Motley Fool Hidden Gems Investing - Aswath Damodaran on the Fed, Inflation, and Valuation

Episode Date: December 18, 2022

If you're impatient, then value investing's probably not for you. But for those interested, there's probably no one better to listen to than Aswath Damodaran, professor of corporate finance and valuation at the Stern School of Business at New York University. Motley Fool CEO Tom Gardner talks with the “Dean of Valuation” about: - Inflation’s new questions for investors - The most important investor you can learn from - Incentives, correlations, and costs in ESG scoring Stocks mentioned: MO, BLK If you're a member of any Motley Fool service you can access the full conversation here: https://www.fool.com/premium/coverage/4056/coverage/2022/08/31/navigating-inflation-behavioral-investing-and-mark/ Host: Tom Gardner Guest: Aswath Damodaran Producer: Ricky Mulvey Engineers: Dan Boyd, Austin Morgan, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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you tell me about how much you believe in value investing, you're just temperamentally unsuited to be a value investor. That's why I end the book with a statement, which is the best investment philosophy is the one that fits you as a person. The person you need to understand the most to be a great investor is not Warren Buffett or Peter Lynch, it's you. I'm Chris Hill, and that's Aswath Damodaran, Professor of Corporate Finance and Valuation at the Stern School of Business at New York University. As we wrap up the year, we're revisiting some of our most popular conversations of 2022 this week. Motley Fool co-founder and CEO Tom Gardner caught up with Damodaran earlier this fall at our FoolFest event

to talk about the cost of ESG, how the Federal Reserve could misread inflation data, and why following great investors may not work for you. I wanted to just start with your reflections on inflation and maybe teaching those who are encountering inflation for the first time in any significant way, what are the domino effects of high levels of inflation for corporations, individuals, etc.? I'm going to start by saying it's not high levels of inflation per se that are the issue. It's high unexpected levels of inflation that are the issue. And to illustrate exactly what I'm saying, let me give you a choice of two economies to operate in.

One is 8% inflation. The other is 5% inflation. At first, I'm just saying I'd rather operate in the 5% inflation economy. It's got lower inflation. But let me add something to that example. let's assume the first economy has 8% inflation, but it's guaranteed to be 8% every year in perpetuity. In other words, it's 8% and fixed. The second economy is 5% inflation, but it goes from 2 to 8 back to 2 to 8. The average inflation is 5%. I would argue that as a business or as an investor, you'd have an easier time operating in the first economy than the other. Why? Because if inflation is fixed, it's easy to build in. Your contract's incorporated. So if you go out

and buy a bond, you charge a 9% coupon rate, you know it will cover inflation. It's unexpected inflation that's so damaging to us, not just as businesses, but as investors. I mean, imagine buying a bond with an expected inflation rate of 5%. So you charge a 6% coupon rate, but inflation comes in at 8%. You've been, you know, you've in a sense given up some of your value because inflation came in higher than expected. I think what has us in the place we're in is we've been spoiled. We've had a decade of low and stable inflation. It's not just inflation has been low. I computed the standard deviation in inflation by decade going back to the 1930s. 2010 through 2020 had the lowest standard deviation in inflation of any decade

in history. We've had low and we've been spoiled. In fact, the way we've been spoiled is most of us haven't even thought about inflation, including me, for a long time. I wrote my first two posts on inflation in the last two years. Why? Because inflation is now back in the game and we've got to think about it more consciously. So if you're 25, 30, 35, you've never dealt with inflation before. It's not that you cannot learn, but there's going to be a learning curve. It'll mean requiring you to build in inflation explicitly into almost every decision you make. And that's going to take a little bit of work. Stanley Druckenmiller, a wonderful investor, has said recently that when inflation or CPI rises about 5%, you really do not get soft landings. So

what does a hard landing in this scenario look like? Well, the first thing it looks like, it could be personal. You could lose your job. I mean, people talk about recessions and recovery is in the abstract. But the reality is recessions are painful. People lose jobs. Their wages get cut. And sometimes and often the only time to deal with inflation that's out of control is to bring the economy to a crashing halt. So a hard landing here would be a recession that is long and painful. A soft landing will be a recession that's much milder and much less painful. But there's going to be pain no matter what. And the question is, how much will the pain be and how long will it last? So I think it depends, again, very much on how quickly inflation

