The distinguished NYU professor expounds on whether stocks look cheap, market efficiency, and the rise of AI.
Hi, and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar. Our guest on the podcast today is Aswath Damodaran. Damodaran is a professor of finance at the Stern School of Business at New York University, and he has been called the dean of valuation. He has written several books on equity valuation, investment management, and corporate finance. This interview was recorded at the Morningstar Investment Conference in April 2023.
Books by Aswath Damodaran
Interest Rates and Inflation
“Inflation and Investing: Is the Genie Out of the Bottle?” by Aswath Damodaran, NYU Stern School of Business.
“In Search of a Steady State: Inflation, Interest Rates, and Value,” by Aswath Damodaran, Musings on Markets blog, May 6, 2022.
“A Follow Up on Inflation: The Disparate Effects on Company Values!” by Aswath Damodaran, Musings on Markets blog, May 20, 2022.
“Malaise in Market Will Last Longer if Investors Behave Like It’s the ‘70s: Aswath Damodaran,” by Nikhil Agarwal, The Economic Times, Sept. 27, 2022.
Equity Risk Premium
“Country Default Spreads and Risk Premiums,” by Aswath Damodaran, NYU Stern School of Business, Jan. 5, 2023.
“Equity Risk Premiums (ERP): Determinants, Estimation, and Implications—The 2022 Edition,” by Aswath Damodaran, NYU Stern School of Business, March 23, 2022.
“Equity Risk Premiums,” by Aswath Damodaran, NYU Stern School of Business.
“Data Update 7 for 2023: Dividends, Buybacks, and Cash Flows,” by Aswath Damodaran, Musings on Markets blog, March 8, 2023.
“Aswath Damodaran: The History of Buybacks,” GuruFocus.com, Aug. 29, 2019.
“The ESG Movement: The ‘Goodness’ Gravy Train Rolls On,” by Aswath Damodaran, Musings on Markets blog, Sept. 14, 2021.
“Valuing ESG: Doing Good or Sounding Good?” by Bradford Cornell and Aswath Damodaran, Portfolio Management Research, Fall 2020.
“Professor Damodaran’s Latest ESG Takedown Overlooks One Important Group of Investors,” by Adam Fleck, Morningstar.com, April 1, 2022.
Valuation and Capital Allocation
“Closure in Valuation: Estimating Terminal Value,” by Aswath Damodaran, NYU Stern School of Business.
“My Valuation Journey: Have Faith, You Must!” by Aswath Damodaran, NYU Stern School of Business, June 2020.
“3 Fund Portfolio: How to Save for Retirement With Just Three Investments,” by Carla Fried, Forbes, July 15, 2022.
“Michael Mauboussin: Finding Easy Games,” The Long View podcast, Morningstar.com, Jan. 25, 2022.
Expectations Investing: Reading Stock Prices for Better Returns, by Michael Mauboussin and Alfred Rappaport.
Hi, and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar. Our guest on the podcast today is Aswath Damodaran. Professor Damodaran is a professor of finance at the Stern School of Business at New York University, and he has been called the dean of valuation. He has written several books on equity valuation, investment management, and corporate finance. This interview was recorded at the Morningstar Investment Conference in April.
Jeff Ptak: Aswath, welcome to The Long View.
Aswath Damodaran: Thank you for having me.
Ptak: It’s our great pleasure. Thank you so much for joining us for this interview and participating in the Morningstar Investment Conference. Our attendees are very excited about hearing from you, as we are. I wanted to start at a high level, widening the aperture so to speak. You’ve described yourself as a teacher first, a researcher, and an investor second. We can’t all teach, of course, but can you talk about how the teaching mindset has made you a better analyst and investor?
Damodaran: Well, the flip side of the teaching mindset is the learning mindset, which is, you never stop learning, and I think as an investor, that’s a lesson that I think is worth remembering. You’re never the master of your craft. You keep working at it. And I think the very best investors know that. They know that they know a fraction of what they need to know and that they need to keep working. So, to me, that’s the essence of investing is to learn that you’re going to continue to make mistakes, market will throw surprises at you. And no matter how successful you’ve been in the past, there are more surprises to come.
Christine Benz: You’re a valuation expert, but estimating a firm’s value isn’t necessarily a humble act. You could argue it shows hubris given all of the different factors involved in coming up with a valuation. So, what are the hallmarks of an analyst who approaches valuation in a humble way?
Damodaran: I think the hubris comes from the fact that you’ve got a crowd estimate of value out there in the market price. If you have a publicly traded company, you are making a bet that your estimate is better than the estimate that millions of people have put into the value of Facebook or Google or Amazon. And that requires faith. I describe valuation and investing as an act of faith. Faith, because you don’t know whether the number you’ve come up with is the right number—it’s different from the crowd estimate, and you need faith to act on it. Most people who claim to be valuation analysts don’t have the faith in their own valuation. And I think a good analyst will start with the premise that it’s OK to have your faith shaken, that you got to make an estimate that that estimate is wrong. And I always have questions for analysts that I feel certain about this number. I’ve never felt certain about a valuation, ever. And to me, if you’re feeling certain about a valuation, there’s something you’re missing in the process that’s leading you to this point of certainty where you feel that you’re right and the market is wrong.
