We Study Billionaires - The Investor’s Podcast Network - TIP654: Investing Across the Life Cycle w/ Aswath Damodaran

Starting point is 00:00:00 You're listening to TIP. On today's episode, I'm joined by the Dean of Valuation, Azwath de Moteran. Aswath is a fan-favorant guest on the show here, and I'm very happy to have him back to discuss his new book, The Corporate Life Cycle. Azwath has written numerous books on how to value companies and invest successfully. He's also a legendary professor of finance at NYU, who's made his classes available for free online to millions of followers around the world. During this conversation, we explore what the corporate life cycle is and why it's important,

Starting point is 00:00:33 why value investors need to be open-minded as to investing at different points in the life cycle, why the job of a management team is to maximize shareholder value, how the story and narrative of Tesla has changed over the past decade, how companies should handle the decline phase of the life cycle, why Azwhath is against concentrating his portfolio and much more. It's no wonder that Azwath is such a popular guest on the show as he always brings a new perspective and valuable insights for our listeners. So with that, I hope you enjoy today's discussion with Aswath to Motiran.

Starting point is 00:01:08 Celebrating 10 years and more than 150 million downloads. You are listening to the Investors Podcast Network. Since 2014, we studied the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Now, for your host, Clay Fink. Hey, everybody. Welcome to the Investors podcast. I'm your host, Clay Fink. And today I'm very happy to welcome back Azwath to Motiran.

Starting point is 00:01:45 Aswath, it's so wonderful having you back on the show. Glad to be on. So Aswath, we less spoke about a year ago. And since then, you just published this new book. It's titled The Corporate Life Cycle. So very much congratulations on that. You just informed me it was book number 12 amazingly. So you're a machine putting these books out.

Starting point is 00:02:06 So how about we start with just what is the corporate life cycle and why is it important for our listeners? It's really a parallel of how we age as human beings. I mean, at each stage in our lives, we get some benefits and some costs, some constraints and some add-ons. And human beings fight aging. And companies, I think, go through very much the same process. A startup is like a baby.

Starting point is 00:02:29 Needs constant care and attention and capital. A very young company is like a toddler. falls, gets up, falls, sometimes doesn't get up. And as you get into your teenagers, you tend to put your potential at risk, which is what a lot of companies do. And then as you get older as a company, you fight aging. And you know what? There's an ecosystem that tries to tell you that you don't have to be old. You can be young again. I mean, an ecosystem that parallels, what do we get in our personal lives? No, plastic surgeons, physical trainers, you can be younger game. Consultants and bankers play the same role with companies. They tell them you can be young again. They charge them

Starting point is 00:03:04 hefty fees. And guess what? No matter what they try, companies get older. I don't think it's difficult to understand. Companies are run by human beings and just as they fight aging in their personal lives, they fight aging as CEOs of companies as their heads of companies. And I wanted to talk a little bit about valuing companies at different points in their life cycle. I feel like that's a skill set in itself because, valuing a company at different parts during their life requires you almost to look at the company almost through a different lens. What are some of the primary differences and considerations when we're looking at companies at different stages in their cycle?

Starting point is 00:03:42 It's not a skill set. It's different skill sets. To value a young company, you've got to be a storyteller. You've got to be able to spin a narrative about the company because there are no numbers. There's no history. There are no averages you can look at. You can't look at that past. Everything about the company is built around a story. So the storytelling side evaluation becomes much more critical when you value young companies. The very best venture capitalists are good at gauging stories. They're not number crunchers. As companies age, the number crunching takes over. You cannot run away from your history. So your skill set becomes more numerical. Can you compute cash flows? Can you compute accounting returns? Can you compute risk measures? So as you look at the

Starting point is 00:04:24 skill sets, you need a different stage in the life cycle. There's a lot of you. shifting skillsets. And to be good at valuing companies across the life cycle, you've got to draw on all those skillsets. So when we're looking at the earlier stages, you're very much crafting a story. I think since our show primarily focuses on valuing investing and studying many great investors like Buffett, Munger, Lelu, Monish Pabrai, you explain in the book how there's really no silver bullet when it comes to investing. Every single investor seems to think. that they have the approach that's best, or maybe they just discovered the approach that seems to make the most sense to themselves. So why might value investors, maybe they should be

Starting point is 00:05:07 more open-minded when it comes to investing at different points during the life cycle? The names you mentioned are all great investors, but they're all old-time value investors. They focused on finding companies that trade for less than what's on the ground right now. It's a throwback to a Ben Graham's security analysis where he said, look for companies which you can buy for 50 cents on the dollar, but the dollar is already on the ground. That's a great strategy. And it worked for a century through much of the last century. I think the problem is if you get focused just on that strategy in terms of my life cycle, you're going to be stuck with older companies, mature companies, declining companies as the companies you're looking at. And unfortunately,

Starting point is 00:05:48 if that's all you're focused on, you missed out on the big winners in this market for the last 20 years. You'd have not invested in young companies, no matter how good they are, because the investment philosophy directed you to look for things like, hey, let's find low PE ratios, high earnings growth, big cash flows, all great things to look for, but you're not going to find them in younger companies. Young companies will tend to have negative cash flows. It's a feature not a bug. You've got to look past it at the potential there and see if there's enough value there for you to buy the company at the right price. And don't get me wrong. It's not just the story that drives these companies. it's a bounded story, a story that's connected to numbers that makes sense. So I think as investors

Starting point is 00:06:29 interest in value, no one don't want to use the word value investors because it's already been captured by a group that essentially defines value investing as buying mature companies. But if you're interested in value, you've got to be open-minded about where that value comes from. And it could very well come from the future and from growth, not what the company already has as assets in place. So you mentioned there that many of them get attracted to more mature companies, primarily due to the profitability concerns. Mature companies tend to be highly profitable, whereas earlier stage growth companies, they tend to be unprofitable. Why is it that earlier stage companies almost always seem to have this characteristic? It's not just the profitability.

