The author and stock analyst discusses the benefits of maintaining a long time horizon, who should invest in individual stocks and who should index, and the biggest mistakes he’s made with his own portfolio.
Today on the podcast, we welcome back author and financial educator, Brian Feroldi. His bestselling book is Why Does the Stock Market Go Up? He is also the founder of a financial education company called Long Term Mindset and a contributor to The Motley Fool. In addition, Feroldi has a big presence on YouTube, where his videos receive hundreds of thousands of views. He received his bachelor’s degree from the University of Connecticut and his MBA from the University of Rhode Island.
Background
Why Does the Stock Market Go Up? Everything You Should Have Been Taught About Investing in School, But Weren’t, by Brian Feroldi
Resources
Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!, by Robert Kiyosaki
Warren Buffett and the Interpretation of Financial Statements: The Search for the Company With a Durable Competitive Advantage, by Mary Buffett and David Clark
The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments, by Pat Dorsey
Checklists and Valuation
“How to Analyze a Company in Less Than 5 Minutes—Key Financial Ratios,” by Brian Feroldi, LinkedIn.
“How to Analyze Stocks,” by Brian Feroldi, LinkedIn.
“8 Ways to Value a Company,” by Brian Feroldi, LinkedIn.
“Face Value, Fair Value, Market Value, and Book Value. What’s the Difference?” by Brian Feroldi, LinkedIn.
“5 Essential Investing Lessons From Brian Feroldi You Can’t Ignore,” by Francesco Casarella, investing.com, Aug. 23, 2023.
Other
“Nick Maggiulli: ‘The Biggest Lie in Personal Finance,’” The Long View podcast, Morningstar.com, April 12, 2022.
“Do Global Stocks Outperform US Treasury Bills?” by Hendrik Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, paper.ssrn.com, July 5, 2019.
Brian Feroldi’s Tribute to Charlie Munger
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Christine Benz: Hi and welcome to The Long View. I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Amy Arnott: And I’m Amy Arnott, portfolio strategist for Morningstar.
Benz: Today on the podcast, we welcome back author and financial educator, Brian Feroldi. Brian’s bestselling book is Why Does the Stock Market Go Up? He is also the founder of a financial education company called Long Term Mindset and a contributor to The Motley Fool. In addition, Brian has a big presence on YouTube, where his videos receive hundreds of thousands of views. He received his bachelor’s degree from the University of Connecticut and his MBA from the University of Rhode Island.
Brian, welcome back to The Long View.
Brian Feroldi: Amy and Christine, awesome to be here. Thank you for having me again.
Benz: It’s great to have you here. So, when we had you on the podcast in 2022, we didn’t really cover your personal story and how you came to be interested in investing. So, we’re wondering if you can share that with us.
Feroldi: Happy to. I grew up in a household that was very good at personal finance but knew next to nothing/very little about investing. So, my financial role models were very good at saving money, very bad at making the money that they saved work for them. So, when I graduated college, which was way back in 2004, despite graduating with a degree in business, I would largely consider myself to be financially illiterate. I knew next to nothing about the stock market. I knew the basics about accounting. But if you were to ask me, what’s the S&P 500? What is the Dow? Why do stocks go up and down? I basically knew nothing.
However, when I graduated, as a gift my dad gave me a copy of a very popular book at the time, which was called Rich Dad Poor Dad by Robert Kiyosaki. For whatever reason, I just devoured that book front to back very, very quickly. And while there are plenty of things in that book now that I disagree with or I don’t fully appreciate the view that he has, it was the very first time that I had heard basic concepts about everybody is in business for themselves. The rich use their money to buy assets that grow their wealth. Your house is not an asset; it’s a liability. You can build wealth in one generation and how the rich think about money differently. Those concepts blew me away. That was the first time that I’d ever heard of them. And that book kickstarted a love affair with learning everything related to money, personal finance, and investing that continues to this day. So, while Rich Dad Poor Dad was like my gateway drug into the world of investing, I tried to consume every bit of content that I could related to investing ever since and my style and my interest in the stock market hasn’t waned.
