Aswath Damodaran, Investing in Uncertainty
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I talked about this yesterday in class. I gave in my students a question. I said, let's suppose you valued a company and you feel 100% certain about the value and the value is higher than the price. Would you be willing to take all of your money and buy the stock? After all, you're 100% convinced about the value. It is undervalued.

And what I want them to think about is even though you're 100% certain about the value, there's another dynamic here that you don't control, which is to make money, the price has to move to value.

I'm Ricky Mulvey, and that's Oswath Damodaran. He teaches corporate finance and valuation with the Stern School of Business at New York University. He's written several books on equity valuation, and he's one of the most respected minds in the space. My colleague Matt Argesinger interviewed Damodaran for our Market Playbook Summit, an event

an event where Motley Fool members first caught this conversation. They discuss why the US is still a safe haven for investors compared to some other parts of the world, how Elon Musk's involvement with the Trump administration changes Tesla's valuation, and why the rise of passive investing isn't stopping anytime soon. It's a great conversation, and I think you'll find value in it. The theme of our discussion today is investing and uncertainty.

And well, it feels like as investors we're always investing in uncertainty. Otherwise, equity investors probably wouldn't have earned such outsized returns historically. But I guess my first question, you know, recently outside of maybe the onset of COVID in early 2020 or and certainly the global financial crisis of 2008.

Does today, this moment feel more uncertain to you than maybe recent times? It's a fairly U.S.-centric question too, right? I mean, the reason I bring that up is six weeks ago, actually not less than that, two weeks ago, I did a valuation seminar for Turkish investors.

And if you think you face a lot of uncertainty in the US, you should put yourself in Turkey right now. Inflation's at 20%, interest rates are at 25%, the political environment is unstable to say the least.

Everything is relative, right? Relative to Turkey, we're an ocean of stability. The world has always been this bundle of uncertainties with different parts of the world feeling different amounts. In the U.S., we had the luxury of the 20th century, and it's a luxury, of being the most mean-reverting, most predictable economy and market of all time. And I'll be quite honest, we got spoiled.

We got spoiled in the way we think about investing. We got spoiled in terms of how we invest. We've developed investment philosophies that are basically mean reversion in fancy form. You buy low PE stocks. Why? Because you always go back to the average. You buy stocks and the margin goes down because the margin always reverts back. Mean reversion was the driving force between much evaluation and active investing in the 20th century. And it worked, right? You bought low PE stocks. You beat

The market by three, four, 5% a year. You bought small companies, you beat the market. And I think that what's changed is that the US is very much part of a global environment where everything is uncertain. Of course, we've added to that uncertainty with political choices and executive choices that drive it. But I don't think of this as particularly unique if you think about investors in a more general scale than as opposed to investors just in the US.

That's a great perspective. I guess since you mentioned Turkish students and how they're thinking about their economy and their political situation, maybe I'll ask this, and maybe it's a little uncomfortable for us in the U.S. because we don't think about it very much, but it does feel somewhat unavoidable at the moment. So you wrote recently in your Musings on Market blog, which for viewers here can be found at aswathdemotorin.blogspot.com, fantastic site.

You wrote that politics and investing have joined together in a way perhaps they never have before, at least in recent history. I'd love to ask what do you mean by that? And does it factor into your approach at all when it comes to valuation or estimating the equity premium in the market? Well, there are two things I always go back to and I feel unsettled. And you're right, we feel a little unsettled because it looks like the world order that we all grew up in.

post-World War II, first with the Cold War, and then with the U.S. as the center of the global economy. It feels like that's shifting. And when things start to shift, you start to feel uncomfortable in your personal life, in your political life, in your economic life, in your investing life.

And everyone I talk to feels a little unsettled. It feels like everything they've learned to know is up for questioning. And it's not the first time that's happened in this century. In 2008, everything we knew about markets got shaken up by a crisis that cut to the heart of, can we really trust governments and central banks to make the right judgments?

So I did what I did then as well, which is when I feel unsettled, there are two things I do. One is I elevate. I try to get perspective, you know, rather than react to whatever the news story of the day is, which right now is easy to do, right? It's a tariff today, a tariff tomorrow. Who knows what the day after will bring, which is a really bad place to be as an investor, because if you react to be already lost control of the game.

