Invest Like the Best - Aswath Damodaran Interview Highlights
With conviction comes arrogance
Takeaways from the interview:
Unexpected inflation is the danger
Inflation kills companies that make long-term investments
It’s not about goods vs. services, it’s about discretionary vs. non-discretionary…and we’re about to find out how non-discretionary some of these services like Netflix truly are
There's only one path to break the back of inflation - a deep and long recession. If you think of inflation as a genie in a bottle, once it’s out, it’s really hard to get it back in
The Fed only has limited power, and the worst-case scenario is the Fed pushing the economy into recession but inflation doesn’t come down quickly
Subscription businesses tend to be less discretionary and will do better than others in the inflationary regime
ROIC is a backward-looking metric designed for mature and declining companies…for young companies, it’s meaningless
Real assets generally hold up better than financial assets during inflationary periods…but we’ve securitized real estate and made it more of a financial asset
With conviction comes arrogance…you’re asking for trouble in this market environment if you have a super-concentrated portfolio
It’s critical for investors to understand the story behind a company and not just think of it as a collection of ratios and numbers
At the right price, any company can be a good buy…and vice versa
The investment world has become a lot flatter…and running screens is definitely not an edge
Active investing isn’t going away…but it’s going to become a smaller business and you have to find a niche
It’s not all about alpha…risk management and consistency are key
Just because you’re right on a macro trend, doesn’t mean you’ll be right on the micro
Investors underestimate momentum…traders are honest about what they do but the problem is people who claim to be investors but are really just momentum traders
Mean reversion works until it doesn’t…when there’s a structural change, it’s one of the most deadly forces in investing
We’ve been spoiled by a decade of low interest rates and cost of capital…and that’s why inflation is going to be such a painful adjustment process
There are no objective numbers in valuation…it’s all subjective
We don’t need more disclosures…we need to know what matters and what doesn’t
Unexpected inflation is the danger
Expected inflation to me is the more benign part of inflation. The part of inflation that's deadly is unexpected inflation, which is inflation coming in higher or lower than expected. When inflation is unexpected, you've not had a chance to adjust to it.
We fell back on, "Inflation's always been low," because that's the only thing we knew. So, I think it's the unexpected inflation that I think is so damaging. What we're seeing in markets right now is markets are trying to adjust to what's the true inflation going to be. I mean, we all agree that the 8%, 9% that we're seeing is probably too high a number, that some of it is supply chains, COVID excuses that were given early on.
But we all also I think finally agree that we're not going to go back to 1% or one and half percent inflation, which is what we had in the last decade. The question of where we fall between the one and a half and the 8 or 9% is what's driving markets. If inflation subsides back, the most benign scenario, goes back to 2%, which is supposedly the fed's target, that's the most benign scenario. But that scenario is becoming a lower and lower probability scenario the further we get into this process. At this point, the question is, will it go to 3? Will it go to 4? Will it go to 5? And adjusting from a 2% expectation to a 5% expectation is devastating for all financial assets. It's not just stocks. It's not just bonds. In any type of financial asset.
Inflation kills companies that make long-term investments:
Companies that have to make longer term investments will be far more hurt by high inflation than companies who can live with short term inflexible investments. Inflation kills infrastructure companies. It kills companies which make long term investments, because those investments now will either be delayed or not taken when inflation becomes uncertain.
It’s not about goods vs. services, it’s about discretionary vs. non-discretionary…and we’re about to find out how non-discretionary some of these services like Netflix truly are
I think it's not so much goods versus services, it's discretionary versus non-discretionary. I think that if your good or service that you provide is something that people can live without, they can delay buying, they can defer buying, you're far more exposed to inflation than if you're not. A grocery store chain will do far better than your special retailer. As you've noticed in the last week, we've seen Walmart and Target, the big retailers all come out and tell the world how badly they're being hit by unexpected inflation. I don't think you're going to see Krogers do the same thing, because you can't delay buying groceries. People are going to pay the higher price. They'll complain about it, but what choice do you have? So, I think that it's discretionary versus non-discretionary. But the big challenge for us, the money we spend now is on things we didn't have 40 or 50 years ago. We don't know how discretionary or non-discretionary your Netflix subscription is. We're going to find out very quickly, right? So, this is going to be the real test. So much of our market cap comes from companies that provide products and services that weren't around 30 or 40 years ago. We're going to find out how inflation plays out on those decisions. Are you far less likely to upgrade your iPhone if the prices are going up 15 or 20% a year than if they're going up 5% a year? We're going to find those things out if inflation is here to stay.
