We Study Billionaires - The Investor’s Podcast Network - TIP577: Valuation Masterclass w/ Aswath Damodaran

Starting point is 00:00:00 You're listening to TIP. On today's show, I'm joined by Aswath Demodran, who's commonly referred to as the Dean of Valuation. Aswath is a professor teaching corporate finance and valuation at NYU and has taught countless students how to appropriately value companies of all shapes and sizes. He's written numerous books on valuation, including the Little Book Evaluation, the Dark Side Evaluation, and Narrative and Numbers. And he's also made all of his university courses available online for free. Azwath is one of the clearest thinkers when it comes to finance and investing.

Starting point is 00:00:34 In this episode, we cover whether recent technological advances should lead us to think about investing differently than in years past, how he thinks about setting an appropriate discount rate for valuation, his thoughts on whether investors should deem the U.S. Treasury rate as the risk-free rate, the future expected return of the S&P 500 implied by the market as of August 2023, Aswas updated views on the valuations of Nvidia and meta, the potential dangers of a buy-and-hold approach, how Azwath thinks about the macro environment, and much more. With that, here is my conversation with Aswath Demodrian. You are listening to The Investors Podcast, where we study the financial markets and read the books

Starting point is 00:01:18 that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host, Clay Fink, and today I'm absolutely thrilled to be joined by Aswat to Motoran. Aswath, thank you so much for sharing your time with us today. You're welcome. Thank you for having me. I wanted to start by chatting about the world we live in today with constant change and constant technological change. So the increasing rate of change of technology and the rate of innovation that's happening, I think it can make it more difficult to forecast the future with some degree of certainty. So I'd like to start by asking you, if you think we should you know, think about valuation differently in today's world or maybe shift or focus in the types

Starting point is 00:02:11 of companies we're looking at in the first place. I think each generation thinks it's special, that it is the generation that's being tested by change. Let's face it, the coming of the automobile to humanity probably created huge disruptions in the first part of the 20th century. The PCs in the 1980s created huge disruption. Each generation feels it's special. I don't think we're that special. I think it just because the nature of technology is each update claims to be revolutionary, we, I think, feel we're exposed to more change in any previous generation. I don't think that's true. I think change has always been a constant with humanity.

Starting point is 00:02:51 And it ebbs and flows. There are periods of more change and less change. So I don't think there's anything different about this age other than the fact that we know about every change that's happened. Maybe that's a difference. Is any change that happens anywhere in the world, become aware of through social media news almost instantaneously. I mean, Alexander Graham Bell or Thomas Edison invented something. It probably took a decade for that news to flow around the world. So I think it's less a function of being exposed to more change and more a function of being aware

Starting point is 00:03:23 of how much change is happening around us. One of the adjustments I think investors have had to make in recent years was understanding things like intangible assets. And I believe you've said recently that you own the top six or seven big tech companies excluding Netflix. So can you talk about the impact of intangible assets and how they play into how you think about these massive companies that now comprise of, you know, much of the indexes today? I'll be quite honest. I've never understood this fixation with tangible versus intangible. It's an accounting obsession. Valuation. The value of something is based on the expected cash flows on that thing. That thing could be a factory. It could be a patent. There's really no difference from a valuation perspective, whether the thing that's

Starting point is 00:04:08 generating cash flows for user trademark or whether it's a physical asset. So to me, intangible, tangible is something that comes from people who are so caught up in balance sheet based valuation. Balance sheet based valuation, you look at the balance sheet and you try to figure out what the value of a company is, which is, I think, an absurd way to think about valuation. For those people who are locked into balance sheets, this is a seismic change. Because the assets that deliver value, you don't see on the balance sheet. So to me, there's really no difference between tangible and intangible from a valuation perspective because I think in terms of earnings and cash flows.

Starting point is 00:04:43 I can think of plenty of intangible assets that are easier to value than tangible assets, simply because their cash flows are more predictable. So I don't think we need to create fresh rules. I just think we need a fresh pair of eyes that recognizes that what you see on the balance sheet is not a reflection of what drives a value for a company. As I've been preparing for this interview, I've learned all about your investment approach and investment philosophies. And I think about the philosophies you've talked about.

Starting point is 00:05:11 And then it kind of takes me by surprise when I hear that you own a lot of these big tech companies. And maybe we can tap into like an Apple or Microsoft where it seems that the valuations seem not like a bargain. I'm not sure exactly how to put it. But I think a lot of investors have kind of sat on the sidelines as many of these companies seem to be trading at what felt like higher valuations. And maybe many people think that, you know, indexing has kind of pushed these companies higher and higher as there's these passive flows. So I'd love to get your thoughts on maybe like an Apple or Microsoft, if you don't mind.

Starting point is 00:05:45 I didn't buy Microsoft today. I bought it in 2013. I mean, this is what people miss. You look at a company, you look at today's price and you say, I would never have been able to buy this company. Take Nvidia. You know, Nvidia's had at least three near-death experiences in the last 15 years. I mean, I bought it in 2018. The stock was down to $27 per share. And it reinforces a point to always make. When people say never, I'll never buy a tech company because it's overpriced. I think what they're missing is that at the right price, you should be willing to buy any company. So I think many of these companies, if you wait, there is a point at which you will find them to be undervalued and you can buy them. Doesn't mean you're going to go buy them now. But I think when people rule out investments in companies saying those companies are too expensive. I'll never be able to buy them and they stop looking at these companies. They're making a serious mistake. So if you feel left out of the invidia rise, I would say add it to your watch list, track it over time.