Starting point is 00:07:14 It's a fact that if you're profitable and a mature company, you're more likely to trade at low multiples of earnings, of epidemic. of book value. Remember, the constraints for value investing are not just profitability, but low pricing multiples. And you're more likely to find those with mature companies. You're not going to find a great growth company trading at 15 times earnings. You can keep hoping that you can do that, but you're not likely to find that. You've got to be willing to give a little on the pricing, as long as there's enough potential to cover the higher pricing that you have up front. So why is it that earlier stage growth companies tend to have this characteristic of unprofitability? Well, I think to begin with, you're setting a business model in place. It's not established. Your market is not clear. And you add to that some accounting inconsistencies. I mean, you take a technology company, R&D is treated as an operating expense. And let's face it, if you're a technology company, R&D is what you've got to invest in to grow. So the more they invest for growth, the more money they will lose. And if you reject those companies as money losing companies without looking at the potential that comes from that reinvestment in R&D, you

Starting point is 00:08:23 missing the boat and where the value for these companies is going to come from. Another section in your book that stood out to me in relation to value investing was the section you titled A New Paradigm for Value Investing. It outlined your thesis for how value investors must change to improve the effectiveness of the approach. How do you think value investors should be adapting to these ever-changing times? The first thing maybe they should try is actually value a company. I find it odd that people call themselves value investors and then pick stocks based on price earnings ratios, a price to book ratios or EV debit down multiples. In my experience, most value investors have never really fully valued a company and they hide behind this defense of valuation requires you to make

Starting point is 00:09:07 estimates for the future. It's full of uncertainties. True. But that's essentially what all investing is about. Might as well look it in the face, make your best estimates and be okay being wrong. And I think that's where I would start value investing on us. Think through value fully. Don't use pricing ratios as a shortcut to finding cheap stocks. Because if you do that, you're really not value investing. You're just screening for cheap stocks and anybody can do that now. And another point in your book that really hit home for me,

Starting point is 00:09:36 you're talking about how a lot of people will say that the purpose of a company is to maximize the shareholder value or the purpose of many public companies is to maximize shareholder value. I was curious if you could discuss why this is easier said than done and how this concept might relate to the corporate life cycle. Let's start with a basic proposition. To run any entity, not just a business, you need a mission, not multiple missions, but a core mission. The core mission for a business is to deliver value for its shareholders.

Starting point is 00:10:08 The reason it's so difficult to deliver on that, a shareholder value is not earnings next year or the year after. It's earnings in perpetuity. Essentially, the value of your business is a long-term. statement. And you have to make trade-offs. Sometimes you have to accept less earnings now to get more growth in the future. Maximizing shareholder values, not just maximizing earnings this year. A lot of people mistake the two and they argue that shareholder value is short-term. Shareholder value is the most long-term concept you can think of. The way CEOs apply might be short-term.

Starting point is 00:10:40 But that's not a problem with the concept. It's a problem with the application. And it's so fascinating to me how there's all the stakeholders. within a company and how one stakeholders can be at odds with other stakeholders. I think about one company I've looked at recently that has paid out a dividend for many years. They pay out 50% of profits as dividends. And I'm sure many of the large institutional shareholders would love that. I'm looking at it with the share price down. I'm like, if they want to maximize shareholder value, then they probably should be doing more share repurchases, is what I would argue. So I think managers are constantly doing this balancing act of different stakeholders,

Starting point is 00:11:19 whether it be the employees, the customers, the suppliers and the shareholders, all these different stakeholders. I think the first is when you talk about stakeholders, I'm assuming you're talking about everybody about shareholders because the example you led in with those different groups of shareholders might have different interests. Institutional investors, pension funds might prefer dividends, you know, wealthier shareholders might prefer stock buybacks because they want price appreciation. poorer shareholders might prefer dividends again because they want the cash in hand.

Starting point is 00:11:47 So I think within shareholders that are different interests at play. And that's, I think, separate from the management shareholder value maximization hypothesis because it says, look, you've got to figure out who the shareholders in your company are. For instance, if you're a phone company, an old-time telecom company, you tend to get a lot of poorer shareholders, a lot of pension funds. If you have a lot of cash flows, you should be paying out more in dividends because your core shareholders like dividends. If in contrast, you're looking at a technology company,

Starting point is 00:12:16 over time you probably accumulated a lot of wealthier investors, a lot of institutional investors who don't want dividends. There you're going to see buybacks. As an investor, you need to self-select. If you like dividends, don't buy a tech company. If you want share buybacks, don't buy a telecom company, because there is a clientele effect at play. But talking about the other stakeholders,

Starting point is 00:12:37 it might seem unfair that when you have employees and you have suppliers. I mean, you have five, six, seven different stakeholders, including society and the government that we put shareholders on top. The reason we do it is very simple. Every other stakeholder group has protections. They have contractual claims against a company.

Starting point is 00:12:55 What I mean by that is your employees in a company and you don't like the way the company is treating you, you can negotiate for higher wages. You can go on strike. If you're a banker lending money to a company, you can put in contractual constraints what the company can do, charge a higher interest rate. Shareholders have no contractual claim.

Starting point is 00:13:13 They get what's left over after every other stakeholder group has been dealt with. If you don't take care of shareholders and they get a residual claim, there'll be nothing left for them at the end. The reason we put shareholders on top is not because they're special, but because they're the only group that doesn't have a contractual claim against a company and you've got to give them something to hold on to. And that's why we give them the reins to the company, the right to run the company and get that residual claim.

Starting point is 00:13:40 So in the book, you have different chapters on valuing and other considerations at different points in the cycle. I wanted to touch on the challenges and potential solutions, starting with the startups and young growth companies. We have the challenge we mentioned of highly uncertain cash flows, highly uncertain return on capital, and then the duration of even how long the company is even going to exist. Can you talk about when you're looking at? at a startup or a younger growth company, how do you sort of think through these challenges?

