Aswath Damodaran - Making Sense of the Market Pt. 2 - [Invest Like the Best, EP.349]

Today’s guest is Aswath Damodaran, who is joining us for a second time on Invest Like the Best. Aswath is a Professor of Finance at NYU’s Stern School of Business and is often referred to as the Dean of Valuation for his clarity of thought on the subject. This conversation picks up where we left off 18 months ago and covers a wide range of topics from macro risks to Nvidia and the process of crafting a personal investment philosophy. Please enjoy this great discussion with Aswath Damodaran. Listen to Founders Podcast Episode #311 James Cameron For the full show notes, transcript, and links to mentioned content, check out the episode page here. ----- This episode is brought to you by Tegus Converge — the first virtual event centered on the world of investor research. When twin brothers Tom and Mike Elnick realized that the research process for investors was broken, they founded Tegus to fix it. Now the people behind the most trusted research platform are bringing institutional investors together to investigate the state — and the future — of fundamental research. On November 8th, join industry luminaries like IGSB Founder Reece Duca and Daniel Gross, AI Expert, Entrepreneur and Investor, to dig into the latest research trends and breakthrough technologies shaping the investment landscape. Register today at tegus.com/register. ----- Invest Like the Best is a property of Colossus, LLC. For more episodes of Invest Like the Best, visit joincolossus.com/episodes. Past guests include Tobi Lutke, Kevin Systrom, Mike Krieger, John Collison, Kat Cole, Marc Andreessen, Matthew Ball, Bill Gurley, Anu Hariharan, Ben Thompson, and many more. Stay up to date on all our podcasts by signing up to Colossus Weekly, our quick dive every Sunday highlighting the top business and investing concepts from our podcasts and the best of what we read that week. Sign up here. Follow us on Twitter: @patrick_oshag | @JoinColossus Show Notes (00:02:45) - (First question) - The general prevailing narrative in markets today (00:05:00) - The biggest business implications given the current market landscape (00:06:45) - Why it’s bad to have risky founders with cheap capital trying experiments (00:08:53) - The natural rate of interest and how it’s priced (00:09:55) - His updated view and thoughts on what’s currently driving inflation (00:11:05) - What it’s felt like valuing companies given rates being where they are (00:13:35) - Macro variables that most have his attention today (00:18:45) - Whether or not international equities will become a place of interest (00:21:53) - The unique absolute basis of NVIDIA’s growth (00:23:25) - His take on the new wave of AI in a broad sense (00:29:15) - Trying to value AI companies without tangible business models (00:32:45) - The parts of his own valuation process that are beyond automation (00:34:20) - Thoughts on a natural end state equilibrium for active management (00:35:55) - Commonalities between investors who beat the benchmark (00:38:35) - Episodes on his own path that lead him towards his investment philosophy (00:42:05) - How he goes about valuing non-traditional companies like sports franchises (00:46:45) - The world of entertainment and how he sees it as a business today (00:53:45) - The best business models he’s ever seen (00:55:40) - What valuing Instacart taught him about online grocery shopping (00:58:55) - The most interesting company he valued over the last year (01:03:25) - How bank failures changed his thinking on our financial systems and banks as businesses writ large (01:06:15) - The changing attitude towards ESG investing (01:11:11) - Why there are still so many pools of capital that pursue an active strategy (01:11:06) - Being sick and tired of the conversation always revolving around central banks (01:15:53) - What he’s most excited to look into over the coming year (01:17:53) - Major differences between a financial and an accounting balance sheet

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Patrick O'Shaughnessy?

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• 0:35Patrick O'Shaughnessy?

  Hello and welcome, everyone. I'm Patrick O'Shaughnessy and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, stories and strategies that will help you better invest both your time and your money. Invest Like the Best is part of the Colossus family of podcasts and you can access all our podcasts, including edited transcripts, show notes and other resources to keep learning at joincolossus.com.

• 1:00Speaker 01

  Patrick O'Shaughnessy is the CEO and founding partner of Positive Sum and the CEO of O'Shaughnessy Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of Positive Sum or O'Shaughnessy Asset Management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of Positive Sum or O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast.

• 1:32Patrick O'Shaughnessy?

  My guest today is Aswath Damodaran, who is joining us for a second time on Invest Like the Best. Aswath is a professor of finance at NYU Stern School of Business and is often referred to as the dean of valuation for his clarity of thought on the subject. This conversation picks up where we left off 18 months ago and covers a wide range of topics from macro risks to Nvidia and the process of crafting a personal investment philosophy. Please enjoy this great discussion with Aswath Damodaran.

• 2:01Patrick O'Shaughnessy?

  So Aswath, about a year and a half ago now, we had our first conversation, which was, I think at the time, our most listened to ever. So let's see if we can top it here today. To do that, we have to do a whirlwind tour of the world of markets and business and investing. And I thought I'd just begin by asking you for your state of the union on the market overall. Just started kind of the last part of the year, the last quarter, been kind of a wild year, last 18 months. I'm just curious for your take on the general prevailing narrative, as you see it, of what's going on in markets today.

• 2:31Speaker 02

  I think there are two prevailing narratives, and one of them has to be right, the other one's going to be wrong, with profound implications. The first is that the last 18 months is actually the aberration, that we're going to revert back to where we were before that, that the Fed is going to reimpose its power, rates are going to go down, everything's going to go back to the way it was. That's one perspective. And a lot of people are doing mean reversion to the last 10 years. That is the perspective they're taking is, hey, you know what? This too shall pass and everything's going to be okay. The other is that maybe the last 18 months are the norm, not the exception. And what we saw in the decade leading into that was actually the aberration. And you know what?

• 3:15Speaker 02

  There's a pretty good argument that the latter is, in fact, the more reasonable assumption. And here are the implications. You look at a 4.5% rate, you're shocked, especially if you're 25 or 30, you're saying, T bond rates at 4.5%, nobody's seen anything like this before. Not true, we've seen much worse than this. But I think because you had a decade of low inflation, low interest rates, complete access to risk capital, it kind of altered, it skewed our perspective and psychology. How we frame what we're looking at is huge. And for people who are framing the last 18 months in terms of what happened the previous 10 years, it looks odd. But if you frame it in a larger perspective, looking back over time,

• 3:58Speaker 02

  this is perhaps more closer to the norm than what you saw in 2021 or 2020. So I think as we look at where will we end up after all of this shakes out, recession, inflation? I wouldn't be surprised we ended up where we were in 2007. Four percent rates and three percent inflation and a market that reflects that.

• 4:19Patrick O'Shaughnessy?

  What are the biggest market and business implications of that new normal or status quo? If that is the case.

• 4:27Speaker 02

  I think for those companies that got used to using six percent or seven percent cost of capital, it's time to let go. I know there are companies that still hang on to those hurdle rates they set in the last decade, saying, you know what rates are low, therefore those costs of capital are not coming back. So the way we assess projects if your company has to change. The mix of debt and equity. When you have one percent risk free rates, your cost of debt is two and a half percent. Your cost of equity is six and a half percent. The mix of debt and equity used as a company is affected by that. That too has to be revisited. And in terms of dividends and buybacks, when you think about what you have to be to be able to give cash back to investors. In fact, everything about the way companies get run is altered when you have four percent rates

• 5:11Speaker 02

  as opposed to one and a half or two percent rates. As investors, I'll tell you from a personal perspective, there's a very, very specific change I've noticed. And three years ago, they asked me how much cash I had in my online brokerage account. I didn't know and I didn't care. After all, what was I going to do with the cash? Put it in TIBLs and make point zero three percent? Today, I'm acutely aware of cash when it's sitting around. And that's something that people have become used not to doing, that you have to start. Because idle cash is losing cash. Because when you have three or four percent inflation, that cash is losing value. And you've got to get it into places. TIBL rates might not stay at five and a half percent, but they're definitely not zero.

• 5:54Speaker 02

  So some of the things we got sloppy on as investors and companies over the last decade, I think we need to revisit. The other, and this has got to do with the risk capital question, which I think is a separate issue. Sometime in the middle of last year, we noticed that risk capital went to the sidelines. Just to put in perspective, for a decade, risk capital was not just accessible, it was excessively accessible. I mean, I know that sounds like a strange word, saying, how can you have too much risk capital? Because when you have too much risk capital, companies are able to raise money too easily. So as a consequence, businesses that should never have become businesses, with founders who were borderline sociopaths, were able to raise billions of dollars

• 6:36Speaker 02

  and then burn through them because risk capital is through money at them. That's hopefully not going to come back. So I think that there are things that you saw in the last decade that reflect the environment we're in, low rates, lots of risk capital. They don't think we're going to revisit, even after we come out of this downturn into a recovery.

