We Study Billionaires - The Investor’s Podcast Network - TIP567: The Evolution of Value Investing w/ Brian Feroldi

Starting point is 00:00:00 You're listening to TIP. On today's episode, we bring back fan favorite Brian Feraldi. Brian is one of the top contributors to the investing community and is widely popular on Twitter and YouTube as he has a combined following of over 500,000 fans. On today's episode, we discuss the valuation mindset spectrum and how we as investors can determine which investing approach fits our own personality and temperament. At the end of the episode, Brian also gives us an updated assessment of NVIDIA's valuation and his thoughts on the progress of one of his top holdings, which has been a big winner over the past decade, Mercado Libre.

Starting point is 00:00:36 We always enjoy having Brian on the show, and I really hope you enjoy this discussion as much as I did. 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. All right. Hey, everyone. Welcome to The Investors Podcast. I'm your host, Clay Fink, and today we're going to be chatting about the valuation mindset spectrum with Brian Feraldi. Brian, it's always great having you back on the show. Clay, thank you for invite me back. I always enjoy being on.

Starting point is 00:01:22 So let's just dive right into the first question here, Brian. What is the valuation mindset spectrum? And what was the premise for educating people on this? When I first started investing, I think I did what a lot of investors do. They immediately gravitate towards. the teachings of Warren Buffett, Benjamin Graham, Charlie Munger. And when they are value investors who said things like, all intelligent investing is value investing. And that makes so much sense to me. However, what's so interesting is that there's also another mindset when it comes to investing that is purely focused on high growth companies, venture capitalist mindset, and they offer essentially diametrically opposed opinions and advice about investing.

Starting point is 00:02:12 And keeping those two mindsets in mind was always really challenging for me because I greatly respect people like Warren Buffett and I also greatly respect people like Mark Andreessen, who are venture capitalists. Only over time did I realize that valuation isn't either or it is more of a spectrum. And where any individual investor thinks about evaluation really depends on where on this spectrum between valuation doesn't matter to valuation is everything. It exists. So I think a big first step with figuring out how to value any business is knowing what type

Starting point is 00:02:52 of investor you are. And it's critical to know where you lie on that spectrum. Let's step more into that spectrum. You mentioned Warren Buffett and Mark Andreessen. Can you just sort of highlight how the Buffets of the world think, how the Andresens of the world think, as well as the investors in the middle? Sure. So let's imagine that you are a venture capitalist. And the Google guys come to you and they say, hey, would you invest in our business today? It doesn't really matter the valuation that they offered you if you got into Google early. If it was a $1 million valuation, a $10 million evaluation, or even a $100 million valuation,

Starting point is 00:03:29 if you invested in Google early at any valuation rate, you did incredibly well as an investor. The right decision was putting money into Google and the valuation that you paid with almost a non-unfactor. That is one extreme mindset. It really shows if you buy the next Google or the next Amazon or the Netflix early, the valuation that you pay almost, almost doesn't matter. However, those are, of course, rare companies. Finding companies that can go up in value $1,000 or $10,000 over time is extremely hard to do. On the other side, on the other side of the spectrum is value investing,

Starting point is 00:04:09 where you're trying to figure out what is the value of this asset and how can I put money to work in this asset at a lower price than it's currently trading at. That builds in a margin of safety to your purchase that really protects you from losing a lot of money on the downside, which we all know is Warren Buffett's rule number one and rule number two of investing well. So what's so fascinating is that both valuation mindsets can work. You just have to know which type of investor you are. And how does this tie in to the history of value investing? I know you've talked about, you know, history and how this sort of ties in. So I love for you to elaborate on this as well.

Starting point is 00:04:51 If you look back at the 140-ish year of the Dow Jones Industrial Average, I think that there are five distinct phases that valuation has gone through during that time. And knowing the history, I think, is actually really important. So prior to 1929, prior to the great crash of 19. The stock market was essentially the Wild West. The data that was given provided to investors was extremely limited. It was largely unregulated. The SEC did not exist at all. And back then, stocks were very much viewed as gambling devices. In fact, one reason that back then, companies paid out such a large portion of their earnings as dividends, that was one way that they

Starting point is 00:05:40 could prove to investors that they were actually making money. So companies were not encouraged to reinvest in themselves. They were, we encouraged to pay out that money to investors to prove that they were actually profitable. Now, immediately preceding that time came the crash of 1929 and then the ensuing Great Depression. A horrible time economically in America's history. Unemployment rates skyrocketed, peak to trough. The U.S. stock market fell by like 89%. plenty of people went completely belly up. And in the wake of that, that's when FDR came in and really enacted some changes that put some regulation around Wall Street. That included the creation of the SEC in 1933 and 1934, the passage of the Glass-Steagall Act, and that helped to

