Invest Like the Best with Patrick O'Shaughnessy - Aswath Damodaran - Making Sense of the Market - [Invest Like the Best, EP. 279]

Starting point is 00:00:00 This episode of Invest Like the Best is sponsored by Canalyst. Canalyst is the leading destination for public company data and analysis. Founded by a former byside analyst who encountered friction sourcing, building, and updating models, Canalyst is now used by over 400 institutions, including the largest money managers globally, and by a number of guests on the show. With detailed company-specific models and data on virtually every public company, panelists clients are able to ramp up faster, update models instantly, and incorporate the highest quality fundamental data into any workflow.

Starting point is 00:00:30 If you're a professional equity investor and haven't talked to Canalyst recently, you should give them a shout. Learn more and try Canalyst for yourself at Canalyst.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 Canales customer, Giuseppe Coco of L-K advisors. We talk about how Giuseppe has built Canales into his process as an international investor and much more. Today's episode 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

Starting point is 00:01:10 one place. Ready to accelerate your business, learn more at brex.com slash best. That's BREX.com slash best. Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. 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 join colossus.com. Patrick O'Shaughnessy is the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi asset management. This podcast is for

Starting point is 00:02:01 informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. My guest today is Aswath the Motorin, a professor of finance at NYU's Stern School of Business. Aswath is one of the clearest teachers of investing in finance in our industry and through his blog, books, and YouTube has open-sourced his wisdom for decades. This conversation is a master class 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, the Motorin. Asphalt, I wanted to do this with you for, I don't know, I guess more than a decade since I started

Starting point is 00:02:47 reading your work on valuation and markets and narrative and numbers, so many different things. 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. Inflation is something that 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 on, I think, on valuing companies, think about inflation as a now dominant force in markets.

Starting point is 00:03:24 I think it's interesting when he 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, sometimes, you know, astronomically high inflation. Turkey, for instance, I mean, they've had to deal with inflation now for a decade. I think that sometimes talking to people outside your geographies can give you some sense of what you need to be scared about. And I think that's one thing that I found early in this discussion when we first started talking

Starting point is 00:03:56 about inflation in 2021, I found it disconcerting that people were so quick to dismiss inflation. Not only did they buy into the feds and the administration salespits that this was transitory, it was going to go away. So also what's the big deal? 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. It drives everything else out of discussion and it drives the market.

Starting point is 00:04:27 And I'm afraid we're in one of those spirals where inflation drives everything we do in markets. 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. So if you're buying a bond, if we expect inflation to be 5%, you set the coupon rate at 7 or 8% to cover inflation.

Starting point is 00:05:00 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. When inflation is unexpected, you've not had a chance to adjust to it. Now, if you own financial assets, unexpected inflation can cut both ways. When inflation comes in below expectations, 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.

Starting point is 00:05:34 But inflation comes in above expectations, 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. What does that mean? With bonds, you've got to mark down the price of the bond because a coupon rate is not high enough. With stocks, the same phenomenon plays out in a more subtle way. With stocks, at least you get a chance to adjust your cash flows unlike bonds. So the effect can vary across stocks. It's unexpected inflation that is so deadly. I was just finishing up a piece in inflation to kind of fall open what I wrote a couple of weeks ago. We're actually in each decade look at both expected actual inflation and the portion of that that's a lot. unexpected. We talk about the 70s as a high inflation period, and it works. The 80s were also a high inflation period. If you look at the average inflation rate, but here's the difference. In the 70s, unexpected inflation was always positive, which meant inflation came in consistently above expectations. In the 80s, inflation was high, but towards the second half of the decade, inflation came in lower

Starting point is 00:06:39 than expectations. 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 how devastating it is for financial assets when inflation becomes high and volatile. My concern with what's been happening in 2021 and 2022 is we're seeing a pattern that we saw in the 70s, which is people's expectations are set by what they've lived through. And the reality is most people entering the market, if you look at the investors in the market in 2021, enter the market in the last 10, 15, 20 years. 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. So one reason I think

Starting point is 00:07:26 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's always been low because that's the only thing we knew. 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 chains, go with the excuses that were given early on. But we all also, I think, finally agree that we're not going to go back to 1% or 1.5% inflation, which is what we had in the last decade. The question of where we fall between the 1.5 and the 8 or 9% is what's driving markets.

Starting point is 00:08:13 If inflation subsides back the most benign scenarios, goes back to 2%, which is supposedly the Fed's target, that's a most benign scenario. 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? And adjusting from a 2% expectation to a 5% expectation is devastating for all financial assets. It's not just stocks.

Starting point is 00:08:41 It's not just bonds. in any type of financial assets. 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 years, we try to find what I call steady state in an expected inflation we can live with. 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, like, obviously, cash lost a lot of its value in the 70s. What about everything else? What is the lesson that you think might be portable from other periods

Starting point is 00:09:21 of high inflation in the West or around the world to today's market? If you think of cash as invested in keybooks, which is what cash has become now increasing in. It actually did very well because it kept up with inflation. What was more dangerous is you invested in longer duration financial assets, bonds, stocks, because their unexpected inflation meant you had to re-eastern. just 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 P.E. stocks, small cap stocks did much better than higher P.E. stocks. So in a sense, if you think about this as a very lazy categorization of value versus growth and the small cap premium,

Starting point is 00:10:06 much of the small cap premium that people keep talking about in valuation was earned in the 1970s. was the decade with the small cap premium was strongest. So for whatever reason, small cap companies had more flexibility to adjust inflation. 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. And I think that the lesson from the 70s and the 80s is there's really no safe spot among financial assets. but among financial assets, there are relatively less damage versus more damaged assets. If we think about something really naive, which would be that equities might be a safe place

Starting point is 00:10:50 because they might have pricing power and aggregate and they can sort of pass the inflation onto their customers. Why is it necessary then that equities as a financial asset are in bad shape in a high inflationary environment? What is happening inside of companies that make that the case? That's where the contrast between expected and unexpected inflation. 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.

Starting point is 00:11:20 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. The problem is with inflation becomes high. It also becomes volatile, which means that when inflation is 10%, it's far more likely to be swinging from 4 to 16 than inflation is 2%. What kills companies is the uncertainty about inflation. And here's why. Let's hear a company with long-term investments. You've got to make a decision on a 30-year project. 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. But now that expected inflation could be four or

Starting point is 00:12:04 16, you're going to be far less likely to take that long-term investment. So here's the first. The first area of disparity, 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. Inflation kills infrastructure companies. It kills companies which make long term investments because those investments now will either be delayed or not taken when inflation becomes uncertain. If you look at outside the U.S., at countries which have had hyperinflation, not just talking about 5-7, I'm talking about 50, 100 or 5,000 percent 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. So you need pricing car in the sense of not just setting prices, but being able to adjust prices

Starting point is 00:13:02 quickly. 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, that the competition behaves the way you do, because you can't unilaterally adjust prices if you're in a competitive environment. And third, that the regulatory framework you work with actually is quick. I mean, I'll give you the example. Utilities should be relatively protecting against inflation. 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. The problem is regulatory commissions are composed of people pointed by politicians.

Starting point is 00:13:48 So inflation is 12%. You know the right thing to do is pass on that 12%. 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. 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, because you should be able to raise rent when inflation is unexpectedly high.

Starting point is 00:14:22 Well, that's true if you don't live in a rent-controlled or you don't own property in a rent-controlled city, I can almost guarantee you that even 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%. If you think they're going to increase rents by 12% if inflation is 12%. I don't think so. So I think the problem is, well, in theory we can talk about how companies can be insulated

Starting point is 00:14:55 against inflation? In practice, they cannot. And there's one more thing. Our tax laws are all built around book value, what you actually invested. So things like depreciation actually become less valuable when inflation goes up because you get the same dollar depreciation that you used to with 2% inflation when inflation is 12%. And all of those benefits become less valuable. What have you learned about goods versus services and that mix in all of this as it pertains to inflation? I think it's not so much goods versus services, discretionary versus non-discretionary. I think that if you're 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

Starting point is 00:15:44 to inflation than if you're not. A grocery store chain will do far better than your special retailer. As you've noticed in the last week, we've seen Walmart and Target. the big retailers all come out and tell the word 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. But what choice do you have? So I think that it's discretionary versus non-discretary.

