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

25:50The 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 to companies. 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.

26:35So 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. 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?

27:16So you could see this has permeated every aspect. I wouldn't be surprised the autoworkers, 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 are aware, whether 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.

27:53They 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 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.

28:33My 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, there will be disrupted. did. 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? 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 side because every big movement creates losers.

29:12I'm a little more cynical about the AI pitch than most people are. 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. 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? 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.

29:47You'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 per 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 open AI is a great option to be part of a business, but you're not buying a business. 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?

30:26One 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 writ 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? But the question that every active investing group, PE, 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.

31:04And I think each new movement, they looked and said, maybe this is what would 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, 80 to 90 % of all active investing, including PE, including VC, including mutual fund investing is mechanical. And it's mechanical and machines going to do it much better than you can. I mean, that's part of the reason that over the last decade, 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 it's going to be able to do that almost effortlessly.

31:43Everything 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 made about as much money as the average S &P 500 investor. Of course, there were winners.

32:17There's a selection bias with PE and VC. We'll look at the winners. One of the talks I give is who put the smart in smart money? because I've looked for 40 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.

32:55What parts of your own valuation process remain outside the reach of automation? 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, dispensable. 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.

33:32I'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. 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 post.

34:13And 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. 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? 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.

34:55It 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 out. So you're right. There is going to be some floor on active investing where it ebbs and flows. My guess is it's going to drop too low.

35:31There 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 is filled in steady state because so much of what's done there is just creating noise. It's not adding value. 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.

36:10Have you noticed anything in common between those investors? In fact, I have an entire class I teach called investment 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, There's 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.

36:48He's a macro trader. So as I looked across these investors, what I noticed is there's no one pathway to greatness, to God. 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.

37:29The 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. 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've 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.

38:06Those 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 that class, I tell people, look, there is no right investment philosophy, but there's one that's right for you. 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 because 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.

38:50What 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. 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 out.

39:29You 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. It's something you're missing that you have to start to incorporate into your philosophy. It doesn't mean you abandon the way you think about markets.

40:02I still believe value matters and I 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. for 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 100 billion. And he said, that's the total market. I ended up giving a value to Uber based on the total market. 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.

40:50He 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? 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.

41:36People 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, this 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? So it's been useful for me to be able to verbalize when I miss something, say, this is what I missed. This is how I'm going to try to fix it. Because it's on the record that I've made a mistake and that I'm trying to change the way I do things.

42:19I love the exercise of valuing non-traditional things. How do you go about valuing something like the Washington Commanders or an NFL franchise? The value of a 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, increasingly high percentage 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.

42:59It 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. One is teams can sometimes alter the magnitude of those revenues by actions they take.

43:37Let's take the Golden State Warriors. 15 years ago, the Golden State Warriors were a mid-level NBA team in terms of visibility and value. Then there are 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. Taylor Swift alone has probably increased the value of every NFL team by 15 or 20 % because she's bringing in women viewers to TV who are going to increase the value of streaming.

44:24So 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, where you live in. The Roonies have owned the Steelers. For them, it is a business. They need to make cash flows. In fact, it is probably 95 % of their wealth. Same thing is true for the Maris. Much of their wealth is in the Giants or the Steinbrenners.

45:03The 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 to franchise? Because it's a great toy to have. I remember valuing the Clippers when Ballmer bought them for$2 billion. And I came up with the 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.

45:41What better toy can you have, especially if you're Steve Cohen, in part 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.

46:20We'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 Shohi Otani 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. A wonderful adjacent topic is the world of entertainment writ large.

47:02You 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? Let's take a 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. 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 16 songs, even if you wanted one.

47:47It was a business that was built around bundling and studios controlling the entry and exit parts. That's how the market business looked like in the early 1990s. Then along came Napster. Napster, of course, was a barely legal or potentially illegal operation with stream 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 was a heaves of sighs of relief across music studios in the late 90s when Napster was shut down. But what Napster did was it revealed the weaknesses in the business. Why make somebody buy 16 songs when they needed only one?

48:28And Apple, iTunes stepped into the breach. And the disruption continued, especially with the coming of Spotify and Pandora. In 2015, the revenues of the music business had halved relative to 1999. 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 are the streaming companies, 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.

49:10Movies and broadcasting put off that disruption. Netflix, of course, started the process with original content. And so until 2012, until Netflix created its original content, they thought they still controlled the process. 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 work for them. Then Netflix rocked the boat. They rocked the board because they changed the way content gets produced.

49:49Because 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. You'd have 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. But Netflix said, no, we're going to produce 100 shows. Throw it against a wall and hope something sticks. Why? Because people judge us in the number of subscribers we have. They're not judging us based on revenues and earnings and cash flows.

50:20And 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$30 billion 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. The entire structure in which the movie and the broadcasting business was built, which is theaters and networks and cable are coming apart, were replacing it with streaming.

51:02The only problem is people are not sure how to run a streaming business. Netflix with its make 100 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 made 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. 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.

51:42And 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 that 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 isn't a single healthy movie theater company left in the world.

52:17Half of them are bankrupt. The other half are run by CEOs who seem to think that their job is to run a mean 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 up, 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.

52:52I'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. Right now, none of them. 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 are Netflix or Spanish or French or Indian.

53:32But 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. So I think everybody is in motion right now, and none of them is a solid business model right now. What are the best business models you've ever seen? Take a business model like Patagonia. I've said, look, I don't believe in ESG.

54:06But 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. 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've benefited from being lucky, but everybody does.

54:46I'm sure nobody planned for Barbie to be wearing pink Birkenstock, but it created a buzz that pushed up their revenues 30 % over the summer. But I think if you look at the company and you say, 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, this is a company that was built around a story. I called it the field of dream story, which is if we build it, they will come. And at every step in the process, they stayed consistent with that story.