It’s one reason—and at this point, I might anger a few old-time value investors—that I take issue with those who go to Omaha and treat value investing as the heart of all investing. I call them value extremists. Their premise says, the market is always wrong, it’s full of shallow, stupid people who we’re the enlightened ones. We think about the things that matter. We have an estimate of value that’s right and the market has to come around to our estimate. I’ve never taken that attitude. I’m going to be wrong. I hope I’m a little less wrong than the market. In fact, one of my favorite sayings to my class is, you don’t have to be right to make money. You just have to be less wrong than everybody else. It brings down your anxiety level a great deal to know it’s OK to be wrong, because everybody is going to be wrong.
Ptak: I was going to ask you a different question about Michael Mauboussin, but since we’re on the topic of the market impounding our collective understanding of a firm and what it’s intrinsically worth—we had him on the podcast and he talked about a book he had written recently, which basically it advocated for working back from the price and trying to deconstruct it. I’m just curious what your take is on a framework like that? I suppose that that could be something that informs the work that you do instead of taking the opposite tack to build from the ground up and coming with your own value.
Damodaran: I tell people it’s the difference between computing an IRR in a capital budgeting exercise and doing an NPV. In an IRR you back out from the cash flows, what rate of return you will make. In an NPV you assume a discount rate and you come up with a net present value. One is no better than the other. The only difference is, when you consider your hurdle rate. So, with Mike’s approach—and this is one thing to remember in valuation—you have one equation, the most you can have is one unknown. So, you can solve for whatever unknown you want. You can solve for the growth rate, you can solve for the competitive advantage period, you can solve for the discount rate. And I think that it’s good to do that. I encourage my students, especially in the value growth companies, after you’ve done your valuation, check to see how much buffer there is between your estimate of the growth and what the market is estimating. It’s as simple as using the solver function in Excel and solving for the growth rate that makes your value equal to the market price. It doesn’t make that number right, but it says, look, I’m estimating 27% for this company, Shopify. The market is estimating 50%. How comfortable am I with my estimate being that different from the market estimate? Because if you’re not comfortable, that basically means you won’t act on your own valuation. So, I think it’s an excellent strategy to get yourself comfortable with what you’re assuming in your valuations.
Ptak: Maybe if I could follow up really quickly since we’re on the topic of Michael Mauboussin. You’ve written about this before—he refers to it and I think others too, is consilience, this notion of bringing a multidisciplinary process to valuation analysis more generally. So, my question is, what’s an example of an opportunity you might have missed were it not for incorporating other disciplines into your process and conversely, maybe a pitfall that you avoided by doing the same?
Damodaran: Mike is one of my favorite people in investing precisely because he’s one of the few people left in investing or on Wall Street, who I think of as renaissance people, people who can talk on psychology and statistics and finance and markets. And I think when we get single-dimensional analysts, people who claim to be experts on one sector and one approach to valuation, you get tunnel vision. And I think I find myself constantly telling people step back, take perspective, elevate yourself. I remember the first time I valued Uber. I knew nothing about ride sharing and I could say the same thing about most of the companies I valued. There are people out there who know 100 times more than I do. Doesn’t stop me from investing in valuation. But I call this keeping the feedback loop open, which is, you value a company, you’ve started a process. It’s not the end of the process. Leave yourself open for when somebody says that doesn’t make sense, rather than get defensive, listen.
I’ve learned some of the most valuable things in valuing companies from listening to people who disagree with me the most. Another hallmark of the world we live in is we tend to hang out with people who think just like we do. We pat each other on the back, we agree with each other, and then we go back to our desks, and the whole thing blows up and say, how could that happen? I encourage people to hang out with people who think less like them. The first person I showed my Airbnb valuation to was not an analyst, it was to a friend of mine who is an Airbnb host. Because I wanted to see the holes in my story. What am I missing in the interaction between Airbnb and a host that I’ve not brought into valuation? You’re not going to hear that by talking to an expert in that area or to another analyst. You’re going to get more about that from talking to people who have rented an Airbnb recently or are hosts on Airbnb. So, I think with every valuation talking to people that you might not think are … These are not valuation people that I talk to but people who know the business. Valuing a company is understanding the business. Understanding a business is not going through a financial statement and computing ratios. It’s figuring out what makes a business tick.
Benz: We wanted to switch over to talk about interest rates and inflation a little bit. You’ve talked about how it’s important to distinguish between expected and unexpected inflation as well as the level and stability of inflation and estimating inflation’s potential impact on the value of riskier assets. Can you explain that?
Damodaran: Let me give you two countries you can invest in, one has an inflation rate of 5%, the other has an inflation rate of 2%. But as to which country would you invest in? The answer that most people would give is the 2% inflation rate, right? But let me add a criteria there. Let’s suppose the country with 5% inflation, the inflation is going to be 5% guaranteed every year forever. The country with the 2% inflation is going to have 0% some years, 4% other years. I would take the 5% guaranteed inflation every year because I can now build a business on the expectation that inflation is going to be 5% every year. It’s not inflation per se that troubles people. It’s the fact that high inflation usually comes with more uncertainty about inflation, and that is what throws people off is being able to plan for that.
Ptak: You made some other distinctions too in recent interviews. I’ve heard you talk about the difference between small and large firms, durable and discretionary demand, subscription-based versus transactional models, unregulated and regulated businesses—distinctions that you’ve said can impact how a firm performs in an inflationary climate. Why do these distinctions matter, in your opinion?
Damodaran: Because it’s a question whether you can pass inflation through on short notice to your customers. If you’re a regulated company, you got to go in front of a regulatory authority. They might agree or disagree with you. So, if you’re a utility and inflation is 7%, you might not get the 7% increase right away because regulatory commissions take months to act. So, those are things that affect how quickly you can react to inflation, and the quicker you can react to inflation and the easier you can pass it through, the better equipped you are to deal with inflation. It’s one reason I think the FANGAM stocks are back in action this year—now they’re going up—is if you think about those stocks are the quintessential pricing power stocks. Apple has no trouble passing pricing through. There’s nothing stopping them, they’re unregulated, they have complete competitive advantages. The more pricing power you have, the better equipped you are as a company to deal with inflation and all of those things can affect your pricing power.