I step back and say, why are these things happening? What are the forces that are driving it? Because I'm convinced that what we're seeing play out is the culmination of a global backlash that started after 2008, where we started to lose trust in all the institutions that had given us globalization.

The second, I think, is we're seeing a force that was in private businesses, disruption, a force that we took for granted in Silicon Valley and technology make its way into government.

It actually started in Latin America with Nayib Bukhali in El Salvador and Javier Millet saying we can bring what we do in companies, disruption, break the process up and start from that process has entered governments. And that is unsettling as well. So the first is, and the second is going back to basics.

The value of a company has always been about cash flows, growth and risk, and will always be about cash flows, growth and risk. And no matter what's happening out there, ultimately for it to affect value, it's got to show up in one of those four places, one or more of those four places. So I go back to basics and say, okay, there's trade wars maybe around the horizon. There might be taxes changing. Where would I expect to see that play out with individual companies? If nothing else, and this would be purely for just comfort,

it makes me feel more secure with where I am. And I write stuff often to get things off my chest, to get my thoughts organized. So that was as much as my reader being my psychiatrist saying, here's where I am in the process. Here's how I'm reasoning my way through. I don't know whether I have the answer yet, but this is the pathway I'm going to use to try to get to an answer.

But I think if you're feeling unsettled right now, you have lots of company. My suggestion is step back and gain perspective. And second, go back to basics. I think that's great advice. I guess what probably a lot of investors are struggling with, and you kind of shared this a little bit in a recent post, is when you're analyzing companies now, you may, maybe at the margins, you may have to start considering a company's political connections or even lack thereof when thinking about its valuation.

Now that's going to make a lot of analysts pretty uncomfortable because that's a different type of analysis than we're probably used to doing, certainly here at The Motley Fool. And you mentioned, I think what might be the poster child for this right now, and that's Tesla and even Elon Musk, CEO Elon Musk, kind of tight knit relationship with the new administration.

Has his political connections altered your view and valuation of the company in any way? No, clearly it has, right? Because people are walking into Tesla showrooms and not buying a Tesla because they're on the wrong side of the political divide.

I think that does affect your value for the company. So I think that historically in the U.S., we've had this luxury of saying the government is a side player in a company. Basically, they collect taxes, they set the regulations, but then government and politics are not driving value. But again, if you've been working outside, valuing companies outside the U.S. as I have,

especially with family group companies in Asia, this has always been part of the game. Your strongest competitive advantage as a family group company in Southeast Asia might have been your connections to the government. That was your moat.

So this is, again, something where I've had one of my advantages because I teach all over the world and I value companies around the world is I have to run into these issues in other parts. Now I find myself bringing what I learned there to what I do when I value U.S. companies. But it doesn't take away from fundamentals.

Ultimately, your job then, if you value Tesla, is to ask, how will this fact that Tesla is now viewed as the center of this political storm affect their revenue growth, affect their margins, affect where they reinvest and how much they reinvest? And there are pluses and minuses that come with what's happening out there. I mean, if you have auto tariffs play out the way they are, Tesla is in fact the best positioned company.

to take advantage of the tariffs because unlike Stellantis or GM or Ford, which get a significant percentage of their parts, even for the cars they sell in the U.S. from Mexico and Canada, Tesla gets almost all of its parts for U.S. cars from the U.S.

So there are things where they benefit, things where they fall. But you've got to bring them into, again, the fundamentals, into the cash flows, into the growth, into the reinvestment, into the risk, rather than let them stay as these stories that are boiling outside the valuation. You talk about them after you've done the valuation, by which point it's too late. There's really nothing you can do to incorporate it.

So, you know, it's not the end of the world. It's been done before in other parts of the world, but it's something that we're not used to doing in the U.S. And it's increasingly something. I mean, let's face it, you value Disney. Is there a way you can avoid politics while valuing Disney? I don't think so. I think it's in there. It's part of the game. It's part of what's driving the value of the company up or down. And it's got to be incorporated in. We've got to live in the world we're in, not the world we're in. This is the world we're in.

