“The Humble Investor” | Dan Rasmussen on Mag7, Value, Private Equity & Credit, and More
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The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough. Thank you. Let's close this door. Very pleased to be joined by Dan Rasmussen, founder and chief investment officer of Verdad Advisors and author of The Humble Investor, How to Find a Winning Edge in a Surprising World. Dan, great to see you. Welcome to Monetary Matters. Thanks for having me on. Let's get right into it.

You've got a chart, a table, I believe it's on page 120s about peak search interest.

Bitcoin 2017, weed in 2018, space 2021, solar 2008, 3D printing, augmented reality. Then you take a look at the 12 month forward returns and they are absolutely abysmal. For Bitcoin, 76% down, weed 57% down, dot com 90% down. Are we at that phase, do you think, in AI now? What are your concerns? What are the

principles in your book about humility that inform your answer. Yeah. So my favorite line is that investing is not a game of analysis. It's a game of meta analysis. It's not what you think. It's what you think relative to what the market thinks. And when you see unchecked enthusiasm about a given topic,

Whether that enthusiasm is right or wrong, you don't even need to evaluate. All you need to know is that as an investor, that's a sign of that excessive interest or excessive enthusiasm is going to create an opportunity for you because the future is unpredictable, right? There's so many unknowns. And one of my favorite studies that we do in the book is looking at how do historic growth rates predict future growth rates? And it turns out they don't predict future growth rates at all.

And by the way, even using analyst estimates or company guidance doesn't particularly help all that much either, right? It might give you a short term one year forward. You might get a little bit of edge.

But the penalty when those companies miss their guidance or miss what's priced in is so great that, again, the primary focus for you as an investor is not what is this company going to grow? How is AI going to do? But is the level of enthusiasm or optimism for this and getting out over its skis relative to an unpredictable future?

And so I think if you look at what's going on with AI today, there are a few really unique things that I would call attention to. The first really unique thing is that in the past when we've had these breakthrough new technologies, these innovations, a lot of it's been funded by venture capital. These have been new companies.

And with venture capital, there's this 90% failure rate. It takes 10 years to commercialize, but the venture capitalists know how to handle that. Now what we have is the largest companies in the world that dominate the S&P 500 index taking essentially venture capital like risk on a new technology and not just spending $100 million into a seed round or something. They're spending $80 billion in CapEx to build out data centers for AI. And yet there's so much we don't know.

We don't know what the return on that investment is going to be. It's very possible that we've seen with other big CapEx cycles like shale gas or fiber or bandwidth, that massive investment is great for consumers, but pretty terrible for the people that invest in them. We've seen often that

New technologies, theoretically, they have to benefit the customer more than they do the person that's selling it. Otherwise, the margins isn't there for it to be adopted. You can't make money if your technology doesn't work for customers. And we haven't yet seen in sort of the killer AI app. I'm sure it's coming. So don't put me on record as an AI skeptic. But how is Microsoft, for example, spending $80 billion or something next year on CapEx? How are they going to get over $80 billion per year in revenue?

What's the, where's that going to come from? And I think the other thing that I would note about AI is that AI in some sense is turning knowledge or services from into a manufacturing problem, right? That requires CapEx, right? Since when did these big software companies have CapEx, right? I mean, the whole thing used to be that they were asset light companies.

You create the software and it's unlimited scale. AI isn't unlimited scale, right? There's gross margin there across a good soul, right? You have to actually run the compute. And I think the other lesson that we've had over the past few years from looking at a lot of these huge advances in machine learning, right? Huge advances in machine learning that enabled the AI revolution. And everyone said, oh, these software tools are going to...

they're going to basically decode your data all by themselves and reveal the truth. And it turns out that's just, that's a false promise, right? Like you look at Palantir's revenue per employee, it looks much closer to McKinsey or BCG than it does to Intuit or Salesforce or something, right? It's much more of a services consulting business than it is a, hey, take the software out of the box and it just works. And I think AI is going to be quite similar to that.

All of which is to say, we don't know. We don't know what the killer product will be. We don't know what the return on investment is. All we know is that the largest US companies are priced to perfection at multiples of sales and are now generally spending pretty large percentages of their net income, if not more than 100% of their net income, investing in this new technology. And we don't know what the outcome is going to be. And I think it's reason for a lot of skepticism

Not just about the Mag7, which at least they have the money to afford this, but think of all the small companies that are being buoyed up on this. And that's mostly where sort of the frauds and the hope and craziness tends to occur that are likely zeros.

And how do you navigate between the spectrum of on one side, the people who say AI is going to be basically the elixir of life, it is going to cure everything and radically transform our society, and it's going to happen tomorrow or very rapidly, versus the complete people who say it is a complete bubble and

I'm allocating completely zero to Nvidia and all of the AI stocks, and maybe I'm even shorting them. How should active managers and investors who manage not just your own money, but other people's money, how should you think about being on that spectrum? Because

You don't want to be the person who's all in because if you're believing the biggest tall tales of the future, then you are not being humble. But also, if you're having confidence that it is a bubble and that it's going to be nowhere, you might be like those people who shorted internet stocks in 96. Or you might be like those people in 2013 who said they were buying oil stocks and said they were shorting Apple. And that did not end so well. Yeah, I think a number of things to note there.

I think when we think about what do you do with AI stocks? How do you deal with them? I'd say the first, we have to think about the context, our historical memory. And investors, it's a human thing that we...

are the same sort of neurons and neural mechanisms in the brain by which we remember things are also the same mechanisms by which we forecast, which makes total intuitive sense. If you're an animal and you remember where you caught the food yesterday and you forecast, oh, I'll go there again to get more food tomorrow. I mean, it's totally intuitive. And when we apply this to the stock market, there are a number of things that happen. We tend to over extrapolate

from things that have happened to assume that it's more likely that because they happened in the past, they'll happen again in the future, like taking historic growth rates and projecting them into the future, which just doesn't work and doesn't make sense. And I think one of the lessons that investors have learned that's so burned into our brain at this point is don't bet against Silicon Valley, right? I mean, think about every good short case that has been made. I mean, I don't even know if there are any short sellers left. I think they've all gone bankrupt, right? They thought Tesla was a fraud. They thought...

They thought Tesla was a fraud. They thought the data centers were all going to blow up. They thought, think of the long list of great, well thought out, elegantly put short theses around anything that Silicon Valley has done over the past 10 years. And basically with few exceptions, they've been wrong. And so I think it's burned into our brain that don't bet against Silicon Valley, right? The technological innovation has been amazing. And I think we have to separate out two concepts, right? One is

Can we have a view that the technological innovations are amazing, right? That, gee, it's Tesla's electric cars are amazing or what AI is likely to build is amazing. But we can't get confused about the quality of the product, the quality of the stock. The quality of the stock depends on the quality of the valuation and value.

That's going to dictate to a large part how your probability of winning. The higher the stock is priced, the more expensive it is on a multiple basis. The more has to go right, the lower the probability you're going to be successful. And the cheaper it is, the more pessimistic the market is and the higher the probability you have of making money on the stock. It's sort of an immutable law that has been wrong for 10 years in the United States because the tech companies have just been so good and so exceptional at growth and innovation.

but will they produce the same miracle again? I don't think so. I think that, so I think that as I think about it, you have sort of two positions, right? There's the humble index position, right? Where you say, gee, right? NVIDIA is X percent of the index. I'm just going to own the index and that's going to be X percent NVIDIA. That's one alternative.