Ptak: The one that seems most counterintuitive to me, that you’ve explained it quite cogently, is large versus small. Maybe intuition would suggest that a larger, better equipped player that perhaps has a dominant perch in its industry would possess pricing power. But I think that you’ve explained that a small firm for reasons of maneuverability in part might be able to withstand the climate a little bit better.
Damodaran: I was trying to explain the 1970s, the last high-inflation bout where small-cap stocks outdid large-cap stocks. And here’s the big test. I don’t know whether that’s still going to hold now because the small caps of today are not like the small caps in the 1970s. So, I’ll take whatever explanation you have for the 1970s small-cap phenomena with a grain of salt here, because we’re in a different environment. Small caps now might be the ones without the pricing power. It’s still an untested proposition. So, we’re watching an experiment in motion without knowing what the outcome is going to be, but that’s the way markets are. Markets don’t repeat themselves. There’s always a surprise.
Benz: The S&P was recently at 4,133, which is just a touch lower than the level you’d estimated it would be at in a scenario where inflation subsided to prepandemic levels, and we avoided a recession. Does that seem like the most likely scenario to you at this point? Or has the market gotten ahead of itself?
Damodaran: The way I describe inflation is it takes markets to always have moods and makes markets bipolar. And in a sense, what you will see with that is swings in the market. Take just this month—in January, markets were benign. The scenario of inflation coming down and no recession seemed to be the accepted story. In February, they went complete opposite, 180 degrees. There were some malignant scenarios, inflation is back, the world is ending. First half of March with the banks failing, we’re again back, and the second half of March, we’re back to being in a good mood again. April has been good so far. I would not be sure that this is the end game. I have a feeling that until the inflation switches off or at least lowered, the inflation heat is lowered, you’re going to see swings in this market, good months followed by bad months. And I have a feeling 2023 is going to be … If you think about 2020, it was a bad year, but in August of 2022 we were up 9%. There are good months embedded with bad months and the net effect over the course of the year, we still have to wait and see how that plays out.
Ptak: Wanted to shift and talk about the equity risk premium. You’ve done extensive work on the equity risk premium, and we should mention that so much of your work is freely available to the public, which is to your great credit. You’ve been calculating the implied equity risk premium of stocks in the U.S. and other markets for years. For those unacquainted with the equity risk premium, can you talk about what it is and why it’s your preferred measure of whether stocks are cheap, dear, or reasonably priced compared with something like a traditional price/earnings ratio?
Damodaran: The way I think about the equity risk premium is the price of risk in equity markets. It’s what investors demand as a premium over whatever is risk-free at that point in time for investing in stocks. If you think about what goes into this, everything goes into it. The fears about the economy, inflation, how you think about future earnings. It is the one number where all your hopes and fears go to say. So, when times are good and you feel really good, that number will come down. The equity risk premium will come down. From a stock perspective, when equity risk premiums come down, you’re going to pay much more for stocks. When times are bad, you’re worried, equity risk premiums go up.
In fact, during crises, especially since 2008, I’ve taken to computing the equity risk premium every day. I do it for my own sanity. Because during crises, if you listen to experts, you listen to CNBC, you’re going to lose your head. This is my way of keeping perspective. Every morning I wake up and say what’s the equity risk premium today? And I put it on charts. So, I remember March 23 of 2020 when that chart hit almost 8%, it looked almost exactly like what happened in 2008. And just as a note of caution that you can’t expect history to repeat itself, look at how quickly the premium went back down in 2020.
So, the reason I like that as a measure of how stocks price is it includes how much companies are earning, it includes their growth rates, it includes what people think about risk, it includes what the risk-free rate is. In other words, everything we’re supposed to think about in investing. As opposed to what? As opposed to looking at a P/E ratio. A P/E ratio is an interesting, a useful metric, but by itself it’s extremely dangerous. Because if you use just the P/E ratio, you’d have been out of stocks for the last decade. That would’ve been catastrophic for your portfolio. Why? Because the P/E ratio over the last decade looked high. It looked high relative to historical P/Es, but there was a good reason why it looked high. T-bond rates were at historic lows. You weren’t bringing that into the P/E ratio. I have not found another metric that incorporates as much into it as the equity risk premium. So, that’s why I compute it at the start of every month for the S&P 500 and once every six months for every market in the world.
Benz: So, how good a job has your approach to estimating the equity risk premium done in predicting subsequent stock performance?
Damodaran: The only way to tell that—remember, stocks are incredibly noisy. It’s estimated you need about 150 years of stock returns before you can conclusively say an approach works, which is one reason I find market-timing strategies to be almost throwing a dart and hoping it gets to the right spot. I think the only way to test it—and I have tested it since 1960s—you take the equity risk premium. After all, if it’s a good measure, it should forecast returns on stocks well for the next decade. It does better than any alternative metric—earnings yields, dividend yields, all the other metrics we use—but the correlation is only 17%, which basically means that it doesn’t help you time the market. That doesn’t surprise me. I’ve never been a market timer. I don’t see why there should be money on the table for market timers because you bring nothing to the table. What new information can you bring in that tells me what the S&P 500 will do over the next decade? It does at least as well as all the other fundamental indicators and much better in many cases with the long-term returns.