Starting point is 00:16:17 But the big challenge for us, the money we spent 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. We're going to find out very quickly, right? And so this is going to be the real test. So much of our market cap comes from companies that provide products and services that weren't around 30 or 40 years ago. We're going to find out how inflation plays out on those decisions. Are you far less likely to upgrade your iPhone if the prices are going up 15 or 20 percent a

Starting point is 00:16:52 year, then if they're going up 5% to year, we're going to find those things out if inflation is here to stay. 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? That, I think, is the human side of inflation. I mean, inflation 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 the capacity to hedge it. I mean, it's not as if their portfolios that they can move around. They're dependent on their income stream keeping up with inflation. If you had concerns

Starting point is 00:17:38 about income inequality coming into this process, it's going to get exacerbated by whatever inflation does, at least at the lowest end of the weight spectrum. There's another hidden cost, is we know that to break the back of inflation, 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. I call this the Volcker scenario. 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, because an election is coming up and you don't want this to get in the way. But I think the reality is if inflation turns out to be higher than expected, and we don't like the results of high inflation,

Starting point is 00:18:26 the only way you get out of it is through a recession that's deep and painful. And guess who's heard by that? Exactly the same piece. So in a sense, you're between a rock and a hard place here. There is no easy pathway out, which is one reason early last year I argued that even if you believe that inflation was transitory, the thing to do was to act. as if it was not and act quickly. I've described inflation as the genie in a bottle. As long as it's in the bottle, you know, you can look at it, you can laugh about it, but you let it out of the bottle, getting it back in is really difficult to do.

Starting point is 00:19:03 Do you think that the policy environment, 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? I fully understand that Jerome Powell doesn't want to be viewed as the next Arthur Banks.

Starting point is 00:19:37 Arthur Banks, of course, was the central banker 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. So I think the Fed is serious about inflation now, but I don't know whether it has the stomach to carry through what that seriousness requires. 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. That's the power it has.

Starting point is 00:20:08 It's not got the power to change inflation rates or change interest rates even. And I think that the scenario that is terrifying is if, in fact, the Fed does push the economy to recession, but inflation doesn't come down quickly. 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. And that's the danger of having let inflation run ahead for such a long period that getting it back under control might take not just three months or six months, but maybe a couple of years. 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. The benefit of hindsight, we've pushed it back so that we don't think about it.

Starting point is 00:20:58 It's not something that I want to live through again, but I don't think I might have a choice in this matter. If you go look at the long-term chart of price to earnings ratios, however you want to calculate them, specifically 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. 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, truest 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.

Starting point is 00:21:44 But if you could generalize, what do you think the smartest companies are doing already in the face of this? Whenever I think about any issue related evaluation, I go back to my value drivers. And in the sense, think about what can companies do if inflation is the bogeyman that they're worried about. The first thing they'd like to do is make the products less discretion. saying, how the heck am I going to do that? 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.

Starting point is 00:22:14 In the last decade, increasingly Microsoft has shifted away from an upgrade, software upgrade business to a subscription business. Subscription businesses, by the very nature, tend to be less discretionary. For whatever reason, people are far less likely to cancel a subscription than they are, does not upgrade. 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. The second dimension, of course, is your cost structure. If you have companies with large costs which are rigid, are more effective inflation. So you're looking for ways

Starting point is 00:22:56 to make your cost structure more flexible. So when you're negotiating with your unions, of your unionized company, you might actually accept higher wages in return for flexibility on those wages, which is a rather than set a 7% guaranteed or a 5% guaranteed increase every year for the next five years, we're going to tie it to inflation. So the more you can tie your cost to inflation and your revenues, the less you're affected by inflation. It's easier for some businesses to do this than others. But I think that you're going to see this disparity play out in companies. In my portfolio, the first time, I have five of the six Fangam stocks, everything but Netflix. And one of the reasons for that is, when I look at those companies, I see the capacity

Starting point is 00:23:41 to their products and services approved. They've actually done a very good job of making their products and services less discretionary. They have cost structures that are incredibly flexible. Their investments tend to be short-term and reversible. And in terms of risk, they're low debt and very little failure risk, things that you worry about with inflation. Because if you're a heavily indebted company and there's big failure risk, swings in inflation can very quickly put you under. When I look for my list of, hey, these are the things I want in a company. 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,

Starting point is 00:24:29 as to where do I go for companies that are best protected against inflation? And I think the places you go now are very different than 40 years ago. 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? I know it's become this magic bullet that people focus on. Every year, I actually compute the return investment capital for every company on the face would be at 46,000 companies. So I'm intimately aware

Starting point is 00:24:59 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 is a nightmare. Why? Because acquisitions create debris.

Starting point is 00:25:14 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 and have a high return on capital if you give me enough accounting discretion to play that game. So I compute the return investment capital. I say it's a metric.

Starting point is 00:25:30 It's a useful metric at least add some broader level of law of large numbers level. But it's not a metric I want to tie my investment strategy around because I can see things that can go wrong. So I think it's one of many metrics you should look at. And the problem with the return investment capital is as a metric, it's designed for mature or declining companies. You can be a great growth company. It's return investment capital.

Starting point is 00:25:55 We either mean English, the return investment capital for, if you take Apple, is negative. Why? Because the cash actually exceeds the book value of equity and debt. If you take that to mean, hey, the ROIC, that Apple takes terrible projects, you're completely mistreating the number. It's a denominator that's negative, not the numerator. For young companies, the ROIC becomes almost meaningless. It's not the kind of metric you want to focus on.

Starting point is 00:26:19 So if you have an investment strategy built around ROIC, and I know that our people, you value investors who buy into this, remember, this is going to leave you with a portfolio of older and declining firms, and some of them will be value traps. Because what you're capturing with the return investment capital is your past, that this company used to have great investments. Kraft Times has a great return investment capital. It's not because of the new projects it's taking. It's because that 57 varieties of ketchup 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 to kind of keep that in perspective

Starting point is 00:27:00 when your investment strategy is driven entirely by ROIC. I mean, I remember in the 1990s, this outfit called Stern-Steward, this measure called EVA, half of the S&P 500 bought into. It's a measure built almost entirely on return investment capital. And the consequences were incredibly predictable, which is, companies gamed it, which is they figured out what showed up in invested capital. 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. So I know companies play games with ROIC. So I'm not saying don't measure it,

Starting point is 00:27:38 don't use it. I'm saying make it part of a portfolio of things you look at and be aware of where it's going to lead you in terms of investing bias. What do you think about thinking about the company management CEOs, CFOs specifically, the employer. 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 to find 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 cash flow from financing type of capital allocation. What do you think about the importance of that skill set for leaders?

Starting point is 00:28:16 It tells me that you're growing old as a company. If you're a young company and your projects make 35%. Who cares what your cost of capital is? 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. So Coca-Cola craft dance, of course they're going to do it. So investment banks will come in and they do the dance. And the reality is the cost of cap for a mature company. No matter how many games you play, it's tough to move. It moves by 20 basis points, 30 basis points. When inflation could be 3% and 9%. This is like moving the chairs around in the Titanic while you're heading for the iceberg. So when you see a focus on capital structure, you're already conceding that your best days are behind.

Starting point is 00:28:59 You're nothing wrong with that. It's good to act your age and say, look, our returns used to be 30. They've come down to 18. They're dropping every day. I want to move my cost to capital to 10% to 9%. I understand that that's where you're focused. But you're not going to be the 10-bagger in my portfolio. You're going to be the company that creates that middle of my portfolio.

Starting point is 00:29:19 you might do better than expected. 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. 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.