Arnott: And then was it fairly soon after reading that book that you started writing about investing as your career?
Feroldi: That was a long time. That was almost a decade later, essentially. So, after learning about the concepts taught in Rich Dad Poor Dad, I did discover that the stock market was the best asset class for my personality. Rich Dad Poor Dad and a lot of books like that, they try and talk up the benefits of investing in real estate. I quickly learned that real estate was not a fit for my personality, but the stock market was. To say nothing of the fact that with the stock market, the amount of capital you need to get going is dramatically lower than it is for buying a rental real estate. So, once I started to discover the stock market, I started to read lots of books. I started to learn about Warren Buffett. I learned about Jim Kramer. I learned about The Motley Fool. And it was really after I started to get involved with stock investing that I started to consume a lot of content on blogs and discussion boards related to investing. And it was only through contributing to discussion boards related to investing—so The Motley Fool’s discussion board, Yahoo Finance’s discussion boards—that I even started to write about investing.
Benz: What was your vehicle of choice when you started investing in the stock market? Were you mainly an individual stock investor at that point or were you in mutual funds?
Feroldi: So, the answer there is both. I did know enough about the stock market to know that I should invest in my 401(k) as soon as it was available. So, I was contributing to that and that was just in broad-based index funds and mutual funds. One big downside to investing through a 401(k) is your investing choices are limited to the choices that the plan offers you. So, the majority of my capital was going into my 401(k), which was going into mutual funds and index funds. However, the capital beyond that that I could invest in the stock market, which was not a lot of money at the time, just a few hundred or a few thousand dollars, I was attracted enough to investing and I was learning enough about investing that I decided to put that money into individual stocks. And that kind of theme continues through to this day where basically all of my retirement funds simply for simplicity are invested in broad-based index funds, and all of my taxable brokerage account funds are invested in individual stocks.
Arnott: So, is that an approach that you recommend for the average investor that they use broadly diversified funds for their 401(k), but then a taxable account for individual stocks?
Feroldi: For the average investor, the “average investor,” I think that index funds will get 99% of the people exactly what they are looking for. To me, the only thing that distinguishes somebody from investing in index funds versus investing in individual stocks is their individual level of enthusiasm for researching how to become an individual stock investor.
When you make that jump from buying index funds into buying individual stocks, there’s a lot of information that you need to absorb. You need to learn the basics of accounting and how to read financial statements. You need to learn how to analyze businesses and business models. You need to learn how to assess risk. You need to learn valuation. You need to have a system for making sure that you’re not making mistakes. You need to study and learn from the greatest investors of our time, all of which is basically free to do nowadays and has never been easier. But if what I just described as the prerequisite for investing in individual stocks bores you or sounds like a mountain of work that you’re not interested in, no problem. Don’t worry about any of that. Just invest in index funds.
However, if you’re the type of person like I am that was just so enthralled with everything about investing and so interested in learning about the nuance of accounting and how business works and how stock works, that you literally spend a portion of your free time studying that, then I think it’s absolutely OK to devote a portion of your portfolio to individual stocks. But you should only do it if you are extremely interested in learning about investing the right way.
Benz: We want to spend more time talking about how investors should approach this. But I want to go back to your story a little bit, Brian, and thinking about the time line, it would seem that the financial crisis hit fairly early in your investment career where you probably saw—everyone who had stocks saw big losses in their portfolios. Can you talk about that and how you navigated that period?
Feroldi: Absolutely. So, I started investing in 2004 and as my salary grew, I devoted more and more of my income to investing in the stock market. And back then my wife and I were both working and did not have kids. So, we were dual income, no kids, or DINK. So, we could actually afford to put a sizable amount of money into the stock market every month. So, by early 2008, we had built up a decent-size nest egg for ourselves, and then came the great crash of 2008 and the ensuing fallout from there. And I, like so many people, saw my personal portfolio and personal net worth fall by, what was it, 60%, 65%, something like that, peak to trough. And that was an extremely challenging period to go through, not just because of the emotions that you faced, seeing stocks that you own take that big of a hit. But moreover, looking at the news on a day-to-day basis was just brutal. It seemed like every day there was a new bank that was going into foreclosure and the government was forced to take action. Sales and business were down across the board, even at very big, large established businesses.