Starting point is 00:06:27 regulate companies and securities that would come public. After that period happened, I think is really when value investing was first, first invented. It was invented in part. It was invented in part. by a guy named John Burr Williams, who wrote a book in 1938 called The Theory of Value Investment, and that was the first time that concepts like intrinsic value and discounted cash flow was really created in 1949. That's when Ben Graham published his, a very popular book, The Intelligent Investor, and he introduced concepts such as margin of safety, buying companies below their book value and really focusing on the price-to-book ratio. Now, after that period, and really after World War II, I think came the next phase of valuation. In 1958, Phil Fisher published a very

Starting point is 00:07:15 popular book called Common Stocks and Uncommon Profits, and he focused on buying businesses that could substantially grow their profits over time to lead to superior returns. And in the 1950s, that's when a young Warren Buffett studied those books, Phil Fisher's book, Ben Graham's book, John Williams Burr book, and developed his own investing style. At the time, And he famously said, I'm basically 85% Ben Graham, 15% Fisher. And during the age from, let's say, the 1940s, 2000s, this was the age of mass media, the age of consumerism. It was still hard for investors to find information on companies, but it did exist.

Starting point is 00:07:58 That information was largely limited to big mutual fund managers and big institutions. And during that phase, we saw the rise of people like Peter Lynch and Charlie Munger, who focused on quality businesses that had wide, enduring modes. You would try and buy those businesses with the margin of safety and let those companies compound over time. That was the style of investing that worked out so well. And I would argue that the fifth valuation phase, the one that we're in right now, really started in the mid-90s to early 2000s thanks to the adoption of the internet.

Starting point is 00:08:29 It was really during that time that we saw a massive rise in venture capitalists. We saw the internet comment and disrupt so many things. We saw data become incredibly easy for investors to access, even individual investors, like myself, to access for free. We saw lots of companies come public because the world is a wash in cash. Companies could now focus on growing their revenue, taking advantage of markets and actually losing money for long periods of time. That wasn't even an option to companies that came public prior to them.

Starting point is 00:09:01 And we've seen if investors become famous during this period like Market and Driesan, or growth investors like David Gardner or Kathy Wood, and their new valuation techniques emerge, such as focusing on total addressable market opportunity and reverse DCF models. So once you understand the history of them, you can kind of understand how valuation has grown in importance over time. You've been on our show a number of times talking about how a lot of investors view certain investments through their lens, and it might not be the appropriate way to view a company and how valuation sort of fits into it.

Starting point is 00:09:38 One example is the PE ratio. People use the PE ratio on these earlier stage companies. I'd like to transition to discuss how investors can best decide where on this valuation spectrum they should sort of fit or how do they decide what sort of game they should play? Because you talked about how all these investors, different people have been successful with different strategies. So how should people think about where they think about where they think. fit on the spectrum.

Starting point is 00:10:07 Yeah, great quote by Oswath Demonoran is the most important investor to study thoroughly is yourself, which I totally, I totally love that phrase. Figuring out what type of investor you are can be incredibly helpful to not only figuring out what kind of investments you're looking for, but also what kind of investing advice you should follow. So again, on one extreme end of the valuation mindset spectrum, you have venture capitalists and growth investors, those type of investors de-emphasize valuation. The only thing that they are focused on is the upside potential of the business. On the other extreme end of the mindset spectrum

Starting point is 00:10:44 is the Ben Graham, Michael Burry type of thinking where valuation is first and foremost, the most important filter to put investments through and anything has a value if you buy it cheap enough. In between those two extreme styles is what's called GARP investors, which is more growth at a reasonable price. Those type investors are willing to pay a premium to own companies that have superior growth prospects, but companies that have lower growth prospects, they're not willing to pay as much of a premium for. So valuation is an important part of their process.

Starting point is 00:11:18 Figuring out where you are on that spectrum depends on numerous things to say your personality is a huge one as well as your risk tolerance. But four other things I'll throw out there. First is your time horizon. If you're going to be investing like a growth investor and a venture your capitalist, you better have a multi-year, multi-decade time horizon because it can take a long time for those early stage companies to execute against the game plan ahead of them and for the compounding to really, really kick in. Another question to ask yourself is, how comfortable are you with volatility? Not in theory, in reality. If you're going to be investing in growth

Starting point is 00:11:56 companies, companies that are an early stage of development, you better be ready, willing, and able to stomach occasional 20, 30, 50, even 70 percent drawdowns in those stocks, which is not easy to do. If you're not comfortable with volatility, you should add more towards the value investor aside of the spectrum. Another question to ask is, are you a bargain hunter at your very nature? This is how I started out investing in my real life whenever I'm purchasing goods for my house, I look for bargains. I like to know that I'm getting a good value for something and I applied that same mindset to the markets when I first started investing. I was looking for stocks that were cheap and dividend yields that were high. That kind of appealed to me. If that appeals

Starting point is 00:12:39 to you, perhaps you're naturally drawn to value investing. And the final thing is, what is what matters more to you? Does protecting the downside of your investment matter more to you? Or does going after the upside matter more to you? If upside, is the thing that you're after and you're willing to give up downside, well, then you should think about adopting a venture capitalist approach to valuation. If you really want downside protection, well, then you better really get to know how valuation works. It's interesting when you look at the venture capital approach to valuation. All you can really look at is what is the overall market potential or the TAM and how much can they

Starting point is 00:13:16 capture from that total market? It's an approach where you're purely looking far out into the future. Then you turn to the pure value approach. You're looking at just the earnings and you're not as concerned as where the business is going to be 10 or 20 years down the line. So all you really care about is what is tangible and what's happening today with the business. So it's interesting to me to compare the difference in time horizons between those two approaches. And you actually have six valuation methods we can use in our own valuation toolkit, depending on where the business is in its gross cycle.