Starting point is 00:29:49 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. Real assets generally hold up to inflation better than financial assets. I mean, that's why real estate did really one in the 70s. The only problem is we screwed up real estate as a physical asset by securitizing it. What's happened as we've securitized 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 store, stocks went up as an individual, those are the years your house probably will also increased in price. Your stocks go down, your house also drops. So we've screwed up at least the segment of real estate

Starting point is 00:30:30 as an inflation hedge. But I think more traditional real estate where you buy a rental property and you collect the rental income can still hold its value. 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 rather than be dependent on companies' bank. But I think in a more general sense, I know I've always been leery about those people who argue for concentrated portfolios. And I've heard some old-time value versus to 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, because conviction goes with

Starting point is 00:31:13 arrogance. If you have conviction, you should be able to find companies and put all your money in five, companies. Maybe that was true 50 years ago. You're asking for trouble in this market environment to load up your bets on five companies. 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 U.S. stocks in the last decade, but they might be the place to be if inflation is coming back more in the U.S. than in Europe. So I think that there's a lesson that you learned from the 1970s or any period of market confusion, it's to be diversified, to be spread your bets.

Starting point is 00:31:58 It 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. But I think even if you're an active investor, owning only five stocks in this market is almost an invitation for disaster. So I would say spread your bets. And I'm glad you brought up gold because, again, there are ways you can invest in gold. I'm not a gold bug. I'm not going to put 50% of my portfolio in gold because that's a loser long term. I have never owned gold in my portfolio.

Starting point is 00:32:29 It might be something I can say because I've never had a portfolio to begin in an inflation period. But let's give gold credit for what it's due. It's a collectible that's held its value for thousands of years. And I think when I see gold wannabes, which is where I put cryptos and NFDs, they've got a lot of proving to do before they can be millennial gold, 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. Gold has a 3,000-year lead on them, and it'll be interesting to see how these

Starting point is 00:33:04 wannabe golds make it through this. This will be the ultimate test. When it comes to equity, specifically, 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 IPOed. 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. now. I valued Amazon

Starting point is 00:33:42 first time in 97. I valued every year since. Now, when I first valued Amazon, it was an online book retailer telling a story. I still have that letter that Jeff Bezos sent to shareholders. I think 97, 98. If you get a chance, read the letter. It's amazing in terms

Starting point is 00:33:58 of the story it tells. In fact, the way I described Amazon and I first started valuing it, as I called it my Field of Dreams Company. In the movie, Kevin Koshner, 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, if we build it, they will come. That has been the Amazon theme. That was the Amazon theme in 97. If we build it,

Starting point is 00:34:21 they will come. If we build revenues, the profits will eventually come. And they've kept that story as their base story and acted consistently with that story for 25 years. And I described Amazon as a company with their patients built into its DNA. Now, I'll give you an example. Amazon Prime. was introduced, I think, 2003, maybe 2004, for the first seven years of its existence. It did nothing. It had a million subscribers in 2010, seven years later. It was a money loser for Amazon. The shipping subsidies were just killing Amazon every year.

Starting point is 00:34:57 In fact, the shipping subsidies alone dropped their margins by about 3 to 4% every year. But they stuck with it. I can't think of another company that would letting the experiment run that long and not kill it. 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. It's not a logistics company.

Starting point is 00:35:20 It's a company that basically targets any business which has softness in it 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. They built the loyalty in that army over 20 years by making sure that in the order things,

Starting point is 00:35:40 they get delivered the next day. And if you don't like it, I mean, I live in San Diego. I can go drop it off in a drop-off box two blocks away from me. 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

Starting point is 00:35:59 from J.P. Morgan Chase? I would do it in a second. But they were willing to wait. So if you look at how Amazon is evolved over time, it shows you how critical stories are. 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 that tell the same story year after year and act consistently with that story. What I hear is from CRO's a big story today, but a different big story next year depending on what's working or not working. You have no credibility.

Starting point is 00:36:35 if your story keeps shifting and you don't act consistently with that story. So to me, Amazon is an illustration of how much stories drive value and how critical it is for investors to understand the story that animates a company. And not just think about it as a collection of ratios and numbers, which unfortunately is what some aspects of old-time value investing lead you to do. You take the 12 screens from Ben Graham. You run them through. You've got a bunch of screens.

Starting point is 00:37:08 Think of that as the Ben Graham branch of a, you know. And I think I've disagreed, 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 anime. 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.

Starting point is 00:37:38 So I would encourage people, even if their number crunches, to start thinking about the stories behind companies and whether those stories actually make sense long term. 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? What is the way to do that with fresh eyes? I listen to their stories. I mean, let's face Silicon Valley is now training founders to tell stories. They promise those stories of fairy tales, which is they tell big stories.

Starting point is 00:38:10 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 of every young company that's gone public. Uber went in public said that total addressable market was $5.2 trillion, trillion. You know, how they came up with that number. They estimated how much people spent buying cars or buying something. subway tickets. They added up everything spelled on transportation. And there is no way that Uber's actual market is $5.2 trillion. But what they did was they put that number up front and they

Starting point is 00:38:42 hope that dazzle investors so much that they would never ask any of the follow-up questions. If the market is big, therefore Uber must be worth a trillion dollars. It's what I call the Kathy Wood approach to investing. Tell a big macro story and say, therefore 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. They look at the total addressable market and they don't try to construct the story of their own. 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. Every big name tech company that's

Starting point is 00:39:27 gone public in the last 12 years, I value. at the time that they filed their prospectors. 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 is the story for the company. In hindsight, I've been horribly wrong on some of these. I don't apologize for it because 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 with my story. And I've tried to stayed true to that notion of, hey, I value a company based in my story. I'm going to be wrong a hundred percent of time, but I'm willing to reconsider. I valued Uber every year since 2013.

Starting point is 00:40:08 For the first six years, I didn't think it was a company that I would invest it. But towards the end of 2019, I told my story, I came up at the value. And for the first time, I found Uber to be trading at a price lower than the value. I bought Uber, even though its story might not shifted for me that much, but the price had shifted enough. I hate Netflix as a company's story. I like to think of my stories in terms of pictures, and for me, the picture I get, when I look at Netflix, it's a hamster wheel, 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. 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

Starting point is 00:40:52 entertainment business for everybody else. So they get more users, make more content, get more users, go back to the market, get a higher market cap. And I said, the problem with this wheel is how the heck you get off that wheel? And we're discovering the pain of getting off that wheeled right now with Netflix is because the user numbers start to slacken off. 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

Starting point is 00:41:21 every day. With HBO, I expect one new show every month maybe. But Netflix, at least 15 shows a day, otherwise something's wrong. And that's how Netflix has trained me. How the heck do you untrain me without losing my subscription? 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 investment. I'm going to say something that traditional value investors might view as sacrilege at the right price, I will buy any company. No matter how damaged it is, how terrible demand. At the wrong price, you could be the greatest company in the face of the earth. And I'm not jumping on the ship with you because the price is not right. We spent a lot of time

Starting point is 00:42:09 assessing company quality and management quality. We need to think about as much what the price we're paying for that is. We're looking for mismatches, a company that is of great quality that the rest of the world thinks is crappy. That's what the great investment is. I love the visual of the hamster. What other visuals come to mind, maybe among the Fangham stocks or something? I just love this concept. Amazon, of course, the field of dreams worked really well. I'd rewatch the movie every time I thought about Amazon. I'd be watched the movie. And now, of course, whenever I see Thanos in an Avengers movie, I think of Amazon. 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

Starting point is 00:42:53 business by buying Whole Foods, the collective market cap of companies in the grocery business dropped by $60 billion. Every time Amazon enters a business, we have no idea whether Amazon will ever figure out a way to make money on that business, everybody else in that business becomes less valuable. So to me, Thanos and Amazon, so it depends on how you think about Thanos is 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 fear than Amazon in my experience in markets. Because companies in every sphere, kind of fear.

Starting point is 00:43:32 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. 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. So whenever I pull up Google on my browser and that search box comes up, I said,

Starting point is 00:44:08 there's the engine that drives it. In fact, the interesting question of Google is it's all, but all these smart people on that campus. It's created all these great products. 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

Starting point is 00:44:26 to take the skills it brought into the online advertising business and convert the success in other businesses? Part of a broader question is to why do establish companies in one business have so much trouble extrapolating that success into other businesses.