And I think certainly a lot of the shift to passive has encouraged that type of thinking. And there's a lot of good humility in that, right, of saying, hey, it's really hard to beat the index. True. Let's just own the market. Good. But then there's the other question of, well, which market do we own? And so I think the first level of analysis is saying, well, most likely today, right, let's think of three different things that you can own, which are U.S. stocks, international stocks and bonds.

I think there are a lot of investors that are probably way overweight U.S. equities and way underweight international equities and way underweight bonds.

And you revisit that and you say, is that the right allocation today? Is that the right risk to reward? What is the optimal allocation? And the passive humble answer is actually, if you think about it, is probably a weighted by the market capitalization in terms of stocks. So you're going to have at least 30% or 35% of your stocks internationally. How many investors have that today versus have cut it out entirely or diminishing their international allocations?

And depending on whether it's appropriate for you, fixed income allocation. And I think that those are things where you can say, hey, gee, even without an active view, what is the right passive view? What is the right humble passive view? And it might not be owning so much of your portfolio. There are natural ways to diversify that are humble. Now, I'd say as an active manager, right, if you're going to try to go above that and beat it, I don't think at these valuations and with the amount of uncertainty about the future of this CapEx spend,

I don't see a strong reason to own any of the Mag7 names. I don't personally own any of the Mag7 names. I don't think the risk-reward looks attractive on any of them. But then again, we're paid to make an active call, and that's the call I'm making. I'm not short them. I think that's crazy too. But I think that...

There's just too much optimism right now about what's going to happen. And Dan, earlier you referenced a study about the stability of growth rates. And this is really surprising that growth rates, is it basically growth rates of a company's revenue, which is obviously one of the most, if not the most important things, is

in one year is not predictive of it in another year or 10 years down the line. We think that Nvidia doubled its revenue last year. Its revenue growth is going to be phenomenal. And its revenue growth of the next 10 years is probably going to be higher than your average stock. But maybe the research suggests that's not true.

I don't know. And also the previous 10 years, I feel like with Microsoft and Alphabet is going to report its earnings later. I feel like there has been a stability of revenue growth and these companies keep on growing. But looking back to the 1990s, 80s, 70s, as you have, and I think you referenced a paper, I forget the name in your book, that actually it's no, it's the stability of cash flow growth and revenue growth is not stable and can't be repeated. That's right. So it's the persistence and predictability of growth.

And I think the key idea is that historic growth rates have no predictive power about future growth rates, right? So even take sort of top quartile revenue growth firms over the past one, three or five years, does that predict the next one, three or five year? It does not at all. It is entirely random chance, which is so counterintuitive. And if you think about the sort of mag seven names,

Usually what happens in the stock market is that there's a wide variation of expectations. There are stocks that people think are going to do really well and things are going to do really badly. The future unfolds relatively randomly, and it turns out the things that people are most pessimistic sort of re-rate up, and the things that people are most optimistic about, the future doesn't come in quite as rosy as it turned out to be. Or it comes in just as rosy, but you're a year in, and the future for the next year is not as good as the

if Outlook was a year ago, right? Even if they did achieve all their numbers. And so the multiple comes down. And so you have this sorting process and that's what makes value work. It's this constant tension between expectations and then realized reality where,

too great. Your expectations are too great. You're going to be disappointed. Your expectations are too pessimistic. You're going to be surprised to the upside. What's happened in the US over the past 10 years is that actually the highest, most richly valued large cap stocks have outperformed even the most optimistic expectations. Things just turned out better for these companies. They grew more. They grew faster than anyone could have anticipated and for a longer period of time.

And so that and because they were so big, it just dominated all the market action. Right. So that U.S. growth stocks just became the engine of the market and everything else looked terrible by comparison. But if you look at his sort of historical precedent on a large scale, sort of the probabilities of these things happening, just the fact that they've done so well over the past one, three, five or 10 years, again, tells us nothing about whether they're going to do well over the next one, three, five or 10 years. Right. Absolutely nothing. It's a roll of the dice.

Which is why I think looking at their very high valuations and now their very high rates of spending starts to make you worried for those two reasons. The other really interesting study that I did recently, it's not in the book, was I looked at Japanese companies which are mandated to provide earnings guidance. And so you can take their earnings guidance one year out and say, did they actually achieve their guidance? Then what happened to the stock? And I divided it into high growth, medium growth, and low growth.

And it turns out that Japanese companies can sort of sort out their growth rates into those categories about 50% of the time. So chance would be 30%, they're hitting 50%. So they're a little better than chance. So it's not like Microsoft has no clue what their earnings are going to be or their revenue is going to be in 2025. They do have kind of a clue. That's sort of intuitively right.

But here's the problem, right? If you are a high growth firm and you hit your high growth numbers, you do a little better than the market. If you're a high growth firm and you don't hit high growth numbers, your stock does terribly. Conversely, if you say you're going to have low growth and you do have low growth, you kind of do what the market does. But if you said you were going to grow 0% and you grow 10%, your stock goes way up.

And so what ends up happening is that guidance as a tool in Japan is a completely useless metric. It just doesn't give you any insight. The only insight it does give you in some sense is the contrarian insight of saying, gee, the stuff where the forecasts are too high, there's much more likelihood likely to be disappointment. That's sort of the only intuition you can get from it, because otherwise what's that sort of growth expectation is priced into the market. Right. And I think you just step back, right? Like market efficiency, things should be priced in.

How could all of the knowledge about the largest seven stocks not be priced in? Why should we expect to earn excess returns better than market returns, owning the largest, most studied? They should be the most efficient. And if anything, at these valuations, they're not only the most efficient, they're the most popular.

And so I think our intuition should be a lot of skepticism. And what about the value factor? You share various charts about how you rank the companies and stocks across deciles, and you show how the companies with the highest value factor or the cheapest stocks rank

have tended to outperform. And that is also true, what was it, about size as well. Was it size or was it quality? Quality. Yeah, quality. So value and quality, the only thing is that a lot of the high quality stocks are, of course, not value stocks because everyone knows that they should command a high price to earnings multiple.

So, yeah, your thoughts on that, as well as, I guess, maybe the covariance between those factors. Yeah. So there's a whole host of academic or quantitative, we call them style factors, things in a company's financials that predict their future returns. And these have been studied to the nth degree. And in the book, I talk about the two probably most powerful factors.

And not only are the two most powerful factors, they've had a very divergent outcomes the last few years. So the single most powerful factor really in the literature is value, right? Buying cheap things tends to work over time. And now there's been lots of allergies to value investing's death.

And it's true that since 2018 in the United States, value hasn't worked. Value worked briefly from call it 2020 until ChatGPT was released and then it stopped working again. And so buying value stocks in the U.S. has been a loser's game for nigh on seven years now. So it's been a bleak thing for value investors. Like short sellers, a lot of value investors are either going out of business or changing to non-value investment.

And so I think there's sort of a dirty name of the value investors, the old people just don't get how the market works anymore. I'd say, however, it's worth noting that value investing has worked just fine internationally. If you've been a value investor in Europe or Japan, you've done quite well. There was a period from 2018 to 2020 where value didn't work anywhere. But since 2020, it's worked internationally. And I think it works because of this. It works because it is based on this

fundamental logic of the way the markets work that is sort of the essence of the arbitrage I'm writing about in The Humble Investor, right? Which is people can't predict the future. We don't know what's going to happen, but people can't resist betting on it and thinking that they can predict the future. And so those places they get too optimistic or pessimistic on are the places where you can make money betting against it. And so I think that that's what value is. And so you see actually on an equal weighted basis, even in the US, value is

worked okay. But what you want to bet on is consistently to take the same bet of saying the things that are undervalued, that people are pessimistic about, that have left for dead, those are the things that over the long term will work. Quality, on the other hand, is a really interesting one. I define quality as gross profit to assets, or you could also think of that as sort of a return on asset metric. And this is a cool one because it's worked really well for the last few years. And if you just pull up

rank stocks in the US by gross profit divided by assets, you'll recognize all the names at the top of the list. They're all the companies you'd think of as compounders or great companies. And actually, it's not perfectly priced in. There are some value stocks that are really high on gross profit to assets. They tend to be the low growth companies, right?