comes back to levels that we can live with. I mean, the last month has been an upbeat month in terms of inflation, but that's often the case when you have inflation that's out of control. You have periods of hope where you say, hey, maybe inflation is coming back under control. In many ways, that can actually be damaging because what happens then is central banks ease up. They say, okay, the worst is over. Why put the economy into recession now? In fact, I think we're going to find very quickly whether Jerome Powell is more Volcker or more Burns, because Arthur Burns was, you know, I feel sorry for the man. He had a long and distinguished career as an economist, but with the way we remember him in history as the Fed chair from 1970 to 78, where they

repeatedly started on an attempt to fight inflation and repeatedly gave up too early. So I think that the worry I have when inflation has a couple of good months is the Fed will say, you know what, let's ease up now. So let's see if the Fed is staying power here to fight inflation, because it will require a lot more than what's already been done, which will also mean more pain for people at the very bottom of the spectrum, because they're not investors. They often work for their wages and their wages are the ones that are at risk most when you have to fight inflation. So your preferred scenario would be to see someone like Paul Volcker step in and take the medicine now. And maybe Jerome Powell has the backbone to do it, I think, because it

will require a backbone because politicians hate hard landings. Why? Because elections happen during the hard landings. You lose your job as a politician. So politically, it's never been easy to have a hard landing. People forget that even Paul Volcker felt a great deal of pressure. And you've got to give Ronald Reagan enough credit to say, look, he let Paul Volcker continue on his path of we're going to fight inflation first and then worry about the economy later. Because that often is the mindset that might be needed to fight inflation. And really, any category, any financial asset can become overvalued or undervalued. And some of them, you can be rewarded for tremendous patience, even with overvaluation. But what are some of

the key principles of valuation that you would apply to at the asset class level? And then we can talk individual companies and how you think about that in this environment. It's all about cash flows, growth and risk, no matter what asset class you're looking in. If you're buying a bond, you're buying constant cash flows, no growth and only default risk. So it becomes a much simpler asset class. You're buying equities. Growth is a much more dicey component. It's subjective. You've got to make judgments, but it's cash flows, growth, and risk. And there are some asset classes where you might not be able to put a value. Why? Because there's some investment classes. Let me not use the word asset. Assets, by definition, have cash flows. So if you're thinking about

adding collectibles to your portfolio, fine art, gold, recognize that those are not investments that can be valued, they can only be priced. And after all, gold has been around for 4,000 years. The pricing of gold is very much a function of what you hold it instead of, financial assets. Which is if you don't trust financial assets to hold their value, you go to gold. So if you're investing in collectibles or gold,

then you're pricing things. You're making a judgment on the pricing of these asset classes relative to others. But if you're looking at traditional asset classes, businesses, equity, bonds, I think you need to keep your eyes on cash flows, growth, and risk. That'll give you the value part. But as you pointed out, the price part is not in your control. It's demand and supply, mood, and momentum. So when you talk about undervalued and overvalued, we're recognizing a very simple truth about markets, which is you control the

value part. You can do all your homework. The price part is not in your control. You can't force the market to do what you want. It's going to do whatever it does, which means the price at any point in time can be very different from value. Let's face it, all of investing is about hoping and praying that that gap between price and value closes. So my only suggestion is if you're an investor, which means you value businesses and you're hoping the price adjusts to value, then start doing some research on catalysts.