Starting point is 00:13:48 Could you walk us through these six valuation methods? There's lots of ways that you can value a company. And a big mistake that investors make, myself included, is they get to know one valuation style and they apply that valuation technique to all companies at all times. I think that that's a mistake to do so. In fact, I think it's really important to know what phase of the business growth cycle a company is currently in before you can know what type of valuation style you should do. use. For example, if a company is in the startup phase or in the hypergrowth phase, it's small,

Starting point is 00:14:27 it's young, it's rapidly growing, the future potential of that business is incredibly wide. If it executes against its opportunity, it could go up 10, 50, 100, 1,000 times in value. Doing so would be incredibly hard, but that's certainly in the realm of possibilities. Also in the realm of possibilities is that company is going to run out of money and go to zero. So the range of outcomes is very huge. On those type of companies, early stage companies, I don't think DCF models or reverse DCF models have any real value at all. I also don't think that multiples have much value at all because oftentimes the only metric that a company has to show is sales. And sometimes those sales are very meager. So for companies that are in the early stage, I think it makes sense to focus on total adjustable market analysis, which is simply how much revenue is available to this company on any given year. Now, once you know that number, you can do some analysis from there to figure out, okay, what is a realistic market share for this company to capture?

Starting point is 00:15:27 What are its margins going to look like once this company scales? What could its future multiple trade at if this company executes successfully? And from there, you can back in what kind of valuation makes sense today, given this company's potential. That kind of analysis is very squishy. There's not a lot of hard numbers that you can go on. But when a company is in early stage, you don't have much data to look at. have to make more educated guesses. As a company grows and as it matures and as its revenue

Starting point is 00:15:56 starts to tick up, that's when you can start to see some meaningful improvement in the company's income statement. Companies eventually start to produce positive gross profit and that number grows. Companies then start to produce positive operating income and then that number grows. And then finally, companies start to produce free cash flow in earnings and those numbers grow. As the company is moving up maturing and the business growth developer cycle is moving up, That's when you can start to look at multiple analysis. When a company is early and sales is the only number that you can look at, the only option you have from a multiple perspective is to look at the price to sales ratio.

Starting point is 00:16:30 As gross profit continues to grow, I'm actually a big fan of calculating a company's price to gross profit ratio, which is not a number or a metric that I hear many other investors talking about, but I think it's an incredibly useful number to look at. As the company continues to mature, then you can gradually introduce things like price to EBITDA or price to EBT or even price to earnings or price to free cash flow, a bunch of companies on there. So that would be something that you, those analysis you can do on companies that are in the semi-mature, semi-growth stage.

Starting point is 00:17:00 After a company is reliably producing free cash flow, which typically the company is fairly mature at that point, then and only then do I think it makes sense to look at discounted cash flow models and reverse discounted cash flow models. Prior to then, you're making so many assumptions about the company's growth rate and the company's margin profile that I don't think that DCF models and reverse DCF models are really that helpful in that early stage. However, those type of valuation methods can be very useful once a company is in the mature phase.

Starting point is 00:17:33 And you could also argue that in the mature phase, things like Tam analysis or the price to sales multiple really aren't useful at all. The bigger point is that businesses go through a relatively predictable business growth cycle, and you need to know which valuation method you should use depending on which phase the company is. And you can get a lot of the trouble if you use the wrong valuation method on a company at the wrong time. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord,

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Starting point is 00:22:00 That's Shopify.com slash WSB. All right. Back to the show. I'm curious if there's an area of this growth cycle and spectrum. An area you believe is more, I don't know, a better phrase than more winnable by your average investor? Or do you think it's just a matter of investor preference? I firmly believe it's a matter of investor preference.

Starting point is 00:22:28 For myself, I like to invest in companies that are in the self-funding or in the operating leverage phase. These are companies that have reached the point where they're no longer losing, losing money. However, they're not making a lot of profit. They're perhaps right at the break-even phase or could be there in the near future. Companies in this phase are easy to miss value because a lot of people, a lot of investors look at the price to earnings ratio, at the price to free cash flow ratio, which are often very inflated because their profits have not matured.