So there's sort of this second thing of growth expectations or growth trajectory, right? You can have very high gross profit assets, very high quality companies that have had slow growth and are therefore cheap versus the really high flyers that are really high on gross profit assets, but are really expensive. So it's not a totally priced in relationship. And the reason that quality works, it's for a few reasons. One is you think about two companies, just think the intuition here, right? Two companies both build a factory for a hundred million dollars.

And the next year, one of them is making $80 million in gross profit, and the other one is making $20 million in gross profit. Those companies should not be worth the same multiple, right? I mean, clearly, the one that produced $80 million of gross profit, first of all, they could build more factories, right? And that's going to generate a lot more growth for them than the company that has the $20 million of gross profit.

Then think about sort of the bankruptcy risk, right? What if there's some sort of downturn? Well, if I'm the lender, I'm going to be much more comfortable with the $80 million of gross profit company than the $20 million of gross profit company for the same assets, right? The assets are just worth more.

And so I think that that sort of intuition around thinking of what's the return on investment historically for the stock, and it turns out that tends to be quite persistent, to be quite persistent, right? So if you've had a 80% gross profit to assets, it's likely five years from now, your company will still have an 80% gross profit to assets versus your growth rate, which is going to oscillate all around. And so again, it's the same arbitrage of letting the market focus on growth, which is unpredictable. And even when it is predictable, it's priced in.

And instead focusing on these other characteristics, the valuation metrics, which measure the optimism or pessimism in the market, and the quality metrics, which say, hey, forget about whether it's going to grow in 2025 or not, or how much it's going to grow. Like intrinsically, is this a business that has attractive return characteristics where they can decide their own destiny? They can go build a new factory or expand their market, and they're going to do that very profitably.

And if there's any downturn, they're so profitable and throwing off so much money that they'll be fine. Or is this a company that's rather at the cutting edge?

that's cut to the bone, very high risk, not a high return on investment where it's very commoditized. And yes, they can grow, but it's very capital intensive and painful to grow. And the return on investment is low. And I think those are the two types of equity investments I really like, focusing on those two things, on value or on quality, or finding places where quality and value are aligned is probably the best case. Is there quality and value to be found in the private equity markets? You

I believe called private equity a bubble. Why do you think private equity is a bubble? Do you think it's going to end badly? Do you think it's going to end badly soon? And also, yeah, what are the general psychological principles at play? What mistakes when allocators are allocating 50% of their endowment to private equity, what mistakes are they making? What, if you dare may say, what are they doing that's not humble? Yeah. So the first thing, Ray, is

Private equity loves to introduce a confusing statistic, which is they say the size of the private markets is massive relative to public markets, right? There are 500 stocks in the S&P, but there are a million private companies or something like that. But I did an exercise where I added up the revenue, right? Just add up the revenue or the profits of the publicly listed companies versus the privately listed companies. And what you'll find is that, or you could even do it by employees, right?

It takes a lot of dry cleaners to get one Facebook, right? So what you end up seeing is that in aggregate, the private markets, probably the sort of investable private markets should probably be two or probably two to 4% of the size of public markets in terms of revenue, profit or employees, right? The vast majority of the economics of the United States are publicly listed, right? This is sort of just obviously true.

Geico or Progressive, right? Like you think of the companies that are making big bucks, those companies are by and large public. The companies that are private and private equity owned tend to be quite small. So the median market cap of a private equity deal is about 200 million, call it about 200 million. Now it's about 50% levered, maybe 60% levered on average. So the total enterprise value of the median private equity deal is about 400 million. And today they're probably paying 20 times earnings, right?

So you're looking at pretty small companies, right? 20 million of profit or something at a 20 times multiple, 400 million of EV, right? These are small companies. So you have to first notice that small companies are more likely to go bankrupt. They're more risky. They're less diversified. They don't have scale advantages. They tend to be lower quality companies.

All of these things are sort of obviously true. And so if you start from a perspective of an endowment or foundation, you say, well, gee, I should have 40 or 50% of my money in an asset class that's probably aggregate economic activity, 2% to 4%. That's a very, very big allocation. And you have to be wondering what's going to drive the excess return there and what are sort of the puts and the takes.

I'd say the big argument that private equity likes to make is that they're better at running companies than people in the public markets, that having aligned ownership or making operational improvements is going to drive a lot of value. I like to joke that where did all these investment bankers become so good at running companies? Is it really likely that your two years building PowerPoints at Goldman really enabled you to run some Midwest industrial business? Or is it more likely that what you're really good at is M&A?

and capital structure engineering, right? Well, it seems much more plausible that it's M&A and cap structure engineering. And in my research, that turns out that that's exactly what happens when a private equity firm buys a company. They re-engineer the balance sheet. They borrow a lot of money. They go and do M&A. And I think what I would say is that those things are borrowing a lot of money makes your stock more risky, not less risky. And doing M&A historically has been negatively correlated with returns.

And so I think people are putting a lot of money into an asset class that's a lot smaller than they think it is and a lot more risky than they think it is because they think it's going to be very alpha generative. And I'm skeptical, very skeptical that it's going to merit the fees. And the question of is the bubble bursting? When's it when's it going to? Right. If you look at sort of the hold periods in private equity, they've already gotten more and more drawn out. Private equity firms are in trouble selling their companies. They're holding on to them longer. The same is true in venture. Right.

And it's just like trying to sell a house, Jack, right? If your house has been on the market for three years, it ain't worth your selling price, right? You can say it's marked at that, but it ain't worth it. If it was worth it, it would have sold. And so I think what you're seeing in this extended hold period is the first sign that returns are coming down.

And has private equity merited the fees going back to the birth of the industry? And I don't know, the 70s or 80s. And do you think those returns, whether they're IRRs, internal rate of returns, or what investors, LPs actually see? Do you think those returns are, I don't want to say honest, because that's judgmental, but truly representative of the fact? Or do you think they're examples of where the returns that are stated are

It's a company that the private equity company kind of just made the valuation up and it's holding it in its honest books for a longer period of time, as you said, or it's in a new continuation vehicle. And no one really knows the true value. It's just being held at an elevated valuation. Yeah, I think there are probably three phases of private equity. I think the first phase was call it 1980 to 2005 or so.

And that sort of first phase, there was a lot of alpha generated. And if you think about sort of the reason why there was so much alpha generated during this period, one of the reasons is that there was a huge discount from buying companies in the public market. So you could buy private companies at a 40% discount to the public market.

And so if you were a savvy private equity guy, you'd say, well, gee, a lot of these public companies, they want to grow their pet food business. And I can buy some privately owned pet store, pet food business for half what the public comp trades at. I'll dress it up a little bit. I'll borrow half the money. And then two years later, I'll sell it to that public company and I'll get a huge multiple expansion because they're willing to pay up for the growth. I bought it cheap and I bought it levered. So I'm going to make a big return.

And during this phase, you saw that a lot of the best performing private equity deals were in very boring spaces, chemicals or natural gas, where you'd make 7X because you kind of got some random chemical or natural gas cycle right. And that's sort of the story of a lot of the pre-2005 successes. It was microcap. It was deep value. It was levered deep value. Think of Apollo as sort of the poster boy of this phase.

really buying stuff cheap. They weren't that high quality assets, but who cared at that price?

