Ladies and gentlemen, welcome to the business Brew.
I am your host, Bill Brewster. As always, this episode features
Dan Rasmussen, founder of for Dad Advisors.
Dan recently wrote a book called The Humble Investor.
It's a it's a great read, especially for those.
Well, I say it in the episode that that like sort of academic
books, you're going to get some confirmation bias if you like
the value factor and you're going to get questioned if you
are a fan of private equity. Dan also has some interesting
research on the profitability factor.
So I would recommend to go out, pick it up.
Also go to for Dad. Let's see, what is it for
dadcap.com, VERDAD, Cap C, ap.com, and you can sign up for
for Dad's weekly research. It's great stuff.
Dan and his team, I refer to them as a Mensa organization in
the podcast. Just go look up who's on the
team and look at their BIOS. It's a smart group, so I hope
that you enjoy the conversation. I enjoyed having it and I think
that Dan is going to challenge conventional wisdom in this one.
As always, nothing in this episode is financial advice.
All of this is for entertainment purposes only.
Please consult your financial advisors before making
investment decisions and do your own due diligence.
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Ladies and gentlemen, thrilled to be joined by Dan Rasmussen.
I was reading your book and I was thinking of titling this
episode. Dan Rasmussen, the Slayer of
sacred cows. I love it.
There you have it. So I'm glad you approved.
I think everybody should be pretty familiar with your work,
but for those that are not, you want to go into your background
a little bit. Yeah, sure.
So I graduated from Harvard in 2009.
During college I interned at Bridgewater Associates.
Then I spent a few years working in Bain Capital private equity.
I left there to go to Stanford Business School and I founded
Verdad Advisors while I was in Business School.
We've grown from about 8 million under management, a little about
about 1.2 billion today across a variety of different strategies.
And I just published a book called The Humble Investor,
which lays out my investment philosophy and describes some of
the lessons from the last 10 years or 11 years of running for
Dad. Yes, and the book is is quite
good. I recommend especially those
that that enjoy academic type books.
I think that that this one is a a very strong read.
I was I was perusing your company's sort of BIOS.
How did you how did you get a Mensa corporation over there?
What what happened? You're you're you.
And then what? What did you say you were like,
I'm only hiring people smarter than me and there's like 3
people on the earth. And that's how the firm became
what it is. Yeah, it's, it's we've, we've
sort of grown slowly and carefully as we met people that
were really excellent and a team of eight now and then we have a
professor at Harvard Business Schools, our consultant.
But I think we're a research shop, right?
I mean, we, we write research, we do research.
That's the day in, day out. And so we're looking for people
that really love that. And if you come to our office,
it's like a think tank. It's quiet, everyone's goes and
works. And then you know, like, Oh my
gosh, I discovered this, you know, come and look and you
know, we all pile in and and it's a wonderful, wonderful
culture. And I'd say what's probably not
in everyone's BIOS, we also have a strong college athlete
profile. There's a lot of rowers,
swimmers, runners. So I think this sort of team
athlete approach also is a contributor to our culture as
well. Yeah, that makes sense.
That makes a lot of sense. So how do you, how do you want
to go about this interview? I mean, the, I guess the way
that I would start and where I feel like your branding sort of
historically was at least until I read this book and maybe it's
my perception, but you are the man that crusades against over
allocations to private equity, in my opinion.
You want to maybe start there and then we can go to what you
found elsewhere. Yeah, sounds good.
So, so you, I, I believe what you, you're pointing out that
there are some endowments that have upwards of $40.40 percent
allocations to private equity. Is that accurate?
Yeah, that's right. I mean, I think that essentially
the private equity returns up until two or three years ago
looked to be sort of consistently 2 to 3% above the
public equity markets. And because of the way the
volatility was reported, when you looked at it looked like it
had the volatility of investment grade bonds and about half the
volatility of the public equity market.
And even though everyone said, oh, we knew, we know that's not
true. And we, you know, we think of it
differently. That was a pretty nice feature.
And So what happened is that the endowment and foundation were
all just went whole hog, right? They sort of said, well, we're
permanent capital if this has better returns.
And we like the risk profile, you know, why wouldn't we just
take it to the Max? And they were encouraged to do
that by investment consultants. And so you saw this this
ratcheting up over time, you know, where pension funds are
maybe 1520 and most of the top endowments are 40, even 50
percent privates. It's just this massive love
affair with an asset class. And you know, my theory of
investing, which I write about in the Humble Investor, is this
idea of that investing is not a game of analysis.
It's a game of meta analysis. It's not what you think.
It's about what everyone else, what you think relative to what
everyone else thinks. And so I think I'm very focused
on correlated beliefs that are wrong.
And I think correlated belief among these top great minds and
investing that private equity and private credit are the best
thing since sliced bread is the single biggest investment
mistake being made by smart people today.
And it's a particularly salient thing right now because as that
smart money has gotten burned, and we can talk about what's
happened as last year or two have been quite dramatic as
they've started to get their fingers burned by private
equity, their fundraising, private equity fundraising has
dropped. And private equity is now
searching for new pools of capital.
And there's a new pool that's being targeted, which is your
4O1K. And so I think it's very topical
to understand, you know, the sort of Arc of private equity,
what's going on in it right now and why these why, what the
sales pitch is and why it's why it's why it's wrong.
Yeah, it's, I mean, it seemed to me that I can understand why
people don't want to see real marks.
So to the extent that they're willing to maybe give up a
little bit of return in order to pretend, I guess I, I don't see
that as completely irrational. It's maybe suboptimal, but not
irrational. But the thing that is wild to me
is I, you know, there are, I, I talked to somebody who when I, I
guess it was 2021, maybe it was 2022, whatever.
When, when mid American and Camden and the the Reitz re
rated downward conversation that I had somebody said, you know,
well, B REIT mark their NAV down a little bit this year too.
And I asked what it was and I forget the exact number, but it
was definitely single digits. And I was like, you're telling
me that the big publicly traded Reit's that are less levered are
down 30%, but a private REIT is down like maybe 9 Max, right?
Like that doesn't make sense to me.
