million subscribers in 2010, seven years later. [35:22] It was a money loser for Amazon. The shipping subsidies were just killing Amazon every year. [35:28] In fact, the shipping subsidies alone dropped their margins by about 3% to 4% every year. [35:33] But they stuck with it. [35:35] I can't think of another company that would let an experiment run that long and not kill it. [35:42] when it's not working. Because today, Amazon Prime, I mean, I described Amazon now as a disruption machine. It's not an online retailer. [35:50] It's not a logistics company. It's a company that basically targets any business which has softness in it. [35:56] and goes after the status quo, which means everybody's fair game. And they have an army. Every time they want to disrupt a business, that army is called Amazon Prime. [36:04] They built the loyalty in that army over 20 years. [36:08] by making sure that when you order things, they get delivered the next day. And if you don't like it, [36:13] I mean, I live in San Diego. I can go drop it off in a drop-off box two blocks away from me. [36:18] No questions asked, I get an immediate credit. They're building up loyalty here. And that loyalty is going to come into place. If tomorrow Amazon says, we're starting Amazon Bank, would you be willing to switch from JP Morgan Chase? [36:31] I would do it in a second. But they were willing to wait. So if you look at how Amazon has evolved over time, it shows you how critical stories are.

[36:41] to driving value and how critical it is that companies stay consistent about their stories over time and acting based on those stories. I can't think of too many other companies. [36:53] that tell the same story year after year and act consistently with that story. [36:59] What I hear from CRZ, big story today, but a different big story next year, depending on what's working or not working. [37:05] You have no credibility. [37:06] If your story keeps shifting, [37:08] And you don't act consistently with that story. [37:11] So to me, Amazon is an illustration of how much stories drive value of [37:16] and how critical it is for investors to understand the story that animates a company. [37:22] And not just think about it as a collection of ratios and numbers, which unfortunately, [37:28] is what some aspects of all-time value investing lead you to do. [37:33] You take the 12 screens from Ben Graham. [37:36] You run them through. [37:37] You've got a bunch of screens. [37:39] Think of that as the Ben Graham branch of Unum. [37:43] And I think I've disagreed with Warren Buffett on many aspects of what he does. But one thing that I agree with is he talks about how when you buy a company, you need to understand not just the numbers, but the business, the management, the story that he doesn't use that word, but that's basically what he's investing in is a story that he understands and he believes is actually meriting a higher price than the price that the market is attaching to it. [38:09] So I would encourage people, even if they're number crunchers, to start thinking about the stories behind companies and whether those stories actually make sense.

[38:19] long-term. [38:21] When you're, let's say, coming upon a new company and trying to figure out its narrative, how it uses stories, what do you do? [38:28] What is the way to do that with fresh eyes? [38:31] I listen to their stories. I mean, let's face it, Silicon Valley is now training founders to tell stories. The problem is those stories are fairy tales. [38:39] which is they tell big stories. [38:40] And I'll tell you the vehicle that drives these big stories. It's this number called total addressable market. You might have seen this in the prospectors. [38:48] of every young company that's gone public. Uber went public, said that total addressable market was $5.2 trillion. You know how they came up with that number? [38:59] They estimated how much people spent buying cars or buying subway tickets. They added up everything spelled on transportation. And there is no way. [39:08] that Uber's actual market is 5.2 trillion. [39:11] But what they did was they put that number up front and they hoped that it would dazzle investors so much that they would never ask any of the follow-up questions. If the market is big. [39:19] Therefore, Uber must be worth a trillion dollars. [39:22] It's what I call the Cathie Wood approach to investing. Tell a big macro story and say, therefore... [39:28] Every company has to be worth a lot because it's that big story. I call it the big market delusion, but they get away with it because people listen to their story. [39:38] They look at the total addressable market and they don't try to construct the story of their own. [39:43] So when I look at a young company, I listen to the management. I listen to people who like the company. I also listen to people who dislike the company. And then based on everything I've learned, I try to construct my own story.

[39:55] Every year. [39:56] big name tech company that's gone public in the last 12 years are valued at the time that they filed their prospectus. [40:02] I don't wait till a banker puts a number because that kind of biases your valuation. I try to value based on what I see in the numbers and what I see as the story for the company. [40:12] In hindsight, [40:13] I've been horribly wrong on some of these. [40:15] I don't apologize for it because [40:17] My investment decisions have to be based on my story, not a VC story, not the management story, not Goldman Sachs story for that company, but my story. And I've tried to stay true to that notion of, hey, I value a company based on my story. I'm going to be wrong 100% of the time, but I'm willing to reconsider. [40:36] I valued Uber every year since 2013 for the first six years. [40:40] I didn't think it was a company that I would invest in. [40:44] But towards the end of 2019, I told my story. I came up with the Valiant for the first time. I found Ubered. [40:50] to be trading at a price lower than the value. [40:53] I bought Uber, even though its story might not have shifted for me that much, but the price had shifted enough. [40:59] I hate Netflix as a company story. I like to think of my stories in terms of pictures. And for me, the picture I get, [41:06] When I look at Netflix, it's a hamster wheel. [41:09] which is this is a company that goes to the market, tells them that they have a lot more subscribers. That's been the selling point. [41:16] The way they get a lot more subscribers is by throwing stuff at the wall and opening. They spend billions on content. They've ruined the entertainment business for everybody else.

[41:25] So they get more users, make more content, get more users, go back to the market, get a higher market cap. [41:31] And I said, the problem with this wheel is how the heck do you get off that wheel? And we're discovering the pain of getting off that wheel right now with Netflix is because the user numbers start to slacken off. [41:42] How do you stop producing or spending as much as you did on content? Because you've hardwired all of us Netflix subscribers to turn on the TV and expect 15 new shows every day. [41:54] With HBO, I expect one new show every month, maybe. [41:57] But Netflix, at least 15 shows a day. Otherwise, something's wrong. [42:01] And that's how Netflix has trained me. How the heck do you untrain me without losing my subscription? [42:08] So I think that Netflix has a bad storyline, or at least a number. But for the first time, the price is getting to a point where even with that bad storyline, I might be interested in investing. [42:19] I'm going to say something that traditional value investors might view as sacrilege at the right price. [42:25] I will buy any company. No matter how damaged it is, how terrible the man at the wrong price, [42:32] You could be the greatest company in the face of the earth. [42:34] And I'm not jumping on the ship with you because the price is not right. [42:39] We spent a lot of time assessing company quality and management quality. We need to think about as much what the price we're paying for that is. [42:48] We're looking for mismatches, a company that is of great quality that the rest of the world thinks is crappy. [42:54] That's what a great investment is.

[42:56] I love the visual of the hamster. [42:58] what other visuals come to mind maybe among the fangham stocks or something [43:02] I just love this concept. Amazon, of course, the field of dreams worked really well. I'd re-watch the movie every time I thought about Amazon. I'd re-watch the movie. And now, of course, whenever I see Thanos in an Avengers movie, I think of Amazon. That's a great one. Because if you're a competitor, that's all you need is one click of the finger, and there goes your business model, right? The day Amazon entered the grocery business by buying Whole Foods, the collective market cap. [43:29] of companies in the grocery business dropped by $60 billion. [43:33] Every time Amazon enters a business, [43:36] We have no idea whether Amazon will ever figure out a way to make money on that business. Everybody else in that business... [43:42] becomes less valuable. So to me, Thanos and Amazon. So it depends on how you think about Thanos as the bad guy or the good guy. I mean, the power that Amazon brings to the game, I think. I've never seen a company more feared than Amazon. [43:57] in my experience in markets, because companies in every sphere, [44:02] kind of fear. [44:03] When I think of Google, I just think of the search box. See, I never call Google out because I've never bought into this fiction that it isn't seven businesses or eight business or whatever it claims to be. If it's an eight business, it's like Snow White and the Seven Dwarfs. If you look at the collective revenues, it's amazing how much of Google's revenue still comes from that search box. [44:25] You might talk Android. You can talk about all the other stuff. But 93%, 94% of its revenues come from advertising driven by that search box.

[44:34] So whenever I pull up Google on my browser and that search box comes up, I said, there's the engine that drives it. In fact, the interesting question with Google is, [44:43] It's got all these smart people on that campus. [44:46] It's created all these great products. [44:49] Nest, it's got Google Home, it's got all the Google documents that we end up using. Why has it been so difficult for Google to take [44:58] the skills it brought into the online advertising business and converted to success in other businesses. [45:04] Part of a broader question is why do established companies [45:08] in one business of so much trouble extrapolating that success into other businesses. [45:15] Because I think we can know the answer to the question. Maybe we can save ourselves a lot of money and ask some companies to stop trying. [45:22] What about Facebook and Apple? What images come to mind for you for those two? [45:25] And Microsoft, I have to ask about all of them. For Facebook, I think the notion of a Facebook friend is actually a very good way of thinking about Facebook status. [45:35] 10 years ago, everybody wanted to be Facebook's friend. [45:38] even six years ago. [45:40] Today, if you think about it, it's friendless. I've never seen a company that is this bereft [45:46] of support from any part. I mean, everybody hates Facebook. [45:50] That's not a good place to be, but it still has a money machine. [45:55] This is, I think, the irony of Facebook is that everybody claims to hate them and what they do, but they complain about Facebook on Facebook.