Starting point is 00:44:44 Because I think if we can know the answer to the question, maybe we can save ourselves a lot of money and ask some companies to stop trying. What about Facebook and Apple? What images come to mind for you for those two 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. Ten years ago, everybody wanted to be Facebook's friend, even six years ago. Today, if you think about it, it's friendless. I've never seen a company that is this bereft of support from any part. I mean, everybody hates Facebook. That's not a good place to be. But it still has a money machine.

Starting point is 00:45:24 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, which to me is the hip-a-and-and-that's why I bought Facebook after the Cambridge Analytica scandal, as I said, I understand. that you guys are very upset about the fact that Facebook has invaded your privacy. But ask yourself a question, how did they get all this data on you? And the answer is, 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.

Starting point is 00:46:02 And that's basically what you need to remember is we've used the technology companies because the conveniences they've given us. I mean, I remember when I used to have to buy a garment GPS to put in my car, I mean, it cost a couple hundred dollars a pain in the neck to maintain. Do people even have traditional GPSs in their cars? It's because our phones are free GPS. 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?

Starting point is 00:46:32 The reality is this is a quid 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, and they're using the data on us to build a business. Facebook's business model is built on invading privacy. I mean, let's be quite real about this, and we're contributing to that business model. I don't think we're going to walk away because we're addicted. So I think that with Facebook, I think about the notion of how you can be friendless and

Starting point is 00:47:02 still be extraordinarily wealthy. Apple's too close to my heart to actually think about anything because I have I still have my Mac 128K, the very first computer that I ever bought. I've been an Apple users since 1981, but whenever I look at the Mac 128K, I realize very quickly that Apple is not a computer company anymore. It's an iPhone company. All I have to think about with Apple is look at my iPhone. It's an iPhone company. 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. The problem with the iPhone is you're now immature business.

Starting point is 00:47:44 Pretty much everybody has a smartphone. So you're very dependent on upgrades and keeping this business going. So with Apple, the problem is you've essentially built a $3 trillion, $2.5 trillion company now on a single product. And I think from that perspective, it's probably more danger than a Google or a Facebook. because any failure on the part of that single product is going to have consequences that are monstrously large. I mean, imagine an iPhone 14 that nobody wants to buy. And I don't even

Starting point is 00:48:19 want to think about the consequence, but that could be disaster because that's 75% of your revenues and profits right there. I'd love to spend some time talking about the nature of 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 love to spend some time here and pick this topic apart. How is it evolved? I don't much care for Tom Friedman, but I'm going to steal the title of his book. The investment world has become a lot flatter. I give the example. In 1981, if you're an equity research analyst who worked in New York, you already started with an advantage.

Starting point is 00:49:03 In those days, to look up an SEC filing, you actually had to walk in 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, let's say, an investor in the Midwest, 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 the backyards. you had execution advantages because of the way in which you were able to trade. I mean, so remember, these were the days before online trading.

Starting point is 00:49:38 If I wanted to trade, I had to call a broker. There was a time gap. There was an execution gap. Perhaps even a cost is disadvantage. So in 1981, you had a comparative edge over me if you're a professional investing. It didn't mean that you took advantage of it to make money because you were trading it. But you could see why some people were able to exploit that edge. I tell people, look, you know, if you take Ben Graham's 12.

Starting point is 00:50:01 screens. To run those screens in the 1950s, 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 app. There were no calculators, you know, whatever it was, and compute each ratio. 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? 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 who didn't have access to those annual reports who didn't have the time and the patients or the resources to do it. Today, I can go online and there are all these automated Ben Grant

Starting point is 00:50:44 12 screens. I hit them. They're under 12 screens for me two seconds later. The companies pop up. And the question is, if I can pull that up, what makes you think that running these screens is going to give you a differential advantage? I am shocked at how much of traditional value investing is just running screens. Whenever I've had a chance to go to Omaha, 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 PE ratios and high dividends or whatever it is. That's not valuing a company if it's running screens. Maybe one in a hundred actually values companies.

Starting point is 00:51:25 And the response is classic. They said, we don't value companies because, we don't like to make assumptions. What? Investing is a set of assumptions. The fact that you have 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,

Starting point is 00:51:44 which is we don't like Bayes. Okay. I don't like Baytas either. So you don't like modern portfolio theory, that's fine. That doesn't mean you can't value companies still. 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.

Starting point is 00:52:01 But I think so much your value investing has become screening. The question I would ask is, what do as a portfolio manager is run screens? What makes you think? You're bringing something to the table. I can run screens. I can run the same screens you can, often on the same databases you do. Where is the differential advantage? So I think the first reality is finding that niche has become a lot more difficult, which is one reason I think active investing collectively has had more and more trouble with passive investing, ETFs and index funds. And that's not going to change. I don't think active investing is going away. I think it's going to become a smaller business, a business where niches have to go beyond, we have a 23-story building with big computers

Starting point is 00:52:48 and lots of databases, because that's not going to be enough of a niche for you to find your alpha. If your focus becomes all about finding alpha, you've lost the script. And here's what. In a sense, you need to find alpha, but not at the expense of creating a backstop on my portfolio. And what I mean by that is that our portfolio managers become so focused in creating alphas, they go out and take insane bets on companies because they want to deliver that positive alpha. 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, than seeking out alpha. So I think the way we rank managers based in alpha encourages them to be not just risk

Starting point is 00:53:35 takers, but reckless risk takers. 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 best performing manager has a much greater chance of being the worst performing manager in future periods than the middle of the group. So I think that rather than look for the highest alphas, you want to go for consistency, even if it means settling for little or no alpha. The hypocritical of doing no harm should really be first front and center for anybody who's

Starting point is 00:54:13 managing other people's money. 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. We take 40% of your portfolio and buy Valiant, 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.

Starting point is 00:54:31 I know you didn't see this coming, but you didn't have to put 40% of your portfolio into one company. 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

Starting point is 00:54:52 from those studies. Do you think there is any utility in studying other investors? And if so, what is it? I think there's something you can learn from everybody, including bad investors. There's something I learned from Kathy Wood. I know, I've learned about how macro trends do matter. I think she's very good at calling macro trends. But I've also learned from her mistakes that just because you get a macro trend right, doesn't mean that the micro bets you make in that macro trend. Correct. So we all agree that 10 years from now, a greater percentage of the cars sold in the face VAT are going to be electric cars.

Starting point is 00:55:29 I think there's consensus on that. But does that mean Rivian is where I want to put my money? Not necessarily. So I think you can learn from both good and bad investors. I think you can learn from retail and professional investors. I think you can learn from your Uber drivers' mistakes on what he did wrong. Because when Uber drivers, you know, I constantly chat with Uber drivers because I've learned more about Uber, but talking to Uber

Starting point is 00:55:51 drivers than I would ever learn from talking to Uber management. And often our conversation veers off into investing and what they're doing in investing. And they talk about what they did. And classic, of course, is I put my money in Bitcoin and look, it's doubled. So I think we can learn from both good and bad investment 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, but that the overwhelming factor driving success and failure in markets. We hate to admit this in academia and practice is luck. It's amazing how as human beings, when we succeed, we attribute

Starting point is 00:56:29 it to our skills and when we fail, it's always bad luck. I remember the Shopify CEO complaining about markets and how markets didn't understand the company. Because the reason there's the stock prices dropped, he's convinced that markets are misunderstanding the company. It's amazing how you discovered markets' misunderstandings when your stock price is dropping, but you never talked about this when your stock price was going up, quadrupling in a year. So I think people often attribute to markets any of their mistakes and then claim for themselves their successes. So recently, Kathy Wood has been complaining how inefficient markets are.