Ptak: Do you tend to think of it as a barometer of sorts for how target rich the environment is? So, if the equity risk premium is quite large by historical standards, then maybe you would feel more comfortable and confident in your company-by-company evaluation work, whereas if the opposite held, you would be more dubious about it?
Damodaran: Well, there are two things to investing—one is your asset-allocation decision, the other is your stock-selection decision. You’re right, an individual stock, when you have a really low equity risk premium, you worry. I could be right about my stock. What if the market is wrong? The reason I don’t let that enter the discussion when I’m looking at individual stocks is then it can paralyze me, because I’m going to finish my valuation, I might like my company and say, but what if the markets are … So, I suggest to people that they separate this process into two steps. They take the equity risk premium, and if it’s too low, invest less of your money in equities. So, make that decision upfront. I’m going to invest only 40% of my money in equities. Or conversely, I’m going to have a lot more cash in my portfolio. Once you’ve done that, put that to the side. You’ve now made your decision based on the equity risk premium. Turn to a stock and keep your focus on the stock. When I value companies, I try to stay as far away from macro judgments as I can because they suck up your energy and they take away your faith. So, I don’t worry about inflation and interest rates 10 years from now. There’s nothing I can do about it. If you ask me to value Coca-Cola and I spend all my time focusing on inflation and interest rates for the next 10 years, how am I going to get enough time to look at an individual company? So, I tell people be as macro-neutral as you can when you value individual companies no matter what concerns you have and let your macro concerns play out in your asset-allocation decision.
Benz: Entering this year, you estimated the S&P was priced to deliver a nearly 6% equity risk premium. It’s down to around 5.4% given the market strength year to date. But that still seems kind of high, given that until last year the market was on a long, strong bull market run. So, how do you arrive at the equity risk premium figure that you estimate?
Damodaran: The same way you get a yield to maturity on a bond. You get the price of the bond. You get the coupons. Yield to maturity is whatever discount rate makes the present value of your cash flows in the bond equal to the price of the bond. Essentially, I’m letting the market tell me what the rate of return is on a bond. With stocks, you replace the price of the bond with the S&P 500. You replace the coupons with the cash flows you get on stocks. U.S. increasingly, that’s in the form of buybacks, one-third from dividends, two-thirds from buybacks. And then, you solve for the rate of return that makes the present value of dividends and buybacks equal to the level of the index today. So, it’s completely model agnostic. I’m not assuming the CAPM arbitrage pricing model. None of those things matter. It’s basically this is what you’re paying for stocks, this is what you’re getting as cash flows, this is your implied rate of return. You subtract out the T-bond rate from that, you get an implied equity risk premium.
The start of 2023 that implied expected return based on the cash flows and the level of the index was 9.82%. The T-bond rate was 3.88%. The difference between those two is close to 6%, the 5.94%. There is one caveat though. Those dividends and buybacks are based on what people think will have the earnings on the index in the future. And one of the things that was a little disconcerting about 2022, is there seemed to be a disconnect between what people who were talking about the economy, were saying about the economy and what analysts were forecasting earnings for the S&P 500 were estimating its earnings. There’s almost no change in the earnings level for 2023 and 2024 as we went through 2022 and talk of a recession mounted up. So, either the macro experts are wrong, or the analysts are wrong. We’re going to find out very quickly. But that estimate might be lower if in fact the earnings turned out to be much, much lower than expected. So, if there’s a recession hit of 20% earnings, that premium drops to about 5%. If the hit is 30%, then it drops to 4.5%.
Ptak: Wanted to shift gears and ask you about stock repurchases, a topic that you’ve written extensively about. I think by your estimates, I think I heard you mention that stock repurchases amounted about 2 times the amount of dividends paid, if I’m not mistaken. And so, it is the dominant mode of returning cash to shareholders. And given that, I wanted to run through a litany of different myths or misconceptions people have about buybacks that I thought you could address—the first being that they’re more tax-efficient than dividends, or at least that explains their popularity. What’s your take on that particular assertion?
Damodaran: They’re mildly more tax-efficient now, but the difference is not like it used to be in the 1960s and the ‘70s where dividends were taxed at rates almost twice as high as capital gains. That’s no longer the case. So, if there’s a tax advantage, it’s far smaller. The primary tax advantage from buybacks now comes to the fact that you have a choice. You have a choice of selling your shares in the buyback and paying your capital gains tax or accepting price appreciation and paying in the future period. And that might be valuable to people, but it’s not the tie breaker it used to be, it’s not of the magnitude it used to be. So, that’s the primary tax efficiency argument. That could be offset very quickly by the change in law this year with a 1% tax that companies have to pay on buybacks that can more than wipe out whatever the tax benefit is. But I think we’re going to find out that that doesn’t stop buybacks because that’s not the prime reason driving the buybacks.
Ptak: One of the prime reasons I think that you’ve cited is the optionality that it gives to the company, whereas with a dividend it’s somewhat irreversible. With the buyback, you have the ability to ratchet it higher or lower depending on conditions or what your imperatives are.
Damodaran: It’s flexibility, yes, exactly. And basically, the way I describe it, the more uncertain companies become about future earnings, the more difficult it becomes to start paying dividends. Because the problem with dividends is, once you start paying them, you are expected it to keep paying them. To me, dividends have always struck me as unsuited to equity. Equities are residual claim. You get whatever is left over. How can that claim be guaranteed for the next 20 years? So, I think, in a sense, the more concerned companies collectively get about future earnings, the more you’re going to see cash return in the form of buybacks, which is exactly what’s happened in the U.S. and it’s increasingly happening across the world. Last year, more than 51% of the cash return by Canadian companies came in the form of buybacks. Last year, 36% of the cash return by European companies came from buybacks. This is not just a U.S.-centric phenomenon. This is a global phenomenon of moving away from rigid dividends to more flexible buybacks.