And you know, I guess as long as if I'm an RIAA, as long as I
have some defensible position to put in front of my clients and
it locks up capital for 10 years and everybody's making money
along the lot along the way. And I get invited to nice
dinners and not just Rias. It can be anybody, right?
But like, the incentive structure makes sense to me, but
the actual outcomes do not. Yeah.
So I think, and this is a really important, I think you need to
develop sort of an intuition around what private equity is to
kind of come to the common sense conclusions about it.
So I'll walk you through sort of what private equity is.
So first of all, you know, you can think in terms of market
size. The S&P 500 is about 500
companies that are worth an aggregate 50 trillion.
Then there are 2000 small cap companies in the US which are
part of the Russell 2000 small cap index.
Those are two trillion, right? So a lot more companies, but a
lot smaller. And then private equity is about
a $2 trillion asset class in the US and there are 12,000 private
equity backed companies, right. So if you think of the, you
know, the sort of Russell 2000, these are, you know, order of
magnitude or two smaller than the S&P 500 and private equities
yet another order of magnitude smaller.
And so you should have an intuition around the differences
between small and large companies, right?
If you're going from one extreme is your local restaurant or dry
cleaner and the other extreme is NVIDIA or Apple, you should have
the intuition that smaller companies are much riskier, much
lower margin, much less diversified, etcetera, a much
more likely to go bankrupt. All these things are true of
small companies. Of course, your local restaurant
could somehow become Chipotle and you could grow 1000 decks
and maybe it's hard to imagine NVIDIA going up 1000 decks from
here just given its size. So maybe there's some more
upside skew, but the downside skew is certainly there too,
right? Your local restaurant is pretty
decent chance of going out of business next year.
It doesn't as none. The next thing is that private
equity used to be called the leveraged buyout industry,
although they rebranded because that sounded so bad.
It's leveraged and we're buying people out.
You know, that just sounds sort of terrible.
So that they rebranded private equity, which sounds so much
better, but but it's right. So fundamentally for every two
trillion of private equity, there's about 3 trillion of
private credit, right? So that there's a lot of lending
associated. So these are companies are big
borrowers. And again, you should develop an
intuition, right? What do we know about companies
that borrow a lot of money? Well, companies borrow a lot of
money or more risky, more likely to go bankrupt than companies
that don't borrow money right now.
Maybe again, there's more upside if it works because, you know,
you're levered. You know, if you buy a house,
the mortgage, let's say 90% levered, you buy a house for
$100,000 and it goes up to $110,000, you doubled your money
because you took out 90,000 of debt.
So your 10,000 of equities. Now 20,000 of equity is a
magnifying effect. But that's true on the downside.
So, so we should have this intuition in our heads.
Yeah, exactly. But we should have this
intuition in our heads, right, That private equity, therefore
is, is, is really risky, right? These are really small, really
levered companies that should be really, really risky.
And yet everybody in the investment community is treating
these things as though they're not risky at all that they have
these are owner operators with long term views who, you know,
are a better form of capitalism because they're aligned owners
and write all this crap. And, and that's the sales pitch.
But the reality is that this is really small companies with a
lot of debt that are obviously really risky.
And so why people are taking this asset class that's, you
know, 2 trillion, It's, it's, it's, it's 4% of the SP500 and
putting 40 or 50% of their assets in it is crazy to me.
But that is the, you know, the basically the number one sales
pitch of every CIO at major large endowments, foundations
and family offices who are saying that, or at least used to
be saying, because things are kind of changed that this is the
biggest source of alpha available in the market today.
So. What has changed over the past
two years that's got people maybe raising some questions?
Yeah. So, so historically, the way
private equity works is you commit capital and then the
private equity firm calls that capital and then they buy a
business. And then when they sell a
business, three to five years later, they return capital.
And then that private equity firm goes and raises another
fund three or five years later. And so you as sort of an
investor, you're putting the money in and then three to five
years later you're kind of getting some of the money back
and then the private equity funds starting a new fund and
you're saying I'll recommit. So the money you're giving me
back, I'm going to kind of give back to you for your next fund.
And that's sort of how the the game goes.
And so typically a private equity as an asset class
distributes about 30% of its NAV per year.
And so you can think of sort of a three-year cycle of buying
companies and then three or four years later, you sell them and
you get the money back and you redeploy it.
But recently its distributions have fallen from 30% a year to
about 10% a year. Private equity has just stopped
being able to sell all the things that they bought 3 or 4
years ago. And so if you think about what
happened 3 or 4 years ago where it was sort of 2020-2021, it was
this kind of big bubble years is COVID everything.
There's a SPAC craze, there's this mania around tech
companies. And so all the money that those
private equity firms put to work in 2020 and 2021 now is sort of
coming up for that time. And they should be selling it.
And it turns out they can't really sell it because they
overpaid and they can't really sell it at a price that's
profitable. And so they've just stopped
distributing money. And so as they've stopped
distributing money, fundraising has dropped off because people
because they're not getting back the money, they can't then re up
and redeploy. And that creates another
problem, which is that because private equity, about 40 to 50%
of the deals are private equity to private equity.
So, you know, Blackstone sells to KKR.
Well, if KKR is new fund is smaller than its previous fund,
it doesn't have enough money to buy Blackstone's deals anymore.
Blackstones, this sort of aggregate exit opportunity is
shrinking as fundraising shrinks, because fundraising is
shrinking, distributions go down even further.
And so it's this sort of vicious cycle.
And as a result, if you look at sort of 135 year horizon,
private equity has been underperforming the public
market, which they all said would never happen.
A few years ago, there was a survey that showed that
something of like 90% of investment allocators thought
private equity would outperform by 200 basis points a year or
more, right? Complete consensus that this
could only win. And now it's losing.
And not only are they losing, but their money's trapped.
And the additional problem is that it's really hard for the
private equity firms to explain why the money is trapped.
You know, you sort of say, aren't U.S. equity markets at
all time highs? Isn't this right?
I mean, how can you not sell? I mean, walk me through why when
the S&P 500 is trading at 30 times PE or something, you're
finding it difficult to sell your assets.