Starting point is 00:57:07 So how amazing how when markets move against you, they're inefficient, but when they move with you, they're efficient. Very strange definition of efficiency, but it sells. serving. If you think about skill versus luck, as you think back on 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? 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. I'd be quite honest. The aftermath of COVID, I've made

Starting point is 00:57:44 COVID part of my stories for a little too long, I finally let go. Because I think it was such a big part of our personal lives that we assume that this was here to state that everything that you saw happening was now a long-term trend. So when you look at the Zoom, the Pelotons, the companies that benefit of 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 in our most recent experiences the most. It's one reason why I look at data. I call this my version of playing money ball, which is 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 a hundred years to think about, because if

Starting point is 00:58:30 I thought about just the last 10 years, it's very easy to dismiss it. So I think my biggest weakness often is the lack of perspective, and of course there's bias, which is sometimes you've fallen 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. I'm human like everybody else. 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. I was wrong. I mean, my most successful valuation exercises have come about after I've said, I was wrong. picturing an Excel spreadsheet in a traditional DCF, one of the things that you tend to find in there

Starting point is 00:59:15 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, which sometimes can drive a large percent of the value, is a lurking error. And the reason is that the life cycle of companies, just the nature of businesses, how fast they grow, how fast they mature, how fast they decline, has changed or evolved over time. Can you describe that shift and change and how investors should think about it? The best way to think about is to think about two examples of companies, one at 20th century classic.

Starting point is 00:59:47 Let's say G, founded in 1893, peaked, I don't know when, then you had the second coming with Jack Welch. And then finally, now if you look at G, it's a walking dead company. I mean, there is no happy ending here. 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. 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,

Starting point is 01:00:18 got to $100 billion in 1999, from nothing to $100 billion in seven years. 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 from start to end. Another reason I emphasize that is when we use that forever assumption that we see in this kind of cash flow valuation, 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 for the 20th century, that was perfectly okay. Companies took a long time to build up, take it a long time at the top, and then took a long time to decline. If you're valuing Airbnb, I'm not sure you want to make that same

Starting point is 01:01:03 assumption because it might be a great company, a great platform, but the nature of platforms is here, today, gone tomorrow. 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. So it's a convenience assumption. You can assume, for instance, that after your 10 or your five, that your company will last another 15 years and be done. And mechanically, there's no reason and you can't do that. 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.

Starting point is 01:01:39 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 when we first started. And I think that unfortunately locks us into practices that might not work for the companies of today.

Starting point is 01:02:01 Two of the strategies, I guess, maybe on other sides of the spectrum that have worked really, really well. I'd love to get your take on. One is momentum, literally just buying things that have done well in the recent past. 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? 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, the price adjusts to value. In fact, much of what you

Starting point is 01:02:41 see in investing discussions is about it. 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, selling at a higher price. There's no value, cash flows, growth. Who cares? 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. So as a trader, you live on momentum, but you die on momentum, which means that 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 perilous

Starting point is 01:03:26 investors. That's why I seldom sell short on overvalued companies. Many of these companies are in the throws 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. So momentum is a force that we've got to respect. So when people make fun of charters and technical analysts, let's face it, they're bringing the right tools to the trade if they're trading. Because those are tools that are designed to detect shifts in momentum. You might not believe in support lines and resistance lines and all the neat candlestick shots, but let's face it, they're trying to detect shifts in momentum and get out ahead. And I applauded to them. They're at least being

Starting point is 01:04:09 honest about what they do. The problem is there are many people who claim to be investors, but they're really playing the momentum game. It's amazing how their 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 10th stocks, traders masquerading as investors. On the second front, though, of just buying good companies and ignoring the bankroll, that worked really well in the 20th century with U.S. stocks. And the reason is the U.S. was the most mean-reverting economy of all time in the 20th century. Everything almost was on clockwork. Recessions lasted a certain period. The way you came out of recessions, you could almost graph out exactly how.

Starting point is 01:04:54 how you came out of recessions. Mean reversion as a strategy worked really well, which means that if macro variables got out of sync, they came back to sync. 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.

Starting point is 01:05:11 The only problem is, let's say you bought Russian companies two years ago based on them being good companies. Guess what? There's no rescue package waiting for you because the Russian economy is definitely not on a mean reverting. So the question I would ask for investors who adopt that strategy is, do you believe that the 21st century is going to be the same as the 20th century for the economy in which you're investing? Is it going to be a mean reverting economy? 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. which is kind of a, you know, I'm not going to be worried about what the oil prices. There's a normal oil price.

Starting point is 01:06:00 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, assuming that cycles will return back to what they were in the 20th century or even the first part of the 21st century seems to be asking for trouble. So I make a general statement. The interversion works. It's a very strong force until it doesn't. a structural break in the economy you're in, mean reversion can be one of the most deadly forces

Starting point is 01:06:30 in investing. The mean you revert to might not be the mean you thought you were to revert to. And unfortunately, it's been the weakest link in people who use shillapes 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 that they don't trade it below 15 times earnings. I don't care what kind of adjustment we get in this market, 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. So I think people have to be careful in assuming mean reversion and at least think

Starting point is 01:07:10 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 to world has changed. You've got to be careful about not making that mistake and just jumping in based on things reverting back. It brings up two things. First, I should have asked about interest rates and discount rates and what the difference is in your mind between those two things. 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? Discount rate is generic word, a rate that I used to discount cash flow. So for instance,

Starting point is 01:07:46 you gave me a T bond, the discount rate is a risk-free interest rate. If you gave me a corporate bond, the discount rate, is a default risk-adjusted interest rate. If you gave me equities, the discount rate is a risk-plus 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 happens. I mean, think about what's happened at the T-Bond rate just in the course of the last four and a half months. Started the year at 1.5 percent. Now, it's flirting with 3 percent. 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.

Starting point is 01:08:35 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. 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. If we settle on 5% as inflation going forward, there is no way the T-bond rate stays at 2.5 or 3%. It's going to 5%. Why? Because why would you ever buy a bond with a coupon rate that's lower than your inflation? That's like making yourself poorer intentionally upfront. Now, this is not an after-the-fact surprise. So to me, whenever I think of interest rates, they go back to basic? 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. It's like a tide rising

Starting point is 01:09:23 somewhere. The tide rises, all boats go up. So the risky or a safe company, everything gets pushed up 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, the cost of capital for a median company in U.S. in the U.S. was about 6%. 6%. The implied expected return on stocks in the start of the year was 5.75%. Think about it. You're buying stocks expecting to make 5.75% returns annually. If I'd offer that to somebody in the 1980s, they'd laugh me out of the office saying, what, do you want me to buy stocks? But the reality is when T bond rates are 1.5%. 5.75% doesn't look bad. So I think that we've been spoiled again by a decade of low discount rates, low costs of capital. And that's why

Starting point is 01:10:16 inflation is going to be such a painful adjustment process. We all have to reset expectations. And that means everybody's discount rates are going up, whether we like it or not. How do you think about equity risk premium 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 collect. Fures and hopes. So when we're feeling good, guess what happens? Equity risk premiums go down. When we're feeling buoyed, everything's going well. The equity risk premium goes down. When you get terrified, when that happens, the equity risk premium goes up, which is one reason why I find it difficult to believe that the equity risk room, some constant number that you can go back to.

Starting point is 01:11:00 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? But that misses the point that this is a shifting dynamic number. Russia invades Ukraine. Guess what? Your equity risk premium needs to go up. We're facing a recession. You might lose your job. Your equity risk premium goes up. That's why at the start of every month, I compute the implied equity risk premium for the U.S. market. I'm not claiming this is the right premium, but I'm saying, given what's happening, this is what the market is pricing risk at in the equity market. Take it or leave it. At the start of this year, that number was 4.24%. At the start of May, it was 5.2%. I wouldn't be surprised if at the start of June, this number is closer to

Starting point is 01:11:46 6%. That's a huge increase in risk premiums over a short period in market like the U.S. But it reflects that collectively we were all much more terrified of the economic future than we were at the start of the year and it's going to show up with the equity risk premium. 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, like a lot of investment in new companies, trying new things is probably going to lead to good outcomes for people in the world generally. What do you think happens in that part of the world and the ecosystem

Starting point is 01:12:27 there? 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. venture capitalists, even public market investors, investing in the riskiest companies. 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 one percent or one and a half percent. So a far bigger chunk of capital in the market became risk capital. That's what saved us in that COVID crash. Is risk capital stayed in the market? It pulled the market back very quickly.