What is it? Because this isn't magical. It's not like there's a moment of revelation to markets where price adjusts to value. There must be some catalyst that causes price to adjust to value. In some cases, it can be as simple as a new management team coming into play. In other cases, it might be a macro event that happens, another company that collapses that makes people look at the realities of what it is that should be driving. So hopefully today's Bed, Bath & Beyond action will lead some of these people investing in

meme stocks to think about, hey, what is it that causes these prices to go up and down? I'll be quite honest, in investing, I think we've spent a lot of time on the value part of the process. We haven't really spent enough attention to the pricing part. In fact, we dismiss people who use charts and technical analysis because their chart is, they don't do the things we think should be done. I think we need to pay attention to those people who drive prices. So I've actually been paying attention to the traders who drive up these AMCs and GameStops because they affect me. It's not because I want to be like them, but their actions can affect me because they're the one setting prices. And guess what? I'm at their mercy when I buy something that's undervalued

because they often are the ones that will push the price up to the value and allow me to take my benefits. So I think the key is to get out of whatever groups agree with you and talk to people who disagree with you. If your investment philosophy is built upon value, talk to people whose philosophy is very different. Maybe they're pure traders. My favorite show on CNBC to be on is Fast Money because they put me in with five traders. And I like the fact that they have no artificial. They're not going to talk about value because they truly believe that value doesn't matter. They believe the way you make money is you buy at a low price, you sell at a high price. And I prefer that honesty because it allows me to talk about where I'm coming from and

how we each need each. I mean, traders can't exist without investors in the market. Investors cannot exist without traders in the market. And I think we need to accept that and be more willing to accept those differences when we think about when should we invest and where should we invest. When you talk about being at the mercy of those who move prices, can you talk about the variable of time? and time horizon to diminish that zone of risk? And what would you say is your time horizon when

you make an equity investment, for example? I think time is your ally as an investor, but I think you also have to recognize that sometimes you run out of time before the adjustment happens. I mean, the old Keynesian saying of, you know, the market can stay irrational for longer than you can stay solvent. In fact, here I would add live. Yeah, didn't he also say, in the long run, we're all dead? In the long run, we're all dead. I mean, he was full of expressions that I think we should keep in mind. So I think time is your ally, which means as an investor, you need a long time horizon.

The problem is we all claim to have long time horizons because that's what we're expected to say. In fact, in my class, I have 400 MBAs. I asked them at the start of the class, how many of you have a long time horizon? to a person, every person in the room claims to have a long time horizon. I wonder how much of that is because that's what we expect good people to do, sensible people to do. But ultimately, your time horizon is not always entirely in your control. If you're a portfolio manager, your time horizon is only as long-term as your shortest-term client. That's a reality that actually gives individual investors an advantage over portfolio managers.

My advantage as an investor is I have one client, actually two, me and my spouse. And since I've turned off statements and my statements are all paperless, she has no idea what we own. So in a sense, I control my time horizon and I can hold as long as I want. So in a sense, individual investors have an advantage over portfolio managers and it's a really big advantage, something we should be taking advantage of. So if you believe something is truly undervalued, you've done your homework, you buy the stock, the only pressure you should feel to sell that stock comes from within you, unless you have liquidity needs, which, of course, can shorten your time horizons. So the long answer to your question, time is your ally, but for most people who manage other people's money, their time horizons are not under their control. It's determined by their clients. So if you manage your own money, that's a power you have.

Take full advantage of it. I've always thought that beta is not a measurement of risk, of course, in the way that it is trotted out. It's a measurement. If it were to be a measurement of risk, it's a measurement of the risk of your client abandoning before they should. It's not a measure of the risk of the business. It's the price movement that's obviously shaking a lot of people out of the stock. That's what it is signaling in part. In some cases, it can be both.

It measures the risk of a business. it measures the risk to investors, it measures the risk that people will bail out because the price moves so much. So, it measures all of those. So, I think I know your answer to this. You've just trotted it out. So, if I buy a stock, it falls 50%, I hold it for 10 years, and at the end of those 10 years, it's up 12% a year. You would say that's a wonderful investment as long as you're willing to endure a 50% decline. And that's, I think, something, and I can't say that's the right thing to do or the wrong thing to do, you have to have the stomach for it. I mean, I wrote a book on investment philosophies. It was driven by what I saw in markets, which is

that if you go into any bookstore, at that time, you actually had physical bookstores, and you walked in the investment section, you had all these books about great investors, Warren Buffett, and then you could go down the list, and you'd see people buying these books, and these books would describe in excruciating detail what these great investors did. to make the returns. And of course, the people who read the book would say, OK, I, too, want to be like Buffett. I know exactly what he did.