Ptak: Before we move to ESG, maybe if I could just follow up. Probably the most politically charged of the criticisms that are levied against buybacks is that they stifle reinvestment in the business, so basically, resources that could be directed toward more profitable uses or those that are thought to be more employee-friendly, instead, the money goes toward share repurchases. What’s your take on that?
Damodaran: Let’s take the employee-friendly part, that’s a different issue. On the stifling reinvestment, good. I’m glad they stifled reinvestment in some companies. Do you want Bed Bath & Beyond to have opened 50 more stores in 2008 and 2009? You want GE to pump another $100 billion into businesses where you’re not going to get the cash back? This notion that reinvestment is better than returning cash is a nonsensical one. Because there are some companies—in fact, there are quite a few companies—that should not be reinvesting anymore. And the cash returned is being reinvested elsewhere, right? It’s being put into other companies. So, the question is not whether you should reinvest your returned cash, but whether the reinvestment should be done by, I don’t know, Caterpillar, or whether it should be done by Nvidia. And I think that’s a choice you have to make. Where would you rather have reinvestment, in old businesses, which are dying, or tobacco, more chemicals, when nobody’s buying them, or in newer businesses where there’s a chance for growth? So, I think it’s a very dangerous argument because it’s disingenuous, because it basically makes a presumption that the trillion dollars that was spent on buybacks last year just disappeared into a black hole. Think of what this market would look like if that trillion dollars had not been out there to be reinvested in other companies.
Benz: We have questions about capital allocation, and we want to tackle that topic as well. But we want to make sure to address ESG, which is a topic that you’ve been quite dubious about. It’s a story, in a sense, ESG, and you’ve shared your fondness for stories. So, what makes the story of a firm being undervalued because it’s believed to be less exposed to the risks of a warming planet any less compelling to you than the story of a firm that has been unduly punished for pivoting to the metaverse or something like that?
Damodaran: Are you sure ESG is about lessening the dangers of the warming planet? My first problem with ESG is, ESG services, including Sustainalytics, including Refinitiv, really have no sense of what they’re really measuring. They keep changing their mind. I’ve actually been tracking the history of ESG—came out of a U.N. document. Initially, ESG was about making the world a better place by reducing climate change. Somewhere in 2012 or 2013 people discovered ESG wasn’t selling very well as making the world a better place. So, I don’t know who made this leap, but the leap was let’s sell it based on alphas, that it actually makes your portfolio a better portfolio, earns returns. And that has destroyed ESG from the inside. Because in the process, ESG has been reoriented around we can deliver higher returns, we can make every company more valuable. Because I think that by doing so, I think it’s hollowed out the inside of ESG. So, when I look at what the ESG services are measuring, I’m not sure what they’re measuring. They’re not sure what they’re measuring. That measure of climate change has now become—it’s really a measure of risk. Now it’s become a question of materiality. I’m just waiting to see what the next stop will be.
So, first, you have an entire concept built around the idea of what are you measuring, and people are not sure. When you have $11 trillion chasing something that is not quite clear, you’re going to be in trouble. So, that’s the first one. Second, can ESG make some companies more valuable? Absolutely. By doing what? By letting them grow faster, by having lower costs. And if that were true, then why would you need ESG? If that’s the very fact that ESG is being sold means that it’s not showing up in the bottom line, and you’re telling people, if you do this, I promise you it will show up in the bottom line. So, much of the research on whether ESG makes growth higher or margins higher is not just extraordinarily mixed, it’s very badly done. Because during much of the last decade, the kinds of companies that scored high on ESG were tech companies. Of course, your alphas were good. Not because you were ESG companies, but because you had Facebook in your portfolio.
Let me pause right there. In what universe is Facebook going to be a measure of a saintly company? Because that’s what ESG scores initially did. Now, of course, they’ve started to shift away from that pure fossil fuel climate change issue. ExxonMobil has a higher rating than Tesla does. And I think that reflects the changing view of ESG, but it might also be that they’re chasing alpha again, because now that fossil fuels are making the positive alphas, you want to get those companies … You can see that the way in which ESG has been marketed, in a sense, undercut its very notion. And as a consequence, when I see it applied, I’m not sure what it’s actually measuring and what effect it’s going to have on value.
I think if you look at the promise of ESG, it was overpromised. And because it was overpromised, it’s now facing up to the issue of, hey, we told you’d get positive alphas, now you’re not. Now, what do we do? I don’t think there’s an easy way back from here. If you’re an investment manager, you have a fiduciary responsibility. And if your fiduciary responsibility means that if you adopt ESG and you lose 30 basis points on your portfolio, then you have to reveal it to your investors and get them to buy in because doing it on your own because you feel good about ESG is a violation of your fiduciary responsibility. There’s a reason BlackRock has gone silent on ESG. There’s a fiduciary responsibility here that’s the size of a mammoth coming at them because of statements that were made in 2018 and 2019 and 2020 about ESG was good for all companies and was going to deliver positive alphas. Those were both lies. And because of those lies, there’s no easy way walking back.