And they're saying, you know, right, And you could have come
around to this view that clearly their assets are just not worth
what they're saying they're worth.
Otherwise they'd be able to sell them at an attractive price and
this whole app cycle would continue.
So now what you're seeing, you know, again, is this sort of
retrenching where the smart money has been burned because
they put 40 or 50% of their assets and say it's now
underperforming and where their money is now trapped and they
can't get it out. And they're rethinking things.
For the first time ever. They're starting to arise
skepticism about private equity in in very important places in
the investment world, which is just a sea change from three or
four years ago. Yeah, I guess, I guess if I
wanted to play devil's advocate, I might argue that though the
S&P is at highs, if you look at some of the underlying sectors
and like the Russell, they're pretty beaten up.
So, but to your point, that just means you don't like your exit
liquidity, right or Mark. So it's not right.
You're just. Really not willing to
acknowledge that you've been beaten up just like the
Secretary Russell 2000. Yeah, that's exactly right.
Yeah. Well, can't you just, you know,
get like a private credit fund to just lend you 8 times
leverage and then you buy it out that way?
That's safe, right? Yeah.
And that's really what's been happening.
It's sort of this extend and and pretend, right?
And private credit firms just this new, new, you know, that
basically exists to lend LB OS have been willing to sort of
extend and pretend. I think the, the problem is that
by my calculations and the data that I've looked at, I think
right now the majority of private equity backed companies,
maybe 6000 of those 12,000 if not more are cash flow negative
after debt service. I think it's a really tough
position, right? Like they can't refinance
because they're never going to deliver.
They just don't have money to pay down debt or basically all,
you know, in aggregate 0 margin. And so it's a really tricky
situation, particularly for that, you know, 10 or 20 or 30%
of the worst ones where they really need to refi because they
really don't have the money. And right now they're doing
payment in kind and things like that to sort of hold some
stopgap. This is going to come to a head
because if they don't refi, there has to be a restructuring
and someone's gonna have to admit that they lost money,
whether that's the private equity firm or the private
credit firm or both. Yeah.
Yeah, that makes some sense. Do you have a sense when you
look at this stuff like the, the statement that a company is, is
not cashflow positive obviously can be objectively correct.
However, there's there can be arguments as to whether or not
they're out spending like overspending on SGNA in order to
invest for future growth. Is there a way to strip that out
or do you just think that like if you look at data in the
aggregate, aggregating the data sort of strips out
idiosyncratic? Arguments, basically private
private equity is pretty inscrutable because it's all
private. You're all sort of you're
looking at either proxies or samples to try to kind of
discern what's going on. You know, there's just no way
with any level of precision or granularity to, to make those
kind of judgments. But my, my intuition is that
when firms have margins that are that low and are so pressured on
debt service that they're going to be cutting everything that
they can cut. And I think the the sort of
quick math to make it more clear what's going on, right is the
private credit loans are generally 10% of 10% interest
rate roughly So and these firms have generally levered up, you
know, let's call it 6 to 8 times EBITDA would probably be the
median. I'm somewhere in that range,
right? So if you're putting 60 to 80%
of your EBITDA into paying interest, right, what about
taxes, What about CapEx, right? Like you know, what about any
differences between EBITDA? What about changes in working
capital, right? That's really tight, really
tight. But that's the scenario that
that roughly we're we're looking at and that's why such a large
percentage of them are essentially cash flow negative.
Well, the good news is if you run at a loss, you don't have
taxes. So you got that going exactly.
Exactly. One of one of the the really
interesting, well actually I got, I got two thoughts here.
So Part 1 is I thought the chart in your book that that
demonstrated that value performs well because of a RE rating.
I think is an interesting observation to ponder when
thinking about why private equity returns have been so
strong over the past 15 years and how it could be problematic
for a group of smaller companies that in aggregate probably
aren't growing much more than GDP if you're paying fair prices
to begin with. Right.
Like part part of the whole argument for value is it's
oversold and over hated. But if you have sophisticated
parties transacting in the exact same bucket of companies and the
majority of the juice comes from RE rating, I, I that's, that's a
hard thing to play forward in my head for the private equity.
I think that's right. And I think this may be to zoom
out from private equity to sort of my broader view of investing
or how I think about it. I'd say the first thing that I
would say is that investing is about making predictions about
the future, right? If you think about the value of
a stock as being worth the net present value of future cash
flows, right, You have to predict future cash flows to
discount them back to the presence of the stock is worth
something relating to how optimistic or pessimistic you
feel about that company's future, right?
So the valuation you pay today is directly a measure of
optimism or pessimism about the future growth of that business.
And I think my next point is that therefore, we should study
as investors, we should study the science of forecasting,
right? We should say, what do we know
about the growth rates of companies?
What do we know about how to predict the growth rates of
companies? Because that valuation is about
predicting the growth rates. We should be the world's leading
expert in predicted prediction, predictive science, and
understanding the sort of base rates and statistical
distribution of growth. And what I would observe is that
there's this wonderful study from 2004 called the Persistence
and Predictability of Growth Rates, which we updated with 20
years of additional data. And that study definitively
proves that growth, revenue growth and earnings growth does
not persist. It is not predictable.
So just because a company has grown fast in the past does not
mean they're predict grow fast in the future.
If slow in the past doesn't break from slow in the future,
that the best prediction of future growth tends to be that
growth will follow a random walk.
Essentially that growth will be equal to GDP growth and that
predicting the spread of high growth and low growth outside of
that one year, right? There's ability to predict over
the very short term is nearly impossible, right?
And so if you then think about the game of, of investing,
right, you're, you're trying to say, well, you know, how does my
optimism or pessimism measure against the sort of likely set
of outcomes for this company that are priced into the market?
And there's a wonderful study we did in Japan, because in Japan,
every company is required to issue guidance.
And so you can divide the world into, you know, companies that
have very high guidance, they expect to grow really fast,
companies that sort of have a middling guidance and then
companies have bad guidance. And you can say, well, Gee, you
know, first of all, you know, how accurate are companies that
sort of sorting it themselves into these categories?