Starting point is 00:06:42 And I wager there will be a time a year from now, three years from now, five years from now where this company will be back on your radar again. At the right price, you should be willing to buy any company. At the wrong price, all bets are off. What's also fascinated me is how you're willing to look at all these days. different types of companies, you'll look at money losing companies, you'll look at beaten down stocks, and then you'll revisit continually revisit companies like Tesla, which are some of the most popular companies in the world that people are following. So given, you know, the vast array of options

Starting point is 00:07:14 that we have in the global stock market, how do you think about deciding which companies you want to dive into and analyze and continually revisit? I mean, I'll be quite honest. I look at companies that interest me. They interest me because there's been an event in the company where they're The CEO changes stock prices down 60% or a product takes off and the stock price is up 80%. I mean, I'd never looked at Moderna prior to 2020. What drew me to Madonna was what happened to stock price in 2020. So sometimes it's a market that triggers my interest because either the market goes up substantially or goes down substantially and I stop and ask, well, did that make sense?

Starting point is 00:07:51 Given what happened to that company was that market reaction merited. I can't start with A and go through Z. There are too many publicly traded stocks in the world for me to track. And it's not my job and not a portfolio manager. And thank God for that. I look at companies that interest me. And they interest me either because of an interesting business model or because of what's happening in the market to those companies.

Starting point is 00:08:12 Is it your love for teaching that sort of keeps you out of wanting to manage your fund? Or what is it about managing a fund that makes you not want to? I got lucky. I found a job or I noticed it's what I wanted to do. It's my passion and my job conversion. why we're looking for trouble. You're well aware that every valuation, it comes with some sort of bias, and you've talked a lot about this when in your teachings.

Starting point is 00:08:39 What have you found to be effective in minimizing the amount of bias when we're performing evaluation? Well, I think being honest with others, one of the reasons I write my blog is it forces me to be open about what I'm doing. Because all too often people muddy the waters after the fact. They say, I'd never said that. I can't do that. My words are there on paper.

Starting point is 00:09:00 So sometimes putting down your thoughts with your thinking behind why you're doing. I mean, I tell people, look, I'd rather be obviously wrong or, you know, transparently wrong than opaquely right. And people say, what do you mean? I think a lot of what you hear from experts is they're trying to be opaquely, right? They use words that no matter what happens, they have something to hide behind. That gives them deniability. I never said you should buy Nvidia.

Starting point is 00:09:24 I just mentioned it might be a good buy. or it might be a good sell. So in that way, you're covered either way. That's the kind of thing that gets you into trouble because it means you're not being open about your biases. So I'd rather be transparently wrong where people can say, you got the Tesla valuation wrong because you got the revenue growth and the story wrong. Then to say, look, you know, I told you Tesla might be a good investment or a bad investment,

Starting point is 00:09:46 but I didn't tell you why. That way you can't pick on me, but it also means I can't, you know, I can be dishonest with myself. I can lie to myself. You wrote one of your books. It was called the dark side of valuation. And it explained how to value younger companies as well as distressed and complex businesses. And you've taken on the challenge of valuing these businesses very early on in their growth cycle,

Starting point is 00:10:09 businesses like Twitter, Tesla, Amazon. Looking back, I'm curious what sticks out to you when you, in 2023, you're looking back at your valuation in 1997 or Tesla in 2012. What sort of stands out to you as lessons in that experience of looking back? Well, I think it's, you know, when I did my second edition of Dark Side, I expanded to cover companies like banks in 2009 or in 2023. You know what they share in common? Uncertainty is at its highest point. We started this interview. What do you do about it? It's faced as human beings. When faced with uncertainty, we either react with denial or we're paralyzed. So all too often, it's exactly at that moment. We'd say, you can't really value companies. There's too much

Starting point is 00:10:51 uncertainty that your opportunities for valuation are the greatest because that's when mistakes are greatest. I mean, I valued companies in March of 2020 at the peak of the COVID bust because people had given up this and we can't value companies now. The global economy is shut down. How do we do it? You know, I think we need to kind of, you know, those are the times when I think you really need to jump in and make your best estimates. You're going to be wrong. But the payoff to doing valuation is greatest when people feel most uncertain. I mean, I tell my students, go where it's darkest. No, go value companies in markets where there's a crisis in sectors where people are uncertain about what's happening.

Starting point is 00:11:28 Because you face uncertainty, but the fact that you're facing up to uncertainty already gives you an advantage of most of the other people who are hiding from it or acting like it doesn't exist. I believe it was in Vitiya. You first entered your position after that stock was getting hammered. It's had multiple drawdowns of 50% plus throughout its lifetime. And I think that's why I said, don't say, ever on any company, no matter how you feel in your gut about that company. I mean, that's,

Starting point is 00:11:57 you know, I think we all have our blind spots in investing. And I have mine and Warren Buffett as his. And Warren Buffett has been open about the fact that he didn't invest in technology stocks enough. In fact, he didn't invest in them at all until you get to the last decade. And I think the point he made is I didn't invest in them because I didn't understand them. Let's face it, as we get over to this, less and less the word we understand. The fact that I don't understand, the fact that the fascination with TikTok doesn't mean that I shouldn't be trying to value TikTok as a company if it goes public. So I think we've got to get past this discomfort of saying, I don't know how that works and still be willing to try to value companies in the midst of that uncertainty.

Starting point is 00:12:37 Because if you don't do that, more and more of the world is going to become out of your universe. You can't invest in those companies because you don't understand them. We recently had Chris Mayer on our show here, who's the author of a widely known book called 100 Baggers. And we've been talking a lot about on the show about the buy and hold approach and looking at companies that have these tremendous opportunities for reinvestment. So can you talk about how you think about valuing a business that ends up reinvesting most of its cash flows? Like a lot of younger growth companies, they end up being cash flow negative or even many companies that are. That's a feature. And I'd love for you to just talk about maybe even a company that's sort of in the middle of its growth cycle.