Starting point is 00:23:00 And it's very easy to draw the conclusion, this company is over, overvalued. However, companies that are in that phase that can grow at an above average rate for five, 10, or even 20 years are compounding machines if you can get them right. I like to look for companies like that, buy them, and let the company execute against its opportunity. And if you can find a handful of those companies that execute the way a Lulu Lemon has or a way that Netflix has, you can earn absolutely gargantuan returns while taking much less risk than you would if those companies were still in the startup or the hypergrowth phase. But I think that investors can do well in any phase so long as they know, they understand the nuance of what goes along with

Starting point is 00:23:43 investing in that phase. I'm somewhat hesitant to, you know, throw the terms value investors and growth investors here, but I almost have no better terms to use it here in this context. But I'm going to go ahead with that anyways. We have a lot of value investors in the audience, which, you know, a term nowadays doesn't really mean a lot because people can see value in many different ways. And skeptics of quote unquote growth investing of that strategy, they might say that paying up for a highly disruptive company, it might not be a reliable way to invest because the market can tend to become pretty optimistic about these types of companies. And they can be prone to facing a lot of competition. And then you throw on top of that things like a charismatic CEO and overly promotional founder. And a lot of people just get really excited about it.

Starting point is 00:24:32 So I'm curious what your thoughts are on that sort of viewpoint and how you might respond to that. Oh, I think that that's totally true. It could be a very tricky way to invest because companies that are viewed as growth companies with very exciting future head them often get caught up in the hype cycle, where there becomes a phase when the company executes very well at stock price goes up. And then the stock price continues to go up and up and up as more of investors pile in and pile in. And eventually, the stock price can get so high that the expectations built into that company

Starting point is 00:25:06 are well beyond what the company can deliver. And there's an inevitable fall. We've seen exactly that thing, exactly that play out over the last three years in a fast-forward phase, given the huge boom that we saw in 2020 and 2021 and the ensuing bust that we saw throughout 2020, too. So if you're the type of an investor, if you're a value investor, there's absolutely nothing wrong with saying, I'm not participating in that at all. I want nothing to do with looking for the next growth stock that will be able to perform, survive that hype cycle and then

Starting point is 00:25:42 execute from there. However, if you look back to the 2000s, we saw an enormous bubble in lots of companies and the ensuing bust wiped out tons of businesses. However, that ones that survived that phase have become household names today. I mean, Amazon is obviously the poster child for such things, but PayPal was also born in the exact same period. So it can be very challenging to figure out which companies are going to be able to go through that hype cycle, emerge the other side and continue to execute. But if you can do that successfully, you can earn life-changing returns on some of those investments. I think a couple other points that relate to that is you definitely have to have a really long time horizon. You have to be able to hold it out

Starting point is 00:26:29 for to see that sort of long tail really play out. And then the other important point, I think, is power laws where a small, very few number of stocks drive the majority of the returns. And just holding one or two of those out of, you know, huge portfolio, it really just pulls the whole portfolio ahead. So I think power laws is another concept that's really important to understand if you're taking that sort of strategy. Absolutely. I mean, that power law strategy that you're talking about is the reason that index fund investing works so well. Yes, you're guaranteed to essentially get every single loser, but you're also guaranteed to hold every single mega winner. And if you look historically over time, it's only a minority of stocks that literally account for the

Starting point is 00:27:15 vast majority of the returns of the market over time. So yes, if you're going to be investing that style, you have to go in knowing that you're going to be wrong a whole lot and literally a handful of investments will make or break your portfolio. But that is how stock investing works. Now, some growth stocks are now trading below or around where they were in 2019, 2020, that time frame. Companies that come to mind are like Roku Square. There's a long list of names. And then the sales of many of these companies are much higher than they were during that time period. And then I think about some other growth companies that are, you know, have done quite well. They're trading at all-time highs or maybe near all-time highs. I think about Nvidia and Tesla.

Starting point is 00:28:05 What are some of the things you look for in a higher growth name to help filter out and distinguish value accretive growth versus maybe value destructive growth? Yeah, the thing that I key in on is you can be a hypergrowth company that is that has a corporate philosophy with we're going to break even or we're going to produce certain amount of free cash flow or certain amount of profits. And some companies reliably do that. You also have companies that are hypergrowth companies and their mentality, their philosophy is we're going to deploy all of our capital back into reinvest growth and we're going to lose money and depend on outside investors for years, years to come. I think that those companies in the latter group,

Starting point is 00:28:49 the ones that were dependent on raising capital from outside investors, they have been hit very hard. And rightfully so, because for those companies, a falling stock price is a massive, massive problem. When your valuation collapse, when you need to raise new capital, doing so can be horrifically dilutive to the company itself. But if you're in the self-funding phase and you've gone to go through that process, A falling stock price is a nuisance for a number of perspective, but it's not a massive problem from a capital raising perspective. So when I think about the companies that have survived that process the best and have bounced back, a common theme that I see is many of them were further along on the business growth cycle

Starting point is 00:29:33 and many of them were already producing net income and profits. So how can you tell the company is producing a growth that leads to shareholder value? The answer is, are they generating profits? Another piece I think I and many other investors struggle with is thinking about stock-based compensation. Do you have any tips for investors and working through stock-based compensation, whether it be a certain percentage of revenue that might be acceptable or isn't focusing more on the company's vision and their management and long-term thesis or maybe even just simply subtracting out the stock-based compensation out of the profits and then just kind of filtering it out and not thinking about it

Starting point is 00:30:17 too much. Yeah, you asked 10 different investors, their views on stock-based compensation. You're going to get 10 different answers. The same is true for companies themselves. Some companies have very generous, almost egregious levels of stock-based compensation, just built into the DNA of the company. Other companies, by their very nature, are very stingy with stock-based compensation, and they only dole it out of small amounts.