There's only one path to break the back of inflation - a deep and long recession. If you think of inflation as a genie in a bottle, once it’s out, it’s really hard to get it back in
There's another hidden cost, which is we know that to break the back of inflation, there's only one path, and it's a painful one, which is you got to put your economy into a deep and long recession. I call this the Volcker scenario. Most of the time, people don't have the stomach to sit through that, which is one reason why a lot of countries start in the fight for inflation, but very quickly give up, because an election is coming up and you don't want this to get in the way. But I think the reality is if inflation turns out to be higher than expected and we don't like the results of high inflation, the only way you get out of it is through a recession that's deep and painful, and guess who's hurt by that? Exactly the same people. So, in a sense, you're between a rock and a hard place here. There is no easy pathway out, which is one reason early last year I argued that even if you believe that inflation was transitory, the thing to do was to act as if it was not and act quickly. I've described inflation as the genie in a bottle. As long as it's in the bottle, you can look at it, you can laugh about it, but you let it out of the bottle, getting it back in is really difficult to do.
The Fed only has limited power, and the worst-case scenario is the Fed pushing the economy into recession but inflation doesn’t come down quickly
The fed has only limited power, and that's the other thing to recognize. The only power the fed has is to make things so painful that the economy, in a sense, shuts down. That's the power it has. It's not got the power to change inflation rates or change interest rates, even. I think that the scenario that is terrifying is if in fact the fed does push the economy to recession but inflation doesn't come down quickly, because then you're caught with this combination of a bad economy and high inflation, which is the late seventies playing out again. That's the danger of having let inflation run ahead for such a long period that getting it back under control might take not just three months or six months, but maybe a couple of years. I started in markets in 1980, and I remember what the world looked in 1980. It wasn't a place where you could easily find a job or you could find places to invest. The benefit of hindsight, we pushed it back so that we don't think about it. It's not something that I want to live through again, but I don't think I might have a choice in this matter.
Subscription businesses tend to be less discretionary and will do better than others in the inflationary regime
Subscription businesses by their very nature tend to be less discretionary. For whatever reason, people are far less likely to cancel a subscription than they are just not upgrade. So, I think about companies pushing towards platform businesses and subscription businesses.
So, when I look for my list of, "Hey, these are the things I want in a company," I find them more in technology companies than I do in old time, brand name, consumer product companies. It's kind of a shift away from what you might have seen in the early eighties as to where do I go for companies that are best protected against inflation. I think the places you go now are very different than 40 years ago.
ROIC is a backward-looking metric designed for mature and declining companies…for young companies, it’s meaningless
The problem with return invested capital is as a metric, it's designed for mature or declining companies. You can be a great growth company. Its return invested capital can be either meaningless. The return investment capital if you take Apple is negative. Why? Because the cash actually exceeds a book value of equity and debt. If you take that to mean, hey, the ROI is that Apple takes terrible projects, you're completely mistreating the number. It's the denominator that's negative, not the numerator.
For young companies, the ROIC becomes almost meaningless. It's not the kind of metric you want to focus on. So, if you have an investment strategy built around ROIC, and I know there are people, value investors who buy into this, remember, this is going to leave you with a portfolio of older and declining firms, and some of them will be value traps, because what you're capturing with the return investment capital is your past, that this company used to have great investments.