Starting point is 00:14:13 The challenge is not even uncertainty. It's the fact that your cash flows are negative and you've got to make it to positive cash flows. Even a young startup with lots of promise has to get through that initial period where they require external capital to keep going from venture capitalists, if they're private companies, from the public markets, if they're public companies. And if that capital is not forthcoming, the promise will not be delivered. So that's the first thing about young startup. Is survival is key. To get to the promised land, you got to make it through the troubles of growing through those growing pains in the early years. So I think that with a young startup, survival has to be put first before you start thinking about measuring returns on capital or

Starting point is 00:14:55 what do we do about margins. And that trade-off is what animates decision-making at young startups. and when you value these startups, that's got to be factored in. What is the likelihood that they will make it? Remember, two-thirds of startups don't make it through year two. They don't survive. So as an investor valuing these companies, you've got to factor in that survival risk into your valuation. And one of the other points that really surprised me was I believe when you looked at the

Starting point is 00:15:21 returns of venture capital, it actually was pretty dang good. Even with considering a lot of these companies just don't make it. Why is it that VC seems to be a good area for a lot of investors? I mean, you look across a VC portfolio, there will be a lot of failures. The winners tend to be big enough that they can carry the failures. So the key to thinking about a VC portfolio is not look at the percentage of their investments that pay off, but look at the returns they make on their most successful investment. Benchmark capital could take the returns they made on Uber and cover 20 failures with that

Starting point is 00:15:57 excess return. It's a very different investment philosophy. It's an investment philosophy where you're looking at very big winners carrying your entire portfolio. And if you're not comfortable with that, it's best to steer away from not just the VC business, but from young company investing. Young company investing, if you get three out of 10 right, you're doing great. It's amazing. Your payoff is going to be good enough or much better than a value investor getting six out of 10 right. So it's a very different way of investing. And for some people, it's not the right way. But for others, it makes complete sense. You look at collectively across venture capitalists, though, their collective returns are not that great. I mean, they deliver about two or three percent

Starting point is 00:16:39 more than the S&P 500, but people think they make 20, 30 percent more. The difference, though, is the winners in venture capital investing tend to stay on as winners. There's continuity. Whereas in the public equity markets, winners this year become losers next year. There's almost no continuity in active investing in public markets. Winners in the VC business tend to get more continuity because once you become winner, you get the best terms. Startups want your money because they want your name attached to them. So there seems to be more, you know, if you become a winner, you will stay on in the VC business,

Starting point is 00:17:13 where if you become a loser, you very quickly fall off. A lot of VC businesses shut down if they lose for a couple of years, or two or three years, they can't keep going because new capital doesn't come in. You also cover the differences in returns in what we can call value investing and growth investing. So growth investing, we can maybe refer to younger companies, higher growth companies, generally trade at higher PEs. And then value investing, more mature, tend to be lower P.E. companies.

Starting point is 00:17:41 In your research, what have you found in how long-term returns vary between these two strategies that generally are investing in at different points in the? the life cycle. This is one of the most studied phenomena in finance. And for much of the last century, the conventional wisdom was low value investors win out, low P.E. stocks and low price to book stocks beat high P.E. and high price to book stocks. And at least in the aggregate for much of the century, that's true. That's faded, especially in the last 30 years. It doesn't mean that the premium is completely gone, but you're in more of a steady state now where some years value stocks are going to win out, some years' growth. And we've actually come off.

Starting point is 00:18:19 a decade where growth stocks have beaten value stocks primarily because of the overperformance of the big tech companies. So I think that the days of just investing in low PE stocks and expecting mean reversion, which is just things revert back to industry averages, making you money. In my view, I think those days are done, partly because it's so easy to do, everybody can do it. I mean, we live in the age of AI. The way you invest actively is you search for stocks with low PE ratios and stable

Starting point is 00:18:49 learnings. Guess what? Chat GPT can do that for you. So in a sense, if a machine can do it, why would you expect to earn excess returns from following a strategy like that one? So I would separate the findings. You look back at the last century, low P and low priced book stocks are won. You look at the last 20 years, things have returned to a steady state where either side or either group can win in any given year. There's no easy way to make money. 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, and every conversation you have is with people who are

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Starting point is 00:23:29 I think I would point to growth just tend to be more exciting. People get attracted to the high growth names, the names that are in the limelight, the invidias of the world, whereas the boring slow grower, or even something that isn't growing just isn't going to attract, sort of attention, so it doesn't have that sort of valuation. But there's a lot of nuance when looking at company to company. And then it's also interesting the point you made where so many of these value companies that maybe would have maintained their mature state for a longer period of time

Starting point is 00:23:58 are now seeing more disruption. And I think another consideration is throughout the 2010s, I think the availability of capital has also made it easier for these startups to get up and running and accelerate their point in the life cycle and that velocity. I think that one way to think about the 20th century is the typical company in the 20th century was a manufacturing company. It took a long time to build up, had physical assets, and you could use things like book value to measure the value of the assets. You look at the typical 21st century company, its assets are intangible. All of the traditional measures of book value tend to break down. It doesn't mean you don't depend on earnings and cash flows. I think you still depend on

Starting point is 00:24:39 it, but the easy ways of finding cheap companies have fallen off the board. So I think it's a shift in economic focus from manufacturing to technology, from smokestack to a very different kind of economy that's driving markets. And we ignore that at our own peril. I think as long as we stay stuck with those old accounting proxies for value, we're going to not be able to invest in the very best companies of the 21st century. I'm not suggesting that high growth companies are always better than low-growth companies. I'm suggesting we need to keep our options open to think about the value of growth and reward the companies that deliver high-value growth. Now, many people in the audience are going to be well aware of valuing a company in terms of

Starting point is 00:25:24 present value of its future free cash flows. So in addition to valuing a company in this manner, you also talk about what you've referred to as pricing, which really is looking at the closest comparables in the market similar to how a real estate agent will look at comparables of recent housing sales. And all equity research, all sales had equity research is pricing. The call it valuation is insult the word. It's all pricing. Nothing wrong with it. It's a very different way of thinking about what's cheap or expensive. I mean, I think of it as the equivalent of whether you seat keek or stub hub to buy a ticket to a baseball game and they do amazing deals, great deals, good deals. That's basically what pricing is, is you look for other companies like yours and you look to see whether your

Starting point is 00:26:07 company is cheap or expensive relative to other companies. Trading is driven by pricing and 90% of the market is trading. So I understand that pricing dominates value in markets and pricing is driven by very different forces than value. Values driven by cash flows, growth and risk. Pricing is driven by mood and momentum. When the mood and momentum is with you, the price will keep going upwards, no matter what the pricing ratios suggest. I mean, take a look at Nvidia this year. You see the mood shifts and driving the pricing. It's almost doesn't even seem to matter what the fundamentals look like at that point in time, because the momentum is with you. How useful do you think pricing is? Do you even consider it a useful tool?

Starting point is 00:26:52 90% of investors are traders. And if you're a trader, pricing is the only thing that matters. I don't even think you should be looking at value. So when equity research analysts and traders talk about pricing, I completely understand. In fact, I don't buy it when they talk about intrinsic value because their heart's not in it. So if you're trading and the essence of trading is you buy at a low price and sell at a high price, pricing is the only thing you should be looking at. In fact, I think it's a distraction to think about earnings and cash flows and fundamentals if you're trying to be a trader.