• 6:58Patrick O'Shaughnessy?

  Can you explain why it's necessarily bad? Or that we don't want borderline sociopaths with cheap capital trying crazy experiments?

• 7:07Speaker 02

  Because those experiments have larger consequences. You provide capital to, let's say, a bike app company. The line, the Bird Bikes, you probably saw them. And I remember looking at them saying, this is a horrific business model. I don't see how this works. But those bike app companies raised billions of dollars of capital. They came into cities like San Diego, where I live. In a period of months, they destroyed an infrastructure of bike rental businesses that used to be in this city. They were able to do that because how can those bike rental companies compete against somebody who's giving away the product for free? Which is what they were doing because they had so much capital. Those bike rental companies are gone, they're not coming back.

• 7:51Speaker 02

  And these app companies that replaced them have now run out of capital because they're bad businesses. The only problem is we can't go back to where we were. So there is really economic damage created when you allow businesses that really shouldn't take off to become large and threaten the status quo.

• 8:09Patrick O'Shaughnessy?

  Could you riff a little bit on the natural rate of interest, whether or not interest is ever really priced and set by a market mechanism versus by central banks or the Federal Reserve?

• 8:19Speaker 02

  I'll give you my simple rule. It's inflation plus one to one and a half percent. So expected inflation in the long term, not last year's inflation plus one to one. That's your natural interest rate. So then when people ask me, where will interest rates go? I turn the question back and say, where do you think inflation is going? Because without answering the inflation question, the interest rate question becomes a search and emptiness. You have really nothing to anchor it to. And it's a rule I've followed even during the last decade when people told me the Fed's had rates. I said, that can't be right. The Fed doesn't set rates. So I would say the natural interest rate I would expect to see would be, and that's why I said in the long term, I see 4% T bond rates and 3% inflation.

• 9:01Speaker 02

  Because even though we might have broken the back of eight, nine, 10% inflation, I don't think we're going to go back to the one and a half percent inflation we saw in the last decade.

• 9:10Patrick O'Shaughnessy?

  Talk more about inflation. We spent a bunch of time at the start of our conversation a year and a half ago, talking about it. That was right at the beginning, when it was very uncertain, like hard landing, soft landing, all these things that everyone was talking about. What is your updated view of what is driving inflation, the past that it could go from here? And anything that surprised you about the story and how it played out?

• 9:28Speaker 02

  Not at all. I think it's taken center stage and like all stage hoggers, it refuses to leave. This is why when we talked a year and a half ago, I said, you know what? You let this genie out of the bottle, putting it back in the bottle is not going to be easy. And a year and a half later, guess what we're talking about? We're talking about inflation, the economy and interest rates. And that's always been the case with inflation. It's not a macro problem that you can get a handle on quickly. That's why if you look at how little resolution we've had of uncertainty in this year, it's partly because one of the big uncertainties is inflation and getting resolution on it in terms of has it gone down, will it stay down? Takes a long time. So I wouldn't be surprised if this spills over into 2024

• 10:13Speaker 02

  and we're still struggling with where will inflation end up? And that's partly what's driving the Fed crazy is because until they have a handle on inflation, they're kind of stymied.

• 10:24Patrick O'Shaughnessy?

  You're someone that values by hand lots of different kinds of businesses. You're a dabbler in valuation and the king of valuation in academic circles. What does it felt like for you valuing companies with rates the way that they are relative to the last decade or so? What are the things that you've noticed as themes when you're valuing companies, let's say, in the last year?

• 10:45Speaker 02

  Quite a while ago, well before the low interest rate environment even kicked in, I decided I wanted to make my valuations as insulated as I could from macro variables. And the reason is very selfish. If you're spending all your time thinking about inflation and interest rates and economic growth, you don't have time to think about the company value, whether it's Coca-Cola or Instacart or Facebook. So the way I've constructed my valuation models is to make the macro variables cancel out. Let me give you an example. Now, in the last decade, low rates allowed every company to have low cost of capital. It's the truth. You can't override and say, I'm going to use a high cost of capital. I don't like these low rates. I used to low cost of capital. That's a benefit. If you think about having a low cost of capital, it should push up value. But here's the counter.

• 11:30Speaker 02

  Those low interest rates also told me that there was going to be low inflation and low real growth in the future. So when I projected out growth for these companies for the long term, I also pushed the growth rate down to reflect those same views. You know, so the same low inflation that pushed interest rates and also meant my growth rates were lower. My pricing power was lower. The effects in a sense offset. That's why my valuations don't change dramatically. And that's why I'm not surprised the market hasn't imploded. Because if you left everything as is and kept the same cash flows you had two years ago and you raise the discount rate by two or three or four percent, which is what we have, stocks should be down 40 or 50%. They're not.

• 12:15Speaker 02

  And the reason for that is companies are flexible, they're adaptable as inflation comes through, guess what they do, they pass that inflation on to US customers and the companies that are better suited to doing that are more protected against inflation. So when I design valuation models, I try to keep my focus on the company and not get distracted too much by macro variables, not because it won't affect my value, but because they affect everyone's value. My job is to assess the value of the company, given where the market is now and given macro conditions now, and I try to stay in that here and now as much as I can.

• 12:52Patrick O'Shaughnessy?

  What macro variable or trend most has your attention now today?

• 12:57Speaker 02

  When I look at all of the macro variables, my worry is more about political risk and crises coming through. The last twenty years, one of the dark sides of globalization is everybody's problem is everybody else's problem. The biggest macro issue to me is China, because China is in trouble. And the problem is, unlike Russia, if China goes down, it takes the rest of us down with it. When you're the second largest economy in the world and you've created interconnections with every big multinational in the world, troubles you have as a country spill over into every company. So to me, that's going to be the country to watch and the biggest macroeconomic risk,

• 13:42Speaker 02

  and that macroeconomic risk could become a political risk. And I am not looking forward to the kinds of damage that it'll create for investments, for companies, for businesses around the world.

• 13:57Patrick O'Shaughnessy?

  Can you describe the nature of the trouble that they're in as you see it?

• 14:01Speaker 02

  I think that in a sense, to see why we're all in trouble, we've got to go back twenty years and look at why companies jumped into China with both feet without even thinking through. One of the big selling points for China was, we can tell you what policy will be, not just for next year, not just for the next five years. But for the next forty years, I've talked about would you rather as a business invest in a democracy or an authoritarian regime? And the answer that many businesses often give is democracy is chaotic. People change their minds, governments change, policies change. I'd much rather go with an authoritarian

• 14:40Speaker 02

  regime, which can give me the guarantee that policy will not change. And that bargain worked out in their favor for many of those twenty years until perhaps three or four years ago, it was viewed as an unmixed blessing. In fact, companies in trouble often use the China card. Look, we're in China, and all of a sudden their price will pop up five percent or ten percent. But we're now seeing the dark side of being an authoritarian regime, which is the same forces that make things predictable can create what I call discontinuous risk. They can change overnight. And you saw this first with big Chinese tech companies, Alibaba and Tencent and JD, which for a long time were rewarded because Beijing was viewed as being on their side.

• 15:24Speaker 02

  And suddenly magically in two thousand and nineteen, Beijing said, no, we're not on your side. We are adversaries. Have the value of those companies because effectively if Beijing is your adversary and you're a Chinese company, you really are stymied in almost everything you do. So I think the China problem is the same government that guaranteed predictability is now going to be fighting for its political life. And in the process, they're going to make decisions and create policies that are going to cut against everything they told you they're going to do for the last twenty years. And companies are looking at that saying, well, what will that mean? They're trying as fast as they can to move their production from China. But even if you moved all

• 16:08Speaker 02

  of your production to China, which will take a long time, China is still one of the largest markets in the world. How do you walk away from one point four billion people? And that's where twenty percent or thirty percent or fifty percent of your growth is going to come. So this is going to be a dilemma that not just Chinese companies, but multinationals, big companies around the world are going to face. And as investors in those companies, we're going to have to face as well.

• 16:31Patrick O'Shaughnessy?

  Do you think that it's a situation of mutually assured economic destruction, given how intertwined everything is that they're both manufacturer and consumer partners to so many companies in the world?

• 16:42Speaker 02

  No, I think I'm less worried about the US-China political tension than I am about companies finally coming to the recognition that China is a mixed blessing. I think even if you took the US-China political relations and put them to the side and say, "We can deal with that," I think the gloss is off. I mean, companies now recognize the dangers they've exposed themselves to because some of them took a Faustian bargain to enter China. They set aside everything they told us they believed in, whether it's Apple or Nike, because the market was so big. They went into the market saying, "We're okay with that Faustian bargain because look at how big the market is." And now they're looking at that bargain and saying, "Maybe it's not worth it for us."