And it turns out that they're about 50% accurate.
So, so better than random chance, right?
That they're, you know, if you say you're going to grow, be
high growth firm, you're, I mean, the top third of firms for
growth, you're 50% of the time you're right and 50% of the time
you're wrong. So there's over one year, you
know, within a year, you know, that's sort of roughly your
accuracy rate. And then you say, well, let's
say I'm good at, you know, let's say that I have that good
predictive accuracy that I'm 50% predicting a 30% outcome.
So I'm pretty good. You know, what does that
translate to in terms of stock prices?
And here's the interesting thing, right?
So if you look at companies that are forecast to grow fast, that
do grow fast, those outperform the market, right?
That they nailed it. They did well, they outperform,
but the 50% of the ones that thought they were going to grow
fast, that didn't really underperform because the people
are really disappointed and rightfully so.
On the other hand, if you go down to companies that are
forecast to have low growth and 50% of the time they're right,
they underperform the market by a little bit, not too much, but
a little bit. But the 50% of the time that
that they're wrong and the company actually grows medium,
moderately or fast, they have massively outperformed the
market. So if you then draw this sort of
crosstab of like, should I use the guidance that's embedded in
these forecasts to make stock price decisions?
It turns out that it all, you know, you do a sum product and
it's all essentially equal. There's no edge in Japan from
using the guidance data to make forecasts because you're wrong
enough of the time and the high growth and the low growth stuff
and the surprises, right? So, you know, if anything, what
you want to do actually is focus on the lower growth firms where
you're more likely to be surprised to the upside.
But I think what this, what this sort of shows is that there's
this sort of persistent resorting happening, this this
continued friction between prediction and reality, between
expectations and surprises. And it's that that drives market
volatility then. So when you're thinking as a
sort of a meta analytic investor, you're trying to say,
what do I think relative to what the market think?
You want to be looking for these places where people have either,
you know, a great consensus that something's going to be great or
a great consensus that it's going to be bad.
And then you want to come in and say, Hey, there's a 50% chance
you're right. But if you're right, maybe
you're so optimistic that you've, you know, you're not
even going to make all that much money.
If you're right, you know, it's like NVIDIA growing 50% and then
the stock goes up 2%. You're like, well, that was an
unbelievable outcome. Yeah, but it was priced in
versus the 50% of the chance you're wrong.
The stock is going to be changed dramatically.
And so I think what, what I would say is this, this sort of
re rating effect and, and value is what's going to drive your
outcome much more than actual fundamentals.
And that's why I'm so focused. You know, I, you said, you know,
we were talking earlier and he said, why are you so focused on,
on private equity or, you know, why have you focused there?
And I said, you know, it's, it's this correlated mistake that
people make. It's the, the most optimistic
thing. If you look at surveys or if you
look at valuations, it's the place people have just gone nuts
over over the last 10 years when I've been investing.
And I think in contrast, there are places like Japan or
Japanese equities or now European equities that are just
so out of favor, so left for dead that they're afflicted with
the opposite scenario. And that's where I, I tend to
make long investments. But but it's that it's
understanding that dynamic and that friction that drives my my
investment process. Yeah, I, I always, I, I guess I
thought of you originally. I was like, OK, this is like a,
a, when I say clever, I mean that in a, in a complimentary
way. I don't mean that in like a
deceitful way at all. But I, I figured that you were
having a clever way of marketing private equity in public
markets. But I don't know when you
started talking about this, like the mistakes that people were
going to make. I don't know when you started
talking about it, but I feel like I first heard you talking
about it in like 2018. So you were way early on this.
And then the other, the other thing that I, I remember you
talking about that like was really, really smart.
And again, like you guys are so, but is how Japan didn't allow
bankruptcy. So it, it allowed for you to
implement a strategy of highly over leveraged Japanese
companies and why that strategy worked.
I was like, man, that's, that's smart.
Yeah, Wait, yeah, we love Japan. I mean, I think the it's sort of
a fascinating story of what's what's happened in Japan over
the years. But but the Japanese equity
market, right, it had this huge bubble in the 80s.
And so, like, if you meet anyone that has been sick in their 60s
that worked on Wall Street and you mentioned the word Japan,
like, oh, I was in the Tokyo office for two years when I was
at Merrill, or, you know, like, there's always some random Japan
connection from the early 80s. And I had to go over in the go
go years. Exactly.
Just like, you know, when we're all retired, everyone's gonna
have some AI connection or, you know, yeah, like, Oh yeah, we
did this AI deal in the early twenty 20s, you know, blah,
blah, blah. But but what happened after the
bubble burst is that Japan's equity market was essentially
flat for 30 years. You know, it just didn't go
anywhere. Well, it crashed and then it
would be a flat and. Could never happen here, right?
Impossible. Could never happen here exactly
market the US market only goes up.
But but one of the big drivers of it, interestingly enough, is
that over that period, Japanese companies returned far less to
cap shareholders as sort of a percentage of earnings as any
other country in the world really.
The dividends were always low. There were no buybacks.
And so one of the reasons stock price went nowhere is there's no
one ever really earned any dividend deals.
But the cash had to go somewhere, right, because they
weren't profitable. These companies were making
money and So what did they do with it?
Well, they ended up just buying stuff.
Either they put where they put money in the bank, they bought
real estate or they did what's called cross shareholding.
So, you know, they just, you know, are in Tokyo and they have
a bank and they'd like buy stock in the bank or they're an auto
supply company that sells parts to Toyota.
So they'd make 50 million in profit and they buy 50 million
of Toyota shares rather than doing dividends, right.
This is like sort of irrational to us as Western investors.
But this happened for like a period of like 20-30 years.
And by 2020 is in late 2010's, these balance sheets had just
gotten so out of control because you had, you might have a
company that had tripled the value of its market cap in these
accumulated assets from the 20 or 30 years they didn't do
distributions. And the Tokyo Stock Exchange
started to sort of take notice of this and started really in
2022 and 23, this big push to say, hey, you know what, we got
to stop doing this, right? We got to start returning cash
to shareholders. And by the way, we got to clean
up these balance sheets. And So what you have is this set
of companies that have this huge, you know, years of
accumulated profit on the balance sheet that now are being
told that they need to distribute that profit.