Starting point is 00:13:19 It's profitable. but it's still reinvesting a lot of those cash flows. So the investor is not going to be seeing a lot of that through dividends or buybacks. So I'd love for you to talk through how you think about valuing a company like this. It's very simple corporate finance. Growth by itself is neither good nor bad. For growth to create value, you've got to earn more than it costs you to raise your money. So when you have a company that's growing, it becomes imperative that you not just look at the growth rate.

Starting point is 00:13:45 It's always going to be impressive, but what they're reinvesting to get that growth. I mean, what are they giving up to get that growth? And if it's a company that's making good investments, net you're going to come out positive. If it's making bad investments, net you're going to come out negative. But learning how to assess how much is being reinvested to get growth is a key part of making sensible investment decisions. One of my problems with equity research is it tends to get fascinated with growth and you're investing in just growth. And people are not asking the right questions about these companies delivering growth efficiently. Are they investing huge amounts to deliver?

Starting point is 00:14:19 to that grow. Because if your objective is to just grow, it's easy to do. Just acquire other companies, pay huge prices, you'll grow, but you're destroying value as you grow. So that's why I think to do valuation well, you've got to learn to understand how to run a business. I think too many analysts jump to valuation and say, I don't need to understand how to run a business. I'm just valuing businesses. You can't value a business if you don't understand fundamentally how to run a business. I wanted to talk about discount rates. Two of the important elements to understand of a discount rate is the risk-free rate and the equity risk premium, which you've both written extensively about. Before we get to the elements which underlie a discount rate, I wanted to touch on if there's an issue of if investors say, they just want to say they want to earn a 10% return.

Starting point is 00:15:05 And maybe they'll use that as their discount rate. Is that an acceptable method to using a discount rate? or should we be going into more nuance? I know people like to just pick a number out of thin air, but let's face it, this is a number out of thin air, and the older you are, the higher the number is going to be. You know why? Because we have in behavioral finance,

Starting point is 00:15:23 is this notion of framing, which is in your brain, you start to get a number set, and it usually gets set between the ages of 25 to 35. So if you're 65 years old, you're going to say, I don't need to make a 15% return to be happy. You know, that's what you made in the 1990s.

Starting point is 00:15:39 So I think one thing to remember is when you make up these numbers, you're just reflecting how old you are as an investor. And the second is when you pick an arbitrary number like 10%, and you're sensible about investing, I'll tell you what's going to happen. You're going to have spent the last decade in cash. Why? Because the risk rate goes to 2%. Earning 10% becomes a real reach. You've got to bend the numbers to get to 10%. So when people create arbitrary discount rates, it's creating asset allocation effects that they've got to be willing.

Starting point is 00:16:09 to live with. So I don't have a problem with people making up numbers as long as they're willing to live with the consequences. They will underinvest in periods of low interest rates. Let's take an absurd example. Let's suppose the T bond rate goes to 12%. You're still accepting 10% for investing in stocks. You're going to find a lot of great investments, at least based on your hurdle rate. It makes no sense to me to pick a number and stick with it through. So when you think about equity risk premiums, at least think about what on top of the T bond rate would I need to make. That's what an equity risk premium is. At least that way you have a number that shifts over time as interest rate shift.

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Starting point is 00:21:06 dollar and the U.S. government's ability to cover their debts, which are denominated in U.S. dollars, which is somewhat puzzling to me, given that they have the ability to create more currency to pay off their debts if necessary. So is the U.S. Treasury rate still appropriate to use as the risk-free rate for U.S. investors? I think 30 years ago, the answer would have been a slam dunk, of course. It's a risk-free rate in U.S. dollars. now there are more questions. And the reason in the U.S. is not economic. It's political. Default, when you have a sovereign defaulting, is as much a political action as it is, an economic

Starting point is 00:21:40 action. And to the extent that you have political dysfunction, which I think we'd all agree on both sides of the divide you have in the U.S., there is the possibility of a default happening, not because you can't print the money, you don't have the money, but because you've got to fight between two sides that can't come to an agreement in time. It's not the kind of default. It's not the kind of default where you're going to be defaulting for decades, but you can default for weeks, and that is still default. So I think that there is this question of how much of that T-Bond rate reflects that political default risk. And I think there is an argument that it's, to me, it's not a huge number. So if you're using the T-Bond rate as your risk rate,

Starting point is 00:22:17 on the list of census is way down the list. But you could argue that some of what you're seeing on the T-Bond rate is a reflection of that political dysfunction. You've also talked about if there's no risk-free safe haven, what does that mean for future economic crises? It's terrifying, right? It's not even an abstraction. Think about how you felt if you're old enough in November of 2008 or in March of 2020, when most people should have. No, hold on to that moment when he said, what do I do now? Where do I put my money? Because there's no place to go that looks safe. When there's no place to go that looks safe, it changes the way you make decisions. It's It's as much as psychological haven as it is in the economic haven, knowing that this is safe

Starting point is 00:23:01 place to go. Now, I think since 2008, the reason people are much more terrified of crisis is pre-2008, the perception was, if you're in Argentina or in Brazil or in India, an emerging market, and there is a crisis, you go to a developed market because developed markets have problems, but it's never a crisis. Europe, the U.S. 2008, we discovered that developed market's not immune from crisis either. So the notion of a safe haven has shifted and perhaps people, I think, collectively have less faith that there is a place, a safe place for them to put their money. Even banks are no longer viewed as safe havens, right?