[46:05] which to me is the hip-hop. And that's why I bought Facebook after the Cambridge Analytica scandal, as I said. [46:11] I understand that you guys are very upset about the fact that Facebook has invaded your privacy. [46:17] But ask yourself a question. How did they get all this data? [46:21] on you? And the answer is, [46:24] You gave it to them. I mean, there's an old saying in Silicon Valley that if you're getting a product to service for free, you're the product. [46:33] And that's basically what you need to remember is we've used the technology companies because the conveniences they've given us. [46:41] I mean, I remember when I used to have to buy a Garmin GPS to put in my car. I mean, it cost a couple of hundred dollars, a pain in the neck to maintain. Do people even have traditional GPSs in their cars? It's because of phones are free GPS. [46:55] But there's a price we pay, which is to use Google Maps. Your location has to be turned on all the time. And you might say, what's the big deal? [47:02] The reality is this is a quit-core pro. We've used the free products or service or what we thought were free. And in return, we gave these companies data about us. [47:11] And they're using the data on us to build a business. Facebook's business model is built on invading privacy. [47:19] Let's be quite real about this, and we're contributing to that business model. [47:24] I don't think we're going to walk away. [47:26] Because we're addicted. So I think that with Facebook, I think about the notion of how you can be friendless and still be...

[47:35] extraordinarily wealthy. Apple is too close to my heart to actually think about anything because I have still and I still have my Mac 128K, the very first computer that I ever bought. I've been an Apple user since 1981. [47:48] But whenever I look at the Mac 128K, I realize very quickly that Apple is not a computer company anymore. [47:54] It's an iPhone company. [47:56] All I have to think about with Apple is look at my iPhone. It's an iPhone company. [48:00] With all its pluses and minuses, the iPhone is perhaps the most lucrative single product in history in terms of cash flows generated for Apple. [48:11] The problem with the iPhone is you're now a mature businessman. [48:15] Pretty much everybody has a smartphone. So you're very dependent on upgrades and keeping this business going. [48:23] So with Apple, the problem is you've essentially built a $3 trillion, $2.5 trillion company now. [48:31] on a single product. And I think from that perspective, it's probably more danger than a Google or a Facebook. [48:38] Because any failure on the part of that single product is going to have consequences that are [48:44] monstrously large. I mean, [48:46] Imagine an iPhone 14 that nobody wants to buy. [48:49] And I don't want to think about the consequence, but that could be disaster. [48:53] Because that's 75% of your revenues and profits right there. [48:56] I'd love to spend some time talking about the nature of... [49:00] alpha or edge in markets. How do you think about the evolving nature of edge and alpha through time in the great investors you've studied? You said last time we talked that idols is a very dangerous word in the investing world. Maybe you can describe why. I'd love to spend some time here and pick this topic apart. How has it evolved?

[49:19] I don't much care for Tom Friedman, but I'm going to steal the title of his book. [49:24] the investment world has become a lot flatter. [49:26] I'll give the example. In 1981, if you're an equity research analyst who worked in New York, [49:32] You already started with an advantage. [49:35] In those days, to look up an SEC filing, you actually had to walk in. [49:39] the SEC offices. The SEC didn't have offices in Des Moines, Iowa, but it did in New York City. You had access to information that [49:48] let's say, an investor in the Midwest, [49:51] An individual investor would not have had. You had mainframe computers that you were able to use as your tools to feed in, and people didn't have mainframe computers sitting around in their backyards. [50:02] you had execution advantages because of the way in which you were able to trade. And remember, these were the days before online trading. If I wanted to trade, [50:10] I had to call a broker. There was a time gap. There was an execution gap, perhaps even a cost disadvantage. [50:16] So 1981, you had a competitive edge over me. If you're a professional investor, it didn't mean that you took advantage of it to make money because you were trading it. [50:25] But you could see why some people were able to exploit that edge. I tell people, look, if you take Ben Graham's 12 screens, [50:33] to run those screens in the 1950s. [50:36] you know what you'd have to do, right? You'd have to sit down with the ledger sheet, take every company, enter the numbers by hand, sit there with, I don't know, an abacus. Like months, yeah. There were no calculators, you know, whatever it was, and compute each ratio. [50:49] Then can you imagine sorting that page? It's not an Excel sort. How the heck do you sort a page where you've computed these ratios physically?

[50:56] Just doing this on 50 companies, the thought of it gives me a headache. But if you were able to do it, you had a significant advantage over other people. [51:04] who didn't have access [51:06] to those annual reports who didn't have the time and the patience or the resources to do it. [51:11] Today, I can go online and there are all these automated Ben Graham 12 screens. I hit them. They're on the 12 screens for me. Two seconds later, the companies pop up. And the question is, [51:21] If I can pull that up, what makes you think that running these screens is going to give you a differential advantage? [51:28] I am shocked at how much of traditional value investing is just running screens. [51:32] Whenever I've had a chance to go to Omaha, I don't go to the meetings themselves, but talk to people who come to those meetings. I ask them a question. These are self-defined value investors. I said, when was the last time you actually valued a company? And don't tell me you buy companies low P-E ratios. [51:49] and high dividends or whatever it is. That's not valuing the company, it's running screens. [51:53] Maybe one in 100 actually values companies. And their response is classic. They said, we don't value companies because we don't like to make assumptions. What? [52:03] Investing is a set of assumptions. The fact that you're using past data doesn't mean you're not making assumptions, just not making the assumptions explicit. And the second argument they give is even more preposterous, which is, [52:16] We don't like betas. Okay? [52:19] I don't like babies either. [52:21] So you don't like modern portfolio theory, that's fine. That doesn't mean you can't value companies still. [52:26] If you're telling me that just because you don't like modern portfolio theory, you don't think risk matters, then you've reached the wrong conclusion.

[52:32] But I think so much of value investing has become screening. The question I would ask is, what you do as a portfolio manager is run screens, and [52:40] What makes you think you're bringing something to the table? [52:44] I can run screens. I can run the same screens you can. [52:47] Often on the same database as you do. [52:49] Where is the differential advantage? [52:52] So I think the first reality is finding that niche has become a lot more difficult. [52:58] which is one reason I think active investing collectively, [53:01] has had more and more trouble. [53:04] with passive investing, ETFs and index funds. And that's not going to change. [53:08] I don't think active investing is going away. I think it's going to become a smaller business. [53:13] A business where niches have to go beyond, we have a 23 story building with big computers and lots of databases. [53:21] Because that's not going to be enough of a niche for you to find a [53:25] You're alpha. [53:26] If your focus becomes all about finding alpha, [53:30] You've lost the script. And here's why. In a sense, you need to find alpha, but not at the expense of creating a backstop on my portfolio. [53:40] And what I mean by that is that our portfolio managers become so focused on creating alphas, they go out and take insane bets. [53:47] on companies because they want to deliver that positive alpha. [53:50] I'd much rather that you go for a tiny or even a zero alpha and keep my portfolio at least keeping up with the market. [53:58] then seeking out alpha. [54:00] I think the way we rank managers based on alpha encourages them to be not just risk takers,

[54:06] but reckless risk takers. [54:08] Because that's how you end up at the top of the alpha list or the best performing. I would never invest in the best performing manager in any year or even over a five-year period because I'm going to almost wager that that best performing manager has a much greater chance of being the worst performing manager in future periods than the middle of the group. [54:28] So I think that rather than look for the highest alpha, you want to go for consistency, even if it means settling for consistency. [54:36] Little or no alpha. [54:38] Now, the Hippocratic Oath of doing no harm should really be first, front and center for anybody who's managing other people's money. [54:45] If it's your own money and you want to make bets, big bets and hope they pay off, fine. But don't play games with other people's money. [54:52] We take 40% of your portfolio and buy Valiant. [54:55] which is what some value investing funds did in the five years ago before Valiant blew up and then say, well, we never saw this coming. I know you didn't see this coming, but you didn't have to put 40 percent of your portfolio into one company. [55:08] As I've grown and studied in this world, I've become probably less interested in investors and more interested in companies. And you mentioned this idea before about being dangerous, maybe to have idols and just study other investors, for example, and then maybe take the wrong lessons from those studies. [55:25] Do you think there is any utility in studying other investors? And if so, what is it? [55:29] I think there's something you can learn from everybody, including bad investors. There's something I learned from Cathie Wood. I've learned about how macro trends do matter.