ROIC is a backward looking accounting number to keep that in perspective when your investment strategy is driven entirely by ROIC. I mean, I remember in the 1990s, this outfit called Stern Stewart, this measure called EVA. Half of the S&P 500 bought into it. It's a measure built almost entirely on return on invested capital. The consequences were incredibly predictable, which is companies gamed it, which is they figured out what showed up in invested capital. In those days, if you lease something rather than bought it, it didn't show up as part of in invested capital, so they would switch. I know companies play games with ROIC. So, I'm not saying don't measure it, don't use it. I'm saying make it part of a portfolio of things you look at and be aware of where it's going to lead you in terms of investing bias.
Real assets generally hold up better than financial assets during inflationary periods…but we’ve securitized real estate and made it more of a financial asset
Real assets generally hold up to inflation better than financial assets. I mean, that's why real estate did really well in the seventies. The only problem is we screwed up real estate as a physical asset by securitizing it. What's happened as we've securitized real estate is it started to behave more like stocks and bonds. If you look at the last 20 years, look at a year in which your stocks went up as an individual, those in the years, your house probably also increased in price. These stocks go down, your house also drops. We've screwed up at least the segment of real estate as an inflation hedge, but I think more traditional real estate where you buy a rental property and you collect the rental income can still hold its value.
With conviction comes arrogance…you’re asking for trouble in this market environment if you have a super-concentrated portfolio
But I think in a more general sense, I know I've always been leery about those people who argue for concentrated portfolios. And I've put some old time value bets to say, it's an admission of failure if you have more than five or six or seven stocks in your portfolio. That if you have conviction, and I hate that word conviction, because conviction goes with arrogance. If you have conviction, you should be able to find companies and put all your money in five companies. Maybe that was true 50 years ago. You're asking for trouble in this market environment to load up your bets on five companies. I would say spread your bets, spread your bets across asset classes, spread your bets across different types of companies.
It’s critical for investors to understand the story behind a company and not just think of it as a collection of ratios and numbers
To me, Amazon is an illustration of how much stories drive value, and how critical it is for investors to understand the story that animates a company and not just think about it as a collection of ratios and numbers, which unfortunately is what some aspects of all time value investing lead you to do. You take the 12 screens from Ben Graham, you run them through, you got a bunch of screens. Think of that as the Ben Graham branch of UNO. And I've disagreed with Warren Buffet in many aspects of what he does, but one thing that I agree with is he talks about how when you buy a company, you need to understand not just the numbers, but the business, the management, the story that... He doesn't use that word, but that's basically what he's investing in is a story that he understands and he believes is actually meriting a higher price than the price that the market is attaching to it. I would encourage people, even if they're number crunches, to start thinking about the stories behind companies and whether those stories actually make sense long term.
At the right price, any company can be a good buy…and vice versa
I'm going to say something that traditional value investors might view as sacrilege. At the right price, I will buy any company. No matter how damaged it is, how terrible the... At the wrong price, you could be the greatest company in the face of the earth. And I'm not jumping on the ship with you because the price is not right. We spend a lot of time assessing company quality and management quality, we need to think about as much what the price we're paying for that is. We're looking for mismatches, a company that is of great quality that the rest of the world thinks is crappy. That's what a great investment is.
The investment world has become a lot flatter…and running screens is definitely not an edge
The investment world has become a lot flatter. I give the example, 1981. If you're an equity research analyst who worked in New York, you already started with an advantage. In those days to look up an SEC filing, you actually had to walk in the SEC offices. The SEC didn't have offices in Des Moines, Iowa, but it did in New York City. You had access to information that let's say an investor in the Midwest, an individual investor, would not have had. You had mainframe computers that you were able to use as your tools to feed in and people didn't have mainframe computers sitting around in their backyards. You had execution advantages because the way in which you were able to trade, I mean, so remember these were the days before online trading. If I wanted to trade, I took on a broker.