Starting point is 00:23:38 Is it just put your money in the bank? Up to $250,000 maybe, because even that's backed by a government backing. And who knows whether the government will carry through? If you don't have a safe haven, it changes the way you behave, not just during a crisis, but during regular time periods. Now, that's why I think, you know, one explanation for the growth in cryptos and NFTs is the less you believe that there's a safe haven, the more you're going to look for alternative places to go. So I think that's a good way of thinking about why we've seen this explosion in these alternative assets in the last 15 years is people are losing trust in traditional safe havens. Now, the equity risk premium is the excess return above the risk-free rate that investors charge for investing in stocks. You've actually been estimating the equity risk premium yourself every single month since September

Starting point is 00:24:28 of 2008, and as of August 2023, you estimated that the implied equity risk premium was 4.4%, and then the implied expected return on the S&P 500 was 8.4%. So I'm curious with the recent rise in interest rates over the past couple of years, this would seemingly lead to a higher discount rate if the equity risk premium were to remain level. Could you talk about how higher interest rates have impacted the valuation of businesses that you're analyzing? I mean, interest rates are kind of a given, right? There's a very alternative to investing in stocks. So one way to think about why they matter is if you can make nothing on T bonds,

Starting point is 00:25:05 you're going to settle for a much lower return on stocks because it beats nothing. And for a long time, you were making nothing on T bills, very low returns on T bonds. And you said, look, I'll settle for 7% on stocks because I can make only 2% in T bonds. This is in no deep economics. I mean, the debond rate rises to 4%. And Teebles are delivering 5%. You need to earn more on stocks just to break even, given the risk you take. Think of the risk-free rate as the level of a lake. As it rises, everything rises with it. Now, of course, one of the things that higher interest rates might bring with them, especially if they're driven by inflation, is more uncertainty. And when you have more uncertainty, it can feed them. So what you can have is a double whammy, a higher-risk free rate and a higher-risk premium, which is what we had.

Starting point is 00:25:47 in 2022. Not only did the risk-free rate go up, but the price of risk also went up because people were more scared. I think the price of risk has gone back down this year, but the T-Bond rate has stayed up. So what you're getting now is a much higher expected return on stocks than you did at the start of 2022. But it doesn't make stocks a bargain that you're getting a higher return because it is to be judged relative to what you could have made by taking no risk at all. So I think with the overall market higher in 2023, I guess I would imply that the equity risk premium is now lower and investors maybe feel more certain because the economy has been somewhat resilient? The equity risk premium is an output, not an input. The input is actually the price. That's the only thing you control as an investor. Nobody goes to the market and say, I'd like to earn an 8.4% return. The way you get the 8.4% return is by moving the stock price up or down. So when you talked about my estimate, it's really not my estimate.

Starting point is 00:26:43 I'm backing out from the market where you collectively as equity investors are demanding based on prices. So rather than think of equity risk premiums explaining prices, they're going to, they're effectively the same way of saying bond prices go up, interest rates and the bond go down. One doesn't cause the other. One is a consequence of the other. So the fact that investors have pushed up stock prices this year must mean that they feel a little less worried about uncertainty than they were at the start of the year.

Starting point is 00:27:12 Is that merited? We can debate that. Maybe markets are in denial about the recession and inflation staying. And that's why you get these ebbs and flows in markets. The last couple of weeks, you've seen markets pull back because fear has come back again. This tussle between hope and fear or greed and fear constantly runs markets. It's not just in 2023. It's been around as long as markets have been around.

Starting point is 00:27:35 And in 2023, you've seen some ups and downs. More ups than downs. But who knows what the rest of the year will deliver? You've also mentioned in the past that you've invested in Alibaba. I'm curious if you think about discount rates and countries like China much differently than when you're analyzing a U.S. company. It's not a discount rate effect. You worry about in China. It's what I call a discontinuous risk, which is that the government may put a, you know,

Starting point is 00:28:03 they have a business model. That business model in most cases, you think about, hey, will the business model work? In China, you've got a player in the game that you don't have in most of the markets. Beijing is part of your story. And to the extent that they can get in the way of your story, and you saw both Alibaba and Tencent, you can have a company that looks unstoppable, that suddenly looks very stoppable. So to me, the big worry about Chinese stocks has always been that intruder in your business story, who is completely unpredictable, who essentially does.

Starting point is 00:28:34 things is, no, for a very different purpose than you would want that company to have. And that I think is always a concern with Alibaba and Tencent. It's kept the stock prices down, even though they have incredible platforms and profitable products. And I'm not sure how that will play out. So it's not necessarily a discount rate effect. It's that other factor that you think can stymie your cash flows and business model going forward. So there's this added risk and uncertainty with Alibaba. So how does that uncertainty sort of get factored into the valuation? Isn't it through the discount rate? It's through the expected cash flows. Discount rates are not receptacles for all your hopes and fears. I know people feel this instinct. I'm scared, so I'm going to increase the discount rate.

Starting point is 00:29:18 What are you scared about? You're scared about a nationalization? That's not going to show up in a discount rate. That has to show up in your expected cash flows. With Chinese companies, you brought to bring into your expectations the real probability that much as there is promise in the business model, There's also this likelihood that the government can put you on a very different pathway if it chooses to, giving a different value. I mean, I'll give an example. You invest in a regulated company. There is regulation risk. If the regulations change, your company could be worth a lot less.

Starting point is 00:29:47 You can't bring that into the discount rate. You actually have to value the company twice, once with the existing regulations and once with regulations changing. And then think about your expected value across those two scenarios. We don't use probability in statistics enough in investing in valuation. and I think we need to do it more. That's statistics class you very quickly abandoned because we're so boring. Might be the most useful class you ever took if you can put its tools into play when you invest. You mentioned Nvidia earlier, and I think this is a pretty good case study.

Starting point is 00:30:20 As many investors, they run into the issue of their stock runs up. Do they hold? Do they sell? Do they sell some of it? And to my surprise, you revisited Nvidia here in 2023. You purchased it in 2018. and you purchased it with no consideration of, you know, the potential impact of AI, but the stock this year has taken off like a rocket.