• 17:27Speaker 02

  So to me, this is, I think, a much bigger issue than getting the politics fixed. This is something which is going to lead to withdrawal from China of many companies. The question is where they're going to go is going to drive the next big market to look at, whether it's India, whether it's Vietnam, or it's Brazil. I think it's going to be a question of where will all that money go, whether it's investor money or company money? And that's going to be a big factor in where you're going to make money as an investor and where you're going to make money as a business.

• 17:57Patrick O'Shaughnessy?

  There used to be this chart that would float around a lot that was this rolling 10- or 20-year return chart comparing the S&P 500 to like MSCI Efa or something, showing US versus international. And you got this very nice back-and-forth pattern. There'd be a period of US dominance and international dominance, and it went back and forth a few times, going back to the 70s. And then you got this just straight line up for the US, just completely dominating the equity markets internationally for a really long period of time. How do you think about that relationship going forward as investors look for interesting things to do that are not the same as everybody else? Do you think that international equities, which have become completely ignored for a lot of investors, are a place of interest now?

• 18:38Speaker 02

  I think it largely reflects the fact that the US has been the country that benefited most from the shift from a 20th-century economy to a 21st-century economy. If you look at the 10 largest market cap companies in the world. You've got five of the six Fangam stocks, other than Netflix, the other five are all on there. And then you've got Nvidia and you've got Tesla. And in a sense, the US, in spite of all of its faults, has created at least an environment where the companies that are most suited for the 21st century economy are most likely to grow. They're definitely not going to show up in Europe. In fact, you can almost guarantee that the next great company is not going to come out of Europe

• 19:20Speaker 02

  because it creates an ecosystem that makes it almost impossible to challenge the status quo. So the same things that worry us about the US, the chaos, the fact that you really can't keep control are what's allowed these companies to explode in value. So as you look at that straight line of the US, I wager that almost all of that gain came from these big tech companies. In fact, we know that the Fangam stocks alone accounted for one in six dollars a market cap created across all US companies in the last decade. The kind of like eight to 10 trillion dollars of value just in those six companies. That's mind boggling.

• 20:00Speaker 02

  The question to ask then, looking forward, is that big run over probably for those six companies? But I'm not sure the next six would come from the US as well. Now, we can debate which the next six will be, maybe Nvidia and Tesla, two of the six. But we really have no idea. But I think in a sense, the kinds of companies that benefit from the uncertainty, from the shifting status quo that you've seen in the 21st century are exactly the kinds of companies that are most likely to grow and develop in the US, not in the rest of the world. So I wouldn't be surprised if the US maintains its lead in that return table. But only if you invest across the board.

• 20:45Speaker 02

  So if you're a US investor who's invested in Coca-Cola and Washington Post for the last 20 years, guess what? You haven't seen that straight line benefit that you've seen by investing US stocks collectively. So I think you've got to be careful about not being diversified, about not spreading your bets, because this isn't just betting on geography, it's betting on a subset of that geography. In this case, it's tech in the US that's carrying us.

• 21:10Patrick O'Shaughnessy?

  Have you seen anything like the recent results from Nvidia? In business that you've covered.

• 21:16Speaker 02

  On a percentage basis, yes. On an absolute basis, no, because you added $700 billion of market cap in one year. That's astounding. Now, you to do it that fast. Tesla, maybe in early 2021, added a half a trillion. I think that it reflects the fact that it caught the mood of the moment almost perfectly, which is AI. I mean, for all the talk of AI and ChatGPT, Nvidia is one of the few companies that actually has a tangible business in AI. It's a $25 billion market now for AI chips. Its estimate could be as large as $350 billion. Nvidia has an 80%

• 21:57Speaker 02

  market share. And if it preserves the large market share of that $350 billion market, that is a huge market on which it makes almost 50% operating margins. So there is a story for why it took off. Whether it justifies the amount of market cap added is different because, as you probably know, I did try to value the AI piece of Nvidia. I doubled the value of Nvidia as a company with AI in there, but I was still 40% below the market price. So I think the market's gone a little over the top in terms of reacting to the AI aspect. But I think that it captures what happens if you're in the right place at the right time as a company, and Nvidia is in the right place at the right time.

• 22:41Patrick O'Shaughnessy?

  It feels like AI is this year's inflation for you and I to discuss. It's pretty amazing that almost all of the AI storyline has happened since our last conversation, like the models that have gotten everybody so excited, ChatGPT and Dolly, Mid Journey and all these things. I'm just going to step back and get your broad take on the technology, the implications, the pros, the cons, everything.

• 23:02Speaker 02

  We ask people, when did AI start? They probably will trace it to the first news story they read about ChatGPT, which was just about a year ago, year and a half ago. The reality is AI is a culmination of two trends over the last 20 years coming together. The first is big data. Data collected, not just the fact that you can collect and put data online, but data is collected on our personal lives by apps, all coming together. So that's been building up. The other is the building up of computing power, where as chips get more powerful, computers are getting more powerful. Big data plus powerful computing power is effectively AI.

• 23:41Speaker 02

  So AI has been building up for years. What ChatGPT did was it brought that to the public consciousness because people could see the effect on their daily lives. I remember my wife coming back, she's a fifth grade teacher and saying, you know what? Now I use ChatGPT to send emails to my parents because it writes a very good email. So ChatGPT, which is really low tech AI, if you think about it. It's been the door that opened that people say, oh my God, there's a whole world there of how things could change in the future. So I think AI has been building up to where it is. It's not something that happened last year, last year and a half. It's something that's been building up over the last twenty years.

• 24:24Speaker 02

  That said, though, the question is, what exactly will AI deliver over the next decade? We've seen lots of these buzzwords come and go. For instance, the metaverse, remember how hard it was for a while? Nobody talks about the metaverse anymore. And I confess, I was never excited about the metaverse because unless you're a twenty five year old who loves virtual reality glasses, nobody wants to spend the rest of their lives in a virtual universe. This is not healthy. So the metaverse never struck me as something. The cloud business, great business, but you can see it's a niche business. It's not a business that most of us can relate to as individuals or even as companies because it's a service provider companies.

• 25:07Speaker 02

  I do think AI offers the promise or the threat of changing the way we live and work. In fact, I'm lucky enough or old enough to remember four big shifts in my lifetime. The AI being the fourth one. The first was PCs. I came into a world where I actually did my first valuation on a ledger sheet with a pencil and a calculator. So I did my first valuation before PCs and Excel. The PC business changed the way we work, changed the way we compute things. So the PCs really made a difference, not just to businesses, but to individuals. The second big shift was the internet. The internet broadly brought together online retail and.

• 25:52Speaker 02

  The third was smartphones and basically what that created in terms of changes in the way we interact, the way we do business. And AI offers that promise or threat of changing the way we live and work, that it could have an effect. You notice the screenwriters, one of the big issues that they were fighting over was, will you let AI write scripts for you or are we guaranteed that we're still going to get paid to write scripts? So you could see this has permeated every aspect. I wouldn't be surprised, the auto workers, one of the things in their demands is an AI component as well. So AI you can see is coming to people's consciousness where they're aware, whether

• 26:36Speaker 02

  true or not, that it could change the way they work and live. The question though is, what will it do to us as an economy, as markets, as a society? There, I'm a lot more muted than some of the biggest AI advocates. Their conviction is, this is going to be amazing, life is going to be so much better with AI. And the reason I'm skeptical is I've heard this before. They told us that PCs would reduce the mechanical stuff we did. They would take this grunt work of entering numbers in a calculator and therefore free us to be creative and thoughtful. Not true. It actually made us more mechanical. We were told the internet would give us this incredible reach in terms of being able to

• 27:21Speaker 02

  get information. Instead, we drowned in data. They told us social media. We'd be able to keep our friendships alive with people who are further away. It actually has destroyed friendship as we know it because everybody's got a virtual friend and very few people seem to have real friends. My point I'm making is every one of these changes is a dark side. With AI, we see some of the dark side up front, which we didn't with the others. But I think it will have a dark side. For every winner, there will be losers. For every disruptor, they will be disrupted. So as I listen to all of these sales pitches for how great ChatGPT is and how much AI will do for us, I keep thinking 10 years from when we look back, what will be the net effect?