I was an early investor in Google, and I think peak to trough Google stock fell like 70% from top to bottom. So, investing and remaining enthusiastic about investing throughout that period was extremely challenging. However, I was able to do so because I was still able to contribute money to my portfolio. And I knew enough about investing at the time to know that, one, the stock market has been through worse in the past and has always recovered; and two, since I was deploying capital into individual businesses, I was making good decisions so long as I was buying high-quality companies at better and better valuations. So many of the best investments that I’ve ever made were deployed in early 2009 when we were near that cyclical low for the stock market to bottom. However, there’s no doubt that going through that period was extremely gut-wrenching.
Arnott: You’ve also been very candid about some of the investing mistakes you’ve made along the way, which I think is a good practice for any investor. Can you share some of the key ones that you’ve made and what you’ve learned from them?
Feroldi: Like so many investors, I’ve made, God, dozens of mistakes along the way. I’ve gotten overly excited about stocks that I thought were a “sure thing.” I’ve put a lot of my capital into companies that I thought there was no way that I could lose and then watch those stocks then proceed to fall 70%. Boy, is that a humbling experience. I’ve bought stocks that were great businesses and I saw those stocks trade sideways or go nowhere, even though the fundamentals of the business were performing quite well. And then after a while, I just became impatient with those stocks since they weren’t going anywhere, sold them, and then immediately after I saw those stocks go up by 100%, 200%, 300%, 500%.
But when I think through the biggest investing mistakes that I’ve made, they generally fall into two categories. Category one is not knowing what I was doing. When I first started investing and I learned a little bit about some of the terms of investing, things like “market cap” and price/earnings ratio, I knew enough to make “smart decisions,” but I didn’t know enough to know the limitations of those decisions. For example, when I first learned about dividends and dividend yield, I thought, well, I’m just going to invest all my capital in companies that have the highest dividend yield. That’s like buying a savings account that pays a 15% interest rate. Well, only later did I realize that those dividends were actually paid with profits that the business made. And the only reason a company has a quoted dividend yield of 15% is typically because the market doesn’t believe that those dividends are going to be paid. So, I learned that lesson the hard way. And I learned many other lessons about just not knowing enough about how to invest in individual stocks the correct way. So that would generally be category one.
Category two is the far more painful and far more expensive group of lessons. I’ve analyzed all my investing decisions that I’ve ever made, and I’ve noticed that the most costly, the worst investing decisions that I’ve ever made all have the same word in them. And that word is sell. I bought multiple, multiple great businesses that had strong moats, that were growing like crazy, led by good managers with big opportunities ahead. And I sold those stocks early because I was just impatient with them. And my net worth has taken the biggest hit not from buying bad stocks that went down, but from buying good stocks that went up. Then I sold them and then they went on to go up and up and up from there. That experience has taught me that the biggest investment mistake you can make is to sell a future mega winner early. And for that reason, I’ve developed a strong bias toward holding my stocks even when I’m not that happy with them.
Benz: I know that you and Nick Maggiulli, I believe he has contributed to your website, to your blog, and his big thesis is that people should, especially younger people, should very much focus on just earning income, that the more income you have, the more you can invest. Are you on board with that thesis and do you think that perhaps people underdiscuss the value of generating steady income so that you have more money to invest?
Feroldi: Absolutely. I think that is a spot-on thesis that Nick in particular has really beat the drum on and he has certainly convinced me of. All things held equally, if you were a mediocre investor that earned a 5% return per year, but were able to save $2,000 a month, by and large, you will do much better over the long term than an above-average investor that earns a 10% return, but only able to invest $500 or $1,000 a month. The biggest tool that every investor has in their arsenal for building wealth is their own personal income and specifically how much income they can convert into assets that then grows their wealth from there. For most people, the best way for them to ensure they have a good retirement and have a big portfolio is to contribute more money to their investments. The only way that you can do that is to dramatically increase your income over time. So, I am fully on board with that—that time spent, for most people, time spent growing their income is better than time spent figuring out how to tinker their portfolio to eke out a few extra percents of return.