I am shocked at how much of traditional value investing is just running screens. Whenever I've had a chance to go to Omaha, I don't go to the meetings themselves, but talk to people who come to those meetings. I asked them a question. These are self-defined value investors. I said, when was the last time you actually valued a company? And don't tell me you buy companies low PE ratios and high dividends or whatever it is, that's not valuing the company, it's running screens. Maybe one in 100 actually values companies. And the response is classic. They said, we don't value companies because we don't like to make assumptions. What? Investing is a set of assumptions. The fact that you have using past data doesn't mean you're not making assumptions, you're just not making the assumptions explicit. And the second argument they give is even more preposterous, which is we don't like betas. Okay. I don't like betas either. You don't like modern portfoliotary, that's fine. That doesn't mean you can't value companies. If you're telling me that just because you don't like modern portfolio theory, you don't think risk matters, then you've reached the wrong conclusion.
But I think so much of value investing has become screening. The question I would ask is what you do as a portfolio manager is run screens. What makes you think you're bringing something to the table? I can run screens, I can run the same screens you can, often on the same databases you do. Where is the differential advantage?
Active investing isn’t going away…but it’s going to become a smaller business and you have to find a niche
I think the first reality is finding that niche has become a lot more difficult, which is one reason I think active investing collectively has had more and more trouble with passive investing, ETFs and index funds. And that's not going to change. I don't think active investing is going away, I think it's going to become smaller business. A business where niches have to go beyond we have a 23 story building with big computers and lots of databases, because that's not going to be enough of a niche for you to find your alpha.
It’s not all about alpha…risk management and consistency are key
If your focus becomes all about finding alpha, you've lost the script and here's why. In a sense, you need to find alpha, but not at the expense of creating a backstop on my portfolio. And what I mean by that is our portfolio has become so focused in creating alphas, they go out and take insane bets on companies because they want to deliver that positive alpha. I'd much rather that you go for a tiny or even a zero alpha and keep my portfolio... At least keeping up with the market than seeking out alpha.
I think the way we rank managers based nav encourages them to be not just risk takers, but reckless risk takers, because that's how you end up at the top of the alpha list or the best perform... I would never invest in the best performing manager in any year or even over a five year period, because they're going to almost wager that best performing manager has a much greater chance of being the worst performing manager in future periods than the middle of the group. I think that rather than look for the highest alphas, you want to go for consistency, even if it means settling for little or no alpha. The Hippocratic oath of doing no harm should really be first, front and center for anybody's managing other people's money. If it's your own money and you want to make bets, big bets and hope they pay off, fine, but don't play games with other people's money.
Just because you’re right on a macro trend, doesn’t mean you’ll be right on the micro
There's something I learned from Cathie Wood. I've learned about how macro trends do matter. I think she's very good at calling macro trends, but I've also learned from our mistakes that just because you get a macro trend right doesn't mean that the microbes you make in that macro trend are correct. We all agree that 10 years from now, a greater percentage of the cars sold on the face view are going to be electric cars. I think there's consensus on that, but does that mean Rivian is where I want to put my money? Not necessarily.
Investors underestimate momentum…traders are honest about what they do but the problem is people who claim to be investors but are really just momentum traders
Momentum is a trading strategy. In fact, I like to draw a contrast between investing and trading. Investing is about assessing the value of something, buying at a price lower than the value and hoping and praying the price adjust your value. In fact, much of what you see in investing discussions is about. Trading is much simpler, you can argue a much more honest way, a much cleaner way of approaching markets. Trading is about buying at a low price, selling at a higher price. There's no value, cash flows, growth, who cares. Momentum is a trader's best friend, and we know that at least in the short term, momentum is the strongest force in markets, much bigger than earnings or cash flows or growth or any of the fundamentals. So as a trader, you live on momentum, but you die on momentum, which means that you make money when momentum is in your favor, but if you don't get out early enough, that same momentum that was your friend becomes your enemy. So I think momentum is a force that we underestimate at our own peril as investors. That's why I sell themselves short on overvalued companies. Many of these companies are in the throes of momentum. You try to sell short on these companies. You might be right in the long term, but you're going to be bankrupt before you're right, and that small consolation. So momentum is a force that we've got to respect. So when people make fun of charters and technical analysts, let's face it, they're bringing the right tools to the trade if they're trading, because those are tools that are designed to detect shifts in momentum. You might not believe in support lines and resistance lines and all the need candle stick shots, but let's face it, they're trying to detect shifts in momentum and get out ahead, and I applauded it to them. They're at least being honest about what they do. The problem is there are many people who claim to be investors, but they're really playing the momentum game.