Starting point is 00:27:21 Now, I think we'd all be better serve if we were more upfront and honest about what we plan to do in markets. If you plan to be an investor, care about value. Try to find something that trades at less than the value, buy it and hope that the gap closes. If you're a trader, then all you care about is pricing. It's mood and momentum. And detecting shifts in mood and momentum becomes the essence of successful trading. So if charts help you do that, technical analysis helps you do that, all the more power to you. So I think we need to pick the tools that best fit what we came to the market to do. And I think if you came to trade, pricing is what matters. matters. So as we walk through this life cycle, eventually all companies enter a stage of decline,

Starting point is 00:28:04 but opportunities for investors, I think, can arise when they can identify a company that can delay that decline for as long as possible and prevent competitors from also compressing their margins. The most prominent examples are many of the magnificent seven companies over the past decade. They've just grown and grown and grown, much larger than many people thought they'd be able to. And I thought this was a good segue to mention Tesla because you've revisited Tesla a number of times over the past 10 or so years. And I think it's a good case study for how we can put some of these concepts into practice. So after crafting your story on Tesla, you look out 10 years from now and put together what you believe to be reasonable growth rates, revenues, margins,

Starting point is 00:28:47 what you think that might look like for Tesla. So for a growth company like Tesla, it's a pretty large company today still can still be highly volatile and unpredictable in terms of what that's going to look like 10 years from now. So for Tesla, how do you go about making those sort of forecasts? Tesla could be a case study of why a narrative is so critical to value. When I first value Tesla, I valued it as a luxury automobile company. And over the last decade, you've seen the twists and turns in the Tesla story. I'm not even sure at some points in time, what kind of company Tesla. It's an energy company, is an automobile company, is it a technology company? And I think what keeps shareholders on their toes is that narrative shift in Tesla is almost mind-blowing when

Starting point is 00:29:32 you have a half a trillion dollar company with this much of a narrative shift. I've never seen that in my lifetime. But that's what makes Tesla such a challenge for investors. So you could look at other auto companies that Tesla looks expensive. But if it redefines itself as a technology company, suddenly it looks reasonable. And I think the back, the back, and forth that you get on that storytelling can explain the ups and downs you've seen in the Tesla stock price. When Tesla controls the story, it's market cap source. When Tesla loses control of the story, it's market cap falters. And I should replace the word Tesla with Elon Musk because it is a personality driven company. And Musk in a sense has done the pluses of creating these storylines,

Starting point is 00:30:13 but he also sometimes steps on his own storyline and in the process create some damage to the company. He's a net plus in my view with the company still, but he creates some of the gyrations you see in the stock prices with his story shifts. So you revisited this one in 2023, and I wanted to highlight some of the headlines for 2023 because it seems like every year or two, there's just so much happening within a company like this. So one of the most important things happening with Tesla is their price cuts. So it's becoming more of a mass market vehicle company.

Starting point is 00:30:46 So on the one hand, it could compress margins because obviously they're getting less up front, but on the other hand, it could mean lead to higher level volumes. Then the second point is related to the technology piece here. So the full self-driving advocates believe that Tesla's way ahead on this. Elon said for many years that full self-driving's just around the corner, but it seems to continue to get pushed back. So the Bulls see it as very positive. Oh, it's coming just around the corner and the bears are just like, he just keeps pushing back his deadline on this one. Of course, the third storyline of 2023 was the cyber truck, which nowadays, I see more and more on the roads and it's got a lot of attention. It's a very novel product and

Starting point is 00:31:24 shows that Tesla is able to continue to expand new product lines and expand their total addressable market. I think the price cuts, I thought, made sense given Tesla's end game. The Tesla's end game is that if you look at the overall automobile market, a big chunk of the automobile market is going to become electric cars and that they would dominate the electric car chunk of the segment of the market. Now, let's be clear. That electric car market, if you're looking at it globally, you need to sell a lot of cars in China and India. I mean, basically, in parts of the world, where you can't charge 80,000 a car and expect to be a mass market automobile company. So in my view, Tesla lowering prices made sense given that long-term story, and it actually made it more difficult for their competition

Starting point is 00:32:08 to kind of stay in there with them. If you notice, the electric car efforts of the traditional automakers, the status quo, have kind of fallen apart. Two years ago, people are talking about how the legacy auto companies were going to become electric car companies, I don't think a single one of them has been able to show profits from doing that. In fact, Tesla's biggest challenge has not been one of the legacy auto companies. It's B.D, essentially a Chinese electric car company that's going directly after the mass market electric car. So BYD might not match up to a Tesla in terms of features. But at the same time, if you're going after a big market share of the electric car market, people are already building

Starting point is 00:32:47 into the market cap of Tesla. You've got to be able to compete with BYD in much of the world. And that's going to be the big challenge for Tesla is can they come out of this competition with a significant market share of the electric car business? And if they can, then I think their market cap becomes justifiable. In fact, my 2024 valuation of Tesla, I gave them a value of 100, you know, it was about 180. So this was when they were trading at 162. I think I came up at the value 188, $190 per share. So I did buy Tesla. It's the only. It's the only, you know, it's the only, you only one of the Mag 7 stocks that I've bought recently. I own all seven, but I bought the remaining six at different points in time in the last decade when they look cheap enough to me relative to their

Starting point is 00:33:28 value. But Tesla, I think, has potential. I've always called it my corporate teenager, which is lots of potential, but it manages to find a way sometimes to put that potential at risk. And that's something you've got to be willing to live with with the Tesla investment. You mentioned the traditional car manufacturers and how Tesla seems to have their act much more together in terms of the EV space. What do you think their biggest competitive advantages in EVs? Is it their mass production and their ability to produce much cheaper cars? Or is it the car itself that they are able to differentiate themselves? I think it's multiple things.

Starting point is 00:34:05 I think the first is they were there first. So in the sense, they have experience with electric cars that the other electric car makers, can't match. Let's face with electric cars getting the charges in place because having the electric car is just the first piece of the puzzle of you're a consumer. You've got to charge the electric cars when you're away from home. So I think being first in the game is given Tesla an advantage. I live in Ground Zero for Tesla, which is Southern California. I mean, there are Tesla chargers all over. It gives them an advantage when you think about somebody buying an electric car saying, which car should I buy? You're more likely to buy a Tesla because there are more charges arounds.