• 28:05Speaker 02

  There will be a few big winners. There'll be a lot of wannabes and there'll be quite a few big losers. You just have to hope you're not on that loser's side because every big movement creates losers. I'm a little more cynical about the AI pitch than most people. I understand that it's going to be a big business. I understand that companies like Nvidia and perhaps Microsoft that can make money on this business. Collectively, as a society or as an economy, are we going to be better off because of AI? I'm not so sure.

• 28:36Patrick O'Shaughnessy?

  Have you tried to value any of the big AI companies like OpenAI or something like this in the same way that you did Nvidia? Understanding there's less information.

• 28:44Speaker 02

  It's not even that there's less information. You need a business model to value a company. Unless you tell me how you plan to make money, you're not a business, you're just a movement. So if your business is that you're going to create the subscription model, then we're ready to talk. If you're saying, look, I'll charge for transaction, I'm ready to talk. But a lot of so-called AI businesses are not businesses yet. They're AI movements, AI ideas. And until they start to take some form, you're buying an option. There's no reason why you shouldn't buy an option. Maybe OpenAI is a great option to be part of a business, but you're not buying a business.

• 29:24Patrick O'Shaughnessy?

  Do you think that investment firms will change a lot and trends of investment firms will change a lot as a result of the interest rates and AI and other big trends? Like one thing that pops to mind is private equity firms that have relied on very, very low cost debt for a long time to earn fantastic returns. Obviously, that picture has changed. Maybe that affects private equity at large. That or other trends like in the investing world, institutional investing world specifically, anything that comes to mind for you that you're thinking about?

• 29:51Speaker 02

  But the question that every active investing group, P, VC, mutual funds is asking is, will this check the slide? Because let's face, they've been on a 50-year ride down. They've been disrupted, they've lost market share to passive investing, to automatic investing, to mechanical investing. And I think each new movement, they looked and say, maybe this is what will stop the slide. Maybe this will bring us back. And I actually think it's going to make the slide worse. Because let's face it, eighty to ninety percent of all active investing, including PE, including VC, including mutual fund investing, is mechanical. And it's mechanical, and machine's going to do it much better than you can. I mean, that's part of the reason that over the last decade,

• 30:36Speaker 02

  active investing lost so much money to passive investing. You could create an ETF to replicate what mutual fund managers did by just watching them. And he's got to be able to do that almost effortlessly. Everything you do is going to be replicated in milliseconds. So if you made money as a high-frequency trader by trading quickly, a little more quickly than everybody else, you were able to do it for two years in the middle of the last decade. You might be able to do it for two months now. Active investing is only going to get more difficult. And when you say PE and VC benefit from low interest rates, they did. But collectively, it wasn't a good decade for either. The average VC investor, the average PE investor,

• 31:18Speaker 02

  made about as much money as the average S and P five hundred investor. Of course, there were winners. There's a selection bias with PE and VC where you look at the winners. One of the talks I give is who put the smart in smart money? Because I've looked for forty years for the smart money, money that presumably gets in before everybody else and gets out before everybody else. There is no group of investors that I can point to and say, that money is smart money. It's just greedy money that ultimately runs into a wall sooner or later. So I think there's going to be more accountability sooner with higher interest rates. But collectively as a group, I don't see groups benefiting or paying a price because the average is still the average.

• 32:00Patrick O'Shaughnessy?

  What parts of your own valuation process remain outside the reach of automation?

• 32:07Speaker 02

  I'm not sure. And I keep asking myself that question because I'm open to the possibility. When I teach, one of the things I tell people is, look, I want to make myself unnecessary, indispensable. That's the essence of good teaching, is you want to make yourself not necessary. We've taught people a way to think where they don't need you to think through a problem. Every year before I start teaching, I say, is this the year I need to stop teaching? Can I basically say, hey, I'm not necessary anymore? And I ask the same question as an active investor. I'm not married to active investing. If next year I discover that what I'm doing is really doing nothing for me, I don't make a living on active investing. I don't have to put on a front. It works even when it doesn't.

• 32:53Speaker 02

  So if it doesn't work, why would I want to waste what's left of my life trying to value stocks and invest on that basis? But it's really not giving me any payoff. So I'm open to the possibility that a lot of what I do can be mechanized. I've passed on all of my blog posts to a friend of mine who's an AI specialist. And he's trying to create an AI engine that can replicate what I do in my blog posts. And he said, would you have a problem with it? I said, not at all. If you can do it, all the more power to you. I'd love to see a blog post valuing ARM or Birkenstock, which is what I'm working on right now with your AI engine. It's not quite there yet. Thank God for that. Could it be there a year or two from now? Absolutely. And I'm open to that possibility.

• 33:39Patrick O'Shaughnessy?

  Do you think that there is a natural end state equilibrium for active management and its role? Obviously, we need some of it. Someone has to price securities. What do you think that end state might be or when it might be?

• 33:52Speaker 02

  It's actually a good question because one of the most famous papers written in the 1980s was a paper titled, this was when efficient markets were at their peak. It was a paper written by Sandy Grossman and Joseph Stiglitz, won the Nobel Prize called, On the Impossibility of Efficient Markets. And they made a very simple case. If markets are efficient, you create the seeds of inefficiency because nobody's looking for information. Nobody's looking for mistakes. Markets don't become efficient automatically. They become efficient because people look for mistakes. They catch them, try to make money on them, and in the process, they drive mistakes up. So you're right, there is going to be some floor on active investing where it ebbs and flows.

• 34:35Speaker 02

  My guess is it's going to drop too low. There are going to be too many mistakes. Active investors are going to come in. But here's what I can say, the steady state number of active investors is going to be far lower than the number we see out there. There are far too many active investors and we're going to see the numbers drop off. So all those buildings that Fidelity and State Street and T. Rowe Price fill up are going to be only one quarter as full. In steady state because so much of what's done there is just creating noise. It's not adding value.

• 35:08Patrick O'Shaughnessy?

  You said earlier, I can't remember the number you used, let's say 10% of investors that are successful in terms of beating simple benchmarks or something like that over the longer term. Have you noticed anything in common between those investors?

• 35:20Speaker 02

  In fact, I have an entire class I teach called Invest in Philosophies because I started with that question. When I started looking at it, I assumed they'd all be students of Ben Graham, the old legend is. And I discovered that when you look at the most successful investors over time, consistently successful investors over time, they're a mixed bag. You've got value investors, obviously Warren Buffett from that group. You've got growth investors like Peter Lynch. You've got traders like George Soros. George Soros, I've never seen George Soros talk about the value of a company. He's a macro trader. So as I looked across these investors, what I noticed is there's no one pathway to greatness, to God.

• 36:02Speaker 02

  There are multiple ways in which people seem to win. So then I started looking at what do they have in common? Two things. One is they have a core philosophy that remains unchanged over their investing lifetimes. Now, I've had disagreements with Warren Buffett on things he says, but here's what you got to give him credit for. He has a core philosophy. You know exactly what it is, and it guides every strategy he adopts. So there's a core philosophy built around beliefs about markets and data that makes sense. The second is, they have personalities that match up to that philosophy. We talk about everybody wants to be a long-term value investor, especially after you read three books on Warren Buffett.

• 36:47Speaker 02

  Of all those people who try, very few people succeed. So you say, what goes wrong? Because to be a long-term value investor, first you got to be incredibly patient, which often is not under your control. Warren Buffett has insurance, capital, he's investing. You and I might be investing our own money or clients' money. So we've got to be able to be patient. And second, you have to be able to withstand peer pressure because you're often moving against the crowd. Those are psychological factors. If you're naturally impatient and you're swayed by the crowd, I don't care how many books about Warren Buffett you read, you're not going to be a successful value investor. When I teach a class, I tell people, look, there is no right investment philosophy, but there's one that's right for you.

• 37:29Speaker 02

  And to find that philosophy, the person you've got to understand is you. Not Warren Buffett, not Peter Lynch. Spend less time reading about other successful investors. Spend more time looking inward at the things that make you comfortable and uncomfortable. Cause that is at the heart of building a successful investment philosophy that you can stick with in good times, which is easy, but also in bad times, which is not that easy.

• 37:56Patrick O'Shaughnessy?

  What were the important episodes of your own path to finding the investment philosophy that's right for you? Couldn't agree more with the alignment of personality and style and commitment, but it's always helpful to hear an actual story about how that came to be because it sounds simple when you say it. I think it can be quite hard to actually pull off in practice.