[55:40] I think she's very good at calling macro trends. [55:43] But I've also learned from our mistakes that just because you get a macro trend right doesn't mean that the micro bets you make in that macro trend. [55:52] Correct. So we all agree that 10 years from now, a greater percentage of the cars sold in the face of the earth are going to be electric cars. I think there's consensus on that. But does that mean Rivian is where I want to put my money? Not necessarily. [56:05] So I think you can learn from both good and bad investors. I think you can learn from retail and professional investors. [56:11] I think you can learn from your Uber driver's mistakes on what he did wrong. [56:15] Because when Uber drivers, you know, I constantly chat with Uber drivers because I've learned [56:20] more about Uber. [56:21] by talking to Uber drivers than I would ever learn from talking to Uber management. [56:25] and often a conversation wears off. [56:28] into investing and what they're doing in investing. And they talk about what they did. Classic, of course, is I put my money in Bitcoin and look, it's doubled. [56:35] So I think we can learn from both good and bad investors as long as we're open to recognizing that there are things that each of these groups does that is good and things that they do is bad. [56:47] but that the overwhelming factor driving success and failure in markets, [56:52] We hate to admit this in academia and practice is luck. [56:55] It's amazing how as human beings, when we succeed, we attribute it to our skills. And when we fail, it's always bad luck. [57:04] I remember the Shopify CEO complaining about markets and how markets didn't understand the company.

[57:11] because recently as the stock prices dropped, he's convinced that markets are misunderstanding the company. [57:16] I said, it's amazing how you discovered markets misunderstandings when your stock price is dropping, but you never talked about this new stock price was going up, quadrupling in a year. [57:27] So I think people often attribute... [57:29] to market any of their mistakes and then claim for themselves their successes. [57:34] Recently, Cathie Wood has been complaining how inefficient markets are. [57:38] So how amazing how when markets move against you, they're inefficient, but when they move with you, they're efficient. [57:43] Very strange definition of efficiency, but it's self-serving. [57:47] If you think about skill versus luck, as you think back on [57:50] the God knows how many company level valuations that you've done by hand. What are the most common mistakes that you've made looking back on those? [58:00] I think the most common one is that you let recent history drive your forecast more than they should. I mean, this is well-established in behavioral finance, which is what's happened in the recent past. [58:12] I'll be quite honest, the aftermath of COVID, I made COVID part of my stories for a little too long. I finally let go. [58:20] Because I think it was such a big part of our personal lives that we assumed that [58:25] This was here to state that everything that you saw happening was now a long-term trend. [58:31] So when you look at the Zooms, the Pelotons, the companies that benefit with COVID and how quickly they've come back, it's a recognition that when we sit down to value companies as human beings, we tend to wait.

[58:41] in our most recent experiences the most. [58:44] It's one reason why I look at data. I call this my version of playing money ball, which is [58:49] I look at data, not because I want to drive everything to data, but to get a sense of perspective. And it's one reason why when inflation came back, I had to go back. [58:58] a hundred years to think about. Because if I thought about just the last 10 years, it's very easy to dismiss it. [59:04] So I think my biggest weakness often is the lack of perspective. And of course, there's bias, which is sometimes you fall in love with a company and your story for the company to the point that you're not willing to listen to others. I call this keeping the feedback loop open. [59:19] I'm human like everybody else. [59:22] I get defensive when people critique my story, but I've learned that to make my story better, I've got to listen and I've got to say the three most powerful words in investing is I was wrong. [59:34] I mean, my most successful valuation exercises have come about after I've said I was wrong. [59:40] picturing an Excel spreadsheet in a traditional DCF, one of the things that you tend to find in there is some term at the end, which is some steady state assumed long-term growth rate. When we last talked, you made an interesting point that maybe that little assumption at the end [59:54] which sometimes can drive a large percent of the value, is a lurking error. And the reason is that the lifecycle of companies, just the nature of businesses, how fast they grow, how fast they mature, how fast they decline, [1:00:05] has changed or evolved over time. Can you describe that shift and change and how investors should think about it? [1:00:10] The best way to think about it is to think about two things.

[1:00:13] examples of companies. One at 20th century [1:00:17] Classic. [1:00:18] with Egg G. It was founded in 1893. [1:00:22] peaked, I don't know when, then you had the second coming with Jack Welch. And then finally, now if you look at GE, it's a walking dead company. I mean, there is no happy ending here. [1:00:32] It's just limping its way towards its end. But it's had a good run, a great run, 130 years from start to finish. [1:00:39] In contrast, let's think about a company that's not truly a 21st century company. It was founded in the late part of the last century, Yahoo, right? Founded in 1992, got to $100 billion in 1999, from nothing to $100 billion in seven years. [1:00:55] Glory days lasted about four years until Google came along, went into a decline that very quickly turned into a steep decline. By 2015, the company was done, 23 years. [1:01:05] from start to end. [1:01:07] Another reason I emphasize that is when we use that forever assumption that we see in discounted cash flow evaluation, we're really not assuming forever. We're just saying if it's 70 or 80 or 90 years, using a forever gives you a number close enough that you can get away with it. So in the 20th century, [1:01:22] That was perfectly okay. [1:01:24] Companies took a long time to build up, stayed a long time at the top, and then took a long time to decline. [1:01:30] If you're valuing Airbnb, I'm not sure you want to make that same assumption. [1:01:35] Because it might be a great company, a great platform, but the nature of platforms is here today, gone tomorrow. [1:01:41] So I think that when you look at technology companies and the companies that are coming at you in the 21st century, there's nothing in valuation that requires you to use a perpetuity.

[1:01:53] So it's a convenience assumption. [1:01:54] You can assume, for instance, that after year 10 or year 5, that your company will last another 15 years and be done. [1:02:01] And mechanically, there's no reason you can't do that. [1:02:04] We don't do it because inertia drives us to do the same things we were taught to do on the companies of the 20th. [1:02:10] So I think then when people talk about the need for new models and new metrics, they're missing the point. The old models work fine. It's this new thinking that's needed with those old models. And that's tough for us to do as human beings because we tend to do the same things that we did. [1:02:25] when we first started. [1:02:27] And I think that unfortunately locks us into practices that might not work for the companies of today. [1:02:33] Two of the strategies, I guess, maybe on other sides of the spectrum that have worked really, really well, I'd love to hear your take on. One is momentum, literally just buying things that have done well in the recent past. [1:02:43] And the second is maybe from the value side of the coin, ignoring macro conditions like inflation that we started the conversation with, that really all that matters is the company specific work. What do you think of those two ideas in today's new market? [1:02:57] I mean, let's take momentum. Momentum is a trading strategy. In fact, I like to draw a contrast between investing and trading. Investing is about assessing the value of something, buying at a price lower than the value, and hoping and praying. [1:03:09] The price adjusts your value. [1:03:10] Much of what you see in investing in [1:03:14] Discussions is about it. [1:03:15] Trading is much simpler. You can argue a much more honest way, a much cleaner way of approaching markets. Trading is about buying at a low price,

[1:03:23] selling at a higher price. There's no value, cash flows, growth, who cares? [1:03:27] momentum is a trader's best friend. And we know that at least in the short term, momentum is the strongest force in markets, much bigger than earnings or cash flows or growth or any of the fundamentals. [1:03:39] So as a trader, you live on momentum. [1:03:42] But you die. [1:03:43] on momentum, which means [1:03:45] Then you make money when momentum is in your favor, but if you don't get out early enough, that same momentum that was your friend becomes your enemy. So I think momentum is a force that we underestimate at our own peril as investors. [1:03:58] That's why I seldom sell short on overvalued companies. [1:04:03] Many of these companies are in the throes of momentum. You try to sell short on these companies, you might be right in the long term, but you're going to be bankrupt before you're right. And that's small consolation. [1:04:13] So momentum is a force that we've got to respect. [1:04:17] So when people make fun of [1:04:19] charters and technical analysts, let's face it, they're bringing the right tools to the trade if they're trading. [1:04:24] Because those are tools that are designed to detect shifts in momentum. [1:04:28] You might not believe in support lines and resistance lines and all the neat candlestick charts, but let's face it, they're trying to detect shifts in momentum and get out ahead. And I applaud it to them. They're at least being honest about what they do. [1:04:41] The problem is there are many people who claim to be investors. [1:04:46] but they're really playing the momentum game. It's amazing how they're [1:04:49] Top 10 stocks happen to be the 10 stocks that have gone up the most over the last two years. It's amazing that your value approach gave you those same 10 stocks.