Starting point is 00:34:40 The second is, I think that Tesla has always been focused on the electric car business. The remaining car makers talk to talk, but they're often not willing to walk the walk. If Ford makes the bulk of its money from the F-150 truck, they might talk to talk about the electric cars being first and foremost, but they have to cater to their cash cows. The legacy automakers, I think, are bound by the fact that their existing business comes still from gas-driven automobiles, and it's very difficult to wean yourself away from it.

Starting point is 00:35:12 Now, the second thing Tesla has done, it's changed the way cars are made. You go into traditional assembly line. You can see the process that Henry Ford, in a sense, put into place 100 years ago. And the legacy auto companies follow that process. I think very early in the game, Tesla realized that electric cars are not like traditional cars. You don't need that kind of assembly line. One reason, their Fremont plant was able to keep Tesla going for almost the first six or seven years their existence. And they've invested less to produce more cars than any other legacy

Starting point is 00:35:43 auto maker. So I think it's a combination of factors and sometimes it's good to be the last player in the game. And Tesla, by always being in electric cars, has built a company built around the electric car. The other companies don't have that advantage. In much of the bullish long-term thesis on Tesla is related to the segments outside of selling electric vehicles. So they have the full self-driving software. They have potential of robo-taxies. They're ramping up their energy generation and storage business. When valuing something like this, how much confidence can an investor really put in something like robotaxies that it doesn't exist? Is it just crafting a story you believe can be true? And like, how do you sort of

Starting point is 00:36:26 handicap that? Robotaxies do exist, right? If you've been to San Francisco, you've seen the Waymo's all over the place. They do exist. They're not a money-making business yet. The technology is not quite there for safety. So it's not a question of whether. It's a question of when. And I think Tesla does have an advantage in that space because, again, they've been full force in it. It's not something they try on the side. It's something that they've focused on right from the beginning. Now, how they will make money in that space is still up for grabs. I mean, are they going to own the cars and operate robot? That's like running an Uber or a lift on the side, a very logistics heavy business.

Starting point is 00:37:09 And I'm not sure Tesla is equipped to do it. Are they going to make the cars and lease them out to Uber and lift to run as their cars? Maybe and share the profits. That's the part that we're uncertain about is when robot taxis will become operational and how that business is going to be structured for Tesla to make money on it. And I think you've got to make your best judgment on it and estimate the value. and I tried in my 2024 valuation to come up with an estimate of how much of Tesla's value could potentially be coming from robot taxis. And remember, they also have the robots that they

Starting point is 00:37:42 hope to market as especially to manufacturing companies, to man their factories. It's a whole set of options in Tesla that right now might not be viable, but if viable could become very valuable businesses. Yes, a lot of what you mentioned there really points to optionality. So I heard you mentioned previously that a lot of investors deem margin of safety in purchasing. And say you were purchasing Tesla in the 160s and you thought the value is 180. Some investors might think, hey, that's not a large margin of safety. But I think you're sort of putting faith in sort of Elon Musk, his ability to innovate. And then just it's almost like inverting the margin of safety, whereas like, hey, I'm betting on this potential optionality.

Starting point is 00:38:23 I'm not sure what that value is going to be, but I think there's a good chance that's going to be pretty large. Not zero, right? That's basically what you're betting on. So in a sense, when you ignore the options, you're estimating an option value of zero. I'm assuming the option value is greater than zero. And I would argue that an even better example is Facebook. When Facebook had its meta, remember the Metaverse fiasco, stock price drop,

Starting point is 00:38:47 I valued just the online advertising business at Facebook. and assumed it would have a finite life. Ten years of cash flows from online advertising, and I was able to cover the market cap of Facebook. And I said, you know what? I'm buying Facebook because everything above that is gravy. I mean, I can think of the analog, right? Remember the Warren Buffett story,

Starting point is 00:39:06 buying American Express after the salad oil scandal? Because he looked at the cash flows from the credit card, and he said, five years of cash flows what I'm paying. Everything else is gravy. I think the 2022 version of that was Facebook, buying Facebook at those prices. That's why when people say the max seven, I would never have been able to afford these stocks,

Starting point is 00:39:26 they all looked expensive to me. That's not true. At some point in the last decade, often two or three times, every one of these stocks has been cheap relative to value, if you're willing to assess value fairly by looking at expected future growth. So I think that the optionality component

Starting point is 00:39:43 is something that allows you to buy a stock that is close to fairly valued and still feel okay with it. Rather than apply this, I want everything to be 30% below value before I can buy it, which is the traditional margin of safety, which strikes me as a bludgeon. And a bludgeon doesn't work in investing. You need a scalpel. I actually covered what you called your doomsday scenario of meta.

Starting point is 00:40:07 I chatted about it on the show, and it's one case study. I'll never forget when it comes to investing. And it's a reminder of just the narrative shifts you can see in the markets. And then just the reality that people and markets adjust, I think a lot of people just assumed, hey, Zuckerberg's throwing all this money down the drain today. You know, the way it was price, essentially they believed that he wasn't ever going to fix his act. But it seems that the capital allocation has just changed a lot since then. And it's been reflected in the narrative and the stock price now.

Starting point is 00:40:35 And I give Mark Zuckerberg credit for listening to markets. And this is why I am thankful for people or traders who drive the pricing process. Because I said it's all about mood and momentum. When the momentum shifts, they can turn so negative on a company, even one with great prospects, that you can get at a great price. So, somebody who's never owned Nvidia saying, I wish I owned Nvidia, trust me, hold on, there will come a day where the momentum will shift enough against Nvidia, that'll be cheap again.

Starting point is 00:41:04 Might not be tomorrow, might not be next week. But never say never when you look at a stock, because momentum shifts can cause a stock to move. I mean, you know, I bought Amazon five times in the last 25 years. I've sold Amazon four times in the last 25 years. And these are companies when the momentum shifts can take them from being undervalued to overvalued. And you essentially have to react to those changes. Let's talk more about management.