Starting point is 01:13:12 The question is, can risk capital survive inflation? And I think inflation is a much tougher test than COVID. Because what inflation does, as I said, brings in the uncertainty about the future that makes it much more difficult to start new businesses. 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. If you're a young company even with great prospects because you need capital to keep going because you're a cash burning machine. You need capital to keep going. And if that capital is not there, then I don't care how great your potential is, you're going to have to sell out to the best better. It's what happened in 2001. It's what's happened every time risk capital. It's been a long time

Starting point is 01:13:53 since we've had a significant drawdown of risk capital, 2009, first half maybe. But I think we're going to see a significant drawdown in risk capital. And that's going to affect the price. of not just young private companies. You saw SoftBank took a big write-off recently for all of its investments in young private companies, but also those small growth companies in public markets that are dependent on continued capital access to keep going. So when you're seeing the peloton's and the Zooms getting marked down, it's because of the worry that, hey, these companies need to raise fresh capital. They're approaching a market that's much less receptive to that pitch than it was two years ago, five years or ten years ago.

Starting point is 01:14:36 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. 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 pervade assets, decisions, Black Rock being sort of the poster child here.

Starting point is 01:15:04 Curious what your mental image of Black Rock is. Talk to us about ESG. I think you've got a very contrary view here. 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? And what made it take off was the establishment bought it.

Starting point is 01:15:27 Usually when you have something new come in, the establishment is, and this case what I mean by the establishment buying in is that was the year that the conference board, 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. And I said, no, what's going on here? So I started looking at the sales pitches that I was listening to on.

Starting point is 01:15:59 ESG. And here's what I found. These services that claim to measure ESG didn't agree with each other. Second, you had all these consultants going around to companies claiming that ESU would make them more valuable companies. And I look 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. And I also heard talk about how ESU is making the world a better play. And I looked at the percentage of energy we're getting from fossil fuels. And guess what?

Starting point is 01:16:32 It's not changed much over the last decade. So I said, where's the beef here? You're making all these claims. There seems to be no basis for it. So my first post was actually an invite to ESG advocates to tell me what I was missing. And over the next year, I heard from ESG advocates. And what I heard from them made me even more doubtful about whether ESG had any foundation to it.

Starting point is 01:16:55 First, I think an ESG expert is an oxymoron. How can you be an expert on a discipline? and there has nothing to it. I use some kind of Eli Lama and Mother Teresa rolled into one that you can see virtue and recognize it when you see it. 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, sustain analytics, basically are making money measuring ESG. Investment funds. You slap ESG on the title of a fund.

Starting point is 01:17:28 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. You have consultants, experts running around, charging companies for ESC advice. I'd love to be a fly on the wall.

Starting point is 01:17:50 Listen in on exactly what it is that I can do to become more virtuous. You've got academics. I didn't think I could deemian who are publishing papers in ESG that shouldn't see the light of day. 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. They take 500 studies and average them up, which is absurd. It's not the way to do research. The law of large numbers doesn't work when you got 500 bias studies and you put them all and you come up with an average.

Starting point is 01:18:25 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 1. And how successful it was at Exxon Mobil. Engine 1 was an activist fund that essentially had BlackRock and others throw the weight behind them. They got Exxon Mobil to divest themselves of some of their fossil fuel reserves. Amazing victory. The key word is to divest themselves. Who do they sell it to? They sold it to a private equity group. You know, in the last decade, private private equity funds have invested $1.2 trillion in fossil fuel reserves. You're not stopping the development of fossil fuels, just pushing them behind the curtain and the people exploiting these reserves now are far as scrupless in the companies. Putting selective pressure on publicly traded companies in the U.S. and Europe to behave virtuously is not making those things go away. You think Aramco's management is sitting around saying, well, what is the ESG? thing to do. They're pumping out oil. And this is, I think, the kabuki dance that ESG leads you to. It's a feel-good scam that is making a lot of people wealthy. The news story passed yesterday when

Starting point is 01:19:38 S&Ps, ESG, whatever index they've created, which is a money machine for them because they create an index, then funds get used to the index. They're at Xon mobile on it. But not Tesla. And of course, I read Margaret Graham, I think, was her name. She's the person in who heads their ESC group. I don't know the person. I'm sure she's well-intention. 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. They all claim it's based on numerical scores, but what determines what factors go to that score and what

Starting point is 01:20:22 weightings you touch, completely opaque. The second is, she actually gave away the fact that it's a gaming model. And what gave it away is in a blog, she said, wasn't that Tesla's score dropped? 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 ExxonMobil has learned to play it, and Tesla is not playing it. So guess what?

Starting point is 01:20:52 ExxonMobil climbs 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. 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. When I hear ESG advocates complain about the political backlash that's coming against ESG,

Starting point is 01:21:17 like some of the red states now have movements to stop their endowment funds. they complain about how it's become political. My response is that's like a pyromania complaining about all the fires that are around. I mean, you brought the politics to the game. What made you think that the politics would always work out in your favor? No, the question is not why it's happening, but why it took so long to happen. So I think the mask is off ESG. To those people who say, but I want to invest in good companies, please do, but use your definition of good,

Starting point is 01:21:49 because your definition of good and my definition of good are going to be very different. If your definition of good is built around data privacy, don't invest in Facebook. If my big issue is climate change, then I want to invest in ExxonMobil, I'm going to invest in Tesla. So I think that by definition, goodness is not going to be global. The E part is where they've had the most success in coming up with the number of carbon footprint. And of course, they've gone crazy with all of the different disclosures. the S part should be a non-starter. And here's why.

Starting point is 01:22:21 Name me one social issue 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 was that the reason Tesla didn't make the list was because of the way they treated employees. And here's what I'd love to see. I'd like to see a comparison of a GM employee. and a Tesla employee in terms of wages and benefits.

Starting point is 01:22:49 And I'll also like to see a survey of how many Tesla employees would like to go to work for GM and vice versa. 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 goodness and enforce it on everybody. This, I think, if nothing else, should make people think again, what exactly is an ESC score and what does it measure? Because even the measurement services have no idea. And to build an entire discipline on something that cannot be measured is, I think, just malpractice.

Starting point is 01:23:35 I can't wait for this concept to die, but I'm afraid there's too much money to be made for this concept to go away quickly. And it's going to be a long and painful death. And guess what? they're going to come up with some other buzzword to replace it because the history of businesses, what was ESC was called SRI and CSR. And I mean, I've seen the acrony slide through. The only acronym I want to attach to ESC 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.

Starting point is 01:24:04 Bringing up Tesla is an opportunity to ask you about the nature of disruption. Two things are curious to me. Tesla versus all of their car companies. You mentioned Amazon earlier as sort of you know, universal disruptor. But one company that it doesn't seem to have disrupted is Costco. And you might think, if you had said in 1999, Amazon is going to be Thano 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

Starting point is 01:24:36 that seem protected from it. That's a great case study to examine. I mean, collectively, brick and mortar retail in the U.S. has been devastated. Amazon collectively. So bed bath and beyond the department stores. So you've got to ask, why do the companies that manage to evade this storm, what do they do? In a sense, we can tell what they shouldn't do. The department stores tried out Amazon Amazon. They thought that what Amazon had was an online site. So we start an online site, then we'll be like Amazon. And then they started cutting costs in their stores. They had less salespeople. I remember going into a masias. I haven't been in a department store in a decade. And part of the reason is my last experience at stores like Macy's, you walk in,

Starting point is 01:25:18 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 cut costs to the bone. So the brick and mortar stores that try to out Amazon, are trying to cut costs and make their experiences worse as brick and mortar stores fare. 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. It might not be a lot of money, but that's whatever it is, $79 or $80 or whatever it is

Starting point is 01:25:55 now, $60, is that entry fee makes it more of a selected group that wants the kinds of things that Costco offers. And Costco is not a traditional retailer. You walk into a Costco, you walk out with not one month's support. of something, but 10-year supply of something. It's found a way in brick and model retailing saying, you will not be able to find this on an Amazon. Every time I walk into Costco, there are at least one or two items that I feel, I never went into buy those, but I said, that looks like something I could use. I don't know what percentage of Costco sales come from impulse buys, but I'd guess that even

Starting point is 01:26:36 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. And the experience to me in Costco is unique. It's an experience that you know what the system looks like. It's 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. 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.