[1:04:57] traders masquerading as investors. [1:05:00] On the second front, though, of just buying good companies and ignoring the bankroll, [1:05:06] That worked really well in the 20th century with US stocks. And the reason is, [1:05:11] The U.S. was the most mean-reverting economy of all time. [1:05:16] in the 20th century. Everything almost was on clockwork. [1:05:19] Recessions lasted a certain period. The way you came out of recessions, you could almost graph out exactly how you came out of recessions. [1:05:27] Meet reversion as a strategy. [1:05:29] worked really well, which means that if macro variables got out of sync, they came back to sync. [1:05:35] And when that's the case, you can, in the very long term, ignore macro variables. If you pick the right companies, everything's going to work out. [1:05:42] The only problem is let's say you bought [1:05:44] Russian companies two years ago based on them being good companies. Guess what? There's no rescue package waiting for you. [1:05:52] Because the Russian economy is definitely not on a mean reverting. [1:05:55] So the question I would ask for investors who adopt that strategy is, do you believe that the 21st century... [1:06:01] is going to be the same as the 20th century. [1:06:04] for the economy in which you're investing? Is it going to be a mean reverting economy? [1:06:08] And if you can tell me with having thought through this, that that's an assumption you're ready to make, then I think it's perfectly okay going out and picking the very best companies and letting the macro variables fall where they might. And I'll give you a classic example. A lot of people invest in oil companies based on normalized oil prices. [1:06:25] which is kind of a, you know, I'm not going to be worried about what the oil prices say, there's a normal oil price. I'm not sure that I could tell you what a normal oil price is anymore, because we're facing climate change and pressure and fossil fuel companies

[1:06:40] assuming that cycles will return back to what they were in the 20th century or even the first part of the 21st century. [1:06:47] seems to be asking for trouble. [1:06:49] So I make a general statement. Mean reversion works. It's a very strong force until it doesn't. When there's a structural break, [1:06:56] in the economy you're in. [1:06:58] Mean reversion can be one of the most deadly forces. [1:07:01] in investing. The mean you revert to might not be the mean you thought you went revert to. [1:07:07] And unfortunately, it's been the weakest link and people use chiller peas and capes to kind of many of those people have been out of markets now for a decade because stocks have looked expensive to them because they've said, I don't care what interest rates look like now. I won't buy stocks if they don't trade in below 15 times earnings. [1:07:24] Anka, what kind of adjustment we get in this market? [1:07:27] The amount of money you've lost by staying out of the market for the last 10 years, because you believed in mean reversion, is money you're never going to get back. [1:07:36] So I think people have to be careful in assuming mean reversion and at least think through explicitly whether they believe that things would revert back to the way they used to be or whether the world has changed and the answer the world has changed. [1:07:48] You've got to be careful about not making that mistake and just jumping in based on things reverting back. [1:07:55] It brings up two things. [1:07:56] First, I should have asked about interest rates and discount rates and what the difference is in your mind between those two things. So we'll do that first. And then I also want to talk about ESG, which is one of the things I've been most excited to talk to you about. But I should have asked this earlier. How do you think about interest rates and discount rates alongside inflation?

[1:08:13] Discount rate is a generic word, a rate that I use to discount cash flow. So for instance, you gave me a T-Bond, the discount rate, [1:08:20] is a risk-free interest rate. If you give me a corporate bond, the discount rate is a default risk-adjusted interest rate. If you give me equities, the discount rate is a risk-less interest rate plus an equity risk premium. So discount rates and interest rates are not alternatives. Interest rates are a part of discount rates. Interest rates ultimately are not set by the Fed. And this is, I think, the delusion that's driven a lot of bad investing choice over the last 14 years. The Fed can keep rates at whatever it wants to, no matter what [1:08:50] Thank you. [1:08:50] I mean, think about what's happened to the P bond rate just in the course of the last four and a half months. [1:08:56] Started the year at one and a half percent. [1:08:58] Now it's flirting with 3%. And you can't say this is because the Fed is raising rates. In this case, I think the Fed is chasing market interest rates. [1:09:06] So interest rates are driven, if you think about macro variables, by expected inflation in the future. And this is why inflation comes back into the conversation. [1:09:15] is as the market tries to find a steady state on inflation, the T-bond rate is going to reflect what that steady state looks like. [1:09:22] If we settle on 5% as inflation going forward, [1:09:25] there is no way the T-bond rate stays at 2.5% or 3%. [1:09:28] It's going to 5%. [1:09:30] Why? Because why would you ever buy a bond with a coupon rate? [1:09:33] That's lower than your inflation. That's like, [1:09:35] making yourself poorer intentionally, upfront. Now, this is not an after-the-fact surprise. [1:09:41] So to me, whenever I think of interest rates, I go back to basics. What is inflation? What is real growth? Because that's ultimately what's going to drive interest rates. And if interest rates rise, all discount rates go up.

[1:09:52] It's like a tide rising somewhere. And the tide rises, all boats go up. So they're risky or a safe company. Everything gets pushed up. [1:10:00] as interest rates go up. So I think that we've had a decade again of really low interest rates and really low discount rates. The start of 2021, [1:10:10] The cost of capital for a median company in U.S. dollar terms in the U.S. was about 6%. 6%. The implied expected return on stocks at the start of the year was 5.75%. Think about it. You're buying stocks expecting to make 5.75% returns annually. [1:10:28] If I'd offered that to somebody in the 1980s, they'd laugh me out of the office saying, what, do you want me to buy stocks? [1:10:34] But the reality is when T-bond rates are 1.5%, 5.75% doesn't look back. [1:10:40] So I think that we've been spoiled again by a decade of low discount rates, low cost of capital. And that's why inflation is going to be such a painful situation. [1:10:50] adjustment process. [1:10:52] We all have to reset expectations. [1:10:55] And that means everybody's discount rates are going up, whether we like it or not. [1:11:00] How do you think about equity risk premiums? [1:11:03] in a market like this? It's a price of risk in equity markets. In fact, I think of it as the one number that reflects all our collective fears and hopes. [1:11:13] So when we're feeling good, guess what happens? Like, would the risk frames go down? [1:11:17] When we're feeling buoyant, everything's going well, equity risk rate goes down. When you get terrified, what happens? The equity risk rate goes up.

[1:11:24] which is one reason why I find it difficult to believe that the equity risk premium is some constant number that you can go back to. [1:11:31] The way in which many people look at equity risk means they look at the past. What have U.S. stocks owned over T-bonds going back 100 years? [1:11:39] But that misses the point that this is a shifting dynamic number. Russia invades Ukraine. Guess what? [1:11:45] Your equity risk premium needs to go up. We're facing a recession. You might lose your job. Your equity risk premium goes up. [1:11:52] That's why at the start of every month, I compute the implied equity risk premium for the US market. I'm not claiming this is the right premium, but I'm saying given what's happening now, [1:12:01] This is what the market is pricing risk at in the equity market. Take it or leave it. [1:12:06] At the start of this year, that number was 4.24%. [1:12:09] At the start of May, it was 5.2%. [1:12:12] I wouldn't be surprised if at the start of June, this number is closer to 6%. That's a huge increase in risk premiums over a short period in a market like the U.S., [1:12:23] But it reflects that collectively, we were all much more terrified. [1:12:26] of the economic future than we were at the start of the year. It's going to show up at the equity risk premium. [1:12:31] How do you think all of this affects what has been a historic period of time for early-stage equity investments? Given, I think, all the trends you've talked about, it's been a lot of cash gone out onto the riskiest part of the return spectrum, if you will. And I think generally, a lot of investment in new companies trying new things is probably going to lead to good outcomes for people in the world generally.

[1:12:55] What do you think happens in that part of the world and the ecosystem there? [1:12:59] The best way to think about that ecosystem is to think about collectively what I call risk capital. Risk capital is the capital investment, the riskiest parts of the economy. [1:13:09] venture capitalists, even public market investors investing in the riskiest companies. [1:13:14] And one of the unanticipated side effects of having really low interest rates is that risk capital became a much bigger part of markets. Why? Because you really don't lose much by not putting your money into something safe when you're making 1%, 1.5%. So far bigger chunk of capital in the market. [1:13:34] became risk capital. [1:13:36] That's what saved us in that COVID crash is risk capital stayed in the market. It pulled the market back very quickly. The question is, can risk capital survive inflation? And I think inflation is a much tougher test than COVID. [1:13:49] Because what inflation does, as I said, brings in the uncertainty about the future that makes it much more difficult to start new businesses. [1:13:56] So I think we're going to be in a period where you're going to see risk capital become much scarcer, which is bad news. [1:14:07] Because you need capital to keep going because you're a cash-burning machine. [1:14:11] You need capital to keep going. And if that capital is not there, then I don't care how great your potential is. [1:14:17] you're going to have to sell out to the best bidder. That's what happened in 2001. [1:14:21] It's what's happened every time, risk capital. It's been a long time since we've had

[1:14:25] a significant drawdown of risk capital, 2009, first half maybe. [1:14:30] But I think we're going to see a significant drawdown in risk capital. [1:14:33] And that's going to affect the pricing of not just young private companies. You saw SoftBank took a big write-off recently. [1:14:40] for all of its investments in young private companies. [1:14:43] but also those small growth companies in public markets that are dependent on continued capital access to keep going. [1:14:52] So when you're seeing the Pelotons and the Zooms getting marked down, it's because of the worry that, hey, these companies need to raise fresh capital. [1:15:00] They're approaching a market that's much less receptive to that pitch than it was two years ago, five years ago, 10 years ago. [1:15:07] It allows us to go to the topic of ESG and one of the big, maybe born of climate change, one of the big trends that's affecting the behavior of companies. You mentioned oil companies earlier. And ESG went from sort of something that early in my career was always kind of around like a gnat or something, [1:15:23] You'd hear that term over and over again, but it didn't really seem to impact anything. To all of a sudden, almost overnight, it's seeming to... [1:15:30] pervade assets, decisions. BlackRock being the poster child here, curious what your mental image of BlackRock is. [1:15:38] Talk to us about ESG. I think you've got a very contrary [1:15:40] view here. [1:15:42] It used to be contrary, but I think increasingly it is becoming more the consensus because when I first wrote about ESC in 2019, I wrote about it because I was really curious, like you were, about what is it that's taken this concept off? [1:15:55] And what made it take off was the establishment bought it.