Starting point is 00:41:30 So we're all told to invest in companies with great management teams. Can you talk about how the role of management might differ throughout the life cycle? I'm reminded you discussed how in an earlier stage company, really, management is all that matters because they're just starting with this. and they need to try and find product to market fit, where management might not matter quite as much in a mature company. I think investing is not about finding great management or bad management. It's about finding mismatches. Let me explain. Right now, if you ask people, if I asked you what you thought

Starting point is 00:42:01 about Jensen Wong, CEO of Invideo, most people would say, amazing CEO. If you think a CEO is great and the market thinks that manager is amazing, you're overpaying for that stock. If you think management is just bad, but the market thinks that management is abysmo, that might be a good buy. So rather than think about good management or bad management, what you're looking for is management that's good, that the markets have concluded that management is not that good as average. So you're looking for a mismatch that works in your favor. So what I would look for is actually finding management teams that you like and then waiting for a time when the rest of the market turns against that management team. Mark Zuckerberg, perfect example.

Starting point is 00:42:43 At that absolute bottom, people had concluded that he could not walk and chew gum at the same time. I mean, that he was the most incompetent CEO on the face of the earth, which I thought was unfair. But I took advantage of that mismatch. And I would argue that there are mismatches like that that show up all of the time. So rather than just looking for great management, you want to find good or great management in a company where the rest of the market thinks management is just average. And those companies might be under the radar. They might not be high-profile companies, but that's where you should have your search. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:46:36 All right, back to the show. You also discussed in the book that I think it's important we don't fall prey to just this idea of a great management team because I think some situations just simply can't be saved by a great manager. It's easy to think that, say, the outsider CEO is just going to bail us out. So I was curious if you could talk more about that. I believe you mentioned Steve Jobs and Jack Welch in the book as examples. I think, you know, depending on where you're in the life cycle, the type of manager, you need to run a company is very different. If you're a very young company, you need a visionary,

Starting point is 00:47:12 a storyteller. Storyteller because you've got to tell the story about a company, you've got to convince employees, investors, the market that this company actually has promised. As you move through the life cycle, you've got to build a business. Very different skill set, right? Because you now have to manage supply chains, manufacturing. Then you grow a business. You've got to be an opportunity somewhere looking for new markets to grow. Once you become the CEO of a mature company, you're playing defense. You've got to be good at playing defense. And in decline, you've got to be good at shrinking your company. There aren't very many people who have the characteristics to be great CEOs all the way

Starting point is 00:47:45 through the life cycle. And this is where I think the 21st century is going to pose some challenges. The great 20th century company took 100 years to go from nothing to beg to shrink. And take Ford, GE. And their time acts as your ally. Henry Ford was the perfect CEO for Ford in the early part of, of the 20th century. He was a company that was being built up as an...

Starting point is 00:48:09 He was a visionary. He had great ideas. But he was also a bit of a crank. But by the time people recognized that his crankiness was getting in the way of the company, he passed away. And you see your team came in. Time took care of those transitions

Starting point is 00:48:23 for the 20th century company. In contrast, think about companies like Yahoo and Blackberry. Both companies founded in the early 90s, soared to success in seven, eight, nine years, didn't stay at the top very long. Yahoo stayed at the top over three years before Google came along and then went to steep decline. And often it's the same people, especially at Blackberry, the same people were running the company all the way through the life cycle and went from being regarded as great CEOs in the early phase of that life cycle to abysmal CEOs in the

Starting point is 00:48:55 later phase. Same people. So I think we have to accept the fact that there is no stereotype for a great CEO. And the reason I use the Steve Jobs example is we think, of Steve Jobs as this amazing CEO because we remember a stinted Apple post-1998. But I'm old enough to remember investing in Apple in the 1980s and looking at Steve Jobs taking decisions that damage the company. I mean, I own the Lisa, a computer that should never have been built in a computer with no expansion capacities, but because Steve was so set in this is what a computer should look like, he insisted in building it. He almost destroyed Apple as a company. What changed him, and his second stint was he was older. Wiser, he'd started another company Pixar, but more critically,

Starting point is 00:49:41 he recognized his strength was being the visionary. He was not a manufacturing guy. He had a person who made the trains run on time, a guy called Tim Cook, a guy without a visionary bone in my body, and I don't mean that as an insult. He's an operations guy. He's a guy who can get things done, and you have to give Steve Jobs credit. He conceded power to a chief operating officer who made the stuff happened and he took care of the vision thing. It's something that I think visionary CEOs who don't like the mechanics of building a business should take to heart is have somebody else take care of that aspect of the business because you need both to succeed as a business. I find the decline phase to be pretty interesting. All companies are bound to eventually reach that

Starting point is 00:50:25 stage and some companies when they face such a period, they're going to fight tooth and nail to try and reinvent themselves. Most companies, not some, most companies will fight tooth and nail. And some will accept decline, right? Some will be in denial what decline. Some will accept decline and some will fight decline. I think that the reason is again very simple. We glorify empire builders as CEOs.

Starting point is 00:50:46 I mean, how many Harvard case studies have you read about a CEO who made his or her company smaller, right? So what do we do? We put somebody as a CEO of a declining company. And we say, look, if you can make this into a growing company, And again, you're going to become a star. We're encouraging people to gamble with your money and my money. I mean, Marissa Meyer gamble what, billions of dollars trying to turn Yahoo around again. But the company she was given had no chance of making it. So I think a lot of declining companies

Starting point is 00:51:13 fight decline because the people who run them know that if they can fight decline and win, they become legends. And if they lose, they always have an excuse. I tried my best. So I think we need to change the mindset of how we think about success or failure for a CEO. growth is not always the right solution. I mean, I have more respect for CEOs who come into a declining business, accept decline, and then manage that decline well. Because a corporation is a legal entity. If the reason for your existence goes away, there's no reason you should be sticking around.

Starting point is 00:51:44 There's nothing gained. So given that, most companies in the later stages of maturity or in the decline phase, you know, may be making capital allocation decisions that aren't wise. They're maybe reinvesting in projects that aren't. returning above their cost of capital. Should that make investors more wary, you know, looking at this space? Absolutely. Because, you know, I mean, think of Blockbuster opening stores for five years after people were no longer coming into Blockbuster stores to rent videos. Blockbuster's business was eaten away on two sides, one by Netflix at that time, it mailed out

Starting point is 00:52:20 videos and DVDs to people. And by Walmart and others who were offering videos for a dollar a piece. Its business model had imploded, but it took them five years to recognize it, and during that period, they kept opening stores. They destroyed half their value. Same thing with BlackBerry. Blackberry threw billions of dollars down the drain thinking it could become the smartphone again when in fact that battle had been lost. So I think companies can make themselves much less valuable but trying to grow. But again, I understand the impulse that people have. Growth is glorified. We value companies that become bigger. And at the same time, we looked down on CEOs who shrink their companies. And maybe, as I said, we need to change that mindset. I had noted here in the book, you actually shared your case study of Blackberry.

