We Study Billionaires - The Investor’s Podcast Network - TIP565: Why Buffett is Doubling Down on Japan w/ Dan Rasmussen

Starting point is 00:00:00 You're listening to TIP. On today's episode, I sit down with Dan Rasmussen, who is the founder of Verdad. Because of the rigorous research that Verdad does, Dan is one of my very favorite guests to bring on the show to discuss markets or sectors that offer the most attractive value. During this conversation, we cover why Japanese equities offer some of the most attractive valuations in the market today. What's keeping investors away from the Japanese stock market? Dan's views on Japan's policy of yield curve control?

Starting point is 00:00:29 how stretched growth stock valuations are relative to value in the U.S., what the financial accelerator is, and how it relates to the 2023 banking crisis, how higher interest rates are affecting corporate earnings, why Dan is skeptical of the Chaos King strategy for profiting off a crisis, what technologies excite Dan in creating a better society for the future and much more. We had Dan on We Study Billioners back on episode 455 to discuss crisis investing and how he profits from a crisis. So if you enjoy this episode, I'd encourage you to check that one out as well. We hit on a lot of different topics today, so I really think you will enjoy Dan's insights. Without further delay, here is my chat with Dan Rasmussen.

Starting point is 00:01:12 You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Hey, everyone, welcome to the Investors podcast. I'm your host today, Clay Fink, and I'm delighted today to be joined by Dan Rasperson. Dan, it's great to have you back. Thanks for me on, Clay. I thought a good place to start here was with a Mark Twain quote. It ain't what you don't know that gets you into trouble.

Starting point is 00:01:52 It's what you know for sure, that just ain't so. So, Dan, what do investors know for sure today that just ain't so? Yeah, I think it's the central question. every investor has to ask, right? I think investing isn't about analysis. It's about meta-analysis. It's what do you think relative to what the market thinks? And investable opportunities, then, almost definitionally, are things that you think that everybody else disagrees with. And so I've tried to think deeply about what are the areas of Max consensus and what are the areas where I think we can have a different or variant perspectives. I think there are a few ones to note. I talk a lot

Starting point is 00:02:29 about private equity, right? Private markets have been the darling of investors for the past decade. You're seeing many smart endowments, foundations, and families take their allocation up to 40% of their assets. And I'm a skeptic, as you know, Clay. I think this private markets thing is way overdone. I think people are getting way out over their skis on a really risky asset. They don't really understand the risks of. And I think there's going to be pain. I think there's already pain in people's portfolios. They don't see it yet. And they're going to feel it. soon. So I think private equity and private credit and private markets just generally are probably my biggest contrarian view. I think a second one to think about is U.S. first international.

Starting point is 00:03:10 Any waiting outside of the United States has been deeply, deeply painful for investors over the past 10 years. And I think we've developed a lot of narratives about why the U.S. is the best and why companies in the U.S. are better and, you know, all of these sorts of things to justify this. And I think people are taking up their allocations. If you look at where the Acqui index is now, it's 65% or so U.S., and I think there are a lot of investors who are even higher. And I think if you start to look, and I think Japan is very topical right now, but you look at Japan and you look more broadly outside the U.S., I think they're really rich opportunities out there. And I think people are missing them in some sense because they're so focused on the U.S. And passive is part of that, by the way, which we can tell. talk about. And I think third and finally, this growth versus value, which is reared its ugly head again this year with the success of Nvidia and the sort of seven or 10 stocks that are driving all of the market's gains. I think people have been way too focused on growth stocks and it's

Starting point is 00:04:09 been a wildly successful strategy. But I think as we saw in 2022, it's not a strategy without its downsides. And it tends to be a strategy that works and works and works and works and then crashes. Whereas I think other strategies like value in particular, have a much different profile and tend to be much better long-term investments as a result. In relation to the U.S. versus international sort of debate, when you look at pension funds and these big endowments, you mentioned that they are heavily weighted private equity. Are they also heavily weighted U.S. versus international? Or what's sort of the dogma in that area?

Starting point is 00:04:46 Yeah. Well, private markets are really U.S. focused. They're much more developed within the U.S. and they are outside of the U.S. So if you have 40% of your portfolio in private markets, you know, I don't know what percent of that is U.S., but probably north of 80 would be my guess off the top of my head, right? So it's going to be pretty hard if you then look at your public equity book and you wait that like the Aquee, which is probably 65, 35 or something. And then you're going to own, maybe you own some corporate credit or some hedge funds. I mean, all of this stuff is so U.S. focused that I think you have a massive U.S. bias in your portfolio. And by the way, if you think about most wealthy individuals and families, right, there's,

Starting point is 00:05:22 business and their real estate ownership is also in the U.S., right? So you own a U.S. house, you probably own a U.S. business or shares in U.S. businesses, right? So I think people end up being massively overweight the U.S. and in some sense that that's worked the last 10 years, right? So I think the things where there's greatest consensus are the thing, you know, I often think about memory, right? So there's been some really interesting studies on how our memory works. And one of the things that they've found is that the same neural circuitry that underlies memory is the same that underlies how we make predictions. In other words, we make predictions based on our memory, right? Our projections are echoes of our past. And so things that are more

Starting point is 00:06:00 salient or more recent or that we can remember more, we tend to project with more frequency. And so when we find things that are consensus, they're generally things that in recent memory have worked really well. And I think that the U.S. has worked so well that the arguments for going international are diminished and diminished and diminished because recent memory is so strong, the U.S. is better. And I think therein lies the danger because we see that strong conviction and consensus very clearly in valuations where U.S. listed stocks earn very big premiums to international stocks. You know, even if you adjust for everything you think you should adjust for, you're ending up with these massive valuation discrepancies. And even if, for example, you think that, gee,

Starting point is 00:06:37 you know, the U.S. is the best place to run a business and so I want to be overweight the U.S., If you run a regression on the percentage of revenue that's in the U.S. versus where the company is listed, right? Because there are a lot of companies listed in the U.K. Or listed even in Japan that have huge revenue shares from the United States. Those companies even trade very cheaply. So it's not really about the economic fundamentals. It's about things being listed in the U.S. exchange.