Right. Well, sticking with Tesla and actually maybe stepping back and looking at the MAG-7 stocks, which Tesla, of course, is part of, each of them is down roughly 20% off their high. Tesla, last I checked, is down close to 40% off its high. Is there one of the MAG-7 in particular?

that stand out to you, either because it's a compelling value or because it has the attributes in its business that you think will drive long-term superior earnings growth. And it'd be one that you'd probably be most interested right now given the sell-off in the stocks. I mean, I own six of the seven, so I'm giving you a biased perspective. But I've owned them for a while. I bought Microsoft in 2014. I know Apple at 2018, 19.

And I've lived with the drop. And the reason I hang on to six of the seven is because I think that in the world we're in, they're actually best positioned to take advantage of the uncertainty. In what way? I mean, let's say we are in a trade war. The kinds of companies that are most impacted in a trade war are the companies that make physical stuff in physical places, factories, cars, because you can see where the cars are made. You can see where they're sold.

But if you're an online advertising company or you get your money from your operating system being this unique system, you are in a position to better get around those

trade issues. It's not that you're not affected, but you're affected less because it's not clear where you make your operating system, right? It's ultimately it's in cyberspace and you sell your stuff on cyberspace. I think these companies, just as they've been able to take advantage of every crisis in the last 10 years to get stronger, are well positioned to continue to be earnings machines. I used to own all seven. I

I did sell Tesla about a month after the election, and it was nothing to do with politics. I just looked at the price. I looked at the market cap. I reverse engineered what the revenues would need to be for Tesla as a company.

That'd be $750 billion. And I said, I don't think they can get there. And this was well before the political backlash and everything else that's played out in the company. And I said, I just can't continue to hold. And I sold about a month out, not at the absolute high, but high enough that I'm not beating myself up.

I own about one quarter of what I used to own on Nvidia. And as you've probably read my Nvidia posts, I've kind of staggered my sales over time because I love the company. I like Jensen Wong. I think it's an amazing company.

I just don't like the price at which I was holding it. It just seemed too high a price. So I want a quarter. The other five I've left intact because I think that they're, I mean, Apple to me has now hit the steady state where the story that I'm telling and the story that the market is telling are close enough

that it can be one of those investments I can put into the middle of my portfolio and kind of let it ride. It'll continue to deliver cash flows. And I'll watch every iPhone update holding my breath because it is a smartphone company. I think Google and Facebook will continue to dominate online advertising. And they both have optionality, which is their platforms, huge numbers of people, if they can ever figure out a way to add to that value by doing other business, it'll be icing on the cake.

Amazon is a company that I've owned off and on. I bought it five times, sold it four times in the last 25 years. And I think it's now a company where it's not as shocking as it used to be. Each story change used to throw off my valuation. I think the story changes have kind of played themselves out.

With Amazon, my biggest concern will be regulatory and government restrictions that come, not just in the U.S., but elsewhere in the world, because it's got very few allies in the business world. Everybody is afraid of Amazon as a consequence. They're happy when government's kind of isolated. So from that perspective, it's targeted. So it's open out there.

But I will continue to own Amazon because I feel comfortable enough at today's price. So even a year ago when I valued all Macs 7, I found them overvalued. I did not find them overvalued enough to sell them.

And that sounds like a weird thing to say, but actually there are, and I don't like it when taxes enter my investment philosophy, but I've got to live in the world I'm in, which is when I sell something, especially if I bought it at the right time, I don't keep the entire amount of the proceeds. I've got to pay the federal government 23.6% or whatever it is that capital gains tax on long-term capital gains. And I live in the state of California.

which takes another 10% off the top. So a stock has to be overvalued by 30% plus for me to even start thinking about selling it because it comes with this burden. And I think that's an interesting factor to consider. We never talk about taxes, but it's this hidden burden

in our investment philosophy. And I worry when taxes drive my choices, but sometimes as in this case, they delay selling something even when it's overvalued because I don't want to bear the tax consequences. But I still think of the Mag7, the companies are collectively good companies, great companies.

And if you've never owned them, you've essentially put yourself at a handicap in trying to beat the market over the last 15 years. Because those seven companies together have accounted for 15% of the increase in market cap of all U.S. stocks. So they've carried the market for the last 15 years. In fact, I don't want to make this a filibuster, but when I looked at what's happened over the last 40 years,

You look at GDP shifts over the last 40 years. The big winner, of course, has been China, going from 1.7% of global GDP to 17%. The big losers have been Europe and Japan. Japan's gone from 17% down to 4% plus, and Europe has gone from 26% to 16%.