I really don’t think that ESG can be rescued as a concept. I think that it’s dug a hole for itself that’s so deep that it’s not worth rescuing. I think that if you want to bring—and finally, on the issue of goodness and climate change, that’s an issue individuals should care about. They should make their investment decisions based on that. There’s nothing that stops them from doing this. But if the way they’re doing it is by buying ESG funds, I would seriously ask them to take a look at what’s in those funds. And they’re going to be horrified at what they’re actually investing in as opposed to what they think they’re investing in.
Ptak: And maybe building on that, I wanted to ask you, for someone that is committed to advancing nonfinancial goals that were important to them—you’ve been quite clear that you don’t think that ESG is the way to go—what would you suggest is the better alternative for those that maybe are trying to advance those nonfinancial objectives like combating the be-spoiling of the environment, that sort of thing? Is it maximizing wealth irrespective of whether the investments are ESG-good or not and then investing the proceeds and causes that advance those nonfinancial priorities? Do you think that’s the prescription?
Damodaran: I think that there is a road there. There’s direct indexing that many services are now offering where you can go in and pick the companies out of an index that you don’t want in your portfolio. You have to be careful though. Because what do you think you’re doing in advancement of your mission might actually be making it worse. And I’ll give an example. Let’s suppose we all collectively decided that—in this room—decided that we’re not going to invest in fossil fuel companies in the U.S. So, we pull our money out. We push the price down. And we still consume our energy from fossil fuel. Investing is not changing that, right? So, if you’re still consuming fossil fuel, those companies are still making earnings. You push the price down. At some point, they’re going to say why are we staying public? I’m going to make a prediction. Over the next decade if we continued to make fossil fuel companies the villains, they’re going to be privatized, they’re going to go behind the curtain. The fossil fuels will continue to be produced by those investors, and we will continue to consume them. Investing doesn’t change the planet. Consumption changes the planet. By making this all about investing, I think we’ve lost a decade, when in fact, we could have made much better progress against global warming or whatever other issues, poverty, other issues that we think we want to make an impact on. In the last decade, private equity investors invested $1.2 trillion in fossil fuel primarily from U.S. and European fossil fuel companies abandoning reserves.
Benz: We wanted to go back to talking about investments and valuation. Valuation was once kind of artisanal, now it’s industrial. We’re awash in data and analytics. So, what would you say to a skeptic who would question whether an increasingly efficient market affords us enough time to scoop up cheap stocks before they’re repriced to their intrinsic value?
Damodaran: I think, it’s not a continuum—markets start off inefficient, move toward efficiency. Market efficiency ebbs and flows. Because the way markets work is, they’re out of inefficiencies. People come in, they try to make money, they make markets efficient, markets become efficient, people stop trying to make money, markets become inefficient again. So, this is an ebb and flow process where there are times when you have more mispriced stocks and times when you have less mispriced stocks.
So, first, I think you have to recognize, depending on the time, you might find fewer or more companies to invest in. So, there might be times when you look around and say, I might as well put my money in an index fund right now, we’re in a period of relative efficiency. But then you sit back and wait because six months later, a year later, crisis hits, and all of a sudden, people are behaving irrationally, they’re panicking. You might have a moment where you might be able to find stocks that are now mispriced again. So, I think you got to recognize there are windows that open up and close up, and you’re trying to find those windows and take advantage of them. So, I am a believer that markets do find mistakes and correct them over time. That’s what drives me to be an investor. If I thought markets never corrected their mistakes, I would never make money. The question is, how long does that opportunity last? I think that lasts long enough for you to take advantage of it if you have faith. That word comes up again. Because the moments at which you can invest in these companies could be moments that are most terrifying for you, like when Facebook reported their earnings report with that Metaverse investment and the stock dropped below 100 and everybody was fleeing and convinced that Mark Zuckerberg was driving the price to zero, was the time to buy Facebook. So, often it means being willing to take actions that make you uncomfortable, even though the rest of the world is telling you don’t do it.
Ptak: You’ve talked before about how, in an increasingly competitive world, we need to revise our definition of terminal and terminal value. I think the example that you cited before is Yahoo as a way of illustrating the way the business lifecycle has been compressed in a number of industries. You don’t have to name names, but what’s an example of an industry where you think investors underestimate just how perishable the business model is likely to be?
Damodaran: Let’s say, you’re valuing Zoom. Let’s say you’re upbeat optimistic about Zoom. It’s a platform, right? It’s a neat platform. We all use it right now. But even the most optimistic person on this platform will accept that this platform is not the platform you’re going to be using 15 years from now. Technology shifts too much. We don’t even know what media we will be using. With the AI who knows what the process will look like. So, if you’re upbeat about Zoom and you’re projecting earnings and cash flows growing over the next five years, I’m all with you. But then if you say, look, it’s going to go on forever, my question is, why? It’s a technology. It will die. When the technology dies, the company is going to go down with it. It’s not like Yahoo was a bad company. It was a search engine, but that’s all it was. It was a search engine. Once Google ate its lunch, it had nowhere to go. And with technology companies, that becomes part of the problem is as the technology fades, the company fades with it. You do have a few companies that managed to find a new life, and of course, they’re often always offered as examples. Look at Apple. Look at Microsoft. But you cannot let exceptions be the driver of how you think about investing. You got to create rules that are looking at across the cross section what companies are able to do.
Benz: You’re not a fan of concentrating a portfolio on a handful of names. To what extent does that reflect your belief that there are fewer fat pitches than there used to be? Or is it just that the risk manager in you feels that it’s a bad idea to go really large in individual positions?