[1:15:58] Usually when you have something new come in, the establishment is, in this case, what I mean by the establishment buying in is that was the year that the conference board. [1:16:07] The bunch of 171 CEOs who signed off on this stakeholder declaration where they said the end game for a company should be to keep all stakeholders happy. Larry Frank, of course, jumped in and saying the ESC should be what they prize as one of the big strategic imperatives. [1:16:23] And I said, no, what's going on yet? [1:16:25] So I started looking at the sales pitches that I was listening to on ESG. Here's what I found. [1:16:32] These services that claim to measure ESG didn't agree with each other. [1:16:37] Second, you had all these consultants going around to companies claiming that ESU would make them more valuable companies. [1:16:43] And I looked for evidence and I couldn't find any. Yet all these ESG funds claiming to beat the market. And I took a deeper look and it looked like their entire outperformance came from the fact that a lot of tech companies in their portfolio, not because they're good companies. [1:16:56] And I also heard talk about how ESU is making the world a better place. [1:17:00] And I looked at the percentage of energy we're getting from fossil fuels. And guess what? It's not changed much over the last decade. [1:17:06] So I said, where's the beef here? [1:17:07] You're making all these claims. There seems to be no basis for it. [1:17:11] So my first post was actually an invite to ESG Advocates to tell me what I was missing. [1:17:16] And over the next year, I heard from ESG advocates. And what I heard from them made me [1:17:21] even more doubtful about whether he had any foundation to it. [1:17:26] First, I think an ESG expert is an oxymoron. How can you be an expert on a discipline that has nothing to it?

[1:17:32] Are you some kind of Dalai Lama and Mother Teresa rolled into one that you can see virtue and recognize when you see it? [1:17:39] And in the two years since, of course, I've become more and more convinced that the reason it's taken off is to become a money machine for the people involved. Services, S&P, sustained analytics. [1:17:51] Basically, I'm making money measuring ESG. [1:17:55] Investment funds. [1:17:56] You slap ESG on the title of a fund, you can add 15 basis points. That's what BlackRock did for its carbon transitions fund, almost exactly identical to its regular index fund. But by taking three stocks out, they're able to charge 15 basis points more. [1:18:13] You have consultants, experts running around, charging companies for ESG advice. I'd love to be a fly on the wall. Listen in on exactly what it is that I can do to become more virtuous. [1:18:25] You've got academics, I think academia, who are publishing papers in ESG. [1:18:31] that shouldn't see the light of day. [1:18:33] I mean, the quality of research in ESG is abysmal. In fact, this is the only area in finance where I've seen people use meta studies. [1:18:43] They take 500 studies and average them up. [1:18:45] which is absurd. It's not the way to do research. [1:18:49] The law of large numbers doesn't work when you've got 500 bias studies and you put them all and you come up with an average. [1:18:56] When I made all these points, the response was, but what's the big deal? We're making the world a better place. And they pointed to engine one.

[1:19:03] and how successful it was at ExxonMobil. Engine 1 was an activist fund. [1:19:09] that essentially had BlackRock and others throw the weight behind them. They got ExxonMobil to divest themselves. [1:19:15] of some of their fossil fuel reserves. Amazing victory. The key word is divest themselves. [1:19:20] Who do they sell it to? [1:19:22] They sold it to a private equity group. [1:19:24] You know, in the last decade, [1:19:25] Private equity funds have invested $1.2 trillion in fossil fuel reserves. You're not stopping the development of fossil fuels. [1:19:34] just pushing them behind the curtain. And the people exploiting these reserves now [1:19:38] Our father's groupless in the company's [1:19:42] Putting selective pressure on publicly traded companies in the US and Europe [1:19:47] to behave virtuously. [1:19:49] is not making those things go away. [1:19:51] You think Aramco's management is sitting around saying, well, what is the ESG thing to do? They're pumping out oil. This is, I think, the kabuki dance that ESG leads you to. [1:20:02] It's a feel-good scam that is making a lot of people wealthy. [1:20:07] The news story passed yesterday when S&P, CSG, whatever index they've created, which is a money machine for them because they create an index, then funds get used to the index. [1:20:17] their ExxonMobil on it. [1:20:19] But not Tesla. And not Tesla. And of course, I read Margaret Graham, I think was her name. She's the person at S&P who heads their ESG group. I don't know the person. I'm sure she's well-intentioned. [1:20:31] And I read a blog post on why Tesla didn't make the cut. And as I read it, the four things that have always troubled me about ESG all came to the surface. First is, it's an incredibly opaque topic. I mean, at the end of the blog post, it was not clear what Tesla had done.

[1:20:47] They all claim it's based on numerical scores, but what determines what factors go up to the score and what weightings you touch? Completely opaque. [1:20:55] The second is she actually gave away the fact that it's a gaming game. [1:20:59] model. What gave it away is in her blog, she said, "Wasn't that Tesla's score dropped? [1:21:04] It was that everybody else's score went up. Now, I'm a teacher. And if I find the scores of a group of people all selectively go up, it's because they're playing the game I asked them to play, which means that there's a checkbox system and Exxon Mobil has learned to play it and Tesla is not playing it. So guess what? Exxon Mobil climbs the ranks, Tesla doesn't. This has been the greenwashing gaming part of it. I've always described it as a feature of ESG, not a bug, and it's kind of in there. [1:21:32] The third is, it illustrates that ESG is political. It's always been political. To argue that it's some objective measure is, I think, delusional. [1:21:42] When I hear ESG advocates complain about the political backlash that's coming against ESG, like some of the red states now have movements to stop their endowment funds. [1:21:53] They complain about how it's become political. My response is that's like a pyromania complaining about all the fires that are around. [1:22:00] I mean, you brought the politics to the game. [1:22:03] What made you think that the politics would always work out in your favor? [1:22:07] Now, the question is not why it's happening, but why it took so long to happen. [1:22:11] So I think the mask is off, yes, she. [1:22:14] To those people who say, but I want to invest in good companies, please do, but use your definition of good because your definition of good and my definition of good are going to be very different.

[1:22:24] If your definition of good is built around data privacy, don't invest in Facebook. [1:22:29] If my big issue is climate change and I want to invest in ExxonMobil, I'm going to invest in Tesla. [1:22:35] So I think that by definition, goodness is not going to be global. [1:22:40] The E part is where they've had the most success in coming up with a number of carbon footprint. And of course, they've gone crazy with all of the different disclosures. [1:22:48] The S part, [1:22:50] Should be a non-starter. And here's why. Name me one social issue. [1:22:54] where you can define a global consensus. There's not a single one. This is where the politics comes in because the minute you start saying the S includes this, for instance, one of the things that was mentioned in the news stories, [1:23:07] was that the reason Tesla didn't make the list was because of the way they treated employees. [1:23:13] And here's what I'd love to see. I'd like to see a comparison. [1:23:16] of a GM employee and a Tesla employee in terms of wages and benefits. And I'd also like to see a survey of how many Tesla employees would like to go to work for GM and vice versa. [1:23:27] So if you're making this judgment, it must be because of some aspect of what Tesla does that led you to believe that maybe it doesn't have a union for you, that's a game breaker. And that's fine if that is what makes or breaks a game for you. But you can't then define this as your measure of, [1:23:44] Goodness. [1:23:45] and enforce it on everybody. [1:23:48] This, I think, if nothing else, should make people think again, what exactly is an ESG score and what does it measure?