Starting point is 00:07:00 And thus, in some sense, also being a recipient of passive investment flows, right, where your 401K is buying the S&P 500 every, you know, month or whatever. It's not necessarily buying the acqui or the, you know, developed FTSC developed International Index. And so you're seeing this consensus, which is built on recent history, push valuations ever higher. And the higher those valuations get, the lower in theory future returns should be. Turning to growth versus value, many of our listeners are aware that value tends to outperform growth over long enough time horizons. But that hasn't been the case with the fangs driving the returns of the overall market over the past decade or so.

Starting point is 00:07:37 And Howard Marx has taught us that oftentimes the market moves like a pendulum. It swings from these different extremes, whether that be growth versus value, optimism versus pessimism. How far in your view has the pendulum swung in favor of growth stocks? Yeah. So I think the way a lot of quantitative investors think about it is the valuation spread. So if you take the 25th percentile valuation and the 75th percentile market valuation or the 80th and the 20th or whatever you want to use,

Starting point is 00:08:07 and you compare those two valuations, you can come up with a spread of, you know, how rich is growth relative to value. And we're in the 95th percentile of that, where we were in the 99th in 2021, 2022 brought it down a bit, but we're at sort of historic extremes in terms of growth stocks trading, very, very expensive relative to value stocks. In the same way that we're at extremes with growth, with the U.S. versus international, then the only way you get to extremes, by the way, is through massive outperformance of one of the sectors, you know, one of the things in the equation, right? In that case, the massive outperformance of growth. And I think there are, to my mind, you know, two real things that challenge that. The first is that growth is unpredictable.

Starting point is 00:08:49 And I think this is easy to forget. But growth is not persistent and it's not predictable. So we updated a famous academic study called the persistence and predictability of growth. And what we did is we looked at every company in the U.S. stock market over a very long period of time, and we looked at whether they had persistent above median growth and whether historical above median growth predicted future above median growth. And what you see is it's just pure chance. Maybe the first year, an above market revenue growing company has a 60% chance of growing above the median, not a 50% chance, but you get to two to three years or you go from revenue down to profits. And it's a coin flip, right? So what you see is that it's really hard to predict future

Starting point is 00:09:30 growth. And because it's really hard to predict future growth, by the way, there are a lot of opinions, right? Everybody has a lot of opinions about what future growth should be or it is going to be. And right now in the moment, we can't disprove any of them. There's no right answer to what NVIDIA is going to grow at for the next three years. We can all have opinions, all of them could be right. We won't know until those next three years unfolds. And so we have markets where some people are, you know, the market can get irrationally, in my view, optimistic or rationally pessimistic or let's say extremely pessimistic or extremely optimistic, but it's not necessarily necessarily irrational, right? Because that growth could happen or that disaster could happen. But over

Starting point is 00:10:09 long periods of time, because the future unfolds in a relatively random and unpredictable and surprising way, it tends to be true that people that are excessively optimistic or excessively pessimistic end up being wrong as the future unfolds in a random fashion. And so this is why growth investing is always dangerous, because you tend to be leaning into consensus thinking and you tend to be leaning into fads. And sometimes that can work for a very long period of time, right? So if you leaned into the fan mag fad or you lent into crypto, those things really worked for a period of time. If you leaned into First Republic bank stock, you know, it worked for a long time. And it tends to work for a long time until it crashes because the narrative that's underlying people's conviction,

Starting point is 00:10:53 consensus conviction about future growth, can be shattered very quickly. Ultimately, multiples drive the majority of volatility in the market, not underlying fundamentals. And so you're really, you know, as I said before, investing as a game of meta-analysis, not analysis. And so if you look at the multiples and you say, gee, these are the things that people are most optimistic about, these are the things that people are most pessimistic about. And you know, basically bet against hubris. You just say, gee, I'm going to take the other end of that bet. You know, you're giving me these crazy odds.

Starting point is 00:11:20 I just don't think it's possible or not likely as possible that this future could end up being quite exactly as you predict. You end up winning over time. that's the central thesis. Turning back to international markets, I want to talk about Japan. Warren Buffett has been buying more Japanese stocks, and you first got into that a couple of years ago, largely because of the really attractive valuations. And you've actually been overweight Japan and vocal about Japan for quite some time now. So talk to us about the dynamics with Japan, and then the recent value mandate that they

Starting point is 00:11:55 announce as well. Yes. So look, there's been a widespread. If you know one thing about Japan as an investor, you know that for 1990 to 2020, essentially, the NICA 225, which is their S&P 500 equivalent, had zero percent returns. It was, you know, lost decade. You never made any money. So people always thought, you know, Japan's a sucker's trade, right? You know, people always get drawn in by some story or another and then they get burned and no one ever makes any money in Japan. And part of that's because people made so much money in Japan in the 80s. So Japan in the 80s was like the U.S. and the 2010s. Japanese companies were on a role. People thought Japanese management styles were the most effective. And you had, I think, the international AQI funds, Acwee might have had, you know, up to 40% in Japan or some nutso number relative to their economic output. And so you were coming off a massive bubble in the late 80s that essentially deflated for 30 years. And there are a few things that underpin those lost decades. One was that valuations kept getting cheaper. So it took a while for the bubble to deflate and then things kept getting cheaper. The second was that growth was relatively mediocre over that period. And the third

Starting point is 00:12:59 is that there was essentially a misallocation of cash. So Japanese companies didn't adopt dividends and buybacks the same extent as the United States and other developed markets did. Instead, they tended to hoard cash or do stupid things with the money. And those things kind of came together to produce this cocktail of badness. And so you fast forward and say, well, what caused Buffett to go into such a dull, unattractive, terrible market, right? And I think one thing is this meta-analysis, right? If everybody believes Japan's a horrible place to invest, if everybody's been burned by investing in Japan and nobody wants to put money there, it's almost certain that there's some attractive bargains there. And Japan's valuations have gotten so extreme, so extremely cheap. I mean,

Starting point is 00:13:40 you're buying things for a third of the cost that you'd pay for them in the United States. It's just silly for equivalent companies, right? It's truly remarkable how cheap Japan is. And so you then have to say, What about the other problems? What about growth and what about capital allocation? And the capital allocation thing is really cool. So there's a very interesting story that's happened is that partially Japan has gotten cheaper and cheaper and partially the Japanese government first under Abe and now there are additional moves, which we can talk about. Dividend policy has really been improving. So Japan's dividend yield has never been the same as the United States until last year. So finally, Japan, the dividend yield on Japanese stocks started to rise above that of U.S.