Starting point is 00:53:05 And it was December of 2011, you argued that BlackBerry needed to start acting its age and accept that it would never be a serious mass market competitor for smartphones. So the company, I went back and looked, the company at that time was valued at $7.3 billion. And here, as of recording today, it's down 85% over the past 13 years. Again, I understand why people who run companies want to keep companies going. Remember, in business school, we have this concept called sustainability, something I don't quite understand. Because sustainability in its worst form is about companies staying alive forever.

Starting point is 00:53:39 And whenever I hear about that notion, I'm reminded of the Egyptian pharaohs who wanted to live forever. And you know what they did, right? After they died, they wrapped themselves in bandages, created mummies, and put in crips with all their favorite belongings around them. And guess what? They still stay dead. A lot of companies, if they want to stay alive, become, I mean, Europe is full of zombie companies, companies that have no business being around. I know it sounds brutal, but the way to have a dynamic economy is for companies that have outlived their welcome to just go away. Because they suck up capital that needs to go to companies,

Starting point is 00:54:16 that can revitalize the economy. I don't want to point to any one thing, but I think one reason the U.S. economy is healthier than the European economy collectively is because we have more of that creative destruction that Joseph Schumpeter talked about, which is when companies outlive their welcome, they're more likely to be put out of their misery in the U.S.

Starting point is 00:54:38 than they are in Europe. And that's a good thing for an economy. It creates pain. I'm not claiming that it comes without pain. It creates pain, but it's a kind of pain you have to be a pain. to go through if you truly believe in an economy built around private enterprise. So I wanted to also ask you about what history can tell us about a company's ability to

Starting point is 00:54:59 continue to outperform. So sitting behind me is Chris Mayer's book, 100 Baggers. In it, he looked at 365 companies that increased their value by 100 times over a 52-year time period. That was from 1962 to 2014. Let's say we find a company, a great company, what we believe that's had above average growth, above average return on invested capital, let's say 15%, and it's done so for a number of years, say a decade or more. You look at history and look at data, I think the issue with this is, you know, survivorship bias, right? Oh, this is survivorship bias on steroids.

Starting point is 00:55:34 I mean, it's one reason when people write these books about amazing companies in the past, I would not even spend my time reading these books because there's nothing you will learn or worse still. The lessons you learn will be the worst. kind of lessons for you as an investor because the kinds of company, you're going to be chasing the next 100 bagger. It's a way in which people get poor. I mean, remember, investing is about preserving and growing wealth. It's not about finding the next 100 bagger. If you do find one, think of it as icing on the cake. But never go searching for the next 100 bagger. You will not just not find it. You'll waste a lot of money chasing for it. Let's start with some realities

Starting point is 00:56:11 to the stock market. If you go back a century, it is true that the biggest winners in the market it account for the bulk of the returns of the market. I mean, there's a study that goes back. Hendrik Besson-Minder went back to 1926, and he looked at what would happen. If you missed the top 50 stocks in the market each year, you would earn collectively on stocks. You'd have earned less than you'd have made on T-bills or T-bonds. In other words, stocks collectively were a terrible investment. Now, I was saying the fall of people then have is, why don't I go find the biggest winners

Starting point is 00:56:39 of the next century? The problem is, that's a search that's going to lead you to overbet, to concentrate. your portfolio to go look for the biggest winners. My advice is don't go for the biggest winners. Go for winners and hope and pray that one or two or three of those winners happen to be the biggest winners. You don't need all of them. You just need a few of those. And you need to hold on through some bad times. That's the other thing these studies don't mention. Even those 365 companies that were pointed to as the 100 baggers, I'll wager there at times in that period where you'd have been tempted to sell those companies because like Facebook, they have been.

Starting point is 00:57:16 a bad year, a bad three year period. So I think in hindsight, it's easy to find ways to beat the market by a lot, but to make that the center of your investment philosophy, I'm going to beat the market by 5%, 10%, 15%, I'm going to find the next 100-bagger, leads you to take actions that actually get in the way of sensible investing. I mean, my advice in investing is to follow the Hippocratic oath. Do no harm. Do nothing in your investment philosophy that can create serious damage to your portfolio. One reason. I've made. never believed in concentrating portfolios, owning five or six of the best companies. I'd much rather take my bets with 25 of the best companies rather than five, because with five, I'd run the

Starting point is 00:57:57 risk of doing harm to my portfolio. Yeah, I think we should remind ourselves, you know, of that study reference where it might look like a company is going to be able to continue to do what it's done, but those long-term winners are sort of the exceptions to the role. When you own, say, 25 companies, you're much more likely to pick up a few of those longer term winners, whereas if you have five, six, seven stocks, your odds of success potentially drastically reduced. You have to be pretty confident in that company's future. Absolutely. I mean, if you didn't own any of the max seven stocks last year, I don't see how you're going to beat in the market. Maybe you could, but your odds got much lower, right? So I think that's why I would spread my bets and invest across the life cycle. That's the other

Starting point is 00:58:42 suggestion I would make. If you have 25 companies in your portfolio and they're all mature companies or declining companies, I think you've over concentrated in a portion of the life cycle. Often people think about diversifying, they think about sectors and different sectors. I think about diversifying across the life cycle. I've young companies, mature companies, growing companies and declining companies, my portfolio, all of which I bought driven by my investment philosophy, which is I want to buy something which trades at less than value. I also want to get that spread across the life cycle in my portfolio because it gives me cover no matter what happens in the market.