Starting point is 00:30:43 As a general statement, if a company is rapidly diluting investors, it better be putting up eye-popping revenue growth numbers for investors to be willing to stomach that number. If a company is growing its revenue 50% per year reliably for many years, investors are willing to put up with 5%, 8%, even double-digit dilution due to stock-based compensation if they believe the opportunity ahead is, is really huge. However, if that same company growth rate falls from 50% per year down to 20% per year and the company is still diluting investors at some very high level, that company

Starting point is 00:31:21 is going to get whacked and that company's management conference called this investors should focus in on what's with this egregious stock-based compensation. My personal rule of thumb, and it's just a rule of thumb, is if a company is growing extremely rapidly more than 25% per year. I'm okay with three to five percent dilution being due to stock-based compensation. More than that is when I kind of get a little perturbed by it. And if I see less than that, that's definitely a positive assign. For companies that are growing slower than that, I don't want anything more than one to two percent dilution annually. And I know that Buffett's rule of thumb is one percent dilution maximum per year. However, Buffett invests in companies that are typically in the capital return

Starting point is 00:32:07 a phase. So he's actually looking for companies that are reducing their share count due to stock buybacks. But if you look back at company like Salesforce.com, for example, Salesforce.com has been issuing tremendous amounts of stock-based compensation to its employees ever since it was founded. And that stock-based compensation remains high to this day. The dilution that investors had had to endure over its 20-year period on the public markets has been very, very high. And that has not stopped that company from delivering multi-bagger market-beating returns for its investors. The reason they've been able to get away with it is their growth rate has been so high for so long. That's why nuance with understanding and judging stock-based compensation is so important.

Starting point is 00:32:49 Totally agree. And another idea that has had a really profound impact on me being a host of the show here is the idea of base rates. When I think about the differences between a growth company and a company that might be a little bit more stable is the base rates between the two. Let's just take a company like Tesla, for example, like Tesla in 2012, totally different company than the Tesla of 2023. I think it's pretty difficult to justify a pretty large allocation to a company like that. you know, very real risk of it going bust. Musk has said that there were times where, you know, they're weeks away from, you know, not having cash to pay employees or anything else. And I think, you know, when you have that very real risk, I think it justifies a relatively small position

Starting point is 00:33:38 in a portfolio and almost thinking of it like more like a venture type bet. And then I think about on the flip side, I look at investors like Charlie Munger, Nick Sleep, and they find something that they're almost certain that's going to be able to continue to grow for 10, 20 plus years. And when they find that, they're going to bet big on it. And that's because they believe the base rate or the odds that they're right is really, really high. And to use an example, they both those investors bet early on Costco and they still hold that investment 20 years later.

Starting point is 00:34:09 I'm curious if you agree with this assessment of base rates and how it maybe applies to this valuation spectrum, if at all. Yeah, I think that that's a wonderful point that, that you, brought up. In fact, I think this gets largely into the debate that many investors have about should your portfolio be concentrated or should it be diversified? Personally, my view is that if you are a venture capitalist, if you're out there looking for companies like in 10, 50, 100 X, it really makes sense to diversify your portfolio and make dozens, a dozens of very small bets on a percentage basis. Because what you're looking for is that next Google, is that next Apple,

Starting point is 00:34:48 is that next Amazon. And if you can buy, if you can buy that that early, even a tiny percentage can literally return the entire value of your portfolio and then some. So if you're going to invest like a venture capitalist, diversify. On the flip side, if you're going to be a value investor and you're going after businesses that are big, dependable, like Costco, like Target, like Walmart, companies that are going to be around for long periods of time, I think it makes much more sense to be a concentrated investor and put lots of capital into high conviction, high probability stocks and really focus in on those stocks. So, yeah, I think the concept of base bait really matters for answering the should I be diversified or should I be concentrated question.

Starting point is 00:35:34 One thing I absolutely love about your YouTube channel is the level of transparency you guys have and all the amazing content you guys are sharing. And over the past 12 to 18 months, you, along with many other investors, have seen significant volatility in your portfolio. So I'm curious if you could share some of the biggest lessons that you pulled from that experience that, you know, it's just a much, much different time period than any other point in your investing career or many other investing careers. Yeah, 2022 was a humbling period for a lot of investors, myself included. I really started, I started investing in 2004 and essentially from 2000. 2008 all the way up until 2022, interest rates almost didn't matter because they were so incredibly

Starting point is 00:36:23 low for such a long period of time that that warped a lot of markets. And I think that that's one reason, not the only reason, but one reason why growth companies did so well over the last 15 years is that interest rates were so incredibly low. One thing that reversed in 2022 was obviously interest rates came back with the vengeance. The Fed raised interest rates at the fastest rate they'd ever done. And understandably, asset prices and asset values were severely impacted. And those that were hit the hardest were the asset values that have the longest duration. So long duration bonds and high growth companies that are losing money. Those are the longest duration stock assets that are out there. So rightfully so, we saw valuations absolutely get clobbered from extreme high levels