Starting point is 00:14:20 stocks, just the first time that's ever happened. And that's a big thing, right? So you're actually starting to see better payout ratios. And that's a real move that you can actually see in the data that's changing about Japan. And the Japanese exchange has actually ordered all companies that trade at less than book value to put forward a plan to start trading at or above book value. Now, at first, this sounds crazy. You know, you just can't tell it's like, I mean, I'd like to just order all of my company's stocks to go up too. But first, it seems crazy. But you dig a little deeper And you say, well, actually, if you have a lot of cash on the balance sheet, you can actually meaningfully change your book value by just distributing the cash.

Starting point is 00:14:56 So it's not as crazy as it would seem. So the exchange is basically putting on notice all the companies that trade up below book, which is a huge percentage of Japanese companies and saying, gee, it's time for you to develop, put forward a real tangible plan to start distributing even more cash. And at the valuations these stocks are trading at, you know, you can go buy an entire portfolio of Japanese small caps at half book. And so if you think that this is real, that over the next three to five years, most Japanese companies are going to start trading it at least book, you know, you're looking at a double, mostly just from returning cash, right, that they already have earned. It's just sitting on the balance sheet and they just need to distribute it. Or they just need to start paying out more of their cash flow in dividends. So I think it's a really attractive story in terms of what's actually changing on the underlying nature of Japan. And then there's this growth issue, right, where Japan is in a different economic stage. So forget the long term growth of the economy, which, Nobody's going to tell you anything.

Starting point is 00:15:48 You know, who the hell knows, right? Growth isn't persistent. It's not predictable. I've no idea what Japan's GDP growth is going to be in 2026. But we do have some short-term view into 2023. And the reason we have some short-term view into 2023 is simple, which is that Japan closed its borders after COVID. From 2020 until October of 2022, Japan's borders were essentially closed.

Starting point is 00:16:11 And travel and tourism accounts for about 8% of Japanese GDP. And so they just shut them. off and then they reopened it. So, you know, if you think Japanese travel and tourism GDP went down 50% when the border was closed, just probably somewhat reasonable. And then you think it goes back to 2019 levels, you're looking at a massive increase in Japanese GDP just from reopening the borders of a small island nation that, for some reason, decided to close its borders to all foreign travel, even though tourism and travel make up a substantial portion of their GDP. So you have, you know, this fascinating dynamic where Japan, you know, in 2022,

Starting point is 00:16:47 was really the cheapest it had ever been. And you had a pretty clear catalyst coming as soon as they reopened the border and started allowing travel and tourism. And I think you'll start to hear probably of friends or friends of friends who are talking about traveling to Japan or their tourists and they're traveling and say, oh, you should probably go to Japan. Well, the yen's cheap, right? It's been closed for a few years.

Starting point is 00:17:04 And people are really going back there. And Chinese tourism is opening up again. So I think all these things are driving this really special, interesting moment in Japan. And I think the other thing worth noting is that, you know, I think if you took the entire Japanese market, I think it's smaller than Amazon's market cap. Maybe I'm a little off, right? But we're talking a very, very tiny market relative to U.S. mega cap stocks. And so if you think that corporate Japan, in its entirety, should be worth the same amount as one U.S. company, I mean, so you think, okay, well, maybe it's worth two U.S. Maybe it's worth Amazon plus Microsoft or something. I mean,

Starting point is 00:17:39 you're looking at, you know, it doesn't take that much in fund flows, that much change of investor sentiment to drive the entire Japanese market up substantially. And we've had such persistent foreign outflows of people giving up on Japan and moving their money away from Japan for so many years that any small movement back into Japan can have such a disproportionate impact on prices. And I think that's a little bit of what you've been seeing over the last three or four months where you've seen big surge in Japanese equities. And I think a part of that is just a change in fund flows driving a very illiquid, very small market, somewhat away from the value extremes it had been at last year.

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Starting point is 00:22:07 hearing. Sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. I'm by no means an expert on Japan. But when I think about Japan, one of the first things that comes to mind is their yield curve control, pegging their yields at ultra low interest. relative to a lot of other countries. I also think of Japan just as being, you know, savers. If they're not able to buy bonds at a decent rate, then surely they're going to be buying stocks. So I'm curious what your take is on that. What sort of the culture is on where people are parking their money if they live in Japan and how do they think about the stock market? I know many Asian countries

Starting point is 00:23:00 are more keen to investing in things like real estate. So I guess this also ties into the question of, you know, why so many investors are so scared of Japan. Yeah. And look, I think it's important to say that when you think about being scared of Japan, it's not that people are scared of it because Japan's not that volatile. One of the interesting things is that the Japanese yen trades in a very correlated fashion with the U.S. 10-year yield. Okay. So if U.S. government bonds are rallying, the yen tends to go up. And if bonds are selling off, the yen tends to sell off. And so since bonds tend to rally in recessions, the yen tends to rally in recession. So if you are a U.S. dollar investor investing in

Starting point is 00:23:40 Japan, you actually have a pretty smooth ride. The problem is you've had a smooth ride to nowhere. So it's boredom and abandonment and a lack of anything to get excited about that's driven investors away, not pain. It's not like they've had, you know, maybe in the 80s there was pain in the early 90s, but not for 20 years. It's been a boring market. But that boring market, if you think that, you know, my dad has always had been a vanguard investor. He's always been a business. He's always been a bogellhead. And so we grew up with that culture and I love Vanguard and I'm a bit of a bogo head myself. And there are all those bogelhead forums. And my dad is not a professional investor. He's a lawyer. But America has this culture, this culture of equity ownership where people

Starting point is 00:24:18 go on blogs and talk about their favorite Vanguard index funds and things like this, right? And whether you're a doctor, a lawyer, a dentist, it's sort of in the DNA to invest in stocks. And so, you know, American retirement accounts are in stocks. And that's not true everywhere. So in Japan, people are much more conservative. They want to be in cash and they want to be in in bonds. And so they end up with much, much lower equity ownership. And part of that is just the equities have gone nowhere. So it's hard to commit. It's not like a generation of people have made their retirement by investing in the equity market and told their kids to do that. They've made nothing in the Japanese stock market. So what's the point? Why not just leave it in bonds or cash?