Starting point is 00:30:41 And you talked about how you believed that you revisited the valuation. You thought it was likely overvalued, but you decided to sell half of your position. So could you talk about your thought process of, you know, you thought it was overvalued, you ended up selling half, but you held on to the other half. In fact, a lot of people have asked me why I did not sell all of it. is an intrinsic valuation, if something is overvalued, shouldn't you sell all of it? There are two reasons. One is psychological. One of the biggest issues investors run into is the issue of regret, where you do something and then a year or two later, or even six months or a week

Starting point is 00:31:15 late, you say, what did I do? That was a terrible thing to do. The problem with regret is not what has already happened, but how it colors future decisions. I was trying to minimize that regret effect within vet. Here's what I mean by that. If I'd sold all of my position and the stock had gone up to 600, which with momentum can very quickly happen. I know that much as I shouldn't be looking back, I will be looking back and saying, should I have sold it at 410, 420, whatever I sold it at? You know, so I decided to have my cake and eat it too. By selling half my position, I took my initial investment and made a 400% return on it. That's including the rest of the position. So I'm feeling pretty good about the profits I've made by leaving the other half. I don't

Starting point is 00:31:57 of this issue of regret. So, I mean, the way I see it, I win either way. The stock goes to 200. I can congratulate myself in a decision well made for selling the half. It goes to 600. I know it sounds like I'm copping up. But I think in a sense, you've got to recognize your psychological impulses and how they will play out and minimize that psychological backlash from doing something you would regret. This is the second reason, which is in video, in spite of the fact that I got an expected value. I'm a great believer in distributions for value. This is property and statistics. And I did a Monte Carlo simulation where I looked at all the possible scenarios for Invitya. And even though I found it overvalued at 410, this is one of those

Starting point is 00:32:37 companies, which is an opportunistic company, which is if it finds a market, it seems to find a way to get into that market early. If it can find another market and after the last decade, who can rule that out? There's a possibility that Nvidia can get there. It's already reflected my expected value, but the way to think about this is that there's a tail on the value. This is how. This is how you get those 10 baggers, right? So when you talk about 10 baggers, 10 baggers that don't happen accidentally. It's from buying stocks, the tail on the value is so long that if something happens, it's a low property event, you end up with that huge a value. That possibility exists. I would never have done this with a Coca-Cola. I'll be quite honest. There's no upside. The tail on a Coca-Cola

Starting point is 00:33:17 value is not big enough for you to hold on to the stock if it becomes overvalue. So with young growth companies, especially with what it's called optionality. That's basically what it is. You sometimes can hold the stock even though it looks overvalue because the tail on the distribution is keeping you interested. You've talked in the past about your investment philosophy and, you know, thinking about just say, we'll call it a value investor's approach of buying a company when it's trading below its intrinsic value and then selling it when it's above its intrinsic value. So do you think this is an example of going against your investment philosophy or has your of philosophy changed and evolved.

Starting point is 00:33:55 Yeah, it's partly inconsistent, right? I mean, you know, if I had to, if you, I mean, here's the inconsistency. If you asked me, would I go buy Invidiya today at $450 per share? My answer is no, I wouldn't do it because much as I like the company, that price is too high. The inconsistency is I have an investment in Invidi that I got at 30, that's now 450, and I'm willing to hold on to it. You're saying, why are you having two sets of routes?

Starting point is 00:34:20 In investing, we actually always have to do. sets of rules, one for new decisions and one for decisions we've already made. We talked about being honest. Might as well be honest about the fact that we're not being consistent. And I'd ask the same thing about, you know, if I'd been at the Berkshire Hathaway meeting of Charlie Munger, if I'd ask Charlie Munger at the meeting, would you buy, let's say he didn't have Apple in his portfolio. So would you buy Apple at today's stock price at 26 times earnings or whatever it's trading at? My guess is he'd have said no. But somebody did ask him, whether he was planning to sell Apple that price? And he said no as well. So, you know, we're all inconsistent sometimes

Starting point is 00:34:58 and our decisions on how we view new investments as opposed to investments you've already made. And I think that if we're open about the fact that we're being inconsistent, at least we can start dealing with that inconsistency. You live in California, which is known to have relatively high taxes. So how does the tax bill play into the thought process of selling a company that's risen by 400%. It raises the trigger at which you sell, right? Because the minute you sell, you've got the California tax, you've got the 20% capital gains tax. So basically, it's almost like a 30% of whatever you get is going to go into taxes, which effectively means you've got to wait for something to be overvalued, but at least 30% before you break even from selling it.

Starting point is 00:35:41 I don't like taxes driving my investment decisions, but it's one of those things you can't be in denial about it. You've got to consider the tax consequences of, you're not. You've got to consider the tax consequences of your actions. In this case, it makes me slower to sell when something gets overvalued and it's already in my portfolio because I've got a factor in the tax bill. Shifting to another company, you've shared your analysis on META, November 22, you published your valuation in a doomsday analysis, I should call it, of META. And it happened to be around where the stock bottomed at roughly $90 per share.

Starting point is 00:36:14 And the market being the manic depressant that it is, it's taken META to over $270. to share at the time of this recording. I'm curious if you've revisited this valuation, given the massive rise in less than one year. I mean, I think that I did not matter what Warren Buffett is rumored to have done with American Express in the early 60s after a salad oil scandal, where he essentially took, I think, 15 years of cash flows just on the American Express card. At that time, it's just the original American Express card. He looked at the value get from 15 years of cash flows, and he said, that's higher than what I'm paying for the company. This is a slam-dum. So in a sense, with META, what I did was I just took their advertising business.

Starting point is 00:36:54 I assumed that the revenues from the advertising business would continue with no growth for 20 years. And I said, if that's all you have, what's the value of META? And I came up with the value roughly equal to the stock price. I know people are saying, but what if the meta... This is assuming that nothing else pays off and assuming that all of the $100 billion they had spent on the MEDAverse would bring no return. I said, even if they can get some returns here, even if it's a bad investment, that's pure pricing on the cake because I haven't counted it. So that's why it was a doomsday analysis.