And that's the sort of private equity I really like. And I think it's possible to do that type of private equity today outside the U.S., right? So I think if you go to Japan or something, there are opportunities to buy at those sort of really discounted valuations and make those sort of returns in that way. But in the U.S., it's not. So the sort of next phase of private equity called since 2006 or so has been the shift towards growth. And what you see now is that private equity is probably 50% tech in the United States. They've massively shifted.

And even the stuff that's called healthcare is really healthcare tech. And it's a shift towards really concentrating on one specific sector. And it's gotten very expensive. It's much more growth equity type.

And they tend to be paying multiples that are equal to or higher than the public markets and justifying that by saying they're going to run the companies better or they're going to do add-on acquisitions at lower multiples, et cetera. And I think during this phase, what you've seen is that pre-2006, private equity returns were consistently way better than the public markets. From call it 2006 to say 2020, what you saw is that returns were actually in line with the S&P 500, which is a great outcome because the S&P did really well and they were charging a lot of fees.

And so you saw sort of this next period where if you are a large endowment that made a big allocation of private equity, it didn't help you that materially relative to owning public equities, but it made you a lot less volatile. And it wasn't a bad thing. It was just neutral. And then I think call it from COVID on, especially that 2021 vintage year, you've sort of seen, well, gee, all those deals that were done with very low rates are now paying very high rates on

And that overinvestment in the tech sector and that really high multiples paid in that 2021 vintage year have really taken time to burn off. And in addition,

in illiquid asset classes, fund inflows can drive up valuations the entire asset class very easily. Private equities growth helped it, right? And you could always sell your assets to another new private equity firm that had opened and that needed to deploy capital. Fund inflows were good. And as that fund inflows have slowed, partially because they have no exits, they can't recycle the capital, and partially because the returns haven't been quite as good recently as they used to be relative to the public market, what you've seen

is, I think, returns coming down. And to a point where over the last two or three years, certainly over the last two, private equity has been a drag for these endowments. It's been a drag relative to their public assets. And I think the longer the private equity stays performing worse than public markets, the worse their fund flows are going to be, and the worse that whole flywheel is going to be as it reverses.

And this is a principle of behavioral finance. I don't know if it's exactly reflexivity, but early on in your book, it could be in the preface actually, or in the first two chapters, you talk about how shipbuilding companies, the reason they're so cyclical is because

When shipbuilding profits are high, everyone builds a ship and that's then dry dock costs and shipping costs collapse. And that's what happened. And so it's the profit margins as well as like in publicly traded stocks, the stock prices and returns inform the fundamentals. It's not only the fundamentals informing the returns. So it's the inflows informing the performance of the asset class as well as the underlying returns.

is this LBO private equity transaction, did it actually make money? And so even though let's say I'm just gonna make numbers up, you can think it's higher or lower. Let's say private equity was overvalued by 20% in 2021 and now it's returned to fair marks. Again, I'm just making numbers up. If everyone was rational, it would stay at perfectly evaluation, but the same thing that led valuations to go to the high, now that those flows are going the other way and things are reversing,

Do you think this train just gets worse and worse? Even if in a year, private equity may be attractive on valuation terms relative to the public markets. Yeah, I think that's exactly right because they got to burn off and sell all the deals they did in the bad years, right? They got to sell the 2021 vintage. They got to sell the 2022 vintage, right? All those deals that were done over those period, they got to get out of them and they're not going to get out of them at a great profit. And I think

Another thing I like to joke about is they're borrowing from the private credit world, which has been the hot growth area of everything. Wow, everyone wants to be in private credit. Private credit's, by the way, done, I think, better than private equity recently. And the reason is they're charging these private equity firms pretty exorbitant interest rates on their companies. And I like to joke, like if your buddy came to you and said, hey, can I borrow some money from you at 10% interest rate? You'd say, no.

I don't know. Why can't you get a loan from a bank? The bank must not think you're a good borrower. But now there's this entire asset class of private equity, which is borrowing at these quite high rates, and yet at the same time saying their companies are really high quality. Well, how high quality could your company be if you have to borrow at the rates that you're borrowing at?

lending markets are pretty efficient. And I think what we're going to see is now that rates have risen and all that's floating right debt, there's this kind of a vise, right? On the one hand, valuations are coming down, which is bad. And on the other hand, borrowing costs have gone up, which is bad. And so are these companies, and I don't think these companies were in great margin position prior to this happening. I think they were running at probably close to zero net income margins for the most part because they were paying so much out in interest. So I think they're in a bad situation.

Dan, a big feature of my interviews over the past three, four years have been the huge rise in interest rates from zero to 5.5% and now slightly lower. In many areas of the financial economy, the

high interest rates are extremely apparent. In the bank world, they impact net interest margin, they impact value of securities holdings, the bond market, Silicon Valley Bank, many banks failed in 2023 because of that. And if you look through an insurance company, if you look through a real estate developer, anything that's publicly listed, you don't have to be a genius within 10 seconds to see how things... It's a different world now. It's

rates are at 4% or 5% instead of at zero. When it comes to private equity, Dan, and I'm really curious what your answer is on this. When it comes to private equity, I go through Blackstone's annual report and I search for command F, anything about interest rate sensitivity. I see nothing. And I guess that is fair because the Blackstone annual report is for general partners and it really impacts the deals of the limited partners, the actual investors, even though Blackstone owns

has a stake in some of those deals or maybe all those deals. So how has private equity hurt? How has it been hurt by rising interest rates or how has private equity been hurt by rising interest rates? Because I think a lot of people intuitively understand it, but I mean, just as an amateur who's not an LP in any private equity deals, I haven't really been able to kind of follow the breadcrumbs. Yeah. So, I mean, the very simplest way they've been impacted is that the vast majority of private equity deals are done with floating rate debt in the private credit market.

And so there's just a linear impact, right? When rates went up, their interest costs went up. And that was usually interest costs are pretty big

pretty big as a percentage of profits for most LBOs. And so that's a material impact. Now, if you remember, the interest rates went up because there was inflation. And so in theory, also, their revenue should have gone up and their profits should have been, everything should have inflated. So it wasn't just a punch without any sort of compensatory good things happening. But nevertheless, you're facing much higher interest rates. And I think even worse is

every new deal is being done knowing what current rates are. So you're not doing deals at 5%. You're doing deals assuming interest rates are 10%. And if you're borrowing half the money for the deal or 60% of the money for the deal, that change in interest rate is changing the valuation multiple you're going to pay for the company by a lot. And so your next buyer is going to be much more skeptical or at least have a much more rigorous model than you did when you did the deal at much lower rates. And so that's

That's probably the bigger mechanism is that change in the valuation multiples for these companies. And you also have to look at the public markets, which don't like levered companies at all. They don't want a company IPOing with half their market

that's half the enterprise value is debt. They're going to be worried about bankruptcy. They're going to worry about liquidity. There are all sorts of worries. It's really hard to IPO those firms, which creates a problem for exiting there. So I'd say, yes, there's a cash flow impact, but that cash flow impact pales in comparison to the valuation impact.

on who the next buyer will be and what price they're willing to pay. And high interest rates mathematically impose a loss on bonds and maybe stocks as well. But when it comes, high interest rates are good for floating rate loans. And that is the world of private credit. That world has absolutely exploded.