Damodaran: I think it’s both. I think it’s that the world has become a more uncertain place. The way I describe concentration is, let me use the word faith again, that you need faith in your value and faith that the price will adjust to value. The more certain you feel about both, the less you need to diversify. So, let me take the extreme example. Let’s say you feel absolutely certain about your valuation and also absolutely certain that the price will correct to value. All you need to do is hold that one stock. I can’t think of what conditions would drive you to do it. The only one is you have inside information, which would land you in jail after you’ve made your money. So, think of that as your limiting case. Absolute certainty in your valuation, absolute certainty the price will adjust to value. All you need is one stock.
The more uncertain you feel about your valuations, because too much is happening around you in the world, and the more uncertain you feel about the market price correcting to your value, because that’s what you need to make money, the more diversified you have to get. In 1980, you might be able to get away with 10, 15 stocks because you lived in a manageable world—domestic economies, predictable sectors, and maybe 15 companies or 10 companies would have been OK in your portfolio. But we don’t live in that world. Say, what if I buy a Kraft Heinz or Coca-Cola, especially if you buy companies like Kraft Heinz, Coca-Cola, and McDonald’s, because, as we’re discovering, the world is shifting under them. Look at McDonald’s—they had to shut their U.S. restaurants down for two days when the management got redone. That’s something you’d never have expected of a McDonald’s 20 years ago. Coca-Cola worrying about what will the pushback against sugar cause us in terms of a beverage business. So, even companies that have a long and illustrious history of delivering earnings, looking forward and say, will they be able to continue to do that? I feel uncertain, more uncertain about the future now than I did 20 years ago. The way it plays out is I have more stocks in my portfolio now than I had 20 years ago. I know for some people this becomes the issue of don’t you have enough conviction? And I hate that word in investing, because it puts us on a spot. So, do you have enough conviction? Can’t you put all your money in this if you feel that strongly? No, I never feel that strongly. I don’t have that much conviction. Maybe you do. And there are investors out there, I think, who overestimate their capacity to value companies and overestimate the capacity of markets to correct and then underinvest. They might still make money for a while, but at some point in time, their portfolios will blow up.
Ptak: Wanted to ask you about capital allocation. It did seem like in some interviews I may have misheard you. It seems like you said that people might in some instances overrate capital allocation in their assessment of a given investment, and that could lead them to overemphasize the stocks of firms that are profitable but kind of over the hill maybe for some reason. It appears that they’ve excelled at capital allocation, but there are other aspects of the business that would call it into question. And so, my question is, what role capital allocation should play in our overall analysis of a potential stock investment?
Damodaran: Capital allocation is central. The point I was making is using return on invested capital as the basis for all capital allocation is an extremely dangerous shortcut. Because in some companies, it works—mature companies where you’ve got a history of earnings. But if I take a young growing company and I compute the return on invested capital, even if it’s the best company in the world, my return on invested capital is going to look lower than my cost of capital. It doesn’t mean that the capital allocation decisions are bad. It’s because they’re still early in the lifecycle. So, I think my point is not against capital allocation, which I think is always central, it’s what metric you use to measure how well capital is being allocated.
Ptak: Makes sense.
Benz: Following up on that, you found that 70% of firms failed to earn their cost of capital in 2022. There are many possible reasons for why these firms might have attracted investment capital to begin with, and those 70% probably aren’t anywhere close to accounting for 75% of the market’s capitalization. But nonetheless, it’s a startling figure. Is that typical and does it raise any questions about how efficient the market truly is?
Damodaran: It’s been about that for the last decade. Sixty to 70% of companies earned less than the cost of capital, because otherwise you could always blame 2022. The reason you can blame 2022, you saw the largest single year jump in cost of capital ever across the global companies, jump of almost 4%. But if you go back pre-2022, 61% had trouble earning their cost of capital. This is a long-term problem. Part of it reflects the use of return on invested capital and you could say, well, maybe 20% of that 61% you’re tracking young companies, you’re tracking a company having a bad year. But about a third of all companies globally have earned less than their cost of capital every year for as long as I’ve been computing these numbers. It doesn’t mean they don’t make money. It’s they don’t make enough money to cover their capital. And many of them, I would wager, don’t think they have a problem. And maybe that’s the problem. Because we measure success as, do you make money? And many of these companies say, look, I’m making profits. Why are you taking issue with what I’m doing? Given the capital tied up in your company, you’re not making enough profits. And it’s sometimes not their fault. They once were good businesses, but the world changed under them. Take telecom: Telecom 20 years ago was a nice solid business. Companies earned above their cost of capital. Today, telecom is a business that has trouble making its cost of capital, it’s become more competitive, technology has provided competition. Its core is being eaten away.
So, I think part of this is again a reflection of the world becoming a much more uncertain place, a more disruptive place. There are fewer and fewer sectors where you can look around the horizon and say there’s no disruption coming. It’s coming to almost every sector and that’s going to show up in those returns. It does push back against the notion that inflation is being caused by money-hungry companies raising prices, because if that were true, you’d see returns on capital going through the roof in 2022, and you don’t see that.
Ptak: Wanted to ask you about AI. You had mentioned it a short time ago. Seemingly, everyone is talking about AI. What impact do you think it will have on the way investors like yourselves value securities?
Damodaran: On valuation itself, not much. But it could have an effect in how investing overall works. And people might be surprised, but I think if active investors are having trouble making alpha right now, they’re going to have even more trouble with AI. That sounds odd because now they have a weapon in their hands. If everybody has AI, nobody has AI. We’ll all spend more money. I remember when PCs first came and people said, this is going to make handlers so much more productive, you’re going to see people with fidelities, which are able to buy these PCs, are going to make a lot of money. Didn’t work out that way. And every one of these things where everybody gets it—whether it’s more powerful computers, whether it’s big data—what you find at the end of the process is, everybody invests in big data and nobody’s really making money on it other than the people selling you the big data products and the big data services. So, I’m not convinced that AI is going to create alphas, but it is perhaps going to put a threat many of the jobs in the active investing business, because it’s going to take any job that’s mechanical. And so, I’m going to replace you with the machine. If all you’re doing is mechanical, a machine can do that much more efficiently than you can.