And again, they don't even need to make new profits because
they've got years of worth of dividends just sitting on the
balance sheet. All they need to do is take the
money that's on the balance sheet and distribute it to
shareholders. And as that has started to
happen, and we're probably 2525% of the way from going from sort
of the old Japan to sort of a Western and more normal capital
allocation philosophy, the Japanese market has started to
go nuts. And what's been most satisfying
is the part of it that's gone the most nuts is the smallest
and the cheapest companies, which were most sort of
afflicted by the syndrome and had been most left for dead.
And and so Japan has just been a wonderful place to do value
investing because the things that people were most
pessimistic about have just become rocket ships.
And now, you know, at least on X, you know, you can read, there
are all these people now tweeting about, you know, I
found this, you know, Japanese soy sauce company that trades at
.4 times book and as a $200 million real estate asset, You
know, like it's kind of crazy. The only other thing people are
tweeting about or axing about or whatever the right word is, or
you know, AI stocks, NVIDIA, but there's this whole like random
subculture of tweeting about Japanese value stocks, which I
love. Yeah, yeah.
I thought, I thought that I thought that that was when you
first started talking about this, you were way early on it.
So that was really interesting and thank you for highlighting
that. I hope you're enjoying this
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Enjoy the rest of the program. The other, you know, sort of, I
guess thing that I into it that you put data to is that
profitability is a strategy that can be embraced and you know,
curious to hear your thoughts on that.
But but one of the things that makes a lot of sense is
profitable companies create value through growth, which
makes a ton of sense, right? Value companies tend to create
it through re rating, profitable companies create it through
growth. I was kind of surprised to hear
or to see that the valuation drag did not offset most of that
growth, but it it does make sense.
Yeah. So I think you got to think
about it in terms of so, so reframing the the question of
profitability and the way I think about profitability and
it's sort of an academic sense of profitability is, is, is
you're dividing something in the income statement or cash flow
statements in the balance sheet. So you're really, it's a return
on assets concept and the ones that we like to use is gross
profit divided by a total assets and sort of the intuition behind
that or this a real world example.
You know, you have two companies that are both spend $100 million
building a factory. Company A spends $100 million in
the factory and in year 1 makes 80 million of gross profit from
that factory and Company B makes 10 million of gross profit from
the factory. And let's say both are valued at
the same multiple of earnings the next year.
Well, you'd say, well, Gee, I like the one that produces
$80.00 for that $100.00 of assets because if they went and
build another factory, think about the ratio of that
investment to how much I would earn.
It's clearly a better company. And by the way, if things went
South in their industry and let's say they borrowed some
money and they had to pay 10 million of interest and things
went S, the industry profits are down 50%, right?
They're still going to be able to service their debt, whereas
the other one is not. So basically this idea of sort
of return on invested capital or however you want to measure
return on assets profitability we could call it is a is a
measure of business quality that's very robust, right?
And you can also think of like think of LVMH or something
that's making some fancy back branded bag, right?
They're going to for every dollar of assets, they're
creating some crazy amount of profits because the value of the
brand and the, you know, the IP, you know, versus, you know, a
frac sand company that right and is basically going to sell for
whatever the like 5% margin on the building of the assets to
extract the sand. OK, right.
It's just commoditized. So it becomes this wonderful
metric of business quality and potential returns on on assets
or in growth. Now, what's interesting because
you immediately say, well, aren't these companies, you
know, how do they sort of does the valuation drag offset it?
And it turns out that essentially, right, Like no
matter what the business is that has these for high returns on
capital, it goes through periods of high growth and low growth
just like every other company. And so the valuations, these
companies don't end up trading at a massive premium to the rest
of the market in aggregate, because everybody in the market
is so focused on growth forecasting.
So if the minute you kind of extract and say, you know what,
I'm not going to play that game, I'm not going to worry about
whether I think it's going to grow 5% or 10%.
All I'm going to care about is it is a high quality business
and is it attractively valued? You end up producing this return
stream that's more differentiated because the,
again, the valuations are so driven by the growth forecast
that sometimes people forget and say, well, if there's an
underlying, you know, great company, even if it grows at
GDP, I still want to own that. It's still going to produce
really attractive returns and be a safer asset than some company
I think has just caught on to like the latest crazy fad in the
market. I.
Apologize if, if this is in the book and I and I forget it, but
how did you control for like that?
What was, what was the either valuation parameter that you put
around or you know, some of the, there's an AI company that I
can't think of that's trading at, I don't know, 30 times gross
profit or something. It's tiny, but the gross profit
to assets is actually large. And arguably as the losses
accumulate, the assets kind of go lower like that, that kind of
stuff can really skew the data. How do you how do you work
through that? Yeah.
So the way I think, I think you can do it separately, right?
So you can treat value and quality separately.
Yeah. And in some sense, that's what's
in the US We talk about international in the US being
focused on quality and forgetting about valuation has
been the right answer, at least for the last 10 or 15 years.
So just pure quality works, works better than trying to
introduce a valuation overlay. Internationally, value has
worked, qualities worked fine, but valuation has worked so well
than anything with a valuation overlay has worked better.
So I think that there's two ways to think about that, right?
That company that you described, you know, one way to look at it,
as you say, well, the gross profit to assets is so high, it
merits a really high valuation. And so, you know, I'm going to
sort of suspend some of my valuation skepticism because
this company is clearly so great.
And that's a perfectly reasonable thing to say, right?
I'm not going to come out and say that that's wrong or there's
a rationale to that. The other thing is to say, well,
if the gross profit assets is this high, I start to worry that
maybe it's over earning for some reason, right?
Like, and I, you know, sometimes you meet, you know, in the
private world. You know, there was a guy here
in Boston who was telling me about a business that serviced
biotech companies here in Boston.
And basically they would build like kind of lab space out in
the middle of nowhere. And then they would truck stuff
back and forth from there, like high and high cost, you know,
Boston Biotech Center headquarters out to the
refrigeration center that was out in the middle of nowhere,
Massachusetts and this business. Until that slams.