Starting point is 00:37:23 I assumed that everything that they touched would turn to dirt or dust and valued what was left at their advertising business. And I said, I don't see a downside here. I'll just collect my cash flows even if people don't agree with me and I can get my money back. And it's at the heart of intrinsic valuation. You're not dependent on other people coming to your point of view. You just collect your cash flows and say, I'm okay with those cash flows. So it was essentially to me, a slam dunk bargain in November of 2022. If you ask me, would I buy meta today at today's price, it becomes a much closer call. It's not as overvalued, at least from my perspective as Nvidia is, but it's probably more likely a little bit overvalued than undervalue. Because I think people have

Starting point is 00:38:06 come to a more realistic sense of what, and meta itself has come to a more realistic sense of what they can do in the metaverse. So I think that it's not a company, I would suggest that somebody put their money in, but if you already have it in your portfolio, And especially if you bought it at the right time, just let it right. 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.

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Starting point is 00:41:37 found in the income fund fund's prospectus at fundrise.com slash income. This is a paid advertising. All right, back to the show. In the past, you've talked about how more activity in your portfolio is directly related to how much you're going to trail the market. And I think what you're getting at here is people generally tinker around with their portfolio too much and not let the magic of compounding work for them is chase one shiny object after another. Can you talk a bit about how much buying and selling is an acceptable amount for someone

Starting point is 00:42:11 like you as an investor? As an investor, I think it should be minimalist. I mean, I think that the more you're trading, the more you're not investing. I mean, I divide the world into investors and traders. And I think a lot of the problem here is people trade, but they like to call themselves investors. You're saying, what's the difference? In investing, you value something.

Starting point is 00:42:30 You buy at less than the value. Then you hope and pray the market comes around to your point of view. In trading, you buy at a low price, you sell at a high price. It's as simple as that. So you use charts, use technical analysis. you follow somebody on CNBC or trading. There's nothing wrong with trading. I'm not one of those of views investing as noble and trading as speculative.

Starting point is 00:42:49 There's different ways of approaching the market. If you are putting in 50, 60, 70 trades a year, you're not investing your trading. And if you're trading, might as well be honest about what's going to drive your success. What's going to drive your success is not really thinking about earnings and cash flows and fundamentals. It's going to be getting in at the right time, getting out of the right time, detecting shifts in mood and momentum. So I think if you're trading, might as well trade.

Starting point is 00:43:15 Trade well. Use the indicators that help you trade well. Don't do a discounted cash flow evaluation and intrinsic valuation because it's a wrong tool for trading. But I think that needs some honesty upfront about what you came into the market to do. And even with this view of generally less activity is better, you're still, you know, you've talked about the potential pitfalls of just a buy and hold approach to investing. This is due to issues like hindsight bias and selection bias and only looking at the investors that happen to do well with the buy and hold approach.

Starting point is 00:43:47 And you've looked at companies like Amazon over the past 20 years, owned it at various points in time and Tesla over the past 10 years. And they both did exceptionally well. And since you've been investing for so long, I'd love for you to speak on your experience of these companies that maybe, you know, using the selection bias, companies that were thought of as exceptional companies, but they end up falling by the wayside. and it would have been, you know, poor buying hold type decision. I mean, you could have bought Cisco in 97. You'd have made a lot of money by 2000. But if you bought and held, you'd be down 60% from your high. And you're never going to make that 60% back.

Starting point is 00:44:23 So when people talk about buy and hold and you look at stocks like Amazon, your reaction is why do you bother buying and selling? You could have just bought a 97 hell through today. Look at how much money you could have made. That's a selection buyer stocking. The question to ask is, what did you have in your portfolio in 97? to Amazon, what would have happened to all of those stocks we just bought in hold? I think buy and hold is a strategy which was designed to minimize the kind of mistakes

Starting point is 00:44:48 people make because they trade emotionally. I understand why that rule is put into place. But it can get you to serious trouble in terms of letting something right in your portfolio just because you're too lazy to look at it again. Ultimately, every investment at some point in time has to reassert why it belongs in your portfolio in the first place. So you have no choice but to at least think about revaluing your companies, especially after run-ups. That's why I looked at InVidio. I could have just chosen to ignore it and say, you know what it's doing well. And that's what we tend to do. We tend to not even look at our winners because we're afraid of what we might find. But we're too quick to sell our losers though.

Starting point is 00:45:26 So I think about Amazon as an example. I believe you've said you've owned it four times throughout your investing career. Was the point where you were selling Amazon, is it similar to an an NVIDIA where there was just like almost no plausible scenario where buying the stock at that price made any sense? Yeah. And it's led me to leave money on the table. I've been open about the fact that when you do this, you are, I mean, I sold Tesla in January 2019, 2020.

Starting point is 00:45:56 So which was, you know, I bought it in June of 2019 when it was at a low. I think it was 180. And I sold it was 610. So I'm not greedy. I made a lot of money. But it went to what, if you look at, we're quadrupled over the course of the year. And I remember people asking, no, are you sorry now that you sold your Tesla? And I said, look, I've got to be consistent with the philosophy that brought me here.

Starting point is 00:46:19 And I think the philosophy is when something gets significantly overvalued, especially if it's giving you axed in your portfolio. And it's going to drive bad decisions. It's better let it go. So I think with Amazon, there have been times I've sold because I found it overvalued. But the market has disagreed. it's taken almost year, two years before the adjustment happened. So I never say I told you so because it's got nothing to do with you.

Starting point is 00:46:41 Markets have their own minds. They decide when to correct something. And it doesn't happen because you did an intrinsic valuation. The market doesn't care about you. You could be Warren Buffett. The market still doesn't care about you. It's the ultimate mechanism for ignoring what individual investors think. And I think as, you know, I tell people, look, I disagree with markets, but I always respect.