[1:23:55] Because even the measurement services have no idea. And to build an entire discipline on something that cannot be measured, [1:24:03] is I think just malpractice. [1:24:06] I can't wait for this concept to die, but I'm afraid there's too much money. [1:24:09] to be made for this concept to go away quickly. [1:24:13] And it's going to be a long and painful death. And guess what? [1:24:16] They're going to come up with some other buzzword. [1:24:18] to replace it because the history of business is, [1:24:21] What was ESG was called SRI and CSR. And I mean, I've seen the acronyms slide through. The only acronym I want to attach to ESG now is RIP, you know, but I think, you know, but they're going to come up with something else to replace it, I'm sure. [1:24:34] Bringing up Tesla is an opportunity to ask you about the nature of disruption. Two things are curious to me, Tesla versus all other car companies. You mentioned Amazon earlier as a sort of universal disruptor. But one company that it doesn't seem to have disrupted is Costco. [1:24:50] And you might think if you had said in 1999, Amazon is going to be Thanos snapping its fingers. Costco is probably one of the first companies you might have thought of, oh, geez, they're in trouble. And yet they've thrived. So I'm really curious how you think about disruption as a force and also about companies that seem protected from it. [1:25:09] That's a great case study to examine. I mean, collectively, brick and mortar retail in the U.S. has been devastated by Amazon, collectively. [1:25:17] So Bed Bath & Beyond, the department stores. So you've got to ask, why do the companies that manage to evade this storm, what do they do?

[1:25:26] In a sense, we can tell what they shouldn't do. The department stores tried to out Amazon, Amazon. They thought that what Amazon had was an online site. So if we start an online site, then we'll be like Amazon. [1:25:37] And then they started cutting costs in their stores. They had less salespeople. I remember going into a Macy's. I haven't been in a department store in a decade. [1:25:45] And part of the reason is my last experience at stores like Macy's, you walk in, you pick up something you want to buy, and you can't find a cash register that's open. This is not a great business model if you're a retailer. We're not letting people pay for things they want to buy, but they'd cut costs to the bone. [1:26:02] The brick-and-mortar stores that try to out Amazon, Amazon, or try to cut costs and make their experiences worse as brick-and-mortar stores fail. Costco built a model that is a different one. I think that subscription model is an act of genius because first, it self-selects the people who walk into a Costco. [1:26:32] group that wants the kinds of things that Costco offers. [1:26:36] And Costco is not a traditional retailer. You walk into a Costco, you walk out with not one month's supply of something, but 10 year supply of something. [1:26:43] It's found a way in brick and mortar retailing saying, you will not be able to find this on an Amazon. [1:26:51] Every time I walk into Costco, there are at least one or two [1:26:54] items that I feel I never went in to buy those, but I said,

[1:26:58] That looks like something I could use. [1:27:01] I don't know what percentage of Costco sales come from impulse buys, but I guess that even people who shop regularly at Costco walk out with one or two items that they didn't think they wanted or needed before they walked in. [1:27:14] And the experience to me in Costco is unique. It's an experience that you know what the system looks like. You're not going to get a lot of salespeople help at those tasting stations. You're not going to get tasting stations on Amazon. I don't think they've figured out a way virtually for you to figure out what something tastes like. But I think it's designed an experience that makes shopping, if not fun, different. [1:27:35] And I think that's what people in businesses that are disrupted by Amazon have to think about is what can we do to make people still come to us? Because they tried out Amazon, Amazon, it's not going to work. I think the other example of a company that managed to fight off Amazon successfully was Alibaba. [1:27:51] 2003 or four, it was any person's game. [1:27:54] eBay, Amazon, Alibaba, anybody could have won, but Alibaba crafted an online retail presence that was uniquely suited to China, starting with a website, Taobao, which is the Alibaba main shopping site. [1:28:10] If you ever click on it, wear sunglasses because you're going to be dazzled by multiple things hitting you. It's basically the way to describe it. It's like walking into a bazaar. [1:28:20] Which is exactly how Asian shoppers shop. They're used to bazaars. They're used to chaos and multiple people coming at them. [1:28:28] That's not what Amazon thought.

[1:28:30] their customers needed. In the US, you had people with a bazaar, they're going to click out and move away. That's too confusing for them. But Alibaba succeeded by creating a [1:28:39] a China-centric version of online retailing. [1:28:43] that essentially allow them to win that game. So it's not that fighting and beating Amazon is impossible. It's you got to do it on your own terms. [1:28:52] And that's not easy for many companies. [1:28:55] When you value an individual company, will you often assign some sort of disruption risk premium to it? And if so, how do you do that? [1:29:03] If you believe that disruption is expected, the best way to do it is to build it into your cash flows and growth and margins. I mean, you've got to build it into your story. [1:29:11] If it's your worry that there will be disruption, then you've got to bring it in as some kind of external risk. I think of decision trees and statistics. When you do a discontent cash flow evaluation, you're evaluating the companies that are going concerned with the assumptions you've made. And then you say, oh, my God, this could happen. There's a small chance. There's a 10% chance of this happening. [1:29:30] then you actually have to value a company with that. So rather than try to put it all into one valuation and try to get the discount rate to carry a weight that was never meant to carry. [1:29:39] If you truly are worried about a scenario that could happen, that could very well change your values. [1:29:46] Treat it as a different valuation. [1:29:48] When I valued Aramco, I valued it as 330 million barrels of oil under the sand, where you stick your finger in the sand, oil comes out. Huge cash machine. And I came up with a value of $1.8 trillion, I think, for the company, based on oil prices then. But the thing that worries me about Aramco...

[1:30:04] is not that they will stop pumping the oil and that oil will cease to be used. I think they will continue to be the one company standing, even if there's climate change and people continue to use less oil. [1:30:14] It's the worry that there might be a regime change, because when you buy a Ramco, you're buying a piece of Saudi Arabia, because 80% of Saudi Arabia's GDP comes from oil. [1:30:24] And by extension, you're buying a piece of the Saudi royal family. [1:30:28] because they're all connected at the hip. [1:30:30] And the question you got to ask is, what if something happens? What if something like what you saw in Egypt 13 years ago? [1:30:36] You woke up one morning and Hosni Mubarak, who is viewed as dictator for life, is no longer running the country. What if that happened in Saudi Arabia? What will that mean? Rather than try to bring it into my Aramco valuation, I said, I value the company twice. I valued with the status quo. [1:30:52] The House of Saud stays on long term, running the country. [1:30:56] And I benefit from the cash flows from oil. And I said, what if somebody else? [1:31:01] I didn't put an ISIS scenario, but a scenario where somebody who's less receptive to foreign investors. I mean, it's very easy to add a royalty tax. What I thought was an incredibly profitable company can become much less profitable overnight. [1:31:13] So I valued the company twice and took an expected value based on the probabilities assigned. Those were subjective. [1:31:20] And I've never felt the need to run away from that word. Subjective is the word that I would use for pretty much everything you do in valuations. [1:31:27] There are no objective numbers in valuations. [1:31:29] last year's numbers objective, but you don't invest based on last year's numbers. You're based on the expectation that,

[1:31:35] that last year's numbers will be next year's numbers. That's subjective. So for those people who critique valuation as being subjective and making forecasts for the future, I'd much rather face up to uncertainty than hide from it. [1:31:48] Speaking of subjective, what characteristics do you think will define [1:31:52] the most successful business, [1:31:54] leaders, I'm thinking specifically like CEOs and investors over the next decade. [1:32:00] Use the word adaptability. That's one word that I think is going to be critical because I think one size fits all is not going to work in this market. [1:32:09] You've got to have people who are willing to change, who are willing to listen, and who build companies that can outlast them. [1:32:16] who build management teams. [1:32:18] It's the one thing I admire that Jeff Bezos did at Amazon is he built a management team at Amazon. Same thing with Bill Gates at Microsoft. [1:32:26] It's the one thing that [1:32:28] terrifies me, even though I admire some of the things that Musk has done at Tesla, the one thing that terrifies me at Tesla is, [1:32:34] is how the entire company is built around a single personality. [1:32:39] I can't name a single top executive at Tesla. [1:32:42] Can you? [1:32:43] Do you know who the CFO of Tesla is? I could probably go look it up. [1:32:46] The fact that we never hear from the guy is kind of interesting. I don't even know if this could be a male or a female. That's how little I know about the CFO. [1:32:54] I don't know about the top management team. I don't even know who the PR person is because every time there's an issue at Tesla, guess who the respondent is? It's Elon Musk on a Twitter feed. [1:33:03] You want companies where adaptability is very much part of the business, where your CEOs are willing to trust the people they hire to make big decisions without constantly looking over their shoulders. Companies run by imperial CEOs, people who think they're Caesar.