But the US has been the surprise in this packet because it's gone from 24 to 26% in terms of GDP. In terms of market cap of all equities, it's now half of, it started this year at least, was half of all global market cap. And the reason the US has not gone through the same pains as Europe and Japan, because you can argue that many of the issues should have, they should share in common. Aging populations, a mature economy,

is because technology has given us this booster rocket and it allowed the U.S. to kind of sustain its share of GDP and increase its share of market cap. So technology companies have carried the market and they're now

30% of the market. And this is not a young, growing part. This is a big part of the U.S. economy. And I think that from that perspective, it has to be part of your portfolios. If you don't like the MAC-7, buy a tech ETF. Have some component in your portfolio for technology because you can't leave it out of your portfolio for the rest of eternity.

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So in this age of indexes, where a lot of investors are gravitating towards index ETFs, sector-based ETFs, trying to get kind of broad exposure with single securities, is price discovery still possible? Because you've had fairly noteworthy investors, David Einhorn being one, the hedge fund manager, or Bruce Flatt of Brookfield Corp, have come out and said, there's problems with price discovery in the market. Stocks that don't fit neatly into indexes, maybe they're small caps or perhaps they're

even mid-cap or larger stocks that don't have the size or sector affiliation to be in the mainstream indexes that investors have so much exposure to. And why the MAG7, maybe the way to invert this is the MAG7 continued to grow and gain prosperity because perhaps they have such a high percentage of the indexes already, which investors, of course, are plowing regular capital in. Where does this leave companies that you might find a small cap or mid-cap company that you think is very undervalued?

But does it ever get the right kind of catalyst to get to the value that you think it's worth if they're not in the big indexes that all the investors are investing in? Three parts to that question. First, let's take the move to passive investing. It's inexorable, right? Over the last 15 years in particular, the shift away from active to passive investing is dramatic.

Last year, for the first time in history, more money was invested through passive investing vehicles than active investing. Mutual funds, hedge funds put together. So ETFs and index funds are now more than 50% of all investing in the market.

And that's a trend worth looking at. Why is it happening? And I think there are a couple of reasons. One is, I think, active investing collectively, and I don't mean to insult any active investors directly, active investing collectively over history has always stuck.

It's stunk. It's always underperformed. And, you know, and it's true in the 50s, the 60s, the 70s. But in the 60s, when they underperformed, there are two problems. One is as a mutual fund investor, you didn't even know they underperformed because you got two statements a year that told you how much your mutual fund made. You had no comparisons. You basically said, I made 9%. That's a good year, right? You didn't track and monitor your investing like we do now.

The second is even if you didn't like what your mutual fund was doing in the 60s, what the heck were you going to do? Find another mutual fund that underperformed just as much. That's why I describe Jack Bogle as the greatest disruptor in financial service history because that index fund he created, the Vanguard 500 Index Fund, essentially revolutionized investing.

But for a long time, it was you could be an active investor or invest in the Vanguard 500 index fund. There were no other index funds. It wasn't like you could index anything you wanted. What's changed in the last 15 years is first we can monitor our active investor performance almost on a continuous basis. So you're having lunch, you can say, what's my mutual fund doing? And right there, you can see it compared to the market over the last three years, the last five years, the last 10 years.

The underperformance of active investing is staring people in the face. It's becoming obvious everybody's monitoring. And while you're sitting there at lunch, you can actually move your money out of that active investment fund into an ETF. You can do it in five minutes. You have more choices. It's no longer just the S&P 500. You can move it into an ETF of tech companies, an ETF of Asian stocks. And essentially, you can find a passive vehicle

which charges you five, 10 basis points that does pretty much what your active investor. So that's why I don't think this is a passing phase. I know active investors think this too shall pass. All you need is a market correction. Then people come running back to us. It's not happening. It's going to continue because