• 38:16Speaker 02

  I think with each big movement I talked about with PCs, with the internet, with social media, what I realized as I went further and further in is the tools I came in with and the beliefs I had coming in were shaken. So when I came into the dot com boom, I came with the old time value investor outlook. You need earnings, you need cash flows, you need them now, you need them on the balance sheet. And the more you went through that dot com boom, I started looking at that and saying, maybe that's not right. We have to start to think about cash flows for growth companies, but there's very little here. So with each big shift where I've been wrong for an extended period, there's a point in time you have to make the judgment. It's not the market that's wrong.

• 39:01Speaker 02

  It's something you're missing that you have to start to incorporate into your philosophy. Doesn't mean you abandoned the way you think about markets. I still believe value matters and have to invest based on value. But the way I estimate value, I've got to be pragmatic enough to expand it. I'll give you a very simple example. The first time I valued Uber, I valued it by looking at the car service business as it existed then. Car service business, when Uber came into the market, was composed of taxi cabs and limousine companies. And I went around the world, added up all of those, came up with a total market of about a hundred billion. And he said, that's the total market. I ended up giving a value to Uber based on the total market.

• 39:42Speaker 02

  And Bill Gurley very rightly pointed out that I was missing something very critical, that these disruptors, in addition to taking share away from existing players, could actually change the size of the total market. He said, you know what, there are people who are not taking car service now, who might start taking car service if an Uber becomes ubiquitous. And he was absolutely right. And in subsequent valuations of Uber, I had to factor in the reality that this is a company that changed the size of the car service business. It was too late for me to fix my 2013 mistake, but I valued Airbnb. I brought that learning into the process when I said, how big can the market for hospitality be?

• 40:27Speaker 02

  And I used to market three times the size of the hotel business. So again, sometimes accepting the fact that you're missing something significant in the way you're approaching some aspect of your investing can be a learning moment. People talk about this all the time. One of the reasons I like writing my blog is I'm accountable because I can never say, I never said that because it's right there. Then 2014 is what you said. And it's also become a place where I can confess my mistakes, not because confession cleanses my soul, but because it's in the process of saying, I screwed up, that you can start thinking about, what can I do differently going forward?

• 41:11Speaker 02

  So it's been useful for me to be able to verbalize when I miss something, saying, this is what I missed, this is how I'm going to try to fix it. Because it's on the record that I made a mistake and that I'm trying to change the way I do things.

• 41:25Patrick O'Shaughnessy?

  I love the exercise of valuing non-traditional things. How do you go about valuing something like the Washington Commanders or an NFL franchise?

• 41:34Speaker 02

  The value of sports franchise now is almost entirely as an entertainment business. Why? Because 50 years ago or 70 years ago, if you bought a football team or a baseball team, most of your revenues came from people coming into the stadium and what they spent in the stadium. But TV changed that with TV contracts.

• 41:55Speaker 02

  Increasingly high percentages of revenues at these teams come from their media contracts. In fact, that's one reason why the Oakland A's have to leave the Coliseum. It looks terrible on TV. It's a terrible reason for leaving, but when your entire revenue stream is based on how you look on TV, you can see why teams are actually going to build smaller stadiums that look better on TV. Fenway is a great stadium on TV, accidental because they didn't build it for TV. So if you ask me to value a sports franchise, I would project out the gate receipts. I'd project out the merchandising and I'd project out the media revenues. Now you could value it as a business, but two things.

• 42:36Speaker 02

  One is teams can sometimes alter the magnitude of those revenues by actions they take. Let's take the Golden State Warriors. Fifteen years ago, the Golden State Warriors were a mid-level NBA team in terms of visibility and value. Then they're two strokes of luck. One was in signing Stephen Curry to come and play for them. And the second was their ownership shifted to a group of tech people who decided that if this was a game about streaming and getting a higher profile, the Golden State Warriors are now the second or third most valuable NBA franchise because their revenues in terms of media and streaming reflect the fact that they're now a national team.

• 43:17Speaker 02

  Taylor Swift alone has probably increased the value of every NFL team by fifteen or twenty percent because she's bringing in women viewers to TV who are going to increase the value of streaming. So if you ask me to value a sports franchise, I can value it. But I can also tell you almost before I do it, that what people will be willing to pay as a price for that franchise is going to bear no resemblance to that value. It's going to be two, three times. Why? Because if you look at the owners of many of these sports franchises now, this is not the Art Rooney Pittsburgh Steelers world you live in. The Rooney's have owned the Steelers. For them, it is a business. They need to make cash flows. In fact, it is probably ninety-five percent of their wealth.

• 44:03Speaker 02

  Same thing is true for the Maras. Much of their wealth is in the Giants. Or the Steinbrenners. The only problem is the rest of the franchises in the league are held by billionaires. Private equity investors, VC investors, Steve Ballmer. Why do they want a franchise? Because it's a great toy to have. I remember valuing the Clippers when Ballmer bought them for two billion. And I came up with a value, even my best case numbers of about 1.2 billion, allowing for higher TV ratings and revenues. And then I said, you know what? I'm not going to keep trying to push my value up because clearly Steve is not buying this team because it's a business. He's buying it because he wants an expensive toy.

• 44:47Speaker 02

  What better toy can you have, especially if you're Steve Cohen, in front of all of his successes as an investor? If you ask him which investment he tracks more closely, it won't even be close. This guy's been a Mets fan since he was a kid. He now owns the team with all the pain and the gain that comes from it. So increasingly, sports franchises are being bought as toys. What does that mean? The pricing is going to bear no resemblance to value. And if you try to explain the pricing based on fundamentals, it's all going to come apart. As long as the number of billionaires exceeds the number of sports franchises, I'm afraid this game is done.

• 45:25Speaker 02

  We're playing a pricing game, which means what these franchises do will also make no sense from a financial perspective. I'm going to sign Shohei Ohtani for 650 million, even if he never pitches again, because think of the Japanese viewers I can get on my streaming with him on my team. Think of how much more lucrative my toy looks when I have the best baseball player in the game. So I think that it's not always good news. As fans, as people who follow sports, you're going to see strange things happen in the sporting world now that it's billionaires owning toys.

• 46:04Patrick O'Shaughnessy?

  A wonderful adjacent topic is the world of entertainment writ large. You mentioned streaming and that being a key component of those businesses. I would love you to talk for a while about how you see the world of entertainment as a business, as a cultural phenomenon, as a business model and how that's shifting. What do you think about media and entertainment today?

• 46:23Speaker 02

  That's a good component of entertainment where in fact the damage has already been done. The disruption has happened, which is the music business. The music business, if you're old enough, you remember, was structured very differently. It's studios. The studios sent out talent scouts who signed stars. Those stars were effectively signed to long-term contracts by the labels, who then put out albums where you were required as a consumer to buy an album with sixteen songs, even if you wanted one. It was a business that was built around bundling and studios controlling the entry and exit points. That's how the market business looked like in the early nineteen nineties. Then along came Napster.

• 47:06Speaker 02

  Napster, of course, was a barely legal or potentially illegal operation, which streamed music for free. And of course, the music studios shut it down. They managed to get the legal apparatus behind them. And I'm sure there were heaps of sighs of relief across music studios in the late nineties when Napster was shut down. But what Napster did was it revealed the weaknesses in the business. Why make somebody buy sixteen songs when they needed only one? And Apple iTunes stepped into the breach, and the disruption continued, especially with the coming of Spotify and Pandora. In two thousand and fifteen, the revenues of the music business had halved relative to nineteen ninety-nine.

• 47:48Speaker 02

  In nominal terms, the business had become half what it was. There's been a bit of a comeback, but not in real terms, in nominal terms. And the business now looks very different. The biggest player, the streaming company, which includes Spotify, but also includes some of the big tech companies, Apple Music, Amazon Music. If you look at the landscape, it's entirely different. The way music gets produced, the way it gets sold, who gets the rewards is entirely changed. Movies and broadcasting put off that disruption. Netflix, of course, started the process with original content. And so until two thousand and twelve, until Netflix created its original content, they thought they still controlled the process.

• 48:30Speaker 02

  A process that was created over a century, built around movie theaters. Now, if you remember, you produced a movie, you got gate to see the movie theaters. A few months later, you released it to cable. So there was a sequence that studios, if not perfected, had worked at, that worked for them. Then Netflix rocked the boat. They rocked the boat because they changed the way content gets produced. Because until Netflix came along, the way you created a new show, if you remember the old days in the networks, new show came along, they'd allow the show to create three episodes. The episodes worked, it had a season. The season worked, you signed for a second. Everything was done in pieces because you don't want to create hundreds of shows and have three work. It's too expensive.