Right, right. And it was crazily over earning
until the biotech crash came and then like, of course, right, a
reset. So there are businesses like
that, right where they are an extraordinary GP to a for a
period of time, but it's, it's because they're over earning for
some temporary dislocation. But you do want to try to
separate. And I think that can only be
done in sort of fundamental way. The ones that are earning that
for a reason that's sustainable for us.
The ones that aren't, but that's sort of the the second
generation passed the first insight, which is that quality
is generally something worth paying for.
Yeah, Yeah, that makes sense. One of the things that I was
thinking about how to describe what I perceive you to do and,
and one of the things that I like about your research and
then your firm is you're building solutions, right?
So one of the things that came out of the book is size and
value matter a lot. How do you, how do you, you may
not have this answer yet, but how do you build a product
that's a good business, but also can exploit the illiquid nature
that's needed to exploit in order to to realize the yeah,
it's re rating food value, right?
We've been spending a lot of time this is just hot, hot off
the press is what we're working on now.
But but there's this really interesting relationship between
the, the, the equity factors, value profitability, etcetera
that predict returns and they and they do predict returns,
right. So value stocks do outperform.
I know there's skepticism around that, but they do.
But. There's an interaction between
that and size. So a very cheap mega cap versus
a very cheap micro cap. The mega cap actually is going
to earn less of a premium for that its value Ness than the
micro cap. And the way to think about that
is the markets are pretty efficient.
And so the more liquid and the bigger you get, the more likely
it's cheap for a reason or that that right, essentially the
valuation is more accurate at the larger cap end of the
spectrum. So everything just sort of
converges to the market return and the ability to generate
alpha decreases as you go up in market cap, at least from
traditional equity style factors.
So you're going to get the biggest juice in the micro caps
and the least juice and large caps.
And so you as an asset manager think are sort of in my view,
thinking through this sort of trade off, right, which is if
I'm going to go play with the big boys, my ability to generate
alpha is going to be very limited.
And that's why indexing has become so popular, right?
If you just want to own market beta, just own it really cheaply
because the offset and fees is higher than the alpha that can
be generated among those large cap equities.
Unless the person is some, you know, once in a generation
genius and the ability of you to predict that person would
require once in a generation genius.
So your genius to find them times their genius and investing
the probability of that happening is so low, whereas in
micro or small cap where things are less liquid, you know, the
factor premium are just juicier. And so and by the way, it's
harder to index because of the liquidity problems.
And so, you know, I tend to think of building an asset
management business in this current era.
Is building a business cognizant of Vanguard, right?
It just has to be right. You don't want to do anything
that Vanguard can or will do or does do because likely they're
going to do it better and cheaper than you, and your
business will lose its risks on Detra.
So I like to think of everything we build as being unindexable,
as building something that's unique and that's sort of a
precondition to doing something for us.
And so we focused a lot on small and micro caps where the
liquidity is a barrier to entry. We focused on weird places like
Japan where they're nichy enough that people don't necessarily
focus on them. And you know, when we pick new
places to do research, we look for that set of things.
So right now we're doing a ton of research on biotech, which
just perfectly fits that right. Very hard to index, tends to be
comprised of lots of small companies and probably big alpha
opportunity in my view. So that's, that's sort of how I
I think about it though. Yeah, the, the biotech research,
I'm, I'm looking forward to whatever conclusions you end up
with. I was listening to your podcast
with Medfaber and it is, it's interesting that business like
CRISPR has more the the R&D magnitude of the larger ones may
actually I, I, I don't want to, I forget how you put it, but I,
I think basically like the R&D size, you might actually have
less risk with similar upside if you ignore some of the small
which would fly in the face of some of the other research, but
potentially applicable there. Yeah, I don't know.
So. Biotech is is really, really
weird. It's just the your typical
equity factors don't work at all in biotech and the simplest one
to understand is is value. So in if you think about a
typical biotech, it's it's spending money on a science
project and it has a bunch of cash that investors have given
it to fund the research into that science project, right.
This is the sort of the structure of a biotech firm.
So in traditional valuation, the more cash you have, the bigger
your enterprise value, therefore the more expensive you are.
And on the other hand the more profit you have, right?
The better if you're losing money, the more you lose, the
worse the company is. But in biotech, you can think of
sort of breaking that down into sort of a sort of X&Y axis,
right? On the X axis you can be
thinking of your spend relative to your market cap, how much you
know, because a company that's sort of spending $500 million a
year on research and development, right?
You're sort of intuition is right.
Well, they've got to be researching something pretty
valuable for any of the money to do that.
Yeah, versus some company out of Miami, some strip mall in Miami,
it's spending $5,000,000 a year on research, right?
Like these are different businesses, right?
And 1 is probably higher quality right than the other, even
though one is losing massively more money.
And then on the other axis you have, you have how much cash you
have relative to your cash burns, right?
Like let's say you have $500 million of.
Spend Runway 5. Billion in the bank.
That's clearly better than $500 million of spend and in a
billion in the bank. And so you think of those two
axis, you're thinking already about biotech, therefore in a
very different space than your traditional valuation.
And you can kind of apply that throughout the sort of value
chain and all the different metrics that you'd think of when
analyzing a firm, you have to fix them and adjust them to kind
of process what's going on in biotechs.
It's such a unique space, which is the sort of project we've
been embarking on. Yeah.
I wonder if there's a way to figure out like patents per
dollar spent or something like that.
I don't know. Yeah, right.
In fact, it's clinical trial data.
Yeah. So we've spent massive amounts
of time and money trying to marry the clinical trial data to
to the public companies. So you can sort of try to figure
out what's going on and how the clinical trial process relates
to how the equities are valued etcetera.
So how are you? You got to be automating a
decent amount of that. Yeah, yeah.
This is all that we all that we do basically is, you know, build
out databases and do kind of quantitative research and build
software to process the information.
That's a big part of our day-to-day life.