Arnott: For people who do want to invest in individual stocks, what do you think are the best ways for them to educate themselves and become knowledgeable about how to buy and sell individual stocks? You’ve obviously created a lot of your own educational resources, but are there any other go-to books or sources that you recommend?
Feroldi: Yeah, absolutely. Investors today are truly spoiled because it’s never been easier for us to find high-quality content that we can use to become better investors. Moreover, the classic way that people have learned about investing has been reading books, and boy, are there just some fantastic investing books out there. Two that come to mind right away: One is called Warren Buffett and the Interpretation of Financial Statements. That’s a great book that can teach you about how to find, read, and interpret financial statements. And another one is The Little Book That Builds Wealth by Pat Dorsey. That’s a great book on competitive advantage and how to find and identify moats. So, they are two quick little, easy reads that can teach you quite a bit about how to analyze individual companies.
But moreover, no matter what social media platform you are on today—LinkedIn, Twitter, podcasts, YouTube—there’s a very good chance that there are good creators on those platforms that create lots of high-quality content that you can consume for free to learn about investing. So, if you’re the type of person that likes to listen to podcasts, listen to this podcast, it’s a great one. There’s also lots of other high-quality podcasts out there that discuss the merits of individual stock investing. Maybe the type of person that likes to watch or learn via video—my God, YouTube is an amazing resource for learning, and you can find tons of high-quality videos on there. If you like to read, there are lots of books, there are lots of blogs. You can certainly go on Twitter or LinkedIn.
So, the medium that you can use to learn about the stock market, it’s truly unlimited today. So, find what medium fits best for your investing personality and for your learning style. Try and find the best creators on those platforms and they aren’t that hard to find if you poke around and learn to follow the right people. And then just consume their content consistently. It’s amazing how much information you can learn about investing simply by consistently reading and absorbing information passively.
Benz: You mentioned learning to find the right people and it seems like that is definitely a skill. And there’s a lot of junky information out there too. Do you have any thoughts on red flags that people should be looking out for if they’re consuming information? Any signals that maybe someone’s advice isn’t all it’s cracked up to be?
Feroldi: Generally speaking, if they are promising you something or they’re bragging about something that seems almost too good to be true, that’s a strong signal right there. This is where you just have to use your spidey sense as a human to see—does this person seem trustworthy or are they coming off as a flashy salesman? So, the best investors that I follow, not only are they open and honest about their process, but they also share their wins and losses with an emphasis on the losses. If somebody is out there as just a promoter of themselves and trying to get you to do something, they typically make it seem like everything they do just turns to gold. My favorite creators are out there and they’re not only talking about things that have gone well, they’ve talked about mistakes that they’ve made. They talk about mental models that they follow to minimize their mistakes. They talk about the process that they use to become a better investor. And importantly, they teach. They come off as a teacher that is looking to explain their process, the thoughts behind it and how to do it easily. So, if you can find somebody that has the attitude and personality of a teacher with the openness and honestness to share their mistakes along the way, the odds are very good that you found a great person to follow.
Arnott: So related to the importance of having a process, you are a big believer in using investment checklists. If someone is creating a checklist, what are some of the key items that you think should be on it?
Feroldi: This is something that I have become a huge believer in. I think that checklists are the closest thing to an investing cheat code that exists. And this is an exercise that I think all investors should go through regardless of whether or not they pick individual stocks. So, one thing that I asked myself or did many, many years ago after I was learning about investing was, I decided to start writing down the characteristics in a business—I’m an individual stock-picker, so, in a business in particular—that if a company had these characteristics, I would find the business to be attractive. So, I wrote things down related to financial statements. For example, I like a company with a strong balance sheet, a high gross margin, high returns on capital, and growing free cash flow. I wrote things down related to a company’s competitive advantage, aka a moat. So, I want to know that the company has a moat, what the source of that moat is, and the direction that I believe that the moat is heading in. I wrote things down related to the company’s long-term potential. I wanted to know that it had a long organic-growth runway, that it was a top dog and first-mover in an important emerging industry, that it had operating leverage ahead, that it had low customer acquisition costs and high customer dependability combined with recurring revenue.