• 49:14Speaker 02

  But Netflix said, no, we're going to produce a hundred shows, throw it against a wall and hope something sticks. Why? Because people judge us on the number of subscribers we have. They're not judging us based on revenues and earnings and cash flows. And when it first happened, I remember talking to somebody at a movie company. They said, this is not going to work. This is stupid. Look at what Netflix is doing. They're going to go bankrupt. Seven years later, Disney joins the Netflix bandwagon. They start spending thirty billion dollars on content as well. And of course, COVID along the way upended the process as well. Because if you remember during COVID, some studios started releasing movies directly to streaming and bypassing movie theaters.

• 49:57Speaker 02

  The entire structure on which the movie and the broadcasting business was built, which is theaters and networks and cable are coming apart, were replacing it with streaming. The only problem is people are not sure how to run a streaming business. Netflix with its make a hundred shows, throw it against the wall, hope something sticks, is trying. Disney with its huge, big budget shows built off existing franchises, The Mandalorian, Star Wars, or with its Avengers, is trying. HBO kind of has this internal conflict of what it is. The old HBO model was just make big by the Game of Thrones model. But now you've got it connected to Warner and you don't know where it's going.

• 50:38Speaker 02

  But everybody here is trying and nobody has a sense of what's going to work. It's not a good place to be if you're an entertainment company. And it's at this stage that the writers and the actors both walk out. You're effectively taking a business that's already on the precipice and you're risking pushing it over the precipice. Here's one thing we can guarantee, we consume entertainment. We need entertainment as consumers. So that part is not changing. But 10 years from now, if you ask me, what will the structure that provides content look like? I really have no idea and I don't think people at the entertainment companies have any idea. Will there be movie theaters left after this? There's the single healthy movie theater company left in the world.

• 51:23Speaker 02

  Half of them are bankrupt, the other half are run by CEOs who seem to think that their job is to run a meme stock rather than a company. I'm not sure where this game is ending. But I think for the moment, I'm looking for entertainment companies that are adaptable. Because if you don't know how this model will shake out, you want either a status quo company that's able to adapt to the streaming world or a streaming company that learns enough from existing movie makers that they can be a little more disciplined in how they produce content. But we're in motion, I don't know how this will play out. But we're going to be watching it play out.

• 51:59Patrick O'Shaughnessy?

  I'm fascinated by this. Do you think any of them are really amazing businesses? Because it's interesting that there's unlimited demand for the products. And yet, here we are talking about how maybe none of them are insured a great, bright business future with lots of free cash flow.

• 52:16Speaker 02

  Right now, none of it. Netflix might have the highest market cap. The analogy I give is Netflix is like a hamster on a wheel. Because it's created a model where it's got to create more content to keep its consumers and still more content. And it's trying by moving its content outside of the US. 90% of the shows now in Netflix are Spanish or French or Indian. But I think from the perspective of actually being a good business model, Netflix doesn't have it nailed down. Disney clearly doesn't. I mean, its struggles reflect that. And every other company in the status quo space is actually in worse shape than Disney. I cannot think of a single company or I can point to that company and say, those guys have a model that they've actually figured out.

• 52:59Speaker 02

  So I think everybody is in motion right now and none of them is a solid business model right now.

• 53:05Patrick O'Shaughnessy?

  What are the best business models you've ever seen?

• 53:08Speaker 02

  Take a business model like Patagonia. I've said, look, I don't believe in E S G. But Patagonia in a sense plays within its limits. It recognizes that it has a particular agenda to push, but it also keeps things scaled down. I have respect for companies that essentially create businesses that reflect their vision and stay true to them. When I'm Valing Birkenstock and one of the things I find impressive about Birkenstock is how well they've nurtured their brand name while growing and being profitable at the same time. I mean, they've actually turned away partnership models because they think it puts their brand name at risk. I mean, along the way, of course, they benefited from being lucky, but everybody does. I'm

• 53:52Speaker 02

  sure nobody planned for Barbie to be wearing pink Birkenstock, but it created a buzz that pushed up their revenues thirty percent over the summer. But I think if you look at the company and you said, this is a business model that's internally consistent, where the management and the company is acting consistently with the story they're telling us. It's what's always impressed me about Amazon. When Jeff Bezos ran it, is this is a company that was built around the story. I called it the field of dream story, which is if we build it, they will come. And in every step in the process, they stayed consistent with that story. They acted consistently. So what I'm looking for is companies that

• 54:33Speaker 02

  have a narrative about themselves where their actions are consistent with the narrative. That's actually rarer than you think. A lot of companies tell stories, but then they act very differently from their own stories. So if you're looking for good companies, that's what you're looking for. Companies that have crafted a narrative that they stay true to. And sometimes that means turning away growth and turning away profits because it doesn't fit into the narrative they've structured for themselves.

• 54:59Patrick O'Shaughnessy?

  What did you think valuing Instacart? And what did it teach you about online delivered groceries? And just that entire market, which has been extremely controversial amongst investors of private and public investors as to whether or not this business model is a long-term viable one or not?

• 55:16Speaker 02

  Sometimes asking common sense question about the business can help us plumb through the depths and get away from the tunnel vision. Ask yourself, do you want to shop for your groceries online all the time? And the answer we'll get from most people are not homebound or who have issues with their health is grocery stores are usually close by, and it's one of the few areas of shopping where you'd prefer to do it yourself. It's not that you're impulse buying, but you want to make sure the eggplant you put in your cart, not all eggplant is created equal. I mean, that's the essence of shopping. I think that even at its height, of course, with COVID, we all were forced to shop online.

• 56:00Speaker 02

  But even at that height, you could look forward and say, this is not steady state. This is not what the world is going to look like. This is a niche business. And what I saw when I valued Instacart is how easily people can let loose or leave their senses in the midst of something happening. In the case of COVID, the reason you saw $39 billion pricing is for whatever reason, Sequoia and Fidelity and T. Rowe Price, I think they were the three big investors, the $39 billion pricing managed to convince us that half of all Americans would, from this day on, be grocery shopping online. And what we're discovering is in hindsight, that was clearly overwrought.

• 56:43Speaker 02

  But I think we knew it was overwrought then if we'd stepped back and had some perspective. The other thing I did note with Instacart, and this goes back to the point I made about VCs and PE investors being a lot more average than we think they are, is I did track every VC round in Instacart, going back to 2012. It's a company that has had a seed round and rounds that go from A through I. So lots of VC rounds, $2.9 billion in venture capital. And I looked at the returns you'd have made as a VC investor if you invested in 2012, 2013, 2014, 2015, all the way through 2021. And what I saw was every VC investor since 2015, that's, I think, Series C.

• 57:28Speaker 02

  Has essentially done worse than the S and P five hundred. Put that table out to show that VC investors are bad. I put that out to kind of counter the notion that VC investors are somehow smarter than the rest of us, better gauges of businesses. Much of this is pricing and you get caught up in the mood of the moment, you could push up the pricing, these companies well above what they should be. And I think at eight or nine billion dollars, Instacart is valued as a niche business. For about ten to fifteen percent of Americans will stay with online grocery shopping for one reason or another. Of course, it could be an option on the next pandemic if you want to make a bet on it. But I think that as a niche business, I'm okay with eight to nine billion, but not with twenty or thirty or forty billion.

• 58:13Patrick O'Shaughnessy?

  What has been in the last year or since we last talked, the most interesting company or thing that you valued?

• 58:21Speaker 02

  I did value the Adani Group. The Adani Group is an Indian infrastructure company and of course was targeted in the short selling behind it, but targeted it. Of fraud and self dealing and manipulation. So I did value the Adani Group. It's an infrastructure company that trades at about a fifty to sixty times EBITDA. Doesn't get priced like an intruder. And as I valued it, you could see how we talked about being in the right place at the right time. The reason Adani's stock price were up was that two things going for it. One is it's an Indian company and India is the next China in many investors' minds. And second, it's an Indian infrastructure company, which is the biggest missing ingredient in the India story.

• 59:06Speaker 02

  So they're the infrastructure companies can create the airports, the ports, the physical infrastructure that'll make India into the next growth destination. And it's got a third connection, which made it a fascinating company to value. It's a company with connections, political connections, government connections. Something we don't talk about explicitly in valuation, but could be a source of value. So one of the fascinating things about valuing Adani was the interplay of politics, markets and economics in a company valuation. You can't avoid it. You've got to bring in all of those factors in. And as a consequence, it made valuation more uncertain because your valuation is conditional who will win the next election.

• 59:48Speaker 02

  And that is not a great place to be as an investor, but it is the reality that you face. So I actually found it to be a fascinating company to value because it's got good things going for it, bad things going for it. And on top of this, you have this issue of has it committed fraud and what can be the consequences of that on investing?