Partly because it's deserved. A lot of passive investing was lazy and easily replicable. And it's easily replicable. You can create an ETF that does what you do. So that's the first part. Second is the rise of passive investing actually having an effect on markets? Absolutely. I think it is making momentum stronger because when money comes into passive investing vehicles,

it goes into the largest cap stocks because it's, you know, especially if it's indexes and the index is a market cap weighted. So it's going into those. So which means that the largest market cap stock, as long as it's fun coming in, will have this ballast pushing them up. So that might partly explain why the MAG7, the winner stocks. But I think it's a mistake to assume that it's passive investing that's driving most of it. I think part of this is a reflection of the fact

The technology in particular and disruption specifically has made a lot of businesses that used to be splintered, where there were 100 different players all making money into winner-take-all businesses. I'll give you a couple of examples. You take retailing. You go back 30 years, you look at the largest retailers, you know, the largest retail might have been 7% market share, 5%. It's a hugely splintered market.

Then you had Amazon and online retailing, and it's become a much, much more consolidated market. You take advertising, hopelessly splintered until Google and Facebook came along, and now they dominate advertising as a business. Car service, pre-2008, largest cab company in the world, might have been 0.3% market share.

Along comes Uber, and now you have three or four or five companies accounting for 50% of all car service in the world. What does that mean? If businesses are becoming winnetic, all businesses, how can markets not reflect that? So I don't think this too shall pass. You could make all of the passive investing disappear, but I still think you'll have those phenomenon markets of the biggest companies carrying the market continue because the economics have changed.

But it does raise the final issue, which is when you buy a company, this is a more general issue because it's undervalued. I talked about this yesterday in class. I gave in my students a question. I said, let's suppose you valued a company and you feel 100% certain about the value and the value is higher than the price. Would you be willing to take all of your money and buy the stock? After all, you're 100% convinced about the value. It is undervalued.

And what I want them to think about is even though you're 100% certain about the value, there's another dynamic here that you don't control, which is to make money, the price has to move to value. And if you're uncertain about that, you can't put 100% of your money.

In fact, this is a piece I wrote that to talk about concentrated portfolios versus more diversified portfolios. When should you concentrate your portfolio? And rather than make it about this is right, this is wrong, I said this is one way to think about concentration versus diversification is how uncertain do you feel about your assessment of value of a company and how uncertain do you feel about the price adjusting to value? The more uncertain you feel about one or both of those dimensions,

the more diversified your portfolio has to be. The more certain you feel about both of those, the more concentrated your portfolio. So I said, look, I invest in spaces where I'm uncertain about value. I value Tesla. I'm not going to even in my weakest moments, I feel certain about it. I feel completely uncertain about that value, even though I've done everything I can do to estimate that value.

The kinds of companies I invest in, I need 30, 35, 40 companies in my portfolio because I'm uncertain about value. I'm uncertain about price adjusting to value. And because I'm so incredibly uncertain about both those numbers, I need 35. If you came to me as an investor and said, I have only five companies in my portfolio, is that okay? I'm not going to say that's bad until I find out what five companies are.

Maybe you bought five companies that are mature, middle-aged companies, but there's not much going on. You can get away with it. I mean, remember the first rule in investing is do no harm. Don't damage yourself, right? So don't be, and if your companies are five mature companies and you might be okay with that, right?

But as the uncertainty we face, we started this talk with how the world is becoming a more uncertain place. The broader lesson I would take out as a U.S. investor is if you've historically had six or seven or eight companies in your portfolio, maybe it's time to rethink that and think about holding 20 stocks. You don't have to hold an index fund. Maybe you don't want to be a passive investor. I'm not a passive investor.

But to show you where the line for me between active and passive investing is, I invest my money and my spouse's money actively. I pick stocks. But for my kids, I buy index funds. Because active investing requires work. It requires maintenance work, which I'm willing to do because I enjoy the process, what I like doing.

None of my four kids have the time or the inclination to do it. And I'd be doing them a disservice by putting Tesla or Nvidia in their portfolio, even if it makes them money, because it's not what I want them to be spending their time on if they don't enjoy doing it.

So I think that, you know, the uncertainty is going to play out. And you don't, as I said, unless you're a Bill Ackman or a Carl Icahn, where you can supply your own catalyst by throwing enough money at the game and getting on CNBC, I'm taking the position. You know, I am, no, I don't think any of us controls that second part of the process. And the only thing you can do is take the karmic view, which is I don't control that. So I'm going to spread my bets and hope and pray that eventually price converges to value.