I also wrote down categories related to management teams. So, I like to invest in companies that are run by their founders. The insiders own a meaningful amount of the company’s stock. The company gets good ratings from employees on websites like Glassdoor. And the management team is good communicators by evidence of the mission statement and the language that they use in their financial documents.
The final category that I use is something I just broadly call a Wall Street. So, I want to see that the company’s stock has outperformed the market over the last five years and since it came public. I want to see that the management team is using its growing free cash flow to reward shareholders via buybacks, dividends, or debt repayments. And I want to see that the company has a history of outperforming its targets. So, I made a big list of all the characteristics that would attract me as an investor.
Then I made another list: All the things that I don’t want to see in investment. If an investment has this, I’m turned off as an investor. So, on that list are things for me like accounting irregularities. If I can’t trust the numbers, why would I invest in the business? I personally don’t like it when a company has a lot of customer concentration. So, an outsize portion of its revenue comes from just a handful of customers. I don’t like it when a company is dependent on outside market prices for success. For example, oil companies are always going to be dependent on the price of oil, which is outside of their control. Gold companies are always going to be dependent on the price of gold, which is outside of their control. So business is hard enough. I also don’t want to have to be lucky with the commodity price to do well. Then there’s things on there like I don’t like it when a company grows by acquisition. I don’t like it when there’s a lot of stock-based compensation, or I don’t like it when I’m reading through the financial statements and my head starts to hurt. So, they’re very complex.
So, I have two lists: things that attract me as an investor, things that detract me as an investor. That right there, if every investor did that, that would dramatically improve their investing decision-making because they have a framework that they can use to make decisions.
I went one step further. I then ranked each of those categories, both the good and the bad ones, by most important to least important. And then I put a simple scoring system for myself on there that weighed them according to how important the categories are to me. So now, with my investing checklist, I can take any publicly traded company and I can go through and score it on my checklist. And at the end, I get a sense for how good of a match is that particular company for what I’m looking for in an investment? So, it’s not, is this company a good stock or not. It is, is this company a good match for what I’m looking for as an investor? And then after taking hundreds of companies through that framework, I get the sense of the companies that are a best match for my portfolio, and I buy those. And companies that are not a good batch for my portfolio, and I avoid those. But that simple process—making a list of the things that you like, making lists of the things that you don’t like—if every investor did that, their investing decisions would improve dramatically.
Arnott: So as a part of your list, you mentioned being able to consistently beat earnings expectations. And I’m just curious. It seems like maybe there’s a little bit of gamesmanship where companies will set earnings guidance at a low enough level so that they can exceed expectations. Is that something that you’ve encountered or that you think can be a problem?
Feroldi: I don’t view that as a problem. I view that as something that truly every management team should do. Like it or not, the stockholders, the shareholders of the business is a stakeholder that management teams do need to consider. And one way that they are measured is by how Wall Street sets expectations for themselves and what the company does in relationship to those expectations. That is just a reality of being a public investor. So, to me, great management teams set expectations that are both attractive and reasonable and then they outperform those expectations. Great management teams beat the numbers. Bad management teams inconsistently do the numbers.
There is certainly gamesmanship that goes on there where companies have a game to play where they’re trying to set low enough numbers that they know that they could beat but high enough that they entice Wall Street. But managing expectations is a job for management teams to do. And those that do well have their investors rewarded. Those that play that game or do poorly generally have a stock that does not do well. So, I recognize that there could be gamesmanship in there, but like it or not, that is a task that management teams have to take on.
Benz: You laid out a long list of criteria that you use when looking at companies’ attributes you’re looking for as well as those that you want to avoid. It seems like that could be a super labor-intensive process. Can you talk about how you can accelerate that a little bit? Because it seems like it might take me a week to look at a company through all of those different criteria.