• 1:00:06Patrick O'Shaughnessy?

  Curious what kinds of companies, maybe even one specific company, that you feel falls in the too hard pile for your method of valuation. So if you had to think of the landscape of decently well-known companies in the world, is there one or two that pops out as like, ah, I wouldn't even bother trying to apply my method to it. And I'm curious the reasons why, if so.

• 1:00:25Speaker 02

  Yeah, I mean, I'll take a company like Moderna. I will steer away from valuing a Moderna because I mean, what it has going for it is a technology that it has proprietary rights on the mRNA technology. But knowing what that technology is going to be useful for and what kinds of things that can come out of it that can create revenues are beyond what I know about medicine. And I could sit there and price Moderna like everybody else, but if you want to do an intrinsic valuation of Moderna, it's going to be really difficult to do, perhaps impossible with what I know about medicine and healthcare. So it's a kind of company where I'm going to say, look, it might be a great company to invest in, but from my perspective, I can't put a value on the company. No.

• 1:01:10Speaker 02

  So that's one group of companies, companies that are operating in the space where I really don't understand the space well enough to be able to flesh out the biggest item. I'm willing to value more traditional pharmaceutical company because there it's about blockbuster drugs and revenues and earnings and cash flows. The other group of companies I put into the too hard to value pile are the companies where you have what I'd call discrete risk. And you come to me with a Russian company now and say, can you put a value on a Russian company? I'm not even trying. In fact, I've reached the point where I probably will not invest in a Chinese company anymore because what you value when you value equity in a company is a share of the ownership of the company. But if ownership itself becomes a fuzzy concept, there's no legal protection for ownership.

• 1:01:56Speaker 02

  Then what exactly are you getting? You can get great earnings and cash flows, but you can't even tell me what your share of it is, which in Russia is effectively what's happened. You might have a company which has earnings and cash flows, but your ownership stake in the company was effectively eliminated if you're non-Russian in 2021 or 2022. And I would say that the more uncertain you feel about protection of legal protection of your ownership rights, the less willing you should be to value a company and invest based on that value. So Chinese companies are getting rapidly moved into I don't want to value the company, but not because I can't get a value for the company, but getting from that value to what my share of that value is,

• 1:02:40Speaker 02

  it's become a much trickier exercise.

• 1:02:43Patrick O'Shaughnessy?

  Another huge storyline since we last spoke is banks, which might fall to the other end of the interestingness spectrum or something. But SVB and related bank failures and crises was a huge storyline in the past year. What was it like for you watching that happen? How did it make you think differently about our financial infrastructure, banks as businesses and so on?

• 1:03:03Speaker 02

  We talk about the effects of social media and the internet. What I thought about as I watched SVB meltdown and the subsequent meltdowns in First Republic and Signature Bank is how those same issues that we talk about as social issues are starting to permeate how we think about economic issues. When you think about it, SVB did things right. If you think about the lessons that came out of 2000, they didn't invest in risky stuff. They invested in T-Mars that should be safe, right? There are duration mismatch made in hell. But at the same time, we're taught that deposits are sticky. People don't pull money up. But those assumptions fell apart in the case of SVB, simply because we discovered that deposits are not that sticky,

• 1:03:47Speaker 02

  especially if your depositors all are homogeneous. They come from the same group and they talk to each other all the time. Almost every player in the bank was somebody in that VC startup space. And guess what? They're the most interconnected group in history because everybody's on the phone with everybody else. So in the space of two days, the bank went from being healthy to effectively dead. So after that happened, I actually wrote a piece on the stickiness of deposits. And I looked across banks and I said, what are some of the things that are going to make me worried about a bank? Do you have younger depositors or older depositors? I want older depositors.

• 1:04:27Speaker 02

  Do you have depositors that are concentrated in one business on one geography? Or you have depositors spread out across the country? I want depositors spread out across the country. And are you a high growth bank or a low growth bank? I want a low growth bank. If you increase your deposits 50%, these are new people you brought in. They're more likely to turn and run if there's a problem. So it made me rethink about the stickiness of deposits. And maybe our bank rules have to be written in terms of deposit stickiness. How much need to maintain as a regulatory capital ratio should be much higher. If you have younger depositors, all happen to be tech people. Maybe we need to keep track of what percentage of your depositors are on Twitter.

• 1:05:11Speaker 02

  The higher the percent, the more regulatory capital. Sounds absurd, but in a sense, we discovered the things that drive deposit stickiness. Things that are not the old factors that we used to look at 20 or 30 or 50 years ago. I think that the rule writers have got at least a period where they have a chance to do this before the next big run happens. Cause there will be one.

• 1:05:36Patrick O'Shaughnessy?

  It seems like the attitude towards ESG investing changed a lot in the last 18 months. Do you think that in some ways, some of the focus there was like a zero interest rate phenomenon to some degree? Like an indulgence of sorts that has gone away in the last 18 months?

• 1:05:51Speaker 02

  I think virtue is always a good mountain to be on top of. For ESE people who's about, look how much good we're doing for the world. So I will give them that starting point. The reality is when you use virtue as your primary selling point, you get no debate because who wants to push back against goodness? So for the decade, ESG advocates got no pushback. And that was, I think, a problem because they overreached. They overreached in what they claimed, basically sold it as all cake, no calories. And I think in the process, they missed a chance to actually develop a movement that was healthier. Because there is a market out there for people who want to invest in goodness, using whatever definition of goodness you have.

• 1:06:36Speaker 02

  And these investors are probably willing to give up returns for being good. And if E S G had been crafted that way right from the beginning, we would be in much better shape. So I think that it was long overdue and the reason the backlash has been so harsh is because when it was sold, it was so oversold. I've turned my attention entirely from E S G because I think that it's an acronym that run its way, but I know that it's going to be replaced with something else. Now I'm actually writing a piece on impact investing and I'll give you the title of the piece because it's going to tell you a little bit about what I think. Good intentions with perverse outcomes and essentially where's the impact and impact investing.

• 1:07:21Speaker 02

  It starts with two presumptions. One is that whatever the issue you're trying to impact is real, climate change, real, let's accept it. And second presumption that your intentions are good. So I'm not going to question what you're fighting. I'm not questioning your intentions. I'm questioning your approach because impact investing, and you can say the same thing about E S G investing, can take one of three forms. You can invest in good companies, where good is whatever increases the impact. You can pull your money out of bad companies, which in the case of climate change will be self fossil fuel companies. The third is you can invest in the bad companies and try to get them to change. Those are the three moments. What I basically did was I looked at the impact outcome that is hoped for.

• 1:08:06Speaker 02

  So when you sell bad companies, here's what you're hoping. You will push down their price by selling them by doing so you increase their cost of equity and cost of capital. By increasing the cost of capital, they do less exploration, less growth, so there's less fossil fuels. The weakest link in that argument, you can get ExxonMobil and Royal Dutch to do less exploration. But if the demand for energy is still there and that energy is being delivered from oil, somebody else is going to step into the breach and do the exploration for you. In the last 15 years, and we talked about in the context of E S G, it's been private equity investors, it's been people who've taken advantage of the seams in this argument to make money.

• 1:08:48Speaker 02

  So what we end up with is the same amount of oil being produced, but now being produced by different people. With good companies, it's supposed to be to push their prices up and by doing so, lower the cost of equity and allow these companies therefore invest more. So we've got green energy companies. You can't tell me that not enough money has been invested in alternative energy. In fact, we've invested tens of billion, perhaps trillions of dollars in alternative energy. But my question is, where's the beef? Where is the energy from this alternative energy? Getting eighty-two percent of our energy from fossil fuels. And the weakest link in that argument is you might be pushing the wrong alternative energies by supplying capital because you decided that wind power was the alternative

• 1:09:32Speaker 02

  energy and in fact, it might have been better nuclear power. The problem with trying to pump money into good companies and push their prices above where they should be is you're essentially giving them an artificially low cost of capital, too much capital to invest. So what I do with each argument is, look, I know this is the outcome you're expecting, but this could happen. And then I say, let's let the facts tell us whatever. So I take the fossil fuel business and I look at what's happened over the last fifteen years. Initially, fossil fuel companies dropped in value, you look at the stock prices. But then they came back. Why? Because in the process of doing what you did, they pushed up the price of oil, you made oil again, a valuable commodity to get out.