Apollo reported their earnings today, an alternative asset giant. And 97% of their growth of net inflows over the past 12 months are from credit. Just 3% is from equity or private equity. Obviously, Apollo is a...

in that it is private credit, private credit Maven. But what, what do you think about this? I believe in your, in your book, you called private credit a ticking time bomb. What mistakes are allocators to private credit making? How does this end? Yeah. So I think that people often leave their efficient market hat off when they enter the world of fixed income and that you got to put it back on, right? Markets are efficient. So what does, what does efficiency mean in the bond world?

Well, efficiency means that yield and total return are not the same. So if I have two bonds that one yields 5% and one yields 7%, I shouldn't say, yip-dee-doo, the 7% is going to earn a higher total return. I should say, well, if the market's efficient, they should both yield the same. That extra 2% yield should be perfectly compensating me for the bankruptcy risk of this firm.

And in aggregate, therefore, I should earn the same amount betting on both. Otherwise, the market and fixed income isn't efficient. And I think we should have as a prior probably that the fixed income market should be more efficient than the equity market, right? Because we're not pricing in any future growth, right? All we're pricing in is bankruptcy risk.

And G, companies have taken out loans and gone bankrupt for hundreds of years. You can get Moody's data back to the 1920s. It's a science. It's very precise. And so you should assume that every incremental basis point of yield that you're earning is compensating you for an incremental basis point of bankruptcy risk.

And I think that that's a lesson that people have forgotten. And so when they go and they look at private credit and they say, oh, I'm going to earn a 12% yield, they think they're going to get a 12%. And my argument is that, well, you're probably going to get something that looks more like 5% or 6%, and you're going to find out that it's 5% or 6% at the worst possible time.

And I think that we've seen that generally innovations in lending and badly, right? Look at the housing bubble, right? I mean, you give people money to borrow at low rates and it fuels a boom. And because the boom is reflexive and more money flows in and there's more borrowers at lower costs. And so the old loans don't go bad and the newer vintages account for a larger share of the whole and all these other classic dynamics. You don't see...

You don't yet see who's swimming naked until the water goes out and the water goes out all at once, right? When there's a credit cycle and a default cycle. And when you start to see bankruptcies, of course, the stocks, sorry, the companies that borrowed at higher rates are going to experience higher bankruptcy rates than the companies that borrowed at lower rates. It just is true, right? The market is efficient.

And I think that we haven't seen a default cycle for a while. We haven't seen massive corporate bankruptcies for a long time. And I think people are acting as though there never will be bankruptcies again. And if there are never bankruptcies again, private credit is a great investment. However, if there is a default cycle, if bankruptcies do happen again, then it's not such a great investment. And so I think you just have to say, should I extrapolate from the last few years, there's never going to be any bankruptcies in the United States, or should I put on

the lessons of history and say, there are always bankruptcies. There are always people that borrow too much. And by the way, the rate at which people borrow is going to be predictive of how likely that bankruptcy is. And, and yet, first of all, I just want to say your book, the humble investor, it is really good and I enjoy it. And I think if my audience is,

is looking to buy an investment book, I do recommend this one. I think it's a nice blend of it's like, it's not pop psychology, well-sourced, very academic, but it's also not dry like a lot of academic stuff is. So I just wanna say that. Now, chapter seven, bond investing, chase quality, not yield. Tell me why I'm wrong.

Dan, but I thought that a lot of bond investors who managed to outperform their benchmark, there actually are a lot of them, whereas for equities, I understand it's way harder. They actually do so by just buying the thing that yields 20 or 30 basis points more than the index, but actually doing work on it and realizing that they're money good. Has the high yield index outperformed the...

investment grade index, which has outperformed treasuries. Isn't it not really true that hasn't higher yielded stuff outperformed? Yeah. So we have this concept of a fool's yield. And so what it turns out is that you're exactly right, Jack. There's a linear relationship between yield and total return from AAA to BB or so. Now there's increased volatility and like during a crisis, of course, the BB stuff will get worse and the AAA stuff will probably go up, but

But generally, over long periods of time, as you've taken incremental credit risk up to BB in corporates, you've earned incremental return. And so yes, the percentage of bond funds that beat the aggregate bond index is extraordinarily high, because it turns out that lending to the Swiss government at 0.1% is worse than lending to Microsoft at 4.5% if total return is what you care about. So if

where the ag is allocating to Swiss government bonds or Japanese government bonds, you instead lend to Walmart or something, right? It turns out that yes, you do do better. But that where we call it fool's yield is that below BB, that relationship starts to break, where the higher yields actually translate into lower realized returns because the impact of downgrades and defaults is so big.

So people get seduced into buying these much higher yielding products and then they end up with worse outcomes. If you remember Lending Club or these other sort of online lending platforms where you could go on and you could make these very high interest rate loans, right? People didn't earn those high interest rates. They just found out the hard way that loaning money to someone at 21% has a very, very high default rate, which is something you could have learned obviously by looking at how credit card companies do.

And I think that that's sort of the fundamental lesson I'm trying to get at is that, yes, to a point.

you can earn incremental returns by increasing your yields. But you have to be very cautious to not go past the fulcrum point where you're starting to get fooled. And I think the private credit is way out in that fool's yield space, as with things like triple C debt or high interest rate loans, etc. And Dan, the world of private credit, let's wind the clock back to either 2014 when you started Verdad or to 2009 when you were at Associated at Bain Capital.

Was private credit, the act of non-banks lending to somewhat risky businesses in order to do leverage finance and finance private equity, was that called private credit? Was it called mezzanine finance? How much smaller was that world now? And did it even have the same name? Yeah. So you saw basically when I started in private equity, typically what you do is you get a bank loan. And then if you needed more, you'd get mezzanine. Or if you were big enough, you'd go to the high yield market. So you'd have...

bank loan and then a high yield issue, or you'd have bank loan and a MS bond debt. And then what happened is the banks basically stopped being very interested in LBOs for a whole variety of reasons. They just weren't good risk rewards. They'd been terrible during the financial crisis. A lot of banks said, gee, why are we doing this LBO lending? It doesn't make a lot of economic sense for us.

And so the private credit firms, the Mez lenders started to say, well, why don't we take the whole thing? We'll give you a unit tranche facility. So we're out in the bank taking that first tranche and then us taking the second tranche. And tranche is one of those great words that you just sound so sophisticated saying, by the way, you could just see yourself at a bar in Manhattan, Manhattan, talking about tranches in your fancy shoes, your deal moccasins.

But rather than having these multiple tranches, you could have a unit tranche facility. The Mez lender could take the whole thing. And it turns out that that became very popular as the banks stopped lending. And then just like people liked borrowing from First Republic, it was pretty easy. It was a lot easier to work with Blackstone than it was or Apollo than it was to work with

JP Morgan's bank loan team, right? They just were faster at execution, better at service, more reasonable. And so you saw this huge mix shift away from

bank lending and high yield and towards what used to be MES and is now private credit over the course of the decade to where private credit is now massively more representative than high yield or bank loans within the universe of LBOs. And that's been really a dramatic shift that's happened over the last 10 years.

LBO is Leveraged Buyout, which is basically private equity. The term private equity was used to replace LBO. That's what it is, borrowing money to buy private companies. So, private credit, I mean, how do you think this ends, Dan? Because you said when the tide comes out, we'll find out who's swimming naked. I have to say, watching the private equity, excuse me, watching the private credit

allocators swim, they're swimming quite nicely. The stated returns are good. And as they say on Bloomberg, it's the golden age and their return, you can get, Dan, I don't know if you know this, you can get double digit returns, bond-like returns, excuse me, equity-like returns with bond-like risk. Who doesn't want that? Are you ready to change your view on public? Is Monetary Matters going to be the first podcast where you're going to publicly change your view?