Time and time again, it seems diversification is the best solution for most investors, no matter how certain you might think you are about a company's valuation. You need to have, I mean, at The Motley Fool, we always say 25 stocks or more is probably what you need in your portfolio. I think that's good advice. And again, in 1980s, we'd run Motley Fool, 10 might have been enough, right? We lived in a very different world.

In 1985, especially if you're a U.S. investor looking at U.S. companies, the world changes. You've got to change your investment philosophy to match it.

Let me turn to a topic that's a little more near and dear to my heart, and that is dividend investing. You wrote recently that many companies that pay consistent dividends might be practicing a form of dividend dysfunction or what you said, dividend madness. Their cash flows might not be growing or consistent, yet they continue to pay a dividend because of things like inertia or because they want to stay consistent with the peers in their respective industries who have payout policies.

What would be your advice to a company that has excess free cash flow looking to return money to shareholders? Where would you fall? Is it dividends, buybacks, somewhere in between, or does it depend on a number of factors? I mean, I think we mystify buybacks more than we do. They both return cash to shareholders. Here's the difference. Dividends, everybody gets a piece of the cash. Buybacks, only those people who sell back get the cash.

dividends, there's a tax consequence. Everybody has to pay taxes on buybacks. Only those people who sell back pay taxes. And with buybacks, there is this, neither dividends nor buybacks can create value. There's cash return, but buybacks can create value transfers. What I mean by that

If your stock price is too high, too high relative to what? To your fair value. And we can decide what that value is. But let's say the price is too high and I buy back stock. I'm transferring wealth from the shareholders who remain in the company to the shareholders who sell back their shares. And if I want to be loyal to a group, I'd much rather be loyal to the group of people who stay in my company. So when you buy back shares at too high a price, you're transferring wealth

from a group that is loyal to you to a group that is selling your shares and moving on. So if you have excess cash and you're saying, I want to return the cash back, I probably want to take a look at your price and your intrinsic value to get a sense of, now, are you hopelessly overvalued? If you are hopelessly overvalued, your price is twice the value, then my suggestion is pay a special dividend.

Why not a regular dividend? Because then people expect you to keep paying that every year and you might not have the excess cash to do it, especially when you're in a risky business.

I mean, I think oil companies, in fact, I'm surprised more oil companies should tie their dividends to oil prices because I know when your oil price is $100 per barrel, you can pay me a lot of dividend. This notion that an oil company pays out a fixed dividend strikes me as going against the reality, which is your earnings and cash flows, even as a mature oil company, are going to go up and down with oil prices. We need dividend policies to become more flexible because if they don't,

Then we have this problem of companies paying dividends they can't afford to. I'll tell you the sector where I think dividends have become shakiest. It's one of the biggest dividend paying sectors out there, financial service companies. Historically, investors have bought banks because banks are nice, they're regulated, they're stable, they pay dividends. You assume that they're run by sensible people. They're paying out what they can afford to. But 2008 broke that script.

Because what we discovered in 2009 is companies with terrible regulatory capital ratios, undercapitalized banks, continued to pay dividends because they'd always paid dividends, inertia, and because everybody else was paying dividends. And they dug themselves into deeper holes.

So I think that with sectors like banking, it might be time for banks to go back and read. It's not that they should stop paying dividends, but have a way of tying dividends, perhaps the regulatory capital ratios. If our regulatory capital ratios look stable, we're making money, we'll pay the dividend. If the regulatory capital ratios get raised, we will reduce the dividend because it'd be absurd for us to pay dividends out of one window and issue equity out of the other because we're undercapitalized.

So I think dividend policy has to become more flexible because the rigid dividend policies we adopted, again, the last century might have worked because the U.S., again, was the center of the global economic universe. You had lots of companies with earnings which were not just high, but predictable. And you could continue to do what you did. I think there are fewer and fewer of those companies around. And the need for flexible dividend policy, I think, is playing out. And how much more cash is being returned in buybacks than in dividends?

As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and are not approved by advertisers. Motley Fool only picks products that it would personally recommend to friends like you. I'm Ricky Mulvey. Thanks for listening. We'll be back on Monday.