Starting point is 00:24:51 So there's a huge amount of money sitting on the sidelines. Maybe it'll always sit on the sidelines, right? Maybe it's a permanent cultural feature of Japan. But a very small change in Japanese household demand for stocks, again, would drive the Japanese equity market up a lot. And there's a very low equity allocation from Japan and Japanese households. And so I think, you know, that's another part of the story. One is that foreign investors haven't been interested in Japan. And then another thing is that Japanese investors haven't been interested in Japanese stocks. And I think, you know, over the last decade, you know, one of the things we've commented on is, as people had such enthusiasm and interests in China. And China hasn't done better than Japan, right? China, it's been a lot more volatile

Starting point is 00:25:24 and hasn't gone anywhere either. And you're owning equities in a communist country where who knows what an equity is. I mean, do you actually own these companies? I mean, you ever get the money back? I mean, who knows? I mean, Japan, we've got a marine base there, right? I mean, they're one of our greatest allies. You know exactly what you're getting, right? And it's safe. And it's as safe as any other country with a U.S. Marine base and it can be. And so I haven't understood this vast investor preference and interest in China and Chinese equities relative to what I perceive to be much safer and generally much higher ethical standards and in Japanese equities. Well, I think that part of that might be your previous employer,

Starting point is 00:25:58 Dalio at Bridgewater, who has been quite bullish on China with his most recent book. Now, you're aware of what's going on in many of these international markets, call it Japan, Europe, emerging markets. I'm curious if there are any other countries you believe offer really attractive valuation levels relative to the U.S. I think all developed ex-US markets. I mean, Europe and Japan, all look really, really cheap relative to the U.S. But cheapness isn't alone. Cheapness over the long term is a thesis. But in order to sort of drive immediate asset allocation, you probably need something more. And I look out today and I say, look, as a long-term investor, do I feel more comfortable putting my money in European equities and the U.S. equities over a 10-year basis? Yeah, I do.

Starting point is 00:26:40 I mean, look at how cheap the U.K. is. These versus how concentrated the U.S. equity market is in a very small set of stocks that could go wrong. I mean, I love Microsoft. It's a great company. They're doing awesome. But will they always do really well? Right. I mean, there are a lot of other, you know, companies that were huge 10 years ago or 20 years.

Starting point is 00:26:56 20 years ago that have really screwed something up than 10 years later, Microsoft itself looked terrible in 2010, right? So people's perspectives can fade. Great companies can become okay companies. And I look at that and say relative to an entire country's market like the UK or Japan that could fit into one of these large US mega caps. I just find that much more compelling. And I think over the long term, you're going to be rewarded for being willing to take those risks. Now, in the short term, I look at sort of your short-term growth forecasts, right? And I think it's pretty clear what's going on Japan. And you can see it in the guidance, right? If you know, all companies in Japan are required to release guidance and they're required to update their guidance if there's a meaningful

Starting point is 00:27:34 change. And these companies are guiding up massively. So it's pretty clear that in Japanese CEOs always are pessimistic. And so if they're all guiding up massively and forecasting big increases in profit, that's a pretty good sign. Relative to say Europe, where I think there still remain a lot of concerns about energy costs and the Ukrainian war. That might all resolve favorably as it has it had this winter, right? Everybody's worried about energy causing a big problem and it didn't. Everyone was concerned about the war in Ukraine causing a big problem. And it really didn't.

Starting point is 00:28:01 But that still remains a really big risk. And I think it makes me a little bit more cautious about Europe. But Japan, I just don't see those same risks. In fact, I see a very clear bullish narrative coming out of this lockdown reopening dynamic. So I think broadly, you know, I'm in favor of if the acquies is 65% U.S., what should investors be? you know, probably 50. That's sort of where I get to. I mean, you want to be, you know, maybe you match the GDP share, the revenue share of U.S. companies or something like that. But being so overweight one country, especially for U.S. investors, again, whose homes or businesses are here, it just seems

Starting point is 00:28:33 like a risk's not worth taking. And I think the conservative path is to choose, actually. And this is always contrary in investing. You say, well, aren't you telling me to invest in stock markets that have done worse over the past 10 years? You know, how could I move away? Look at how well the U.S. has done. That's a much safer, better performing market. And I think that it's the psychology of investing, where you say, well, no, the safer market is the one that's done poorly. And the harder one, the riskier one is the one that's done better. And that's true because valuations drive the majority of volatility. And so when you've had a big run that's as big and as amazing as the U.S. has run over the past decade, it tends to be in part, in large part driven by a changing

Starting point is 00:29:09 valuation dynamics. And that's in fact what we've seen. Very interesting. Now, in your previous conversation on our show, episode 455, we talked all about your approach to, investing during a crisis and crisis investing. And earlier this year, we saw the banking crisis. So I wanted to get your take on the collapse of SVB and others. And also maybe talk about this concept of the financial accelerator and how small things in the economy can lead to really big consequences in the end because of things like leverage and such. So I'd love for you to talk about this financial accelerator concept and how it relates to the banking crisis we saw. Yeah, so small shocks can lead to big crises. And if you look at all the previous major market shocks, a lot of them seem to be driven by very small things, right? Sometimes it's even impossible. You know, what was the 1987 flash crash caused by? You know, what was the crash in December of 2018 crashed by? Sometimes you never really know, right, some small thing that can cause a big shock. And Ben Bernanke did some of the, you know, most important research into this question. And what he found is that small shocks lead to big crises when the financial intermediaries, who are

Starting point is 00:30:20 who generally are the banks, but also the investors, say, gee, that small shock makes me more risk of her, so I'm going to lend less money. And if I don't just lend less money, but I say, I'm going to stop lending, that's when things really go into it, get problematic. The U.S. economy runs on credit. It runs on debt. And the level and amount of debt that's being circulated really, really matters. Now, people focus a lot on the Fed, and the Fed matters, but most people aren't borrowing from the Fed. Most people aren't getting, you know, right, you're getting your money from your local bank or you're getting the money for your small business from a private investor, private credit originator. So most people actually care, you know, when the rate that matters to them is the spread over the government rate that their businesses are getting. So we look at the high yield spread as being the best sort of indicator, therefore, of actual credit that's going to businesses who are driving employment and consumption, et cetera, for the economy at large.