Maybe I'm just wrong. It is the golden age of private credit. It's just time to roll over and just lend. I mean, but what stops, Dan? Let's say, I don't know, private credit spreads are 200 basis points over high yields, and the private credit space is $2 to $3 trillion. What stops, Dan, from in 2027, private credit spreads are 100 basis points over high yield, and the private credit space is $8 trillion? Yeah. And I think, right, so private credit

is now trying to do investment grade, right? They're trying to go up and do investment grade, right? And I think that, again, I'm not criticizing lending as an activity, right? Lending money can be very profitable, right? There's ways to generate excess returns than lending.

Lending to corporates is not necessarily a bad thing. What I'm criticizing is that there is a point on the risk spectrum where lending doesn't pay off and higher interest rates don't pay off. And so people get fooled. And I think that as what has happened, for example, with high yield bonds is that the high yield bond market has gotten higher quality over time because the lower quality stuff has all gone to private credit. So only the biggest, best issuers could issue in the high yield market or wanted to.

And so and also the high yield market at a higher share of people that used to be investment grades for the fallen angels coming down. So high yield has gotten higher quality. And so what used to be risky credit and high yield bonds actually not that risky anymore. And it's possible that private credit moves into investment grade, right, and becomes a lot less risky. And I think that would be a good thing, right? It'd be a good thing for investors. Now, they'd still be paying private credit fees to do investment grade bonds, which probably wouldn't be a good thing, right? You'd probably better off in the Vanguard corporate

bond index than doing that. But at least it would be less risk. I think where I'm worried is about that riskier tail, the stuff that is lending money at very high rates where people think they're going to earn those very high rates.

And I think that it just doesn't work out that way. It's just not how markets work. Markets are efficient. Something that's worked for five years is not necessarily going to work for the next five years. And I think people tend to pile in. They chase past performance. They chase yield. And chasing things, it doesn't work. You've got to be a contrarian to win over the long term.

And Dan, is it possible to predict bubbles? I believe you predict, again, I think on page 120s, that market crashes and bubbles peak when credit spreads are unusually low. I think credit spreads are unusually low right now. The high yield index

My data doesn't go back as long as your data, but for the Federal Reserve website, you're going back to 1997. I think the high yield credit spreads are in like the 95th percentile. Honestly, maybe a little bit higher. Is a bubble forming? Has a bubble already formed and we are at the peak?

Is it possible to predict crises and prepare for crises using credit spreads? And if so, what does the current credit spread say now? Yeah. So the availability of cheap credit increases the probability of a crisis. The longer the cheap credit is available, the more likely the crisis is.

And that you can see over long periods of time. There's been great studies by Sam Hansen and Robin Greenwood at Harvard that have shown this. And we've had a period of prolonged, very low credit spreads. And I think that that puts us at the moment at quite high risk of being in a bubble, of there being too much easy lending. And we don't know which pockets are going to default, but

But there's enough risk being taken that something's going to default. And when it does, that's going to kind of flow through the system in a way that it always does, where if you're going to slow lending, we call the financial accelerator, right? If you start to experience losses in one part of your loan book, you start to reduce lending in other parts. And that causes huge impacts to the whole economy. And that's the way crises tend to unfold. So, yes, we are at higher risk. The problem is that the probabilities are still relatively low.

And it's always that tendency of most smart people to call bubbles too early, right? You call it the first sign of overvaluation. And the first sign of overvaluation is sort of the first wave of high performance that attracts the next group of people in to say, gee, wow, those people have earned a lot of money doing that. I should really pile in. And so there's that reflexivity which drives things way past the point at which rational people might have said we're in a bubble or high valuation. So smart people are always too early.

I say too early to avoid looking like I'm going to be wrong, always too early in calling bubbles. But I think the risk of bubbles and the risk of impending crises is always higher when the availability of easy credit is too great for too long. Dan, do you think that if and when this private credit bubble bursts, do you think a recession is a necessary, not a significant condition for this private credit thing to unravel? Because if there's no recession and defaults continue being low,

What else could stop this train? That's right. You need defaults. It needs to be defaults, whether that's a recession or a quasi-recession. But without a spike in defaults and a spike in high yield spreads, private credit is going to roll on forever. If there are no defaults, then you will earn your yield. The question is, is that true or will, in fact, there be defaults in the future? And I think there will be.

Dan, I'm curious comparing private equity returns, which are pools of small cap companies, to the Russell 2000 or literally publicly traded small cap companies. I know the Russell has drastically lagged the S&P, so small cap has drastically lagged the large cap stocks. To me, Dan, an uninformed...

I haven't really looked at the data, but I just have a theory that a lot of that is because so many companies IPO'd in 2020, 2021, and to some extent 2022, that were really low quality companies that the venture capitalists just unloaded the worst turd sandwiches on public investors who happily ate it all up. And that's why they went into the Russell and that's why the Russell is performing poorly. Am I onto something or not? Yeah. So broadly...

Large caps in the United States have done better than small caps for the past 10 years or so by a lot. And private equity has done about equal to large caps and therefore much better than small caps. And so I think the argument that I've long made was that private equity is micro caps exposure.

with leverage and with sector exposures and with high fees and with a lot of other layers on, but fundamentally it's small cap exposure. They've done way better than their exposure to the size factor would have suggested they would do, which would militate in the positive direction about private equity, that they're doing something to make the returns better than if you just bought small caps in the public equity market.

That's one interpretation. The other interpretation is that if you look at what's happened to small caps, the valuations for small caps have just gotten cheaper and cheaper and cheaper. So 80 plus percent of the underperformance has been valuation driven, call it. I'm not getting the exact number. And 20 percent has been driven by large caps just growing a lot faster than small caps, thanks to the max seven stocks.

But if you think about then a private equity, what private equity has not seen as much valuation compression, private equity has not gotten a lot cheaper relative to the large caps, right? Private equity has stayed expensive or gotten more expensive. And so they haven't seen that multiple compression. And I think that my argument is that all these things are sort of disconnected, right? Why should small caps in one market trade really cheap and small caps that are in another market trade expensive?

that these things have got to normalize. And when you think about what's driving it, I think it's capital flows, right? I think that people have been allocating more money to private equity and they've been allocating less money to active managers and less money to small cap equities. And they've been allocating more money to passive and therefore more money to the mag seven. So the places where more money has been flowing seem to have naturally had increased valuations and the stuff where money has been taken away from conversely seen falling valuations.

But I think at some point, again, these things reverse. And when they reverse, they can have the same impact. As money comes out, the valuations fall and 80% of the returns and the downsides explained by multiple compression. And gee, when you're trading at very, very high prices, the multiples falling has a lot more impact. Or when you're levered as private equity does, small changes in multiples drive very big changes in valuation outcomes.

Dan, in the book, you talk about how so many funds with the name value on them really don't capture value. And because a lot of the really truly value companies that you can take advantage of the value premium are tiny companies, micro cap or maybe even nano cap stocks. Tell us about that. Why is that?

the Vanguard value ETF, why might that not capture the value stuff? And can even funds such as yourself, which I know you are now over a billion dollars, congratulations, by the way, can you capture that if the value capture is to be found in a $150 million Brazilian fintech company like

Who can capture that besides people like individual investors who read a Substack newsletter of someone who's just really into Brazilian fintech? Yeah, exactly. I think that there's basically your ability to get raw value factor exposure where you say, gee, I want to own stuff that trades below book value or something, right? The vast majority of the companies that trade below book value are going to be micro cap or small cap, no matter what market you're in.

And so if you want to own a basket of these stocks, you're inevitably going to be forced to own micro or small caps. The number of companies that trade that are in the U.S. that are, call it more than a billion in market cap, that trade at below price to one person's book or pick some other valuation below 10 times BE or whatever you want to call the value is just infinitesimally small.