Mean reversion works until it doesn’t…when there’s a structural change, it’s one of the most deadly forces in investing
So I make a general statement, mean diversion works, it's a very strong force until it doesn't. When there's a structural break in the economy you're in, mean reversion can be one of the most deadly forces in investing. The mean you revert to might not be the mean you thought you were going to revert to. And unfortunately it's been the weakest link and people use Sheila Pease and Capes to kind of... many of those people have been out of markets now for a decade because stocks have looked expensive to them. Because they've said, I don't care what interest rates look like now, I won't buy stocks if they don't trade it below 15 times earnings. I don't care what kind of adjustment we get in this market, the amount of money you've lost by staying out of the market for the last 10 years, because you believed in mean reversion is money you're never going to get back. So I think people have to be careful in assuming mean reversion and at least think through explicitly whether they believe that things will revert back to the way they used to be over the world has changed, and the answer world has changed. You got to be careful about not making that mistake and just jumping in based on things reverting back.
We’ve been spoiled by a decade of low interest rates and cost of capital…and that’s why inflation is going to be such a painful adjustment process
So I think that we've had a decade again, of really low interest rates and really low discount rates. The start of 2021, the cost of capital for a median company in U.S dollar terms in the U.S was about 6%. The implied expected return on stocks in the start of zero is 5.75%, think about it. You're buying stocks expecting to make 5.75% returns annually. If I'd offered that to somebody in the 1980s, they'd laugh me out of the office saying, "What? Do you want me to buy stocks?" But the reality is when T bond rates are one point half percent, 5.75% doesn't look bad. So I think that we've been spoiled again by a decade of low discount rates, low cost per capital, and that's why inflation is going to be such a painful adjustment process. We all have to reset expectations and that means everybody's discount rates are going up, whether we like it or not.
There are no objective numbers in valuation…it’s all subjective
Subjective is the word that I would use for pretty much everything you do in valuation. There are no objective numbers in valuation. Last year's number is objective, but you don't invest based on last year's numbers. You base it on the expectation that last year's numbers will be next year's numbers. That's subjective. So for those people who critique valuation as being subjective in making forecasts for the future, I'd much rather face up to uncertainty than hide from it.
We don’t need more disclosures…we need to know what matters and what doesn’t
I think disclosure is the issue where I think I'm most in disagreement. A lot of people think that more disclosure is the answer to our problems. I hear this from value investors, growth investors, just let companies disclose more, from ESG people, more disclosure. And my experience, disclosure is this double-edged sword. Do you think that more disclosure leads to more information and more sensible decisions? But if there's anything we've learned from behavioral research of giving people information, is sometimes less is more. I think we're actually doing a disservice to investors by having what I call disclosure diarrhea. Have you read the risk section in any prospectus?
50 pages of garbage. And this is the problem, companies have learned to play the game. They've discovered that if you disclose everything, it's like disclosing nothing, you lose perspective. They don't know the big thing versus the small things. You throw them all into the same pile. It's like going to confession.
I think that's a problem with disclosures. If everything is disclosed, then I have no idea what matters and what doesn't. And that's unfortunately where we're headed. And that train's left the station again, because the accounting firms have jumped on, the disclosure firms have jumped on, the activists on every single issue have jumped on. And we're going to end up with disclosures that nobody reads.
Thanks for the summary, short and informative. Overall good thoughts from Damodaran, especially on excessive disclosure and iflation. I do not completely agree with his view on ROIC as a useless backward-looking metric, given the proven persistence of ROIC for high ROIC companies. His critique of value investors (dummies looking at screeners) also sounds strange - does he really believe those people look exclusively at low multiples without trying to underwrite bull/base/bear cases, weighing risks and potential rewards? Sounds biased on his part.
But overall, a nice interview!