55:22They acted consistently. So what I'm looking for is companies that 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. 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?

56:10Sometimes asking common sense question about a 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.

56:54But 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 the grocery shopping online. And what we're discovering is in hindsight, that was clearly overwrought.

57:37But 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 invest 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, has essentially done worse than the S &P 500.

58:25Put 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 of these companies well above what they should be. And I think at$8 or$9 billion, Instacart is valued as a niche business, where about 10 % to 15 % 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.

59:00But I think that as a niche business, I'm okay with eight to nine billion, but not with 20 or 30 or 40 billion. What has been in the last year or since we last talked, the most interesting company or thing that you valued? I did value the Adani Group. Adani Group is an Indian infrastructure company. And of course, it was targeted in a short selling, but Hindenburg targeted it for fraud and self-dealing and manipulation. So I did value the Adani Group. It's an infrastructure company that trades at about a 50 to 60 times EBITDA. It 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.

59:44The 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. So they're the infrastructure company that's going to 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.

1:00:22So 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. 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?

1:00:57And what can be the consequences of that on investing? I'm 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. I mean, I'll take a come 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.

1:01:32But 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 the 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. 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.

1:02:12the 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've put in the too hard to value pile are the companies where you have what I call discrete risk. And you come to me with a Russian company now and say, can you put a value in 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 as a share of the ownership of the company.

1:02:44But if ownership itself becomes a fuzzy concept, there's no legal protection for ownership, 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 legal protection of your ownership rights, the less willing you should be to value a company and invest based on their value.

1:03:22So 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, it's become a much trickier exercise. Another huge storyline since we last spoke is banks, which might fall 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 they make you think differently about our financial infrastructure, banks as businesses and so on?

1:03:57We 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-bonds. That should be safe, right? They had a duration mismatch made in hell. But at the same time, we're taught that deposits are sticky. People don't pull money up.

1:04:35But those assumptions fell apart in the case of SVB simply because we discovered that deposits are not that sticky, 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 done. 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?

1:05:17Do you have younger depositors or older depositors? I want older depositors. 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.

1:05:59If 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. 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, because there will be one. It seems like the attitude towards ESG investing changed a lot in the last 18 months.

1:06:36Do 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? I think virtue is always a good mountain to be on top of. For ESG people, it'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 I think, a problem because they overreached.

1:07:13They 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. And these investors are probably willing to give up returns for being good. And if ESG 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.

1:07:52I've turned my attention entirely from ESG 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 in impact investing. 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.

1:08:26So 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 ESG 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-fueled 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.

1:09:01So 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 ESG, it's been private equity investors.

1:09:37It's been people who've taken advantage of the seams in this argument to make money. 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 billions, perhaps trillions of dollars in alternative energy. But my question is, where's the beef? Where is the energy from this alternative energy, getting 82 % of our energy from fossil fuels?

1:10:16And 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 energy when, 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.

1:10:50So I take the fossil fuel business and I look at what's happened over the last 15 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. 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.

1:11:26Maybe 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. 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.

1:12:02How would you think about approaching that problem? 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. It's 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 found a niche, something special that they do, and stay disciplined enough to stay in that niche.

1:12:48So 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 &P 500 or something. 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.

1:13:36And that's why in BCNP, 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. 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? 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. The reason for not dealing with fundamentals is the Fed will do it. Or the Fed did it. Now, how many active money managers I've talked to in the last few years?

1:14:18If 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 share. 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. If I were to wish it's over the next decade, we stopped talking about the Fed.

1:14:56I mean, there was a time when if you asked people who the Fed chair was, they wouldn't have been able to give you the name. Or when the next FOMC, 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. The problem with 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 would be in giving power to the Fed in determining what the future is going to deliver.

1:15:38I 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. What do you think the ideal alternative would be? There is none. 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.

1:16:21I 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. What do you think you have the best taste in? And how did you come to that taste? Leisure activity, basically. I enjoy my walks to the beach, 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.

1:16:58I 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. I know there's an old saying an idle mind is a devil's workshop, but an idle mind is often where you get your best connections of ideas, 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. Power of an open schedule. What are you most looking forward to studying, thinking about learning in the next year?

1:17:38Something 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, in 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 appraisers who use intangibles as an argument for adding premiums on. With Birkenstock, I'm actually breaking the value down into how much of this his 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.

1:18:22This 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 bus? There is a bus. You can't fight it. How much is the Barbie bus? And how much of it comes from the fact that they managed to find, I mean, after all, this is a 250-year-old company. By all chronological age terms, this should be an old company. But 10 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 does great management, but he's actually done an incredibly good job in keeping a balance between growing the company and preserving what makes the brand special.

1:19:09So 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 intentions, my response is 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. But so it's keeping me occupied this week. But next week, I'll be back to what will interest me next week. So who knows? Is there any other major difference in your mind between a financial and an accounting balance sheet? The biggest difference, I think, is the financial balance sheet is forward looking.

1:19:42The accounting balance sheet is backward looking. I am 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 lists. They want to get brand name. They want to get tech that each of these intangibles separately value.

1:20:16And in my view, that's an impossible task. You're going to create very artificial numbers for these. 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 80 % of the value of this company comes from intangibles. There's 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.

1:20:51As with 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. Thank you, Patrick. If you enjoyed this episode, check out joincolossus.com. There you'll find every episode of this podcast complete with transcripts, show notes, and resources to keep learning. You can also sign up for our newsletter, Colossus Weekly, where we condense episodes to the big ideas, quotations, and more, as well as share the best content we find on the internet every week.

1:21:50Thank you.