And so my argument is that then if you look at most of the value funds, yes, they're buying value as defined as the cheapest large caps, the cheapest mid caps, or even the cheapest small caps. But the cheapest large caps might be the 60th percentile of the total market in terms of valuation, right? To get the 90th percentile, you have to own stuff that's 200 or 300 million in market cap. Otherwise, you just can't get there. And that's, I think, the argument I'm making in the book, that if you want to access a

the most extreme value names, the most extreme exposure to the value factor, the most undiluted bets on pessimistic stuff. You've got to be able to own micro caps and small caps. And for us, that means capacity constrained funds that we close a fund when it reaches close to capacity. Maybe we create a new fund to target something else, but that's how we've grown rather than having one big fund where if we had all of our money, all of our 1.1 billion or so in one fund,

it would be very hard for us to gain microcap exposure in that strategy because we'd have to own a one percent position would just be too big uh to get in or out of a microcap

Dan, you talk about volatility and how volatility can be a drag on performance. I don't have the exact quote in front of me, but you basically say that if an asset class has the same characteristics, but asset class A has a higher volatility, over time, asset class B is going to outperform and asset class A is going to underperform.

Explain that mathematically, and then I'm going to add a little twist on that. Yeah, this is the idea of volatility drag, where everybody says, I don't care about volatility. All I care about is total returns. But if you do care about total returns, you also need to care about volatility. And the simple math is that if you take an asset that has volatility,

a bunch of assets that all have a 0% average return, but they have different levels of volatility. And one goes down 10 and up 10. Although it's gone down 10 and up 10, you've lost 1%. If you go down 20 and then up 20, you've lost 4%. If you go down 30 and up 30, you've lost 9%, right? So your losses are going up at the square of your volatility. It's an exponential volatility drag. And I think people don't realize this. And so the more volatile the thing is at the same rate of return, the worse your compounded returns are going to be.

And I think once you realize that math, it drives you to say, well, gee, I actually do need to be volatility conscious as I make investment allocation decisions because volatility is actually something that matters to my total return calculation.

Okay, thanks for laying that out, Dan. What I would say, and I'm sure obviously you've thought about this, is that stocks and bonds are constrained by fundamental valuation. So let's say I have a pharmacy and you have a pharmacy, and they're both publicly traded companies. We are the exact same company. We literally are the exact same company. It's a model. My ticker is JACK, your ticker, of course, is DAN.

my stock is a little bit more volatile than yours. So mine goes up 2% and yours goes up 1%. And then mine goes down 2%, yours goes down 1%. So the volatility drag argument just to

really belabor it for our audience is the up 2% down 2% is 1.02 times 0.98. The up 1% down 1% is 1.01 times 0.99. And basically your number will end up being greater than my number. Mine will suffer from more volatility drag. But let's say that happens after 250 trading days in a year. A year later, my stock is going to be

is going to be depressed relative to yours, even though we have the exact same results. So shouldn't on a fundamental basis, volatility drag not really matter if people are fundamentally driven? Yeah. So I think that volatility drag is you're weighing the volatility against other things, right? There are multiple things that predict return. Volatility is one thing that predicts return, but it also... Right?

But there are other things to break return like value. And so once you start thinking in this way, you really have to go into sort of this multi-factor type model. But if you have to separate risk and return, right, for the same expected return, the less risky thing is better.

Right now, you can say, well, if I have a higher risk thing that is a higher rate, that's sort of the standard capital market line. You're just making a choice about what exposure you want that are economically the same. But you need to be compensated with higher return to take on that increased volatility risk. Otherwise, it's not worth the trade. Dan, can you rank these three models? Let's say efficient market hypotheses.

capital asset pricing model, CAPM, and the dividend discount model. Rank from worst to best and why. And can you also explain what they are? Yeah. So the efficient market hypothesis is there are various forms of it.

the sort of most practical one to investors is index funds are really hard to beat. And that's a pretty good model, right? It's generally a pretty good model. Markets are really hard to beat. Markets are generally efficient. Where efficient markets theory is sort of leads you to the wrong intuition is where you say markets price in all available information accurately.

And that's where it's wrong because markets are too volatile. We don't know what the future is holding. What is the information we're getting today really tell us about the future of a stock? I don't know. That's why markets are so volatile. So efficient markets theory is a great theory and a very useful one. The capital asset pricing model is next. The capital asset pricing model is actually in its earliest form is just wrong. There's not a linear relationship between volatility and return.

in the stock market, for example, within individual asset classes. Now on an asset class level, there is a relationship. So you can think of every asset class as having a 0.4 sharp. And so

have a 0.4 sharp and a volatility of six and stocks have a 0.4 sharp and a volatility of 12. And right. So there is a relationship there. And so that's where CapM can be useful in terms of thinking about multi-asset or cross asset allocation. But it's not useful within stocks, right? If you just said, hey, I'm just going to go buy the most volatile stocks, it's not going to end well.

for you. I mean, that's not a good investment strategy. And there's just not a linear relationship between volatility and returns, which is why Cap-Am has basically been disproven in that sense since the 1970s or 80s.

And then there's the dividend discount model, which is the intuitive logic that a stock is worth the net present value of its future cash flows. This is the worst of the model because it leads you in the totally wrong direction. Because the first thing you do is say, well, I just need to then predict future cash flows and future discount rates. And then you're immediately off in la-la land because nobody can predict future cash flows or future interest rates. And so you just said, well, a stock is equivalent to whatever the hell the numbers I make up in my head are.

And where does that lead you? Right. It's untestable. It's unfalsifiable. And it's going to lead you to spend a lot of your time making up numbers about Coca-Cola's earnings in 2027, which are inherently unknowable. Okay.

But I think that's the dividend discount model, which is discounting the future dividends. And I think, again, I couldn't get the number wrong. You said Robert Shiller, you may have won the Nobel Prize for pointing out, or more than pointing out, having a very rigorous paper, that if you could predict with perfect accuracy dividends, and I think it was dividends, not earnings. If you could forecast with perfect accuracy dividends and interest rates, that's responsible for only like 20% of the stocks, which is really important. Okay, but that's dividends. What...

about earnings. Berkshire Hathaway does not pay a dividend, has never paid a dividend, as long as Warren Buffett, I believe. But their earnings have grown tremendously. If you do a discount dividend model, but instead of dividends, you do earnings, does that look better? What do you think about that? No, because you still can't predict earnings into the future, right? That's the challenge. It's the predictability of growth. It just doesn't exist.

And so your dividend discount model, you can't predict growth, right? So you don't know what the trajectory of future earnings is going to be. And you don't know what discount rates are going to be. And that's why it's a bad model. Really? But you can't say that like the median tech stock is going to have a higher growth rate, like the median SaaS business that's young, that's even in the VC market, it's an infant, an orphan is going to have a higher growth rate than a tobacco company that's existed for 200 years. Because Dan, I

As someone who started a business like four or five months ago, if you have zero dollars and then you make one dollar and then you make two dollars, you just doubled your revenue. Yeah, it's actually funny. We went and tested that because I was curious about it. And actually...

None of those things are true. Tech stocks, on average, don't grow any faster than other types of stocks, right? I mean, it's yes, we all think about the salient outliers that yes, there are these group of tech stocks that have grown amazingly. But, and there are periods in which, of course, tech might grow faster than energy or energy might grow faster than tech. But your ability to predict those things into the future is zero. It's just random chance. Past is always explainable. We can always see patterns in the past, but predicting the future based on our understanding of patterns and past data just doesn't work.