• 1:10:16Speaker 02

  So the price effect has gone away. You've got private equity investors making tens of billions of dollars in their fossil fuel investments. If you look at the evidence, the evidence is that the perverse outcomes are the ones that have come out of this rather than the good outcomes. Maybe there's a better way to do impact investing. But I think we need to have a healthy discussion of what are you impacting? Because the one thing I can guarantee impact investing will impact is your returns in a bad way. Everything else is up in the air.

• 1:10:48Patrick O'Shaughnessy?

  You were forced to fly in the face of something you said earlier, which is probably active management is in a secular decline in terms of market share, maybe not in terms of absolute, you know, in absolute, the market grows. So there's a countervailing force there. But I said, there's some sort of Hunger Games or something, and you have to try to enter this contest to build the biggest possible investing firm that you could. How would you think about approaching that problem?

• 1:11:10Speaker 02

  I would actually change the starting point. Instead of making the biggest, I would want a firm that I can sustain, which often means settling for smaller scale, looking for a portion of the market where I have something to bring to the table, and then not getting tempted. This is tough to do, right? Because when you're successful, more money comes in, is saying, look, this is not scalable. This can be done only up to a $10 billion, $15, $20 billion amount. I can't do much more, but that requires discipline. And I think the active investing that I see surviving will be active investors who've found a niche, something special that they do, and stay disciplined enough to stay in that niche.

• 1:11:54Patrick O'Shaughnessy?

  So the Patagonia strategy, we'll call that. Why do you think that there are still so many huge pools of capital, we'll call them LPs writ large, that pursue a mostly active investment mandate and strategy? We don't have more of the guy from Nevada that just put it all in the S and P 500 or something?

• 1:12:17Speaker 02

  Hope springs eternal in human beings. Who wants to be average? Everybody wants to be above average. I don't think that search is ever going to go away. And in a sense, active investing takes advantage of the fact that you want to be better than average. So I think as long as that is part of human beings, you're going to see people trying, and they'll be attracted by stories of winners. And that's why in VC and PE, the stories that are promulgated have that selection bias of, look how much money you could have made if you'd invested in Uber on the ground floor.

• 1:12:52Patrick O'Shaughnessy?

  Is there anywhere else that we have topics that we have not covered today where you feel like your opinion is the most off consensus narrative today?

• 1:13:01Speaker 02

  Probably something we talked about last time, which is the Fed. I am so sick and tired of discussions that revolve around central banks, because I think it's become a reason for copping out.

• 1:13:15Speaker 02

  The reason for not dealing with fundamentals is the Fed will do it. Or the Fed did it. You know, how many active money managers I've talked to in the last few years? If you ask them, why did you underperform the market over the last decade? Their answer is the Fed did it. It's the Fed. Or we say, what will happen in the future? The Fed's going to set rates. I mean, it's very unhealthy because it means we're not talking about the things we should. But it's still the conventional wisdom. Every time there's an FOMC meeting, the entire world, at least the investing world, comes to a standstill. It's like watching a pope get selected, right? Smoke's coming out of the smokestack. There's a new FOMC policy. Let's see how the world will look.

• 1:13:58Speaker 02

  If I were to wish it's over the next decade, we stop talking about the Fed. I mean, there was a time when if you ask people who the Fed chair was, they wouldn't have been able to give you the name. Or when the next FOMC meeting, they had no idea what the FOMC even was. This is a recent phenomenon. And it feeds into all kinds of conspiracy theories, which is the Fed and a few hedge funds and these smart money are all together in a room. And that the rest of us are essentially being taken advantage of by this cabal. Promised conspiracy theories is you no longer take responsibility for your own mistakes. So if there's a page on which I am entirely off the page, it'd be in giving power to the Fed in determining what the future is going to deliver.

• 1:14:43Speaker 02

  I think the Fed is just as confused as everybody else in the market about where inflation is going. And where the economy is going, and it terrifies them.

• 1:14:53Patrick O'Shaughnessy?

  What do you think the ideal alternative would be?

• 1:14:56Speaker 02

  There is not. Markets are ultimately set by demand and supply. Inflation is not something that magically comes from above. It comes from our behavioral factors. So I think in a sense, we have to give up expecting somebody up there to give us answers. The answers are in the market. And I think that if nothing else, in the last three years, we've recognized when experts and markets diverge. It's the experts who are usually wrong at every turn in this road. I have a new respect for markets after the last three years, in spite of all their mistakes and their foibles. In terms of coming to a judgment on the big issues of the day.

• 1:15:37Patrick O'Shaughnessy?

  What do you think you have the best taste in? And how did you come to that taste?

• 1:15:42Speaker 02

  Leisure activity, basically. I enjoy my walks to the beach, live two blocks from the beach in San Diego. So what I find I enjoy doing the most is letting problems clatter around my mind. Sit there, watch the ocean, try to think of answers. I have the luxury of doing that. I admit, I mean, most people have jobs that they have to go to and they have to get things done. I have nothing to do. I can sit there and think about issues. And I've often said, we read too much and we think too little. I don't have that problem. I have lots of time. And I know there's a rule saying an idle mind is a devil's workshop. But an idle mind is often where you get your best connections of ideas.

• 1:16:23Speaker 02

  Your best thinking is done when you have nothing in your mind per se that you have to get done. So to me, I think the advantage of not having a to do list on most days is I get more done when I have no to do list than when I do.

• 1:16:37Patrick O'Shaughnessy?

  Power of an open schedule. What are you most looking forward to studying, thinking about, learning in the next year?

• 1:16:44Speaker 02

  Something new. I mean, as I said, I'm a dabbler. I lose interest very quickly, so I'm always looking for what's interesting. For instance, Birkenstock, the reason I find the valuation fascinating is it's giving me a vehicle to talk about intangibles. This big issue with accountants and often badly misused by praisers who use intangibles as an argument for adding premiums on. With Birkenstock, I'm actually breaking the value down into how much of this is branding? How much of this comes from the fact that you have celebrities? Steve Jobs, Birkenstocks just went on sale, I think, and sold for 216,000 or some absurdly high price of celebrities who essentially are your best brand carriers and you don't even pay them.

• 1:17:28Speaker 02

  This is not today's TikTok and YouTube celebrities. These are celebrities who have roots, who basically reflect the history. How much of the value comes from that? How much comes from the Barbie buzz? There is a buzz, you can't fight it. How much is the Barbie buzz? And how much of it comes from the fact that they managed to find? I mean, after all, this is a two fifty year old company. By all chronological age terms, this should be an old company. But ten years ago, it got a new lease of life because the family let go of the company and essentially hired an outsider to come in as CEO. And the guys, I don't easily fall for management as great management, but he's actually done an incredibly good job in keeping a balance between growing the company

• 1:18:12Speaker 02

  and preserving what makes the brand special. So I'm actually breaking down the value, asking how much of the value per share comes from each of these? Because the point I'm trying to make is when people talk about intangibles, my response, it's already in there. And this time, I want to be able to say, this is where it's in there. This is how much it's worth. So it's keeping me occupied this week. But next week, I'll be back to what'll interest me next week. So who knows?

• 1:18:39Patrick O'Shaughnessy?

  Is there any other major difference in your mind between a financial and an accounting balance sheet?

• 1:18:44Speaker 02

  The biggest difference, I think, is the financial balance sheet is forward looking. The accounting balance sheet is backward looking. I'm less concerned about breaking things down in a financial balance sheet. What I mean by that is I really don't need to know how much of Coca-Cola's value comes from the brand name. Why? Because it's not like they can sell off the brand name and keep what's left of the company because there'll be very little left. So I'm less concerned than accountants in deconstructing balance sheets levels of detail, which I think is the problem with accounting rules, is they want to get customer list, they want to get brand name, they want to get tech. But each of these intangibles separately valued. And in my view, that's an impossible task. You're going to create very artificial numbers for these.

• 1:19:28Speaker 02

  So I'm willing to accept aggregated values on a financial balance sheet because I don't have to pass it by GAAP or any other rule writers. All I have to do is be okay with it. And I'm okay with generically saying eighty percent of the value of this company comes from intangibles, a bunch of them. The case of Apple, it's style, it's brand name, it's having your own operating system. Why does it matter to me what portion of the value comes from each one? Because none of that is separable and for sale.

• 1:19:57Patrick O'Shaughnessy?

  That's what every time we talk, I love hearing you as an example of someone in the investing world who is clearly passionate and curious about the thing that they're doing. I know in the next year, you'll have another 25, 30, 40 posts of great interest, and I hope we can make this an annual tradition. Thank you again so much for your time.

• 1:20:15Speaker 02

  Thank you, Patrick.

• 1:20:17Patrick O'Shaughnessy?

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