Starting point is 00:37:13 in 2021 to more normalized numbers that we saw in 2022. So one thing that I learned is just how impactful interest rates are on affecting the valuation of markets. It also taught me during that period that the value of having cash in an economic crisis. And really, for the first time in my investing career, I'm now actively considering putting money into the bond market. I never even consider that a couple of years ago because the yields that you would get on bonds would be so incredibly low compared to the risk that you were taking. So it wasn't even

Starting point is 00:37:49 an alternative asset class. You can say the same thing about holding cash in a bank. When banks are paying zero or 0.25% interest, you're going to lose money compared to inflation because the rates are so low. Now that rates are more normalized and that bonds are actually a viable, attractive alternative when compared to stocks. So 2020 through 2022 taught me a lot of painful lessons. 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 and brings compliance, risk, and customer trust together on one AI powered platform. So whether you're

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Starting point is 00:41:43 to hit new all-time highs almost every single year, then people would be very hesitant to raise cash. So in 2021, very few investors likely were raising cash. And then, you know, 2022, many people found that to be a big mistake. So in hindsight, I think that's another really big lesson too. Absolutely. Or how about this one? investing is hard. Investing is hard. Investing the right way is very, very challenging. Not only

Starting point is 00:42:11 you have to be good with securities, a selection if you go that route, but the markets put a tremendous amount of pressure on the psychology that you face. You can have euphoria when stocks are going up and utterly depression when stocks are going down. Analyzing stocks is hard, dealing with the emotions of investing is hard. So investing is hard, and that's okay to acknowledge, and it should be. One of the things that makes investing really hard is coming back from whenever you lose money. There's always going to be years where your investments don't do so hot. And Buffett once said that the number one rule of investing is not to lose money.

Starting point is 00:42:47 And his second role was don't forget in the real number one. So I'm curious how people like the Andres and Horowitz's of the world or the venture-like approach, how they work around this or work through this approach of protecting for the downside. while still exposing themselves to the upside. I'm curious what your thoughts are on how these type of venture-type investors can protect for the downside. I think this is a great reason that shows why understanding where you are on the valuation mindset spectrum is so important.

Starting point is 00:43:21 If you are a valuation-focused investor by your very nature, Buffett's rule number one, don't lose money is fantastic advice. It's the first do no harm, right? focus on minimizing your downside protection. That's great advice if you're a value investor. That's terrible advice if you are a venture investor. Because to a venture investor, the biggest mistake that you can make isn't striking out nine times in a row. The biggest mistake you can make is not putting money into the next Amazon, is not putting money into the next Google. So for them, losing money, bleeding capital out a small bit is perfectly acceptable.

Starting point is 00:44:03 That's a part of the process. That's not their concern. Protecting the downside is not their biggest concern. Their biggest concern is getting the next mega winner into their portfolio. If that is your mindset, then you should basically ignore Buffett's advice of rule number one, don't lose money because you are going to lose money. That's part of the game if you're going to invest like a venture capitalist. That reminds me. I almost wish I could rewind and look at some of these VC funds and see how they weathered through something like a great financial crisis.

Starting point is 00:44:33 Because another Buffett quote comes to mind here where as investors and you don't want your investments or you don't want businesses to have to rely on the kindness of strangers is the way Buffett put it in order for the business to be successful. And essentially it means that you want the business to be self-reliant. You don't want it to have to rely on other people to essentially survive. And you think about a business at its core, it can fund its operations three different ways. It can fund it using internal cash flow. It can issue new shares or they can take on debt. And when times get really tough, like during the great financial crisis, you know, options two and three might not really be an option.

Starting point is 00:45:12 So, you know, there's no choice. But for the cash flow positive companies to weather through quite well and then a lot other companies not weather through quite well. So that's again why the PE ratio isn't helpful for a lot of companies that aren't profitable. So how do you think about maybe an earlier stage company, how they're able to weather through and not have to rely on the kindness of strangers? I think that the core of the question there for early stage companies really depends heavily on the internal philosophy of the management team. Some management teams, by their very nature are more conservative when they're reinvesting in the business. They might be okay

Starting point is 00:45:54 with losing a little bit of money, but they want to ensure that those investments are paying off with a high return. And they want to minimize the amount of capital that they have to raise from outside investors. And also, they want to make sure that they always have ample cash on hand to survive, let's say, in the next three years. That is a philosophy decision of the management team. They control their internal reinvestment rate. They control how much they pour into R&D, into hiring, and all that kind of stuff, which directly impacts what kind of losses they are putting up when they're in those earlier stage. So some companies really swing for the fences. They say we're completely okay with being dependent on outside markets and outside

Starting point is 00:46:38 debt markets to raise capital whenever we need it. That's a philosophy decision. Other ones are far more conservative and they want to reach profitability far early. year after the company was founded than others. So one way a company can protect themselves is just by being more conservative when they're the raising capital to make sure they have plenty of cash and more conservative with hiring decisions and spending decisions to ensure they never have to rely on outside investors. You know, Bill Gates famously, when he was running Microsoft for decades, always made sure that they had enough cash in the bank to pay off all of their bills for an entire year, assuming they never made another dollar of revenue.