Starting point is 01:27:15 I think the other example of a company that managed to fight off Amazon successfully was Alibaba. 2003 or 4, it was any person's game. eBay, Amazon, Alibaba, anybody could have won. But Alibaba crafted an online retail presence that was uniquely suited to China, starting with a website. Taaba, which is the Alibaba's main shopping site, 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's like walking into a bazaar, which is exactly how Asian shoppers shop is they're used to bazaars. They used to chaos and multiple people coming at them. That's not what Amazon thought their customers needed. In the U.S., you hit people with a bazaar. They're going to click out

Starting point is 01:28:03 and move away. It's too confusing for them. But Alibaba succeeded by creating a China-centric version of online retailing that essentially allow them to win that game. So it's not that fighting and beating Amazon is impossible. You've got to do it on your own terms. And that's not easy for many companies. 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? If you believe the disruption is, 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. If it's your worry that there will be disruption, then you got to bring it in as some kind of external risk. I think of decision trees and statistics.

Starting point is 01:28:49 When you do a discounted cash flow evaluation, you're valuing a company as a going concern 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. 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. If you truly are worried about a scenario that could happen, that could very well change your value, treat it as a different valuation when I valued Aramco. I valued it as 3.30 million barrels of oil under the sand where you stick your finger in the sand, oil comes out. A huge cash machine. And I came up with a value of $1.8 trillion,

Starting point is 01:29:28 I think, for the company, at base in oil prices then. But the thing that worries me, of Bararamco 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. It's the worry that there might be a regime change, because when you buy Aramco, you're buying a piece of Saudi Arabia, because 80% of Saudi Arabia's GDP comes from oil. And by extension, you're buying a piece of the Saudi royal family, because they're all connected at the hip. And the question you've got to ask is, what if something happens? What if something like what you saw in Egypt 13 years ago, 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. The House of South stays on long term running the country. And I benefit from the cash flows from oil. And I said, what if somebody else? I didn't put an ISIS scenario, but a scenario.

Starting point is 01:30:32 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. So I value the company twice and took an expected value based on the properties assigned. Those were subjective. 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 valuation. There are no objective numbers in valuation. last year's numbers objective, but you don't invest based on last year's numbers. You're based on the expectation that last year's numbers will be next year's numbers. That's subjective.

Starting point is 01:31:09 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. Speaking of subjective, what characteristics do you think will define the most successful leaders? I'm thinking specifically like CEOs and investors, over the next decade? You used to word adaptability. That's one word that I think is going to be critical

Starting point is 01:31:33 because I think one size fits all is not going to work in this market. You've got to have people are willing to change, who are willing to listen, and who build companies that can outlast them, who build management teams. It's the one thing I admire that Jeff Bezos did at Amazon, is he built a management team at Amazon.

Starting point is 01:31:53 Same thing with Bill Gates, Microsoft. It's the one thing that, 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 how the entire company is built around a single personality. I can't name a single top executive at Tesla. Can you? Do you know who the CFO of Tesla is? I could probably go look at it. The fact that we never hear from the guy is kind of interesting. I don't even know this could be a male or a female. That's how little I know about the CFO. I don't know about the top management team. I don't even know who the PR person is.

Starting point is 01:32:26 Because every time there's an issue at Tesla, guess who the respondent is? It's Elon Musk on a Twitter feed. You want companies where adaptability is very much part of the business, where your CEOs are willing to trust the people they're hired to make big decisions without constantly looking over their shoulders. Companies run by imperial CEOs, people who think they're Caesar. I think are companies I would stay away from. You give me the perfect excuse to close on a really fun topic.

Starting point is 01:32:55 what do you make of everything going on with Twitter and Elon Musk right now? Yeah, 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 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.

Starting point is 01:33:25 lawsuits. But I do think that he feels for him, and I think about his investing in Twitter for the same reason Steve Palmer, but 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 censoring them. So I believe that that's his main motivation. No, 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. And what you're looking at is financing is essentially his personal financing, funding a deal, which normally I would say is not a good idea.

Starting point is 01:34:05 You don't want to borrow against personal assets to fund a $45 billion bet on privacy. 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 bridges we've got to get and cross before the end plays out. Are there any major topics on which you have a divergent view that we haven't talked about today? I think disclosure is the issue where I think I'm in most in disagreement 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,

Starting point is 01:34:48 disclosure is this double-edged sword. I mean, do you think that more disclosure leads to more information and more sensible decisions. But if there's anything we've learned from 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.

Starting point is 01:35:18 And this is the problem. Companies have learned to play the game. They've discovered that if you disclose it. everything, it's like disclosing nothing. You lose perspective. They don't know the big thing versus the small things. You throw them all into the same pile. It's like going to confession. And in a sense, disclosure is a very good analogy to confession, confession. And you confess for an hour to a priest. And along the way, you confess to small sins like, I coveted my neighbor's car with, or I murdered my neighbor along the way. And because you spend an hour, the priest doesn't remember what

Starting point is 01:35:48 you said by the end. He says, three Hail Mary's, and you're done with your sins. I would I think unfortunately, disclosures become the same way. For many companies, disclosure is not about telling you that they won't do things in the future. It's about confessing the past sins and in such detail that you don't even remember what they confessed to and that they can go back to sinning again. 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.

Starting point is 01:36:30 Last time I was an ESC conference. I asked people and they know 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 people had flown to the conference. I assume that when you flew to the conference, you picked an airline. How many of you picked their airlines based on carbon footprint? If you've noticed, when you take an airline, it tells you what your carbon footprint is going to be. There's a room full of ESG advocates, not a single person picked an airline based on carbon footprint.

Starting point is 01:36:57 And I said, so what are we accomplishing by disclosing this? Are we actually not diluting the value of a carbon footprint by having everybody disclose it? 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. of why direct democracy is dangerous. 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 that the product could create cancer.

Starting point is 01:37:34 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. I go to CVS, coming in through those doors could cause you cancer. And after a while, you just stop reading it because to close this, actually, my neighbor has an 18-year-old son.

Starting point is 01:37:56 He was standing outside the other day smoking a cigarette. 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, then how do you separate tobacco from tacos? And I think that's a problem with disclosures. If everything is disclosed, then I would.

Starting point is 01:38:21 no idea what matters and what doesn't. And that's unfortunately where we're headed. And that trains 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. 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 and 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.

Starting point is 01:38:55 What is the kindest thing that anyone's ever done for you? Probably how I was treated when I first came to the U.S. I came from a part of India where I'd ever watch TV. I mean, I'd seen TVs when I'd travel, but I grew up in a part of India that was probably 200 years behind the times in terms of where the rest of the world was. I landed in L.A. 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. And I was completely lost and I am still thankful for the kindness that the people around me showed for my complete ignorance about how things worked. When people ask me about why I prize being a U.S. citizen, I still talk about, that's a kindness. I wouldn't have anticipated in much of the world.

Starting point is 01:39:48 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. 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 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.

Starting point is 01:40:16 So the notion of teaching is powerful. Say a little bit more about that goal that you have. 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 how to do things the way I do them, five years from now, three years from or even six months from now, they're going to find themselves lost.

Starting point is 01:40:37 So I view my job as letting people see how I come to the conclusions that I do, why I do what I do. No, 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 has ruined thinking. Because when you have a question now, what are we trying to do? Go to Google Search, look up the answer.