Feroldi: It certainly is. I’ve been analyzing businesses for almost 20 years now. So, I can take a company through check work and through this framework, depending on my level of knowledge ahead of time in about an hour, hour-and-a-half, something like that. If it was your first time doing this, it would probably take you 20 hours because you don’t know how to look up the information. You don’t know how to interpret the results. And moreover, this is a process that I think works best for me. But as I said at the start of the show, if the idea of going through a framework like this or developing a checklist for yourself sounds overwhelming and sounds like something you just don’t want to do, no problem. Put most of your capital, if not all of your capital, into broad-based index funds and call it a day. Individual stock ownership is not for you. Or if you do want to dabble in individual stocks and you just want to hold, say, one, two, or three companies that really excite you, again, no problem. Put 90% of your capital into index funds and take a small portion of your capital and use that to build out that process for yourself. There’s no harm in taking a small bit of your portfolio and using it to risk and learn about individual stock investing. You will learn a lot about yourself once you have capital on the line. But how much time you devote to the process totally depends on what fits your personality. So, if this sounds like an overwhelming amount of work, there’s absolutely no shame, no problem at all with just using index funds and calling it a day.
Arnott: You mentioned that some of your biggest personal mistakes have been selling too early. But what role do you think valuation should play in the process for buying individual stocks? And are there certain valuation metrics that you like to look at?
Feroldi: Valuation is a really tricky thing for investors to understand and to wrap their heads around. Moreover, if you just think through what has happened at the geopolitical level or broadly speaking, at the very macro level in the United States over the last 20 years, interest rates have a big impact on the way that stocks are valued in this way that stocks should be valued. From 2009 all the way up until pretty much 2022, interest rates in the United States were effectively zero. And when the cost of borrowing is effectively zero, that can really warp the way that stocks should be valued. So, for me personally, from the period of 2009 until 2022, the lesson that the market taught investors was to de-emphasize valuation. And when the interest rates were set at zero, that lesson came through loud and clear where the thing that mattered most was quality of the business and growth of earnings, and the valuation you paid mattered less.
Now that we’re in a more normalized—and I put that in an air quotes, “normalized”—interest-rate environment, interest rates have returned to near the historic norms, valuation has retaken its role as being a very important thing that investors should pay attention to. So, for many years, valuation was de-emphasized as part of my investing process. Now with interest rates normalized, it is more emphasized. And when it comes to valuing businesses, one of the biggest mistakes that I made historically was I didn’t use the right valuation metric at the right time. So, companies go through different phases in their growth cycle. There’s an early startup phase, there’s a high-growth phase, there’s a shareholder-return phase, and there’s a decline phase. And which valuation method you should use depends heavily on which stage the company is currently in. So, if a company is big and mature in the shareholder-return phase, it’s got a wide moat, I think very common valuation metrics, such as price/earnings ratio, price/free cash flow ratio—those metrics make a lot of sense for valuing companies in that stage. However, if a company is earlier in its development, you have to use very different metrics such as the price/sales ratio or the enterprise value/total addressable market ratio, or other simplified metrics simply because the company isn’t yet optimized for earnings. So again, a big mistake that I made early in my investing career, I didn’t understand that you should use different valuation tools at different times, but now I do.
Benz: We have a lot more questions about valuation and you’ve written a lot about valuation, but I wanted to follow up on your comment about interest rates and their role in all of this. When growth stocks fell in 2022, that slide was widely ascribed to rising rates and the implications for growth companies’ distant cash flows. But more recently, some market watchers have argued that value companies, especially smaller companies, are more vulnerable to rising rates because they tend to be more highly leveraged, so they are most affected by higher rates. So, which of these narratives is correct when thinking about the role of interest rates in affecting stock market returns?
Feroldi: That’s an interesting question. And it’s generally a very tricky question. I think that both narratives do have elements of truth to them. If you think about companies that do have a lot of debt on their balance sheet that are very highly leveraged, in other words, those companies are clearly paying interest—they take a portion of their operating income and they use it to pay off the interest that they have. Well, the higher interest rates go, the more that debt becomes a burden on those companies’ earnings because they have to use a bigger and bigger portion of their operating income simply to cover their interest payments. So, it makes sense to me that rising interest rates would really hurt those companies that aren’t very highly levered simply because their cost of capital was going up so dramatically.