And one of the most fun things that we've been thinking about,
right. Is that one of the things that's
sort of unique about biotech, if you if you go and talk to the
the best biotech investors, you know, they often have, you know,
50 pH D's on staff or something that are going and reading
clinical trial data and coming of you.
And is this molecule good or is that molecule good?
And for us is sort of a systematic quantitative manager.
You know, we don't have the only pH D's we have to borrow from
G's are the poor, hungry, desperate to get rich type, not
the so, so, so that's us. But but you know, you think
about it at that and what we say is, you know, we're never going
to compete on that front. And you know, analyzing molecule
by molecule, the 500 biotech companies, you know, but you
know what's great? Because every biotech hedge fund
files A13F filing, you know, we, we have an approved list, right?
So if you think, if you know, if you think the guys at that
biotech hedge fund with their 50 PhDs are really smart, we have
an approved list from them of every company that they
validated through their fundamental process.
So, you know, you could pick the 10 how tech funds you want and
you can say, let's, let's let's create sort of fundamental
validation by industry experts as a factor and you can actually
see that that factor outperforms over time.
Interesting. It's a I mean that makes.
Sense any other factor? Yeah, it makes sense, huh?
That's neat. And then how do you, how do you,
how does your firm generally manage money?
Are you Smas? Is it like you don't have an ETF
do you? No, we, we do everything.
We're a hedge fund firm. So everything OK is generally
commingled hedge funds and some Smas.
Interesting. That's cool, dude.
How do you how did I mean, what happened?
You got out of college? Well, I mean, I know you get you
started to work, but I I like how you said in the book that
that you you quickly, you don't really get too far being the guy
in the office saying, wait a second, none of this makes any
sense. We we should we should be doing
things differently. So what did it look like when
you decided to go out on your own and and how did you get
traction with your writing? Were you writing pieces and just
cold sending it to people or did it?
I know, I know Grant supported you a little bit in the
beginning. How'd that happen?
Yeah. So, you know, I think that I had
this sort of experience of sort of doing a lot of research.
I was probably really turned on by like the Phil Tetlock and
Daniel Daniel Kahneman stuff about cognitive biases and also
the science of forecasting. And then I started kind of going
down that route and thinking about how that applies to
investing and reading a lot of these academic studies about,
you know, predictive power and resistance and predictability of
growth. And right, like you kind of go
in through this literature and you sort of start to come to
this world view that like the future is really unpredictable
and that a lot of the work that we do to try to predict the
future increases our confidence that increasing our accuracy.
So it's actually bad. And basically doing all that
research and like thinking through all that, maybe a
horrible employee at a private equity firm, right, where the
entire job is like building future cash flow models.
And like, what do we think is going to happen to this industry
in four years, right? And like no one wants the
analysts, but like, fuck if I know.
Like this is completely unpredictable.
It's a huge waste of time. Like we do two months of work,
we're just gonna be more confident and no more accurate.
Like that's not a helpful. Answer No it is not.
It's. Really.
Actually quite insufferable. I think I became sort of like
the world's worst, most insufferably arrogant, obnoxious
employee. Yeah, they're like, Sir, do you
understand the job that you were hired here?
You're not doing it. Yeah, we're paying you here.
What the hell are you doing? You're just like creating
problems. You're.
Like the family member that argues at every dinner.
Right, that was just awful. And, and so I think, you know, I
was so young, it was my first job out of college.
And so I sort of like that process that the way I process
that experience, it's like, wow, I'm a terrible employee and I'm
like anyone I go to work for is going to hate me.
And therefore like I need to find something different to do
where I I'm not going to get into this trap again because
clearly this isn't working. So I sort of feel like I became
an entrepreneur because there was number other option, or at
least I didn't perceive one rather than that I'd always
dreamed of being an entrepreneur, which is the story
for so many people. And so I started the firm and I
sort of thought, well, the best I can do is do it by myself
because again, I'm I clearly am so insufferable and pissed
people off. And so that was sort of what led
me to do it. And then I just my next thing
was to come out with these things and it's out.
The future is unpredictable. No one can predict earnings.
And, you know, if you're someone trying to allocate money and you
hear that you're sort of like, well, who's this punk?
You know, What does he know? And I realized, like, I had to
explain myself that it like wasn't like, I just kind of like
thought this. It was like, oh, I spent years
reading about it and studying the literature on it.
So I just felt like a sort of try to defend myself.
I had to write. And so I started writing about
my views and where they came from and what the evidence for
them was. And I sort of started sending it
to everyone I knew. And then everyone I met with.
I, I don't know, maybe there are 50,000 people that read our
research now, but maybe there were 500 to start with.
And so it just sort of grew and grew overtime and the firm's
grew with it because there was like minded people out there who
liked what I was saying and liked my research.
And they'd come and call and say, hey, you know, Dan, do you
manage money? And, you know, can we, can we go
along for the ride with you on this, you know, intellectual
journey. And that's been a really
rewarding part of what we've, what we've done is sort of
finding these people all over the world that sort of think in
this sort of a unique or, or, or a different way that like what
we're doing and are willing to take some, some chances on some
of our risky ideas. And, you know, I, I think that,
you know, one of the things that I've been talking about recently
is the importance of waiting and investing because it, it, it
turns out that, you know, you were very nice to note that I
was early on private equity that and, and now it's good that I
was early, right? I thought of it first.
That was great. But for a while early just meant
that I was wrong. And you were just somebody that
was angry that private equity was doing well for a little
while. Exactly, exactly.
I was a sort of nasty cynics, snark, snarking in the corner or
whatever. And now people say, oh wow,
maybe we should have listened to Dan's warnings.
Maybe that was prescient. And maybe we should have gotten
out of private equity in 2018. We'd be in a lot better of a
place today that we had, but that wasn't evident for a few
years. And so I think that one of the
lessons I've learned is the importance of waiting and a
patience. And I think what you sort of
want to do and investing the sort of right answer is you put
yourself in the right position, right?
You, you, you, you think through what you're trying to achieve
and you put yourself in a position that reflects those
sort of core beliefs and values. And then you wait.