Starting point is 00:47:02 I know, so I might say, look, I think the markets make. a mistake, but to view the market as something you can bend to your will is a recipe for disaster. Turning back to sort of what we were talking about in the beginning of kind of evolving as an investor and evolving to the changing times. One accounting metric that companies have, especially tech companies have started to use more and more is adjusted EBITDA. In some cases it might be helpful where companies truly trying to show sort of how their

Starting point is 00:47:30 business is trending over time, but other times it can be used to deceive investors and of what's actually happening. I'd love if you could share your thoughts on how investors can uncover the truth and really truly understand the adjusted EBITDA and if it's being used in a proper way of, you know, assessing business performance. I mean, if you're using it to track trend lines over time, I don't have a problem with you tracking adjusted EBITDA over time. But let's face it, the reason companies like to compute an adjusted EBITDA is it always makes the number look better than the number you had is your actual EBITDA. I mean, to me, an honest adjustment process should cut both ways, right?

Starting point is 00:48:08 Sometimes it should lower your EBITDA. The fact that it always seems to make your EBITDA more positive indicates to me that there is a bias in this process. You're looking for adjustments that make you look better. And if people fall for it, you know what? I think it's a cost to being lazy. And I don't blame companies for doing this. I blame analysts who go along with this because, you know, I've never understood the adding

Starting point is 00:48:30 back of stock-based compensation. I just don't get the logic behind it. And the fact that both analysts and companies do it suggests to me that they've been co-opted into a process where they think this is somehow justifiable. It's not. So some adjustments to habit actually do make sense. For instance, if you're a user-based company and you have a lot of customer acquisition costs, I think accountants are messing up by treating that as an operating expense.

Starting point is 00:48:56 This is your capital expense. This is your equivalent of land in factory. I would like that expense to be separated. So I think that there are some adjustments that make sense, but I would prefer to be the one to decide what adjustments to make rather than have companies make them for me. So even if a company that reports is adjusted habitat, do your own homework, decide what adjustments make sense and what don't, and then decide how you're going to use that adjusted number in your investment decision making.

Starting point is 00:49:23 I wanted to transition here and talk a little bit about your macro views and how you think about the macro in light of analyzing companies. these in the micro. Now, you've been immersed in the investment world for over 40 years now, and I'm curious if anything from a macro point of view causes you any warrior concern. You think about the U.S. debt levels, currency debasement since 2020, affordability of housing, all these issues that the U.S. alone is starting to run into. Are these something you even think about, or do you see them as issues that essentially will be worked through and worked out? It's not that they will be worked through or I think about them, but thinking about things that

Starting point is 00:50:04 you can have no control over is a recipe for, you know, all kinds of problems because you're distracted, you're not focusing the company in front of you. I'm not saying these things don't matter. Of course, inflation is a clear and present danger. And I've wrote about it at the start of 2022, saying we need to take the serious. And this is where being older sometimes can give you a benefit because I remember coming into the market in 1981 and recognize, how much inflation drove the market. Inflation, once it's out of the bottle, it's like a genie in the bottle. Once you let it out of the bottle, it's very difficult to put back in.

Starting point is 00:50:38 So to me, the biggest, I think, danger in the way we think about the macro now is we believe in mean reversion. That drives a lot of decisions. What does it mean? We assume that things will revert back to the way they used to be. And in the 20th century, it worked really well in the United States. Why? Because we had the most mean reverting, predictable economy of all times.

Starting point is 00:50:58 Things operated almost like clockwork. I think 2008 for me was a wake up call saying, we're in a new century. You need to wake up. It took me eight years into this century to wake up to the fact that the world had shifted under us. The U.S. is the largest economy, but it's not the global economy. You've got China, you've got the rest of the world to worry about. So what it effectively means, assuming things will revert back to the way they used to be is going to get to a lot of trouble in investing. So to me, the one thing in macro investing, you've got to take carefully is when people plot our charts of the last 100 years. This is where we're going because this is where we used to be.

Starting point is 00:51:35 I'd be cautious about that. You know, history doesn't repeat itself when the underlying structure that you're looking at has shifted. And I think it has. I think conventional wisdom looks at sort of the 2010s and looks at the low interest rate environment. And I think people generally believe that companies had an easier time growing in that environment. They had, you know, easy access to capital. were able to get funding to fund their growth. Has higher interest rates impacted how you think about the future growth rate of companies today?

Starting point is 00:52:07 You remember the old Clara Pellew ad for Burger King? I said, Where's the Beef? Let's take the story. I've heard the story. Capital was accessible. I know companies could raise capital. They were taking investments. If that were the case, shouldn't we have seen like four or five percent economic growth every year?

Starting point is 00:52:23 So if the story is true, then how come we didn't see it in terms of massive reasons? investment, huge growth. We didn't see that. There's a reason why interest rates were low in the last decade. They were an output of two effects. One was low inflation. The second was anemic growth. I think the people who tell the story, the cart and the horse mixed up. They're getting the wrong driver. Interest rates were low because companies were not finding investments. Inflation was low. Deflation was existing in some economies. So I don't buy this story. In fact, if you talked to, and this is where knowing how to run a business and talking to people who run businesses would have helped equity research analysts. All they need to ask was CFOs is, are you finding lots of projects now that your cost of capital is down to 7%.

Starting point is 00:53:10 They weren't. The percentage of companies that earned less than their cost of capital actually increased over the last decade. Strange, the cost of capital went down, but fewer and fewer companies were able to earn a return higher than that cost of capital. It was not a good time to be a business, even though your capital was over. was low cost. During your chat with William Green on the richer wiser, happier podcast, a part of the TIB network here, you said the following.