Starting point is 00:31:14 And when those spreads widen out and when they widen out a lot, which they do when people stop lending, when the financial intermediaries stop lending. But Bernanke calls this a financial accelerator event where the financial intermediaries are accelerating a crisis. They're actually to become the cause of it because they're cutting off credit. They're cutting off that lifeblood to the economy. And so what we found is that when that lifeblood of the economy is cut off, the results are actually relatively predictable.

Starting point is 00:31:39 And so what ends up happening is that small companies get hammered, right? The less liquid, smaller companies that tend to be more reliant on borrowing. money get absolutely whacked in the stock market. The large caps aren't as affected because, you know, Microsoft is always going to be able to borrow money and they generate enough cash. They can just pay off all their debt if they wanted to. But some small manufacturing business that might have a very large number of employees, you know, if they can't get a new debt facility, you know, they're in trouble. And so those companies get absolutely hammered. And what we found is that, gee, if you can go invest in small, illiquid, cheap companies that

Starting point is 00:32:16 have really been hammered during a time of crisis, and take the other end of that trade, when intermediaries start lending again, when that whole process reverses, you can see just astronomical gains owning those types of companies coming out of a crisis. So we designed this whole strategy in 2019 around a crisis investing where we said, hey, gee, the next time high yield spreads blowout, going by really small, really illiquid, really cheap companies, especially in cyclical sectors. And if you buy them, you know, soon after high yield spreads blow out, you're going to do really well. And so we did that to great success during COVID, which was sort of lucky. We came out with all this research in the beginning of 2020,

Starting point is 00:32:51 and then the crisis had, and it turned out the research was right, basically, because it's a very simple, logical idea, and thankfully, it turned out to be, to be right. And so we've been waiting for the next crisis. So we have, we have investors, we have a lot of investors who have backed us to go and do this the next crisis. And our metric is do high yield spreads go above 600 basis points? That's what we look at. And Silicon Valley Bank and First Republic, they indeed caused the high yield spreads to bump, to jump up above 500, but they never got close to 600. And actually, they've come back down to about 420, which is pretty close to the 10-year median. And so the banking crisis could have become a financial accelerator event. It could have become a real

Starting point is 00:33:26 crisis, but it didn't. And I think that's one of the puzzles of 2023. 2023 is a strange, a strange year from a macro perspective, right, that typically when you see every banks in the country stop lending, you know, it tends to be bad. But this year, all the banks in the country essentially stop lending and it wasn't bad. And so, or at least it doesn't seem like it's been bad and the market's basically completely shrugged it off. But I still think if you look at sort of a composite of macroeconomic indicators, things look worse than the equity market would suggest. I think we continue to see risks that inflation comes back and our sort of immaculate disinflation wasn't quite so good as it looks right now. And if it does come back, that rates need to go high

Starting point is 00:34:09 or stay higher for longer and that might not fully be done raising rates. And I think a lot of those things could be quite devastating to gross stocks in particular. They could be quite devastating to private equity, which relies on floating rate debt. And I think people aren't necessarily pricing in that type of scenario right now. Well, you're a student of history, and you previously stated that if history is any indication, as it oftentimes is, a Fed pause would come after the Fed has felt like there's been some sort of economic slowdown, and then equities tend to bottom sometime after a Fed pause. As we're recording today, the S&P 500 is sitting around 7% below its all-time highs. We saw a Fed pause last week.

Starting point is 00:34:55 They paused their hikes. So I'm curious what your take is on the equity markets. We've seen a lot of the gains and equities be driven by the big names, the top seven or so. And a lot of the other company has sort of lagged. So what are you sort of seeing here? Yeah. So, you know, when we think about the Fed, it's important to have a model for what rates should be. And I think the simplest model for what rates should be relies on the work of John Taylor as an economist at Stanford who came up with this Taylor, what's called the Taylor Rule, which is a monetary guide. It's a calculation based on macroeconomic inputs of what the real rate should be. And you can simplify it or approximate it and just say basically what Taylor is saying is that your real interest rate should roughly equal nominal GDP.

Starting point is 00:35:44 So you take what real GDP is, you add the inflation rate, and roughly, that's where your interest rate should be, right? So if you think, you know, inflation's running at three and real GDP's at two, you know, maybe you think rate should be at five or something like that. And so you'd say, hey, maybe we're roughly where we should be. Now, there's a little bit more math to it. And so that's an approximation, but the really nice instinct that that gives you is if you have in your mind that rates should equal nominal GDP, then you should also understand that when nominal GDP is going up, whether because growth is doing well or inflation is doing well, rates should be rising. And when real nominal GDP is collapsing as it does during a recession, rates should come down,

Starting point is 00:36:25 right? So your mental framework should be in good times, rates go up and in bad times, rates go down. And I think that people have in their minds rates going up is a bad thing and rates going down is a good thing. But that's not really the way it actually is theoretically, right? It's just been the recent experience where people have sort of said, oh, you know, rising interest rates put a damper on asset prices and lower interest rates have been good for growth stocks, etc. But over the long term, that's the way you should think about it. And so what you've seen is that when the Fed stops hiking, right, they've stopped hiking because nominal GDP has stopped for rising and started actually to decelerate or fall. Now, part of that's because of inflation,