And waiting almost always seems like a precondition to success
in investing is the ability to wait.
And the ability to wait is dependent on the rigor of the
process that you went through to evaluate what you do at the
onset, because you won't be able to wait if your views are
shallowly held. And so I think a lot of my role
is sort of spending huge amounts of research time upfront to get
myself in a position to wait. And that's, that's sort of I
think what what we do these days.
That's interesting. How do you how do you?
Well, I don't think that you're you're you probably can lean
back on process, but how do you make sure that all of the
research that you're doing doesn't give you overconfidence
in the confidence that you're not confident in anything, if
that makes any sense That's. Pretty meta.
It's like we're looking in a mirror of a mirror.
Of a mirror of a conversations with yourself.
Yeah. I mean, I think a lot of it, you
know, through a sort of scientific or quantitative
process, right, of, of trying to say, Hey, can we, you know,
create a back testing environment that, you know, and
even then knowing that, hey, even what we back test is going
to be overconfident and, and real life's always going to be
worse than the back test. But I think it's, it's sort of
trying to apply a rigorous scientific quantitative approach
as sort of the best we can do. And then we bring in outside
experts to that what we do. So we have Sam Hanson, who's a
professor at Harvard Business School.
We bring him in once a month. He comes in like we, we present
his, you know, it's like a murder board.
We're going to present our research and, and, and he's
going to RIP it apart and we'll go back to the drawing board.
And, you know, I, I found that, you know, and, and we have a
great team, really smart people. And so if we create that sort of
environment where we're testing ideas and pushing on them and
everyone's reviewing them and arguing about them, you know,
we're going to get to a great outcome.
And and that's sort of what I've been trying to build if I if I
can. Yeah, I like it.
One thing that we haven't covered and it popped into my
head so apologies for jumping around here, but if earnings, if
like growth is not predictable, why is volatility or auto
correlated and why does that phenomenon exist in the world?
Is it just uncertain times breed uncertainty, or is there
something else that you've been able to sort of think about?
Yeah. So volatility is quite
predictable and it's predictable both in a cross section and a
time series. So, and I would say think about
it this way, right? In a given month, I'm very
confident that bonds are going to be less volatile than stocks,
but I'm actually less confident whether bonds are going to beat
stocks or underperforms. Like I know that stocks
outperform bonds in the long run in any given month, right?
Stocks, probably a 55 percent, 60% chance of beating bonds, but
it's like almost 100% that the stocks are going to be more
volatile than the bonds. And so in sort of a cross
section, right? And then you can think of like
within the stock market, like, hey, next month our biotech
stocks going to be more volatile or utility stocks going to be
more volatile. It's like, well, probably
biotech. And what about our small caps
gonna be more volatile? Large, yeah, small caps, right?
So it turns out that sort of volatility on a sort of
cross-sectional basis is very predictable.
And again, returns aren't, but the file is.
And then the next thing is that sort of in a time series right
now if if last week or last month was really volatile,
probably this month is going to also be be volatile, right.
Volatile doesn't follow a random walk because it's sort of like,
you know? People get kind of last month.
They're still going nuts and it'll take a little while for
them to calm down about whatever it is that sort of riled them
all up. And so you see that sort of last
month's fall is a pretty good predictor of next month's fall
and sort of an asset class level.
And so you combine those two cross-sectional and time series
fall predictability and you come up with a world in which you can
manage risk pretty well because you can understand the Vol
profile both of your assets and time and relative to other
assets that you're trading. Yeah.
And what I what I took away from the book, which is probably too
simplistic, but if, if Val is low and spreads are tight, maybe
people are overly confident. But I don't know what you do
with that information. And and I think we got to stay
tuned to your research to figure out what you do with the
information. Yeah.
I think that I would think about it as sort of like a California,
a California forest. And the longer the longer
there's been no rain and the longer there's been no effort to
manage the forests, the riskier the forest is for a forest fire.
And that's the way I think about low Vol and tight spreads,
right? It's the longer it's been, the
more risk doesn't mean it's gonna happen, right?
You still need a spark arsonist or someone to light a fire or
something bad to happen. But, but the probability is much
higher if there's been a protracted period of drought
than if there hadn't been. And, you know, in financial
markets, the longer the debt's been cheap and there's been no
bankruptcies, the more likely that there's a lot of risk of
people that have sort of gotten away with borrowing too much
money for for bad projects. Yeah, makes sense.
That's well, that's interesting, man.
I tell you there are, there are podcasts that when I do the
prep, it's less enjoyable than other ones.
I really enjoyed reading the book and I enjoyed doing the
prep for this. I, you know, I've read some of
your research that you have posted in your monthly research
and I thought the book was really interesting.
It's one of the few books that I, I mean, I don't want to give
away the end, but there's sort of isn't an end, right?
It's still a work in process. Exactly.
I'm hoping that in 10 years I can write the arrogant investor
because I've just been right about everything.
But the one in process is the humble investor.
So, so I think, but, but no, I think thank you for that.
And you know, I, I, I think, I think I've learned a lot from
the last few years. And I think if you're interested
in learning what I've learned, the the the book and the humble
investors is a is a great place to start.
As is the website, right? So that's where you publish
everything. And if people want to sign up
for your stuff, you know, where should they go?
Yeah, you can my ex account at Ford Adcap.
We've got a link to sign up for our weekly research in the bio
And we, we publish every Monday morning at 9:00 AM and it's
always sort of whatever the latest thing we're thinking
about is. And and and I, I tend to think
we think about pretty interesting things.
Yeah, I would agree. You're always you're always
interesting to listen to And I I thought, you know, people that
like this interview, listen to the MEB Faber interview that's
more long firm on biotech. I thought that was a great,
great podcast you did. Thank you.
Anything that I didn't cover in this interview that you want to
get out there? No, this has been great.
All right, cool. Well, thank you very much for
joining the show. My.
Pleasure. Thank you.
This was a lot of fun. Thanks for doing all the prep.
That really made it a great interview.
So it's fun for me, no? Worries man, again it was a
pleasure so look forward to staying in touch and thanks
again. You too.
Bye. None.
Music.