[1:33:20] I think are companies I would stay away from. You give me the perfect excuse to close on a really fun topic. What do you make of everything going on with Twitter and Elon Musk right now? [1:33:30] With Elon, you never know. It could be a big, long game in which he's willing to throw away a billion dollars. I think that for him, it's not about buying a business. I believe him when he says it's about... [1:33:42] buying a platform for free expression. I don't think he understands fully what that means, because I don't think you can actually have a social media platform, which is completely free and open to everybody because there'll be chaos and lawsuits and [1:33:57] But I do think that he feels for him, it's, I think about his investing in Twitter for the same reason Steve Ballmer bought the San Diego Clippers. He wanted a play thing. And for Musk, this is more, I think, reflection of his belief in people should be able to say what they want without having somebody... [1:34:15] censoring them. [1:34:17] So I believe that that's his main motivation. Now, I don't think he's going to keep Twitter as a private business forever. I think he intends to change it and then take it back to the market. [1:34:27] And what you're looking at as financing is essentially his personal financing, funding a deal. [1:34:34] which normally I would say is not a good idea. You don't want to borrow against personal assets to fund a $45 billion bet on privacy. [1:34:43] But it's his money. So I think he's serious about it. But I think also that by the end of this process, there are going to be lots of

[1:34:50] bridges we've got to get and cross. [1:34:53] before the end game plays out. [1:34:55] Are there any major topics on which you have a divergent view that we haven't talked about today? [1:35:01] I think disclosure is the issue where I think I'm in most in disagreement with people. A lot of people think that more disclosure is the answer to our problems. I hear this from value investors, growth investors, just let companies to disclose more. From ESG people, more disclosure. And my experience, disclosure is this double-edged sword. I mean, you think that more disclosure leads to [1:35:31] behavioral research of giving people information is sometimes less is more. I think we're actually doing a disservice to investors by having what I call disclosure diarrhea. I mean, have you read the risk section in any prospectus? It's ridiculous. Yeah. 50 pages of garbage. And this is the problem. Companies have learned to play the game. They've discovered that if you disclose everything, it's like disclosing nothing. You lose perspective. They don't know the big things versus the small [1:36:01] to the same, well, it's like going to confession. And in a sense, disclosure is a very good analogy to confession. Confession, you confess for an hour to a priest and along the way you confess to small sins like [1:36:12] I coveted my neighbor's car. [1:36:14] with, oh, I murdered my neighbor along the way. [1:36:17] And because you spend an hour, the priest doesn't remember what you said by the end. He says, three Hail Marys, and you're done with your sins. I think, unfortunately, disclosures become the same way. For many companies, disclosure is not about...

[1:36:31] telling you that they won't do things in the future. It's about confessing their past sins, [1:36:36] And in such detail that you don't even remember what they confessed to and they can go back to sinning again. [1:36:40] And I think the SEC has kind of missed the entire script on this one by focusing on one size fits all. And take the latest climate change, things that are coming out of the SEC. I'll predict that 10 years from now, you're going to have 300 pages on carbon footprint at every company and that nobody's going to read those pages. Last time I was at an ESG conference. [1:37:03] As people, and how many of them had flown to the conference, I was actually doing it on Zoom, but they were actually at a physical conference. About three quarters of the people had flown to the conference. [1:37:11] I assume that when you flew to the conference, you picked an airline. How many of you picked your airline's basement carbon footprint? If you've noticed, when you pick an airline, it tells you what your carbon footprint is going to be. [1:37:22] There's a room full of ESU advocates. Not a single person picked an airline based on carbon footprint. [1:37:28] And I said, [1:37:29] So what are we accomplishing by disclosing this? Are we actually not diluting this? [1:37:35] the value of a carbon footprint by having everybody disclose it. [1:37:40] California, we have this system of propositions which allows people to get things before, you know, in fact, the Athenians, when they argued against direct democracy, should have used California as an example. [1:37:52] of why direct democracy is dangerous. As you can put anything on, in the mid 80s, they passed this proposition that, well intentioned that any product with the ingredients that could create cancer had to label.

[1:38:03] that the product would create cancer. [1:38:05] But it was written so badly that it covers pretty much everything. That proposition, if I go down the street from where I live, I go to the taco store, there's a sign that says our tacos could cause you cancer. [1:38:18] They're going to CVS coming in through those doors could cause you cancer. [1:38:21] And after a while, you just stop reading it because to close this, actually, my neighbor has an 18-year-old son. He was standing outside the other day smoking a cigarette. [1:38:30] So I said, you're smoking a cigarette. We've known for 40 years, you know, it causes cancer. He says, everything causes cancer. And this is exactly where we're going to end up is if you label everything as cancer causing, you know, [1:38:44] then how do you separate tobacco from tacos? And I think that's a problem with disclosures. If everything is disclosed, then... [1:38:51] I have no idea what matters and what doesn't. And that's unfortunately where we're headed. And that train's left the station again because the accounting firms have jumped on. The disclosure firms have jumped on. The activists on every single issue have jumped on. [1:39:06] And we're going to end up with disclosures that nobody reads. Well, Eswath, I've so enjoyed this conversation, but I'm more thankful just for a decade plus of writing that you've done that's taught me a lot. I'll definitely point people specifically to Narrative in Numbers being a book among your many books that really had an impact on me. I've so enjoyed our time together. And I ask everyone the same traditional closing question. [1:39:26] What is the kindest thing that anyone's ever done for you? [1:39:29] probably how I was treated when I first came to the US. [1:39:33] I came from a part of India where I'd never watched TV. I mean, I'd seen TVs when I'd traveled, but I grew up in a part of India that was probably 200 years behind India.

[1:39:42] The times in terms of where the rest of the world was. I landed in LA my first day and talk about a culture shock. You go from never watching TV to watching roller derby as your first show on TV, followed by, you know, I don't know, some talk show where people are screaming at each other. [1:39:58] And I was completely lost. And I am still thankful for the kindness that [1:40:04] The people around me showed for my complete ignorance about how things worked. [1:40:09] When people ask me about why I prize being a U.S. citizen, I still talk about [1:40:15] That's a kindness I wouldn't have anticipated in much of the world, but I did get it here and it made me who I am and allowed me to stay and flourish. For that, I'm always grateful. [1:40:26] You've reminded me of one more question I want to ask, which is about teaching. You've taught for a long time. And you've said to me before that, [1:40:34] What your goal is when you're teaching is really not the facts of the class. It's a change in mindset for some subset of the students. Can you just describe that idea? Because I think everyone out there, like you said, you can learn from anyone and you can teach to anybody. So the notion of teaching is powerful. Say a little bit more about that goal that you have. [1:40:52] Everything I teach is going to be dated, even as I said, things change. What works today will not work tomorrow. So if all that people learn is... [1:41:01] how to do things the way I do them. [1:41:03] Five years from now, three years from now, even six months from now. [1:41:06] they're going to find themselves lost. [1:41:08] So I view my job as letting people see how I come to the conclusions that I do, why I do what I do. Now, I call this having a window on process so people can see why I value companies the way I do. So it's not what I value Tesla, but why I ended up with that value. In the process, what I hope they will get is a way of thinking through questions. I mean, I think my biggest worry as a teacher is how Google search works.

[1:41:35] has ruined. [1:41:36] Thank you. [1:41:37] Because when you have a question now, what are we trying to do? Go to Google search, look up the answer. Let's take as an example, what tax rate should I use in valuation? Rather than think through... [1:41:47] How you would answer that question, you say, that takes a lot of time. Let me go to Google search. Somebody must have answered the question already. [1:41:53] And odds are there's somebody up there says this is what you should use. [1:41:57] But what you lose is that capacity. Your mind is a muscle like everything else. We don't use it to reason your way through to answers. [1:42:05] then you will find it very difficult to ever start reasoning. [1:42:09] So I view teaching as giving people a window to my reasoning so they can see my reasoning. They can agree or disagree with my reasoning. [1:42:16] but at least they can see how I think. And hopefully that will rub off on them. So they develop their own way of thinking. It doesn't have to be my way of thinking, but their own way of thinking through issues. It's a wonderful place to close. Again, I'm thankful for your time. I've learned a lot today and always do. Thank you. Thank you. Next, you'll hear my conversation with Canalist customer Giuseppe Coco of LK Advisors. We talk about the good, the bad, and the ugly around proprietary models and how Giuseppe has made [1:42:47] So Giuseppe, I think the place to start is with the concept of a deep economic model on a business. You've got a unique background in banking, where I think you've spent God knows how many hours building complex models. And I'd love to just begin there. Just talk us through your early experience building models, sort of the good, the bad, and the ugly. Yeah. So we started out with investment banking, which is very much on the private side. And there, obviously, you have a lot more information. And so you can go in a lot more detail. So

[1:43:16] that we were building for deals were frequently 20, 30, 40, 50 tabs, thousands of lines long, only like to get to a very simple output. And you would spend hours just changing this, changing this, updating this. It would literally take forever. And it was very difficult, almost like to audit. You would find something, okay, this number should be this, this number should be that. And you would literally go back and spend hours and hours and nights just trying to [1:43:46] times people are just adding more and more complexity. [1:43:49] to those models and always ask for incremental complexity. What do you think is the most useful and the least useful part of how those complex models are built on the banking side? Obviously, precision is good if you can get to it, but false precision is bad. What do you think the good and the bad is of that style of model building that's so complicated? I think to a lot of people, it provides false comfort because it's more like the more the merrier, but it's actually not the case. It's more sort of, what are the relevant things? What are the key things that actually [1:44:19] that unfortunately just gets lost in the detail. On the good side, to be frank, I don't think there is actually much because think of a solution like Canalyst, which the first time I opened the Canalyst model, I was amazed by... [1:44:33] the level of detail and precision that they could get basically into their one-tab models. I was totally amazed by that, that it was even possible, you know, until that point. I mean, that hasn't even crossed my mind that it was really possible to build such a