Starting point is 00:37:05 but inflation and GDP tend to actually be, and real GDP tend to actually be quite correlated when the economy is really heating and GDP is ripping, then inflation starts to be rising. And when the economy's collapsing, GDP's collapsing, inflation tends to be sharply negative. And so because of that correlation, you do see this phenomenon where Fed raises rates, raises rates, raises, rates, they stop. Why do they stop? Well, they stop because they say, gee, we've raised too much. The economy is really slowing down. And they're, by the way, looking at backwards indicators. And then what then happens next is that the economy, in fact, does slow down. Corporate earnings then drop. The equity market drops. And then the Fed says, oh, shoot, now we need to cut rates because we need to bail the economy

Starting point is 00:37:45 out of this bad situation we've now gotten ourselves into. Now, the lag between when they stop raising rates and when, you know, when that final raises and then when markets bottom, you know, there's not an exact science or number to that. But it's, you know, a few months after. Now, don't know when the Fed, you know, we don't know, is this the last hike? And so we don't know, say, is there some clock ticking from now? You know, I don't know that it could raise rates again and reset that clock. But generally, from whatever point it is, the FOD stops raising rates, that tends to be when things become really problematic. And that's one reason I've objected to this, the way the market has priced growth stocks, where they say any indication that the Fed is stopping

Starting point is 00:38:21 raising rates should be good for gross stocks because it should mean that discount rates are now coming down again. And so the terminal multiple should go up. And I've said, you know, gee, that's a crazy way to think about it because what really matters is also the corporate earnings. And, you know, those corporate earnings are going to go down if, in fact, the Fed starts cutting rates because they'd only cut rates in a recession. So I think that people have it a little bit backwards. And I think the market's got in the head of itself. And they've gotten into this euphoria around AI.

Starting point is 00:38:47 And I think market euphorias and fads, you know, they tend to rip for a little bit. And then, you know, a year or two later, when all of the excited, enthusiastic buyers have moved on to some other fad, the multiples tend to decompress and the air comes out of the balloon. And, you know, I'm afraid that that's likely what's will happen with this AI thing. And I think it, you know, who knows when Nvidia stops working, but at some point it does. And I think that from a macroeconomic perspective, there's a lot more to worry about in the U.S. than there is to be excited about. Whereas I think if you look at a place like Japan, there's a lot more to be excited about

Starting point is 00:39:21 than to worry about. And the valuation gap is huge. You know, you can get, you know, pay a third of the price for a company in Japan, the would for the same company in the U.S. And Japan seems to have better economic prospects. So for me, it seems like why solve the hard problem, the really hard problem, which is why is the equity market going up in the U.S. when macroeconomic conditions don't look that great?

Starting point is 00:39:41 Why don't you look at the easy question, which is they're really cheap valuations in a place like Japan and really good economic fundamentals. And that seems a lot safer. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up. And customers now expect proof of security. just to do business. That's why VANTA is a game changer. VANTA automates your compliance process

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Starting point is 00:43:10 Back to the show. Yeah, one thing that's sort of been ingrained in me is Buffett's famous saying that interest rates are like gravity and we've had this deep. increasing interest rate environment for 40 plus years until the Fed cranked up interest rates. So it's like, oh, well, if the Fed's cranking up interest rates from practically zero to five percent, then, you know, equities should be going down. But that's not what we've seen lately. And essentially, we've had many guests on who have kind of called for the giant kind of super bubble in the U.S.

Starting point is 00:43:39 And it's like, when you're in a bubble, you don't really know when it's going to end. I'm not saying the U.S., you know, it's going to be seen as downfall or a lost decade over the next 10 years. but it's quite tricky to time these sort of things in the short run. Yeah, we actually did a study on that where we looked in the 90s and we looked at all of the who we'd think of as the great investors, right? The Ray Dalio's and the Seth Clarmons and the Howard Marks of the world. And they all called the 90s tech bubble. They all did.

Starting point is 00:44:06 The problem is they called it in 95, 96, and 97. And the bubble went on until the late 99. And so, you know, in some sense, overvaluation and bubbles, If you're smart and you're quantitatively oriented investor, you're always going to call bubbles two or three years too early. I mean, it's just a constant problem because you're going to get out before the real euphoria starts. And that can be a real pain trade. And it was a real pain trade for those very smart investors in 98, 99, 97. That was tough.

Starting point is 00:44:33 But you fast forward to 0102, because those growth, very expensive glamour stocks tend to go up and they go up and they go up and then they go parabolic and then they crash. I mean, first, probably is a great example because it went to zero. But that was everyone's favorite bank stock. It was the only growth stock in banking. And you look at what happened to that, right? That's the pattern these growth stocks follow. We call them growth bankruptcies. It's actually riskier to invest in very expensive growth stocks than it is to invest in

Starting point is 00:44:59 companies that have risk of bankruptcy, right, that have a lot of debt on the balance sheet, which is counterintuitive. But it's because these valuations actually do matter. They don't matter until they do. As long as it's just story-driven and narrative-driven, they don't matter. But at some point, they do matter. And then you can get really, really whacked. And I think it's much more prudent as a result to play it a little bit safer.

Starting point is 00:45:19 And even if you can look like a total idiot, like this year, if you are a U.S. value investor, you look like a total idiot, right? The NASDAX up 30 and large value stocks or maybe up one or two or something disastrous like that. So you look like a total idiot. But on the other hand, I think it's a more prudent strategy over the long run. Most would naturally assume that with much higher interest rates, companies rolling over their debts, is going to lead to a lot of downward pressure on companies' earnings and income statements. What are you sort of seeing in regards to this?

Starting point is 00:45:51 And then I also didn't even mention inflationary pressures on their costs and maybe not able to keep prices up with inflation. What are you seeing in terms of earnings and companies rolling over their debts? Yeah. So I think one important thing to realize is that the U.S., especially U.S. large caps in terms of net indebtedness is very low. I mean, these companies don't have a lot of debt relative to their market cap or relative to their profits by and large.