Starting point is 00:47:17 That's a philosophy decision to be so conservative financially at that level. And that really paid off. But again, it really depends on the philosophy of the management team of the company. Yeah, I totally agree. And I think you really need to look for management teams that are able to think long term and aren't so focused on the current growth rates and the current metrics are hitting just I think of Bezos's letters where he was just constantly preaching the long term, the long term, the long term.

Starting point is 00:47:42 So I'd like to transition here to some of the analysis you've been doing on your YouTube channel, you've been doing, you know, doing a ton of updates and analysis on a number of different companies. What I love that you've been doing is plugging each company into a reverse DCF. And essentially that shows you what sort of growth the market is expecting at the current market price, which I think is super helpful for investors and thinking about whether they should trim, add to their positions or whatever else. So let's start with Nvidia. It's a stock that's catching a ton of people's attention here. A lot of investors that have been holding that one, they probably feel that they've struck gold as it's up over 300% since it's October 2022 lows. So using your

Starting point is 00:48:29 reverse DCF model, how much growth is the market expecting from this high flyer? Yeah, the, what's the run that Nvidia has been on, has been nothing short of a remarkable. I mean, this is a company that's currently valued at over $1.1 billion. And we should, I'm going to really timestamp when I say this because this could change it at any moment. Yeah, do I say billion? Yeah, one trillion. Excuse me. One point a one trillion dollars.

Starting point is 00:48:55 So, Nvidia is an incredible, incredible business. Fantastic competitive advantage, fantastic margins, fantastic management team, tons of good things to say about it. Currently, the share price of Nvidia is about $468 per share. So using my reverse discounted cash flow model, I see that over the trailing 12 months, Invidia has generated about $8.1 billion in free cash flow. And if we assume a terminal growth rate for the company after 10 years of about 2% and a discount rate of 10%, so our required rate of return is 10%.

Starting point is 00:49:28 You could argue that's too high. You could argue that's too low. I'm going to say 10% return is what the investor could expect. I see that Nvidia would have to grow its free cash flow over the next 10 years at a 36% compound annual growth rate for today's. price to make sense. Now, that might not seem all that high of a number, if you think, an answer, at 36%, but to give you some perspective, that would mean that Nvidia's trailing tree bond free cash flow, which is $8.1 billion today, would have to reach $176 billion in a 10

Starting point is 00:50:05 year's time. So that's a 2023x, 23x growth in the company's free cash flow over the next 10 years, in order for today's price to be justified and earn a 10% return on there. Now, I'm not betting against Nvidia doing that. I would never, never do that, nor would I short a company based solely on its valuations, but color me skeptical of the company being able to achieve that. And I say that is someone that has a huge admirer and believes that it's an incredible company. Yeah, I mean, the stock market's a place where you want to place bets that make a lot of sense. And sometimes there are bets that just don't heavily stack the odds in your favor to put it lightly.

Starting point is 00:50:48 So I want to transition to one more company here that you've covered on your channel. It's one we've actually been discussing here within our TIP mastermind community where members of our audience have had the opportunity to connect. And the company is Mercado Libre, which I kind of think of as the Amazon of Latin America, a very interesting company that's doing a lot of really cool things, I think. And I believe you've held this company for years, and it's really been a big winner for you. So what's your updated assessment of Mercado Libre's progress? Yeah, Mercado Libre has been an incredible performer, both from a stock perspective and a business perspective.

Starting point is 00:51:27 And it is a fabulously well-run business. To your point, it's the eBay of Latin America and the Amazon of Latin America and the PayPal of Latin America and the PayPal of Latin America and the Craigs list of Latin America. It really is all of those businesses wound up into one. And it's been an incredible performer for me. To your point, I first purchased Mercado Libre in 2010 or 2011, so I've held it for more than a decade. And it's one of my biggest winners ever. And this company has just grown at an incredible growth rate. Over the last 10 years, it's compounded its revenue at a 44% growth rate, and that number clocked in at over $11 billion last year. Now, what's interesting about Mercado Libre is that it's gone back and forth on the business growth cycle as it's grown

Starting point is 00:52:18 as a company. If you know a little bit more about Mercado Libra, they essentially started as the eBay of Latin America and then over time they started the fintech business and become the PayPal Latin America. And they've been using the profits from those businesses to build out their own like Amazon delivery service so they can actually deliver packages to customers. That's an incredibly expensive thing to do. Building out that infrastructure is not cheap.