Benz: How about the impact for higher education? We posed one of your final exam questions to ChatGPT for the question on how to estimate the net capital expenditures and value of a fictional firm named Corax, and it answered it effortlessly. So, can you talk about the implications of AI for higher education?
Damodaran: I think it does mean that if you give exams and you give the same exams every year—it’s always been asked, you’ve been asking for trouble for a long time. It’s now catching up with you and I have no sympathy if it does. I think if you can’t stay one step ahead of this, because all AI is going to do is take past exams and solutions and feed you back—of course, it’s going to give you the right solution. So, in a sense, my job is to write something with just enough of a twist that you can’t just take all my past solutions, repackage them, and deliver them back to me. So, it’s going to make teaching harder, because we’ve got to think of creative ways of asking people questions that in a sense haven’t been asked exactly that same way before.
Ptak: Maybe to turn back to the investing professional, which you were describing before. I think you could say it’s been plagued by a mismatch between the excess return an active investor can realistically deliver before fees and the fee they charge, which is math a first grader could handle, but that scores of active managers seemingly cannot handle. And so, my question is, do you think we put too much emphasis on technical proficiency and not enough on the way skewed incentives can defeat even the most trenchant analysis that we might do?
Damodaran: Absolutely. I’d point to people that bias is the biggest enemy of good valuation. You start off with strong preconceptions. I don’t care how good your skills are, your preconceptions will play out. So, you’ve already decided that something needs to be bought, you’re going to find a way to buy it. I think that incentives and biases play a huge role in how your active investing plays out. I can live with mistakes; I can’t live with bias. Mistakes average out, bias doesn’t. So, anything that doesn’t average out is going to be a problem that works against you in the long term.
But I think active investing, it’s not just that there’s a mismatch between what you can deliver and what you charge. It’s whether you can deliver at all. That still remains one of the great unknowns, as collectively, even if you took all the fees and the costs out, would an active investor—because when you look at the returns of active investors even before fees, they’re actually lower than index funds. The very fact that your actives seems to eat away at your returns. It’s one of the most depressing aspects of these studies is the more active you’re as an investor, the less successful you become as an investor. And I think that’s where having access to social media and the kind of data that we have today is, I think, undercutting our objective of being good investors, because we’re getting constant feedback on our portfolio and that’s actually leading us to become more active than we should be. So, many of the things that people point to as advantages for small investors, you can trade at low costs, you can trade at no cost through Robinhood, you have all this data, is actually making them worse investors rather than better investors because they’re overacting.
Benz: Following up on mistakes, apart from putting too much weight on the recent past, what’s the most common mistake you see your students make? Why do you think it’s so commonplace? And what does that tell you about the way we inculcate students and young professionals?
Damodaran: I think the most common mistake I see my students make is when they look at a company and they look at what the company is doing, they forget that the rest of the world responds. It’s not just my students. I see it with analysts, where they’ll tell a great story—this company is going to cut prices; it’s going to get a higher market share. I’d say, wait. It’s going to cut prices, but how do you know other people are not going to cut prices in response? And if they do, you’re going to end up with the same market share and lower margins. But I think all too often when you look at an individual company, you act like it’s the only one moving and everybody stays in place. That’s not the way the world works in my experience. So, when you think about investing, you always have to think in terms of dynamics. What will happen if I take this action and play it through? And I think that’s one reason I tend to be a little less optimistic about these big markets playing off as big profits for these companies than analysts are, because everybody sees these big markets—they’re all coming after the big market. We might all be spending more in this big market, but we might not get the profits that we expect to get.
Ptak: We’ll end on a light note. We also asked ChatGPT—we prompted it to come up with a question that would annoy you, and without missing a beat, it responded as follows. It said, “Can you give me a hot stock tip that will make me rich quickly without any research or understanding of the company’s fundamentals?” And so, my question for you is actually, do you get this question more often from Uber drivers or from others in academic and social circles?
Damodaran: I think I get it from 95% of investors. I think that they miss the essence of investing. You don’t invest to get rich. You invest to preserve and grow wealth. I think the minute you think of investing as a pathway to getting rich, you set yourself up for all kinds of mistakes. You overreach, you overbet, because that’s the way you get rich is you gamble. And I think we need to redefine investing. Investing is about preserving and growing wealth, which means if you’re a doctor, go back and do your job, earn your income. That’s going to be at the heart of your investing. If you’re spending most of your time as a doctor looking through the stock pages, trying to pick stocks, your wealth is not growing. Your investing can be great, but it doesn’t pay off. So, I think that it’s much more common than we accept. They’re traders. They’re not investors. They want to trade their way to riches, and they look at success stories. This is selection bias. You’ve got YouTube videos of people who got rich in five years by trading and you use those as role models. It’s an extraordinary dangerous pathway you’re on because history suggests that sooner or later, you’re going to leave that casino with nothing in your pocket.
Ptak: Well, Aswath, it’s been a pleasure speaking with you. Thank you so much for sharing your time and insights with us. We greatly appreciate it.
Damodaran: Thank you.
Benz: Thanks so much for being here.
Damodaran: Thank you.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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