Starting point is 00:53:37 The historical record of macro forecasters is worse than abysmal. Macro forecasting makes us all feel better. That's really it. It accomplishes very little in terms of actual substance, but it gives us a sense of being in control. And I definitely agree with that analysis. And I think many people who call themselves value investors would agree with you as well. But I think some in the audience may be wondering, well, if macro forecasting is extremely

Starting point is 00:54:02 difficult, if not impossible, then accurately assessing the value of a business is also really difficult because of all this uncertainty within the environment. So why bother? So what do you believe is your biggest edge to picking stocks and doing well as an investor? Not in assessing the macro environment. Nobody can. It's finding companies where there's a mismatch between what you believe about the company and what the market in consensus believes about a company. At this table I put together like six months ago, maybe a year ago in one of my posts, where I broke companies down from awesome to awful. So let's say you have a company and you classify based on whatever,

Starting point is 00:54:44 whether it's an intrinsic valuation or your ratios or qualitative judgments from awesome to awful. And then on the other axes, I'd what the market thought about the company from awesome to awful. So I said, let's assume you may have an awesome company. an amazing company, but the market also thinks it's awesome. This isn't a bargain as an investment because buying an awesome company at a price that reflects its awesomeness means you're going to earn at best a fair rate of return. What you're looking for a company is where your assessment of the company is mismatch with what the market thinks about the company and you're hoping you're right. So let's say you buy a bad company, but the market thinks it's an awful company. An awful

Starting point is 00:55:22 is worse than bad. You're actually getting a good investment because you got at the right price. So I think too often when people talk about investments, they talk about the quality of the company. You see often with Tesla, people who are investors in Tesla, they tell you how great the company is. And I tell them, look, I agree with you. It's an amazing company with a product that attracts people who really love the product. I'm not disagreeing on that one. The question is, are you getting it at the right price? That's why I said when you look at a company and it's, I wish I'd bought this company that company is special. That's fine. For the moment, you might not buy the company, but keep a watch in the company. Every special company at some point in its life will be priced

Starting point is 00:56:02 right, Facebook in November of 2020. And that's your time to buy the company. So look for mismatches and markets. And then the question you've got to ask is, what do I do to become better at assessing the quality of a company than the market is? And that's why I think you need to understand basic business, understanding what drives growth. And what are they in investing for growth. And so don't think of this as an Excel spreadsheet you got to run through. It's more an assessment of how do I understand a company's quality and make judgments and when I'm getting that mismatch from what the market thinks about it. That's why it's a good idea to focus on companies after the market price dramatically shifts because that's a big 80% drop

Starting point is 00:56:42 in the stock price because those are the times of the mismatch becomes more likely. It's not guaranteed. The 80% drop might be merited. When you see big moves in the market, I'm you are when you're most likely to see mismatches in what you think about a company and what the market thinks about that company. I had more one more question before I let you go, Aswath. One of the things that really stands out to me about Buffett and Munger is they're like you and that they're willing to push back on things that, you know, they don't believe to be true and really willing to, you know, stick your neck out there and, you know, voice your opinion on things. And one of the things they are outspoken about is, you know, business schools teaching

Starting point is 00:57:20 things like the efficient market hypothesis. And it's interesting how you're talking about picking individual companies, obviously believe the market isn't efficient. So what are your views on when you have these ideas and you're a professor within these schools and, you know, they're wanting you, do they just give you leeway in what you can teach and you're able to, you know, diverge in your viewpoints? I think maybe the time Warren Buffett and Charlie Munga sat in a business school finance class was the 1970s. I can't think of a single first. I can't think of a single finance class that's built around efficient markets anymore. So first, you're 50 years behind the fact you have an entire area of behavioral finance. We've got three Nobel Prize winners in economics

Starting point is 00:58:00 coming out of the area. Today, I think you've gone to the opposite extreme that you're taught that markets are inefficient. It's easy to find winners. There are 15 studies that show it. So I think the Buffett-Munger critique of business schools is they're missing the point. They're critiquing of finance that used to be true in 1971 maybe, but not in 2024. That said, though, I do think that at least investing in valuation part of finance, what's taught in business schools has become is not pragmatic enough. The challenges in investing in valuation are not theoretical challenges. They're estimation challenges. How do you estimate cash flows on a company when you're worried about a government nationalizing? There's not theory here. That's why I said the most valuable

Starting point is 00:58:41 discipline in investing in finance is not finance itself, it's statistics. The essence of statistics it gives you the tools to deal with data that's plentiful in pulling you in different directions. Let me repeat it again. It helps you deal with data that's plentiful and pulling you in different directions. That's the challenge we face in investing today. Our problem is not that we have too little information. We have too much information pulling in contradictory ways. One says it's cheap, the other says it's expensive. Statistics is a tool that will help you get. get through that fog and see the reality. Look at the data as it actually is.

Starting point is 00:59:16 So my encouragement to people is don't read a finance book. Don't read another, an auditory book about Warren Buffett, how amazing he was in the 20th century. Spent some time picking up a statistics book and understanding the tools you can use to assess the data that we're surrounded with, qualitative as well as quantitative. Aswath, thank you so much for joining us today. This was such a pleasure having you on the show.

Starting point is 00:59:38 Before we close it out, as always, I want to give you the opportunity to give the audience a chance to learn more about you and any resources you'd like to share. I'm easy to find. Just type in my name into Google and you'll probably find my website, my blog. So I really have nothing to sell. If you want to buy a book, you're welcome to, but you can probably find much of the same material for free on my website. My publisher won't like me saying that, but that's the truth. Amazing. Well, all the information you put out on your YouTube, your website, everything is just incredible amount of knowledge and wisdom that you all share for free. So thank you so much.

Starting point is 01:00:14 And I'd encourage the audience to check it out. Thank you. 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.

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We Study Billionaires - The Investor’s Podcast Network - TIP577: Valuation Masterclass w/ Aswath Damodaran

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