Starting point is 00:52:46 Because of that decision, the company's profitability over the last four or five years has been in and out of favor. When you throw in COVID to the mix, this company has not consistently generated consistent growth and profitability over the last couple, couple of years. So it has gone back and forth between the phases that it's been in. More recently, though, the company has achieved profitability on both an earnings-based, basis and a free cash flow basis. However, there's a big difference in this company between its earnings and its free cash flow. And there's a number of reasons for that. One big reason is the

Starting point is 00:53:21 company's provisions for credit loan losses. Because of their provisions have been a relatively high, that makes a stark difference between this company's reported earnings and it's reported free cash flow. So its free cash flow is actually much higher than its stated earnings. However, when I look at Mercado Libre today, I see a business with a very strong competitive. competitive position, still growing at a very strong rate, has multiple businesses that are growing on its wing, and I think can continue to grow at a rapid rate for many years to come. So it's valuation today, depending on how you judge it, looks fair to me or fair to being on the pricey side, but this is a company that I can easily see myself holding for the next

Starting point is 00:54:04 five, ten years plus. Given the drastic differences between net income, free cash flow, how do you think about which metrics do you think are most valuable for valuing Mercado Libre? Yeah, I'm a free cash flow guy. When forced to choose between earnings and free cash flow, I will take free cash flow every time. And Ricardo Libre's reported free cash flow is much higher than it's reported in that income. Now, I do respect the fact that this company is provisioning for credit losses. And it's hard for me to gauge, it's an outside investor, whether those provisions are appropriate or too high or too low, that adds a whole other level of

Starting point is 00:54:44 complexity. So one thing you can do is just kind of go in the middle of the company's reported earnings and it's free cash flow and use that as a profitability number for the business. But for me, when I'm looking at Mercado Libre, I'm not necessarily solely focused on the bottom line. I want to know what the growth rate are, the companies, the businesses, is the fintech business continuing to grow rapidly? Answer there is clearly yes.

Starting point is 00:55:07 They're attracting new customers. They're rolling out new features. They're shipping more packages than ever. More people in Latin America are still coming online. So as long as the valuation doesn't get incredibly egregious, I'm personally content to hold so long as the business continues to grow that has. As I mentioned previous times on our show, you've called out why we shouldn't be using the PE for a lot of companies.

Starting point is 00:55:32 And Amazon's the poster child for this. So I'm curious if you sort of take the free cash flow at face value. when valuing Mercado Libre or if there are any adjustments you think are necessary for a business like this? I wouldn't take the free cash flow at purely face value when you dig into the sources of that free cash flow and the difference between that and the earnings. I think that you need to make some adjustments. So if I'm looking properly, I see that Mercado Libre is training at about 17 times a price

Starting point is 00:56:00 to free cash flow basis. I don't think that that figure is accurate. I think that that is understated, given the dynamics that happened between net income and free cash flow, its price to earnings ratio, at least on a trillion basis, currently at about 98. So, PE ratio of 98, price to free cash flow of about 17. Obviously, there's a lot of differences between those two numbers from evaluation perspective. If you kind of take the midpoint, I would think it's priced appropriately given its

Starting point is 00:56:27 growth potential. But again, this is a company that has to continue to execute to justify today's price. And still relating to this company back to Amazon, I think about how so much of Amazon market value, in my opinion, is derived from AWS. And it seems like Mercado Libre sort of turned into a play like this where you purchase it with the intention of thinking that this company has so much optionality and you trust the management team and the way they're able to navigate entering new markets, new regions throughout Latin America and such.

Starting point is 00:56:59 So do you still foresee sort of a similar dynamic where it's almost a bet on the management team and their ability to really just almost like a call option on all these different business units. And one of them is almost certainly, in your opinion, able to become not obviously as big as AWS, but something like it. Absolutely. When I think back of the best investments that I've ever made, many of them, not all of them, but many of them, I bought for one business and while I've owned it, they've developed a completely different business that has moved the needle from a revenue perspective. Amazon has does that, has done that. Mercotta Libre has absolutely done that. Tesla is really starting to do that. So I think the optionality of a business, the ability of a company

Starting point is 00:57:49 to launch new products and new services that open up needle moving revenue opportunities is a very, very attractive business trait. When I think about Mercado Leadbry, I absolutely think that it has that in spades. Well, Brian, like I mentioned, we always, always appreciate you joining us on the show here. Before we close out the show, how can the audience get in touch with you and get a hold of any resources you'd like to share? So the easiest place to connect with me is on Twitter. I'm at Brian Ferraldi. I do want to call out a free resource that I have created.

Starting point is 00:58:21 I have a website that's valuation.com. It's dot school. If you type that into your browser, I created a free seven-day email-based valuation school that goes through many of the valuation multiples that we talked about here, discusses the valuation mindset spectrum, talks about the business development cycle as well as has visuals along there. So if your listeners are interested in learning more about valuation, check out valuation. Check out valuation.com. Awesome.

Starting point is 00:58:50 We'll be sure to get that linked in the show notes for those interested. Thanks a lot, Brian. Thank you for having me, Clay. Always a pleasure to be here. 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.

Starting point is 00:59:13 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. Thank you.

We Study Billionaires - The Investor’s Podcast Network - TIP567: The Evolution of Value Investing w/ Brian Feroldi

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