[1:44:47] detailed, and sophisticated, yet simple model in a manner that they do. If you think about those early days and what [1:44:54] Canalyst does or when you first encountered it, what did you like about the service when you first encountered it? What did it replace for you? And because you didn't no longer have to do those things, what did it open up or unlock for you with your time? When I first started on the buy side, it started out by models manually. My former boss asked me to put out models manually and do this and do that. And then obviously your work basically piles up. And it just takes hours. It can easily take a few hours until we don't want to, potentially even like three weeks, depending [1:45:24] to build a proper and running a fully integrated model for any of the companies. What Canalyst does is basically condense all of that process. So it's as simple as downloading any PDF file just from the internet. And you have the whole model there with all the relevant KPIs, with all the relevant drivers, so you can overlay basically your inputs. I think from all the tools I have been using on the Viseit and I'm using today, it is the one that reduces friction the most. [1:45:52] Giuseppe, I'm curious, where did you first hear of Canalist? Funnily enough, I actually heard about Canalist on your podcast in an ad. And it was one of those evenings where I was at home listening to a podcast and I heard automated models, auto-updating. I was like, oh my God, this is exactly what I need. And I'm curious if you've interacted with others in the investing industry too that are using it more and more. Are you seeing... [1:46:14] more colleagues or even competitors or friends using it too? Is that part of the growing network of it? Here in the UK, my previous firm, I started using it and our team started using it. And then a team that was sitting next to it was like, okay, hey, what are you guys doing? How are you doing this so fast? And then they started using it as well. So it became sort of

[1:46:32] viral. And then when I joined here, so our CIO, funnily enough, when we first met, we talked about it. It's like, hey, there's this amazing solution, which I'm using as part of my process. He was like, oh yeah, he's ex-Fidelity. One of the Canalyst founders is also ex-Fidelity. So he had it very much on the radar and it wasn't even a discussion to get up and running with it. [1:46:51] coming here. Maybe just talk about your day-to-day life at LK Advisors. What exactly is it that you are doing? What is the daily workflow so that we understand how it slots in? Depends on the time of the year. Currently, we're going into earnings season. So what we're doing right now is lining up our numbers across the models for the companies that we're holding, seeing where our estimates are. And then obviously, that's just like preparation work at the moment. The rest of the time is screening for new ideas. Right. [1:47:17] speaking to management teams, attending conferences, setting up costs. And for all of this, Canada is extremely helpful because you always have a single source of truth, which you can refer to look at the numbers and to get a better sense for where that is and how something that a management team may say, something that we learn may impact our estimates and where and how that could potentially translate into value. That single source of truth thing is interesting. [1:47:47] analysts and PMs, how is ownership of the model typically handled? Because it seems like one nice thing, like you said about catalysts is it's a single source of truth. It's almost its own ownership. You don't have to worry about it as much. But how in the absence of something like catalysts are models typically shared?

[1:48:02] and responsibility for them shared between teammates? Maybe like even going back to the previous experience, I think generally in finance, and I think most people will agree that models are sort of, the model on a company, on a deal, whatever it may be, is sort of viewed as the holy grail. The numbers that people use based estimates on of value. And it's sort of like the most things sort of, you know, what is the impact of fill in the blank, get X, Y, Z. So people hold it a very, very high regard. [1:48:32] jealous of their model. And everybody thinks that if you own the model, you own the process and you ultimately have the deal. But the model also is, it's usually in pre-canalist type of times, it is extremely time-consuming and inefficient to maintain. The way it's normally shared among teammates is usually it's quite easy for [1:48:53] mistakes to sort of sneak in. Canalyst is great because there are no mistakes in their models. If you want to have something added, right, you can just read out to the support team and product analysts and they will demand it to your satisfaction. [1:49:06] So thereby using Canalys, you don't need to worry about maintaining your single source of truth. How would you compare how you use Canalys from your sort of hedge fund days to what you're doing at LK Advisors? Is it different? Is it similar? Is it highlighted anything for you about the product or products? It's a bit different. I think in my previous role, the coverage universe was a bit more fixed, a bit more Europe focused. [1:49:31] So it was more about updating, maintaining, forming a rolling view. I think in today's role, it's very different because our coverage, our universe is basically global. So when I came in, I had to think of, okay, so how can we actually leverage this? And one of the thinking was, for instance, I was very keen to build a, what I would call a quality scorecard, which would allow me basically to, when you have to think about cross-developed markets,

[1:49:59] what is what most of what we do, potentially even like some emerging markets. How do you compare, cross-compare companies on a qualitative basis? So we started building out this process, which looks at more than 250 KPIs to help us build sort of a scorecard, which helps score any company [1:50:16] along those KPIs from one [1:50:18] to 10. And this is a process that we found very well working for us. And that without Canalyst, I mean, it would have been virtually impossible. Taking years or something. Yeah, it would have taken multiple years, multiple years. What do you think is interesting about where you sit? You're in London, obviously a global coverage and universe is probably a little bit more important to you sitting there than if you sat in New York or something. How does that transfer into the use [1:50:48] since I started. [1:50:49] first using the product, they have expanded massively and wider into, especially like European companies, as well as EM and developed Asia companies. So the universe has expanded tremendously. The other great thing is, we work closely with the product team to make suggestions on sort of companies that we care about and companies that we know, sort of people here in Europe care about, and they are extremely reactive to initiating and launching on new models when we ask them to, [1:51:19] waitlist. So yeah, we continue doing that as we take an interest in different companies in Europe. [1:51:25] And I think the roadmap is to get to 10,000 companies/models, which is a pretty wide scope. What do you still do that's, I'll call it very manual, that you don't think is too high value and you wish could be automated? Another way of asking it is, what do you hope is on Canalys product roadmap? I think it would be nice to have something what I would call a by-side consensus. If you ask many people in the industry today,

[1:51:50] Buy-side consensus is this very elusive concept of whisper, what some people may even call it. It's like an unformed expectation, and it may vary. What would be amazing would be to have some sort of catalyst user-weighted, anonymized average of what actually the users on the other side do. [1:52:12] thinking and then, you know, sort of providing an opt-in or an opt-out, whether you kind of think you want to participate in that. I think that would be amazing. The other thing is they're currently working on this Canvas platform. And we have like an internal developer who's working with their team to scale this scoring mechanism that I have just mentioned to you through a Python-enabled web platform to basically like run that even at larger scale through the entirety of their platform. [1:52:42] more life and [1:52:44] more consumer-friendly as the website. I think that could open up very exciting opportunities and use cases down the line. I'm curious, Giuseppe, if there's anything that you think is lost in the process of outsourcing some of this model updating [1:52:58] Another way of asking it would be, if you're updating these things manually, does that give you some sort of felt sense for the business that you can't get just by looking at the numbers? And do you think that's worth it at all? I mean, obviously you're a big analyst user, so I can guess your answer, but I'm just curious whether there is a downside to, I'll call it outsourcing some of this manual work around updating the models. I think the first part is that once, I remember when I opened my first analyst model, you see all these things and it's more like, okay, how does this work? You would click

[1:53:28] I think it's more when you have your sort of, you know, the companies that you know, and you follow them and you have a sense for the history. Obviously, you know, you need to look at the numbers and you just anecdotally get a feel for what it is. But I think, you know, [1:53:41] The beauty of Canalyst is, as you mentioned, right? So you open a Canalyst model, there are five tabs, and they have these beautiful summary sheets. And I almost find it... [1:53:49] a lot easier to just look at those trends and get a sense for how something has performed, what is driving X, what is driving Y. They actually enhance, in my view, [1:54:01] that process of understanding what is going on. I had this debate with multiple friends and my view is that it's totally overrated to say, you need to build the model to entirely understand the business. I think you just need to look at the numbers, understand how they flow, [1:54:18] which is what Canalyst helps you with and do. I think the other thing that I found super helpful that initially wasn't as intuitive is their custom templates. So Canalyst has like standard templates or an LBO or a DCF. [1:54:31] comms, all these usual things. We have our sort of proprietary process of how we look at things, how we value things, the scorecard that I've mentioned to you. So we spent, we invested, you know, a decent amount of time into like building our own templates that correspond to our process that work exclusively on the Canada platform. Once we scale it, we put in that, you know, it incrementally helps us understand and make sense of a business. And whilst we can, you know, continue to comply with how we do things and how we think about things.

[1:55:01] Awesome. Well, Giuseppe, thanks so much for taking the time to do this today. Really interesting career arc that you've obviously done a lot of modeling. So a great set of experience to understand why this is valuable. Thanks so much for your time. Thank you. [1:55:31] week.