Starting point is 01:41:11 Let's take as an example. What tax rate should I use in valuation? Rather than think through how you would answer that question, you say, that takes a lot of time. Let me go to Google. Somebody must have answered the question already. And odds out there's somebody up there. He said, this is what you should use.

Starting point is 01:41:26 But what you lose is that capacity, your mind is a muscle like everything else. If you don't use it to reason your way through it to answers, then you will find it very difficult to ever start reasoning. So I view teaching as giving people a window to my reasoning. So they can see my reasoning. They can agree or disagree. my reasoning, but at least they can see how I think. And hopefully that will rub off on them.

Starting point is 01:41:49 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 catalyst a key component of his investment process. So Giuseppe, I think the place to start is with the concept of a deep economic model on a business.

Starting point is 01:42:22 You've got a unique background in banking where I think you 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.

Starting point is 01:42:41 And so you can go in a lot more detail. So you would look at the models that we were building for deals were frequently 20, 30, 40, 50 taps, thousands of lines long, only like to get to a very simple output. And, you know, 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.

Starting point is 01:43:04 You would find something, okay, you know, 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 reconcile that just because most of the times people are just adding more and more complexity 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

Starting point is 01:43:36 complicated? I think to a lot of people that provides false comfort because it's more like the more the merrier, but it's actually not the case. It's more sort of, you know, what are the relevant things? What are the key things that actually make a difference? And frequently, 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 catalysts, which the first time I opened the canalyst model, I was amazed by 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

Starting point is 01:44:15 to build such a detailed and sophisticated yet simple model in a manner that they do. If you think about those early days and what Canalist does or when you first encountered it, what did you like about the service when you first encountered it? Like, 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 by side, it started out where they sort of models manually. My former boss asked me, you know, to build out like the models manually into this and that.

Starting point is 01:44:42 I mean, obviously, like, your work basically piles up. And I mean, it just takes hours. It can easily take a few hours until, you know, if we don't want to potentially even like three weeks, depending on the degree of complexity, to build a proper and running and fully integrated model for any of the companies. What Canada does is basically condense all of that process. So it's as simple as downloading, you know, any PDF file just from the internet. that and you have the whole model there with all the relevant KPIs, with all the relevant drivers,

Starting point is 01:45:10 so you can overlay basically your inputs. I think from all the tools I have been using on the Bicite and I'm using today, it is the one that reduces friction the most. Giuseppe, I'm curious, where did you first hear of Canales? Funny enough, I actually heard about Canales on your podcast in an ad. And, you know, it was one of those evenings who was at home listening to a podcast and like, you know, I heard automated models auto-opdating. 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.

Starting point is 01:45:42 Like, are you seeing 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 then, you know, a team that was sitting like next to it was like, okay, hey, what are you guys doing? You know, how are you doing this so fast? And then they started using it as well. So it became sort of viral.

Starting point is 01:46:02 And then when I joined here, so RCIO, finally. enough, you know, when we first met, we talked about it. It's like, you know, 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 Canadaless founders is also ex-fidelity. So he had it very much on the radar. And, you know, it wasn't even a discussion to get up and running with it when 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, you know, we're going into earnings season. So what we're doing right now is lining up our numbers.

Starting point is 01:46:35 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, speaking to management teams, attending conferences, setting up calls. And for all of this, Canada's is extremely helpful because, you know, you always have a single source of truth, which we can refer to look at the numbers and to get a better sense for where that is and how, you know, something that a management team may say is something that we like. learn may impact our estimates and where and how they could potentially translate into value.

Starting point is 01:47:10 That single source of truth thing is interesting. How historically in firms like yours or in your experience knowing other analysts and PMs, how is ownership of the model typically handled? Because it seems like one nice thing like you said about Canales is it's a single source of truth. Like it's almost its own ownership. You don't have to worry about it as much. But how in the absence of something like Canales are models typically shared 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, Monudea or whatever it may be, it's sort of viewed as the holy gray, the numbers that people

Starting point is 01:47:47 use based their 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, and people are very, I want to say, almost jealous of their model. And everybody thinks, things that if you own the model, you own the process and you ultimately have to do. But the model also is, it's usually in pre-canalyst type of times, it is extremely time-consuming and inefficient to maintain. The way it's normally like shared among sort of like teammates is usually it's quite easy for 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

Starting point is 01:48:31 the support team and product analysts and they will manage it. it to your satisfaction. So thereby using Canales, you don't need to worry about maintaining your single source of true. How would you compare how you use Canalyst from your sort of hedge fund days to what you're doing at LK advisors? Is it different? Is it similar?

Starting point is 01:48:50 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. So it was more about updating, maintaining, forming. a rolling view. I think in today's role, it's very different because our coverage and our universe is basically global. So when I came in, I had to think of, okay, so how can we actually like leverage this? And one of the thinking was, for instance, I was very keen to build a, what I would

Starting point is 01:49:20 call a quality scorecard, which would allow me basically to, when you have to think about across developed markets, 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 has to score any company along those KPIs from one to 10. And this is a process that we found very well working for us, and that without Canada list, I mean, it would have been virtually impossible. Taking the years or something. Yeah, it would have taken multiple years. multi-periors. What do you think is interesting about where you sit? You know, you're in London,

Starting point is 01:50:05 obviously a global coverage in 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 of Canales and the global nature of what you do? Canales over time, you know, since I started first using the product, they have expanded massively, you know, and wider into, especially like European companies, as well as EM and developed Asia companies. So the universe has expanded tremendous. The other great thing is, you know, we work closely with their product team to make suggestions on sort of, you know, companies that we care about and companies that we know, sort of, you know, people here in Europe care about. And they are extremely reactive to initiating and launching on new models when we ask them to that gets put on sort of like a wait list. So, yeah, we continue doing that as we, you know, take an interest in different companies here in Europe.

Starting point is 01:50:54 And I think the roadmap is sort of, you know, to get to like sort of 10,000 companies slash 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. I was like, what do you hope is on Canada's product roadmap? I think it would be nice to have something what I would call a by-site consensus. If you ask many people in the industry today, by-side consensus is this very elusive concept of whisper, what some people may even call it. right, second sort of unformed expectation and it may vary. What would be amazing would be to have some sort of

Starting point is 01:51:34 channelist user-weighted, anonymized average of what actually the users on the other side 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 are 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 large a scale through the entirety of their platform.

Starting point is 01:52:10 And as that becomes basically like more life and more consumer-friendly as their website, you know, 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. Another way of asking it would be, you know, 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?

Starting point is 01:52:35 And do you think that's worth that at all? I mean, obviously you're a big catalyst 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, you know, when I remember when I opened my first tenant is small, you see all these things and it's like, okay, how does this work?

Starting point is 01:52:52 You would click an introduction. It's like, I like it, I like it, do I trust it? And 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 the beauty of catalysts is, again I mentioned, right? So you open a canvas model, there are five tabs and they have these, like, beautiful summary sheets. And I almost find it a lot easier to just look at those trends and get a sense for. or how something has performed, what is driving X, what is driving Y. They actually enhance, in my view, that process of understanding what is going on.

Starting point is 01:53:33 I had this debate with multiple friends. And my view is that it's totally overrated to say, sort of, you know, you need to build the model to entirely understand the business. I think you just need to like look at the numbers, understand and how they flow, which is, you know, what Canada 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 Canada says like standard templates or an LBO, a DCF, comms, all these usual things. We have our sort of proprietary process of how we look at things, how we value things, the scorecut that I've mentioned to you.

Starting point is 01:54:10 So we spent, we invested a decent amount of time into building our own templates that correspond to our process that work exclusively on the Canada's platform. Once we scale, we put in that, you know, it incrementally helps us understand and make sense of a business and wise we can, you know, continue to comply with how we do things and how we think about things. 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.

Starting point is 01:54:39 Thanks so much for your time. Thank you. If you enjoy this episode, check out join colossus.com. There you'll find every episode of this podcast complete with Transcendant. transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

Invest Like the Best with Patrick O'Shaughnessy - Aswath Damodaran - Making Sense of the Market - [Invest Like the Best, EP. 279]

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.