I'm going to replicate it. But actually, if you look at the history of people who've tried to read the books and be like Buffett, in fact, I asked this question at my last stint in Omaha, where I was invited by portfolio managers to come and talk to them about value investing. I don't think they're going to invite me back. I asked them a question.

I said, if I took their returns of the people in this room, these are long-term returnees to Omaha. They come every year. They pay homage to value investing. They claim to follow its adages. I would wager that the returns of the portfolio managers, the so-called value investors in that room, would have been beaten by an index fund over a long period. So the question is, what is it that happens between the time we set off to imitate these great investors and are trying to do it, that causes this leakage. And the reality is, it's not just an approach, it's a mindset. And you need a psychology that actually allows you to adopt the mindset. If you're naturally impatient and you try to be a value investor,

you're going to fail. You're going to fail because no matter how much you tell me about how much you believe in value investing, you're just temperamentally unsuited to be a value investor. Now, that's why I end the book with a statement, which is the best investment philosophy is the one that fits you as a person. The person you need to understand the most to be a great investor is not Warren Buffett or Peter Lynch. It's you. You need to know what makes you tick, what makes you comfortable, what makes you uncomfortable. So I tell investors to keep note of things that happen that make them uncomfortable in their portfolio. What happened today that made you uncomfortable. Keep a journal because it'll allow you to understand what it is

that makes you uncomfortable and try to reduce that. Because if you let those discomforts stay on, you're going to get in the way of your own success. You're going to be selling things too early because you just can't take it anymore. So I think understanding yourself is key to being a successful investor. And that means being open to the fact that sometimes you look at your portfolio, and it makes you really uncomfortable. We try to push it away. We try to deny it. We try to act like it's not there. I think it's a mistake. Among the many things that I love about your work and your approach is that you're a skeptic, a contrary voice. You're a lifelong practitioner. I see you as those things anyway and experience you that way, and a philosopher.

And so I've loved your take on ESG, and I also want to ask you a little bit about Tesla as we come to the close. So, I'll just lay out what I think is your view of ESG, which is that there will always be these expressions that come along, and they are really as much about the sales opportunity and the marketing hype around them as something that could be truly evaluated for its merit and seen and thought through what the unintended consequences are, the implications, et cetera. And so for you, ESG borders on an outright scam or sales-driven, but however you would express it, it is not beneficial to the world that we are concentrated on ESG. And I want to hear, again, you explain why. And then I'd like to hear, do you have an alternative?

I think that what made me suspicious, 2019 was the first time I wrote about ESG because it had kind of invaded the corporate and investing world. You know, BlackRock buying into it, CEOs buying into it. And what made me suspicious was a pitch that seemed too good to be true. And let me explain. Through humanity, being good has always been the tougher choice. Otherwise, you wouldn't need religions, right? Being good was the easier choice. Then you won't need religion telling you don't be bad. Being good has always been the tougher choice. It is required sacrifice. And what struck me as off-putting in the ESG sales pitch, at least as it was made in 2019, is ESG advocates were going around telling companies and investors that they could have it

all. They were telling companies, you can be good and you'll be more valuable. They were telling investors, you can invest in good companies and earn higher returns. And that struck me as unlikely. So I decided to take a look at the research supposedly that these advocates were using to back it up. And the more I looked at this research, the more inclined I am to take the word research as my descriptive of it. Because these were advocacy pieces, some of the most shoddy pieces of empirical work that I've ever seen backing up any concept. Written by people who are true believers. I mean, I'll give you a classic example. One of the ways that they justified ESG being good for companies is it's almost like every paper did the same thing. They ran a

regression of profit margins or returns on capital at companies against ESG scores. And guess what they found? They found that there was a positive relationship and they jumped to the conclusion that must mean that good companies are more profitable. Sounds reasonable, right? But let me offer you an alternative hypothesis. What if more profitable companies can do all the things that give them higher ESG scores. Let's face it, if you look at ESG scores at sustainability or any of the others, there are a set of things you have to do as a company to get a higher score.