Right. Well, what about, I guess, small cap that they when you when you have, like, for example, the Virgin Galactic or some company that has such a small amount of revenue, like it's easy to double your revenue when you make. It's also easy to go to zero. I mean, I think that's what that's what people miss, right? That these things. Yes. Small companies. Yeah, it's easy if you have 10 million to go to 20 million or 20 million to go down to 10. Maybe I don't know as a person who runs a business, it's always pretty hard. It's always a knife fight.

But I think that the risk is there on the downside as much as it is on the upside. Oh, you get one big contract and then you're doubled. Well, what if you lose one big contract? Then you go down 50%. And so it's just always a coin flip. The volatility can be higher, but the sort of persistence of growth is the same. That's really interesting. So you believe in predictability of quality, right?

It has a moat. It doesn't have a lot of competitors. It's going to be stable cash flows. But you don't believe in predictably of growth at all, even if that growth comes at the cost of quality, which it very often does. You can't predict growth. It's not persistent. But there are other things that you can predict, right? So I can tell you with a much higher degree of certainty what a company's gross profit to asset ratio is going to be five years from now. I can't tell you what its growth rates are going to be.

I can tell you also what its volatility is likely to be. There are very good vol models, and neither of those things conflict with efficient markets theory. It's not like efficient markets theory doesn't say anything about predicting volatility or predicting correlations, which are very predictable things.

But it does say something about predicting expected returns. And that's where I think the efficient markets theory is most useful. And Dan, just to nerd out a little bit, so many people I know measure quality in a different metric. You chose gross profits to assets. Why did you pick that? And often there is a conflict. For example, companies that have the most expensive on a price to book ratio, what that really means is they just buy back their stock and they have an insanely high return on equity.

What are you selecting for when you do gross profits to assets? Because I've heard of return on assets in the context of banks, but not so much non-banks. Yeah, it's a beautiful metric. It comes from Robert Novy-Marx, a great academic who wrote this paper called Profitability, the Other Side of Value. I think he was the first one to come up with it. But it turns out it's just a very clean, smooth metric.

quality metric that sorts stocks really well. Now, you always have a trade-off between how well something can explain the broad swath of things and then how precise it is, right? So of course, there are ways in which gross profit to assets might not apply to a specific sub-segment or comparing stock A to stock B, you say, well, it's not that useful. But if you're trying to sort 3,000 stocks by quality or an entire industry by quality, it ends up being a very good one.

It's crude, but the crudeness is what makes it useful. And Dan, tell us about your last chapter. It's called Designing a Countercyclical Asset Allocation Strategy. What is that and how can people implement that? Yeah, this is what I've been working on for the last few years. That's sort of my Skunk Works project, which is basically trying to take in all of the work I've done on factors, all the work I've done across asset classes, and

and predicting different factors, return streams and say, well, how do we integrate all that together? And the way I think that you do it is that you have to build when you're building a portfolio as opposed to choosing individual securities, you have to have much more focus on volatility and correlations and volatility and correlations because of volatility drag and because portfolio construction sort of its own problem. They're actually really a beautiful ways to build better portfolios, right?

You can constantly calculate, even if you have just a very simple insight, right? Like I think that stocks earn more than bonds and gold earns a little less than bonds, but roughly what bonds earn. Let's say I start from that view of the world. And then I might say, well, gee, over time, when stocks and bonds become highly correlated, I should own less bonds and when instead own more gold.

And when gold and stocks are more correlated than bonds and stocks, I should own more bonds because what I want in my safe asset is something that's not correlated with my risk asset. So if I just have a simple three portfolio problem, I should constantly be changing my allocations to bonds and gold based on their correlations to stocks. And I should take into account their volatility in sizing those positions, right? So these are portfolio construction math problems that actually lead to better returns by reducing volatility drag. And so what I've been doing is trying to

kind of accumulate these insights, code them into software, develop rules around them, and to try to therefore build sort of optimal portfolios that change based on volatility and correlation statistics in real time. So that's sort of my sort of big project, what I've been working on, and hopefully will be something that works really well over time. That's interesting. Dan, in the world of correlations, I know

Since the late 90s, for a long time, stocks and bonds prices were negatively correlated. So stocks went down. Often during a recession, bonds rallied. The Fed cut rates, inflation fell, yields fell. We know this. In 2022, what was so traumatic to a lot of investors was that stocks and bonds fell. So that correlation turned positive. In the world of correlation, what's been going on recently?

whether it's between stocks and bonds or commodities or between stocks in the S&P market, like what is sticking out to you in terms of correlation where you're seeing something that's either interesting or something that is potentially you see an opportunity? Yeah, I think the stock bond correlation has been rising again this year.

which is worrisome and probably pushes you to more to saying, let's own some more commodity exposure, some more inflation sensitive assets. Now these are very short term insights, right? So ask me a month or two months from now, the correlation of all structures might have changed. So these are high decay rate insights. But I'd say certainly that's one thing that we're observing. The other big thing is that US growth stocks have become sort of their own asset class.

And if you look at almost any asset class with inequities, whether that be international equities or even value stocks in the U.S., they're increasingly disconnected and uncorrelated with U.S. large growth. They've gone from, say, U.S. large value used to be 95% correlated with U.S. large growth. Now it's called 80% or 75% correlated with U.S. large growth, which is roughly where international stocks are. So there have been some interesting developments in the market. And I think increasingly, again, U.S. growth stocks have become their own asset class.

And everything else has become less correlated to them. And so your ability to diversify versus to own just one thing, I think that's probably the single choice people are making today. Do I just want to put my entire portfolio in U.S. large gap growth or do I want to diversify outside of it? When I diversify outside of it, I'm diversifying into things that have lower correlation to U.S. large growth and worse returns historically.

but in my view, probably better historical, better future returns on a relative basis than historical returns. Dan, it's been such a pleasure getting to speak with you. We've covered so many topics and I think that's really interesting for our audience. In terms of any overall message or lessons

Timeless lessons rather than analysis of particular asset class. Any closing words you want to leave our audience with? Yeah, I think it's my favorite mantra, which is that investing is a game not of analysis, but of meta analysis. It matters not what you think, but what you think relative to the market. And the best way in my view to have good insights into the market is to some with a very humble perspective and say, I'm not looking for places I have an edge because I'm so brilliant and I know so much.

But I'm looking for places where the market is too confident, where other people are too arrogant, where they're too optimistic or too pessimistic, and where I can take the other side of the trade, not because I'm so smart, but because I'm so humble.

Dan, people can find you on Twitter @VerdadCap. You have a lot of research at Verdad Advisors, so I believe that's available on your website. People should buy the book, The Humble Investor: How to Find a Winning Edge in a Surprising World. A few housekeeping things for our audience.

we talked about Silicon Valley Bank briefly. I'll be interviewing the former CEO, Ken Wilcox, so people should stay tuned for that. And also in the interest of balance, Dan and I were maybe a little tough on private equity, private credit, and we love that Dan's got his own personal views. But I am interviewing

John Bowman, who is the president of Kaya or the Chartered Alternative Investment Analyst, who likely will have some opposite words to say. So people should stay tuned to that. And also, if anyone listening is a manager of an investment fund, entrepreneur, fund entrepreneur, or is thinking of doing so, they should listen to my

my colleague, Max Wheatheys interview of Dan Rasmussen on the Other People's Money podcast, which came out one to two months ago. It's available on the Monetary Matters YouTube channel on the Other People's Money podcast feed, which they should check out as well as the Monetary Matters podcast feed. So people can just scroll down to, I think, late November, early December. Thank you everyone for watching. Until next time. Thank you. Just close this door.