Starting point is 00:59:19 Since you mentioned you owned some declining companies, when I think of declining companies, I sort of think about like melting ice cubes. So how are you getting kind of an expected return out of that? Is it the market's just far underpricing the cash flows or do you expect dividends in the future? How is that? I'll give you an example. I bought GE in 2018. Nobody who looked at GE in 2018 would have argued that it's going to be a growth company. In fact, it was a classic zombie company. I actually valued each of GE's businesses, and it turns out that you look at the GE's

Starting point is 00:59:52 businesses, six of them were creating, had some value. But there was a seventh business GE Capital was acting such a big drain on value. It was bringing down the overall value of the company. The answer was very simple. If you can somehow break it into pieces, this company is worth a lot more than what the markets assessing, not the market who's making a mistake. As a company, GE was worth a lot less than as its pieces. And luckily, you had a CEO and GE who understood that, it was essentially, I still owned the pieces of GE that came out of it. And one piece of GE is more than what I

Starting point is 01:00:24 paid for GE as a company. If you had across the pieces, it's turned out. So it was again, the keywords are at the right price. So when people talk about buying great companies and avoiding terrible companies, my response is, why isn't price entering the discussion? I will not buy a great company if I have to pay too high a price. I will buy a terrible company if the price is right. So I think price has to be very much part of your investment philosophy when you talk about value investing. And at the right price, you can buy a declining company and walk out of this. I mean, you have a tobacco company in your business, fossil fuel company in your portfolio. I think that you could argue that these are businesses which are going to decline over time, but that doesn't mean the bad

Starting point is 01:01:05 investments at the right price, you should be buying Philip Morris or ExxonMobil, but at the right price. And I think that becomes the key phrase to use when you think about looking at a company. So with the difficulty in trying to get good returns in the market, I'm sure many in our audience have some or a lot of their portfolio and index funds, oftentimes something like the S&B 500. And a number of guests on our show have expressed concern around expected returns and the valuation levels of the index. So many companies haven't performed very well. So it's like that study you mentioned earlier where the top companies are really carrying a lot of the overall performance of the index. I'm curious to get your views on today's valuations and maybe what expected returns investors

Starting point is 01:01:51 can expect to get out of something like the S&P 500 today. Maybe the strongest argument for investing in index funds is precisely because the big winners get bigger and keep winning. If you bought an index fund in 2010, you had the Mag 7 in your portfolio. I mean, you had it indirectly. So I think one of the advantages in an index fund is you're not going to be that investor misses out on the biggest winners. Are there downsides? Yes. With an index fund, you will never beat the market. You'll match the market. The argument is that the market is overvalue. That's a different argument. You're making a market timing argument. I'm a terrible market timer. One of the things I do at the start of every month is I compute the implied equity risk

Starting point is 01:02:30 premium for the S&P 500. Essentially, what can people expect to earn as a return on the S&P 500 given the level of the index? That equity risk premium tells me how much I'd make over and above the T bond rate. Start of July of 2024, that number was 4.11%. The way to think about it is you could make about 4.4% in a T bond. You're making 4.11% more on an expected basis buying the S&P 500. That's a much lower premium than at the start of this year or for much of the last decade. So one way to look at that is maybe I'm getting too lower premium, which is a different way of saying, stocks are overpriced. But the question is, what are you going to do instead? Where are you going to take the money? It's not like there are other asset classes that are cheap that you can move the money to.

Starting point is 01:03:14 So when I look at the 4.11%, I'm less comfortable than I was at the start of the year about the pricing of stocks. But I can't act on it. I don't know what to do with that information. Maybe if the equity risk premium, got down to 2%, which is what it was at the end of 1999, I might lower my allocation to stocks saying stocks look overpriced. But that's not where we are right now. So my final question or talking point here, I wanted to touch on today. So in preparation for this, I heard you discuss part of the reason you enjoy teaching is that you like reigniting people's love for learning and just share your love for learning and love for teaching. And it reminded me of when I was in college, I was listening to this very podcast. And it sort of helped me

Starting point is 01:03:57 reignite my love for learning about investing in particular, especially. And it's an interesting point because I think school in many ways nowadays can almost kill that love, which is like the opposite of what it should be trying to do. So I was curious if you could talk about that, just like sharing that passion for learning and teaching and trying to reignite that within your students. We live in what I call the Google search era, which is when you have a question and you want to get the answer, the easiest way to get the answer is to type the question into Google search and you get the answer instantaneously. I think that one of the problems doing that is we're losing our power to reason our way to answers. To me, that's what learning is. When you have a

Starting point is 01:04:38 question, you try to reason your way to an answer. And I think we live in a period where we're being spoon-fed the answer. They might be very good answers, but they're not the answers we reasoned through. I think evolution takes away skill sets you don't use. I cannot read a physical. map anymore because I have GPS all the time. I worry about the fact that as we get more and more into this Google search era where everything has an answer online, who are losing our capacity to reason. So I teach because I want people to see how I reason my way to an answer. I can't tell them what the answer is because that's my answer right now. It could change over time. But if we can teach them how to reason the way to an answer, I'm hoping that they will rediscover that reasoning side.

Starting point is 01:05:23 me, that's a fun part of learning, is reasoning your way to an answer. But I think we're fighting technology. We're fighting a world where we're constantly busy because reasoning requires having some open space and time to think about things. And we're in a hurry. In a hurry, it's difficult to find that time to reason your way to answers. Yeah, and I think that really resonates with what we're trying to do here with the show. I think a lot of people, when investing gets brought up, they want to know what stock should I buy. We can't just share the answer. We can share maybe some thought processes to help aid you in that journey, but, you know, that's not the way you should be approaching investing.

Starting point is 01:05:57 When I value a company, I'm very open about the fact that I value companies for an audience or one, me. My value drives my decision. It shouldn't drive your decision. That's why when I value companies, I provide my story and the architecture of the valuation to you so that you can disagree with my story, value the company on your own, and make your decisions. I think when you outsource investment decision making and say, I'm.

Starting point is 01:06:22 I'm buying the stock because Goldman Sachs told me to buy the stock. Or I'm buying the stock because Warren Buffett bought the stock. You're outsourcing a decision-making. And we've got to take ownership of our investment decisions because that's the healthiest way that I can think of investing. Well, Aswath, as always, greatly appreciate you joining me on the show here again. I'd like for you to give a handoff for how people can get a hold of the corporate life cycle if they like to. Amazon will always work.

Starting point is 01:06:51 I think almost every books a million has, I mean, most of them are online anyway, bonds and noble books a million, you can find them in. Target, I think, carries it too. So I'd be interested walking to a target to see if my book is actually on that book stacks. Sounds good. Well, thank you so much. Thank you. Thank you for listening to TIP.

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We Study Billionaires - The Investor’s Podcast Network - TIP654: Investing Across the Life Cycle w/ Aswath Damodaran

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