Starting point is 00:46:19 Now, you go into small caps, you'll see more levered companies. But by and large, rising interest rates and thus rising interest costs for public companies in the United States is not a huge problem. Another thing to remember is that good companies borrow long and fixed and bad companies borrow short and floating. So just like someone with a very good credit score can get a 30-year mortgage at a very low rate and it's a fixed rate. If you are of bad credit, you know, you're going to be paying your credit card company 1,800 points above LIBOR and for a one month loan, right?

Starting point is 00:46:50 So there's this dynamic in U.S. market as well. And so by and large, if you're investing in public markets, this isn't a real risk to you. Who it's a real risk to is private equity and private credit. So the really small, really risky companies, who, by the way, have all borrowed, the private credit market's all floating, right? pretty much. It's a loan-based market. It's all floating. And so great idea borrow, you know, short and floating in 2018, 2019, 2020, 2021. That was a great idea. And there was a binge on that debt, a total, total binge in private markets. And we wrote a piece on it recently. And we think that, you know, the median private equity back company probably is around eight times net debt to

Starting point is 00:47:30 gap EBITDA of debt on their balance sheets. And so if interest costs are 10%, which is essentially L plus 500, right, which is probably not an unreasonable number, 80% of EBITDA is getting eaten up by interest, 12, 15, all of your EBITDA is going to interest. So I think that this is a real, real current direct right now problem for most private equity portfolio companies. And so I think everyone's favorite asset class that is now 40% of a lot of portfolios is in a lot of trouble. Now, when companies aren't hitting their targets, that earnings targets set by Wall Street, many of them will try and manipulate their earnings higher if possible. And this tends to occur more often when the economy is teetering into a recession.

Starting point is 00:48:15 And it's actually tracked into what's called the M score. Could you talk to us about the M score and what we're seeing in it today? Yeah, I'm not, I haven't run the M score model myself. It's not something I actively use. But I think you can see it in these adjustments to EBITDA, adjusted net income, adjusted EBITDA, or in companies you see it in the accruals line. So what they're doing with accruals. And you've seen a lot more of those types of adjustments recently.

Starting point is 00:48:42 And some people would say that's a bad signal. You know, I don't know. I haven't looked at it as a macroeconomic signal. I don't have a strong view on it. But on an individual stock level, looking at those types of adjustments and accruals, it's generally a bad sign. And so the more of that you're seeing, the more concern you should be. I recently had Scott Patterson on our show who wrote this great book called The Chaos Kings,

Starting point is 00:49:04 which covers investors like Bill Ackman, Nassim Teleb and Mark Spitznagel, and how they make billions of dollars during a crisis. And when I was reading it, I was like, if anyone's smart enough to implement this sort of strategy, I think it's that I know personally, I think it's Dan Rasmussen. So since you have your own strategy of investing in a crisis, I'm curious if this is something you've looked into,

Starting point is 00:49:25 considered, or maybe even implemented. Yeah. So if you think about the Talab and Spitznagel strategy, Let's broaden that into the category of tail risk hedging. This tail risk hedging idea has gotten a lot of traction of late. Interestingly, at the same time, shorting stocks has gone down in popular. So why would I short stocks? That's a crazy idea.

Starting point is 00:49:47 Instead, I'm going to buy tail risk hedging, right? So there's just different ways of hedging. But if you then say, okay, let's look at tail risk hedging as a strategy. The first problem you're going to face is that tail risk hedging is done through options, right? Essentially buying out of the money puts. Now, if you want to put any money into buying out of the money puts, you'll very quickly find that there's only one index where you have liquid out of the money puts, and that's the S&P 500. So if you're running a tail risk strategy, you are almost definitionally buying S&P out of the

Starting point is 00:50:17 money puts. Now, there's a lot of other stuff you can be doing around VAL trading and there's some interesting VAL trading to be done and whatever, but the bulk, the sort of intellectual core of tail risk hedging is buying S&P out of the money puts. And buying S&P out of the money puts is a terrible strategy, right? a money losing strategy because you're buying insurance. And the people that make money in insurance are the people that sell insurance, not the people that buy insurance. Now, owning insurance, when something really bad happens, always seems smart and prudent. And so there's an argument to

Starting point is 00:50:46 be made that's logical and consistent with people's common sense judgment that they should buy this type of insurance. But the problem with S&P out of the money, S&P 500 puts in particular, is that the market not only has to fall a lot, but it has to fall a lot fast in order for you to make money. And And historically, it hasn't fallen a lot fast, except in a very few occasions. And most of the time, it's fallen a lot slowly. And when it falls a lot slowly, it's hard to make money on options-based strategies because you're always recycling the options. And so the options market prices in that decline and that volatility.

Starting point is 00:51:19 And so every back test I've done of buying S&P out of the money puts, which is, albeit a simplified strategy, but is the essence of tail risk hedging, suggests that it's a real waste to money and, you know, not a good addition to a portfolio and that there are much better ways to risk manage. One of them is, you know, for example, to use trend following signals to help reduce exposure. Even shorting stocks isn't all that bad. At least there's alpha and shorting, right, in theory, there's alpha in shorting stocks, right? You're picking which stocks to short, not just shorting the index, which is essentially what you're doing when you buy out of the money puts. And so, you know, I tend to be on the skeptical end about this tail risk hedging. And I think what makes me

Starting point is 00:51:55 doubly scepticals. You see these Bloomberg articles where they say, I made 3,000 percent returns and something, right? And then you look at the actual hedge fund return database for that month and their fund is up 5 percent or 10 percent. You say, well, they must be quoting that they made 3,000 percent on one option that they bought, that they put 50 bips of the fund in or something. Right. And so I think that's sort of that marketing rubs me the wrong way because it's just not an accurate picture of what's going on. And so broadly, I think tail risk hedging sounds really good and sounds really sexy and sounds really smart, but it doesn't seem like it's actually, to me, at least a useful thing to do with your portfolio.