And they're all things that require resources, that require money. If you're barely making any money or you're a company at the very edge, there's no way you can come up with the resources to play these games because these are gaming systems. So much of the, almost all of the research I found making the argument that ESG was good for companies was fundamentally flawed. Then I looked at ESG returns to investors. And of course, if you look at those studies, almost all of it comes from the fact that

at least over the last decade, ESG portfolios have been overweighted with tech. This is a tech stock phenomenon you're discovering. So to me, ESG strikes a false note because its advocates are promising things they cannot deliver. So here's my alternative. We all want to be good, but accept the fact that being good will cost you money. As a business, being good will cost you money. That's okay. As long as you get your shareholders are sent to do these things, go ahead and be good

and say, no, we're accepting less profitability because we want to do good. If you're an investor, being good might mean avoiding certain groups of stocks because you think that they do more damage to society. So if you think tobacco is the ultimate sin, avoid tobacco stocks, even though they might deliver high returns. But it's a choice you and I should be making. Goodness is a personal choice. I decide what's good for me. But S&P is in no position to make that judgment for me. We're outsourcing our consciences to S&P and Morningstar and whoever else

might be delivering these ESG scores, and that never ends well. So I think if we want goodness, and I think this is the pushback I get, which is, but I want to be good. That's why ESG is a good thing. You want to be good, then you have to do the homework on what kinds of companies you should be avoiding rather than buying companies with high ESG scores because you have no idea what you're actually getting in your portfolio.

So the mistake is to propose that you can get better returns by being good rather than saying, if you want to be good, the return should be the second factor. Otherwise, let's not pretend that that's what's happening when we come up with these scoring systems and that these scoring systems can be gamed by the companies that are already high enough margin, have tremendous balance sheets. But when you get closer to the break-even line and to a troubled balance sheet, it's going to be hard to really make a case to the shareholders, let alone other stakeholders of the company, that they should be prioritizing it in the same way. I remember talking to an executive who said, really, when you compare the cultures at Google and Starbucks, I would say,

this person said, somebody I admire said, I would say Starbucks has the better culture because they have a much greater challenge. At Google, you have tremendous margins. You have $100 billion sitting on the balance sheet. You can offer every perk in the world to attract the best talent. at Starbucks, it's a tough decision to say, we're going to provide health care. We're going to provide university access. Can you imagine if you go from Starbucks to GM, how much tougher the task becomes? Because you're, in a sense, fighting for your existence as a company. How the heck can you play these games that ESG scorers want you to play because you want to get a higher score? You don't have to share the factor or the companies. But do you have a personal

approach that says i would not buy a company like that or into an industry like that or or i mean i'll give you i'll give you a very personal example about 25 years ago i valued monsanto no maybe 20 years ago and i found it undervalued but i knew that if i bought the company i would be divorced because for my wife monsanto is the satan of all companies she hates roundup she hates the fact that no she and and this was well before the roundup problems even came into existence. So I think, you know, I don't own any tobacco stocks in my portfolio, not because, you know, it's a legal product, I perfectly understand, but it doesn't fit into my moral rubric of something I'd invest in. But I do it with open eyes, which is Altria might be a

great stock to have in my portfolio. It's solid cash flows, maybe exactly the kind of company you want if inflation is coming back. So that choice still has to be a personal choice. There are groups of companies. I generally don't invest in Chinese companies simply because I find that whenever I invest in a Chinese company, the Chinese government is part of my story, whether I like it or not. And I generally don't trust the Chinese government as a partner in any business venture. So it has left me out of some markets, which were high return markets, but I'm perfectly okay with it. It's what I need to have a conscience that I can live with. And that's true for all of us. So we can all bring in goodness and virtue into our investment decisions. So that's not what

the fight we're fighting. The fight we're fighting is whether you want to outsource that to S&P or Morningstar or some other service to do it for you. And I'm not willing to do that. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.