Starting point is 00:52:32 Yeah, your strategy is much different than the Chaos King. So I'm curious, in light of the banking crisis earlier this year, equity markets recently rallying how you're positioned today. Yeah. So we have had a long overweight to Japan, and we've added to that overweight over the past year. And so a pretty large chunk of our monies in Japan. And Japan's doing better in the end, doing better than the NASDAQ this year, albeit if you're a dollar-based investor, it's not quite as good as the NASDAQ, but still probably substantially beating the S&P 500.

Starting point is 00:53:05 And so we feel very lucky in that sense. And I hope that Japan becomes a bubble like it did in the 80s because we have so much money there that if it becomes a bubble, we'll be one of the big beneficiaries of it. And I forget, I think it was Jeremy Grantham who said, you know, the goal of every investor should be to capture just one bubble, the course of their investor lifestyle. So I'm really, really hoping that Japan becomes a bubble so I can cash in big. But I think the by and large, you know, what we're focused on here at for Dad, you know, we have a lot of Japanese equity holdings, which we're really excited about and are really thriving this year. We also manage a lot of high yield credit.

Starting point is 00:53:36 She thinks it's a really interesting market. And then we have crisis funds when we're waiting. We're just waiting for spreads to blow out and for a crisis to happen. And I think if you think about that relative to the chaos kings, right, in some sense, chaos does create opportunity. Right. Crisis does create opportunity. In our view, the opportunity is having money when the crisis happens so you can buy really dislocated stuff rather than trying to buy insurance for when the crisis does happen, which seems like a place might be harder to make money. Related to Japan, how do you think about their central banks, their policy of yield curve control and how that relates to history and how that affects maybe currency to basement, how you figure out your returns and what to expect?

Starting point is 00:54:16 Yeah, I mean, look, the Japanese model is the model for what the U.S. has been doing, right? The U.S. has been copying for the last, since 2008, they've just been copying the Japanese central bank and looking at the tools the Japanese central bank came up with and trying to apply them here in the U.S. And a lot of the tools that Japan was using were to try to stimulate some inflation or at least stop deflation. And they've been unsuccessful. So Japan has been, let's call it not unsuccessful. They haven't produced inflation, right? They've maybe produced a little bit. but nothing like what we've seen in the U.S. or anywhere else, right? And mostly they've had deflation. And so you compare that to the U.S., which adopted the same policies and pretty quickly had a lot of inflation. I think if you said, well, who's the more prudent central bank? And so, I don't know, I kind of, and if currency debasement specifically is what you're worried about, I think a country that experience is persistent deflation is probably the definition of something they see like, especially when, again, the yen tends to trade with the 10-year treasury. So it tends to be a flight to safety asset even more so than the dollar. And so I like the Japanese yen. I like it as a currency. And I look at at that, you know, I look at what our central bank and what our government is doing. And maybe you could say Japan was irresponsible from a debt to GDP perspective 10 years ago. But, you know, you look at what the U.S. did during COVID. And I think we're worse than Japan now. And so, you know, I think on a relative basis, Japan's gotten a lot more attractive just because the U.S. did so many stupid things from a fiscal perspective. So as a student of history, as I already mentioned, and given your understanding of base rates, you tend to be pretty skeptical of new technologies that people get

Starting point is 00:55:49 really excited about and just pile into. I'd like to flip this idea on its head and ask you if there are any technologies that excite you, maybe not from an investment standpoint, but maybe just the technology itself and improving society as a whole. You know, it's funny because we're quantitative. We use a lot of quantitative tools and, you know, I like to think we're pretty sophisticated. So I'd never own Snowflake stock, but we use Snowflake and we love it. And it's an amazing product. Okay. Right. So, and it's really, really revolutionized the way we do our work. And, you know, you look at ChatGPT, we're not there where it's revolutionized anything. Does it make our lives a little bit easier? We need to look up how to do some sort of code. Yes. Is it helpful? Yes. Is it

Starting point is 00:56:28 enhancing productivity? Yes. It's not the leap for us that Snowflake was, but we're certainly using it. And so I like to think that I'm a skeptic, but I'm not a Luddite. I'm a highly technologically advanced skeptic. And I think, you know, in that regard, I think the promise of all of these technologies is ultimately that they benefit the consumer, right? They've got to benefit the consumer more than they benefit the company that created them. And so we in the U.S. should be delighted about economic progress and technological innovation and thrilled that so much of it happens here. And we should be thrilled about AI and the advances in the cloud and database technology. All these things are wonderful for companies like mine.

Starting point is 00:57:03 and I'm thrilled about them. Where I'm more skeptical is whether they work as investments, right? Should you buy Snowflake stock? Should you buy AI company stock? And I think one concept that I really like to think about in this regard is competition neglect, right? Which Sam Hanson, who's a consulting economist for us, has done some really interesting work on, which is, you know, when you see a really interesting investment opportunity,

Starting point is 00:57:25 probably there are 10 other firms that see the same investment opportunities. So if the market size is, if the Tam is huge, probably there are a lot of other people chasing that same Tam and only a few of you are going to win. And people invest as though their company is going to be the winner. But there are 10 other people investing in 10 other companies that all think they're going to be the winner. And so in aggregate, investing in that hot space ends up being a losing bet, even if the Tam is massive and even if there was one massive winner, because of competition neglect, people don't realize that the game is a lot harder and more competitive than simply saying AI is going to be huge. I'm going to buy this AI stock. I'm going to

Starting point is 00:58:02 therefore make money. The problem is, again, that there are other people doing that. And investing ultimately is a game of meta-analysis, not analysis. It's where's your view divergent from the market, not whether your view is right or wrong AI could still be amazing and awesome and you could still lose money buying AI stocks. Well, Dan, it's always a pleasure having you on our show. As always, we want to give you a chance to hand off to how people can learn about you, how they can get connected with Bairdad and any other resources you'd like to share. Thank you, Clay. I'm on Twitter at Verdad Cap and we write a weekly research email and you can sign up for it on my Twitter bio or on our website, Verdadcap.com. And so if you liked hearing about what we're studying and some of our

Starting point is 00:58:43 findings, I encourage you to follow me on Twitter and subscribe to our research. Awesome. Thanks so much, Dan. Thank you, Clay. This was fun. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

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