On the flip side, when you think about very high-growth companies, companies that are, like say, in the software-as-a-service space, growing 50% per year, a lot of those companies are valued very, very highly and a big portion of their current value is on the assumption that their growth will continue into the future and that a lot of their cash flows that they’re going to be generating are five, 10, 15 years out. So as interest rate rise, that causes the discount rate on those future cash flows to be raised. That in turn dramatically impacts the current price that investors should pay for those stocks given that the discount rate on those future cash flows has gone up. So, I would argue that rising interest rates has hit both companies, very highly valued stocks that have their future cash flows in the future, and companies that have high debt levels both equally. So, it makes sense to me that both categories have seen their share prices decline given interest rates have gone higher.
Arnott: Sticking with the theme of valuation, you recently made the case that Nvidia, in your opinion, isn’t terribly overvalued, although you’ve also conceded the stock might not be cheap either. Can you run us through some of the key metrics that you would look at to make that assessment?
Feroldi: What has happened to Nvidia over the last two years has been nothing short of remarkable. I can’t remember the last time that a company that was already big—and Nvidia had a market cap that was like over $100 billion—then went to dramatically, dramatically grow its revenue, its margins, and its profits so much that its stock price has just exploded. And meanwhile, the valuation on a trailing basis does look insanely expensive. However, if in the denominator of your multiples, you look at the forward price/earnings ratio for Nvidia, which incorporates that growth, that extreme growth into it, Nvidia might not be as expensive as it first appears on paper. So, this is why valuation can be so tricky and can trip up so many investors because many people, myself included, are taught from the get-go that price/earnings ratio is the ultimate measure of valuing a business. And if you look at Nvidia’s price/earnings ratio, just last year, it was over 100, even over 200, at some points during the year. And there’s no way that a rational person would look at that price/earnings ratio on a trailing basis over 200 and say, well, this stock is a buy. That just defies conventional thinking.
However, if you bought Nvidia stock, even at those very high price/earnings ratio, you have earned multiples on your initial investment. The reason is the E, the earnings in that equation for Nvidia, has gone up far more on a percentage basis than the stock price has. This is a great example about why valuing companies can be so tricky and why using traditional valuation metrics, such as the price/earnings ratio, really has a ton of nuance to it. Because it’s not just the price/earnings ratio in absolute terms that you can use to determine if a company is cheap or expensive. It is the direction and magnitude of the increase or change in the company’s earnings that dictates where a stock price can head. So sometimes stocks can go up, their price can increase, and their valuation can be lower in the future simply because their earnings have gone up more.
The inverse is also true. Sometimes stocks can fall 50% and their stocks can be more expensive if their earnings are falling by more than 50% during that time. So, valuation is tricky in general, but valuing hypergrowth companies like Nvidia is particularly tricky, especially since the big question on investors’ mind, or at least mine is, is Nvidia’s earnings growth sustainable? Or are they riding a one-time boom that will inevitably result in a bust? I don’t know the answer to that question, which is why I’m not an Nvidia shareholder. But the point of this is, if you look beyond the traditional valuation metrics, Nvidia might not be as insanely priced as you think it is.
Benz: Speaking of Nvidia, it’s kind of the mother of all growth stocks, and growth stocks have outperformed value for an extended period, leaving some to question whether value-style investing is somehow fundamentally broken. What’s your take on that question, on the fact that we’ve had this narrow subset of winners and everything else has not been performing nearly so well?
Feroldi: I’ve been investing for 20 years, and during that time, I have seen investing styles and investing ideas go in and out of fashion. And if you look actually back at the data, even on a more historic basis, this seems to happen even at the macro level. So, during periods where US stocks have underperformed, international stocks have oftentimes shined through. And there’s also been periods where growth stocks have outperformed, and value has been left behind. And the inverse has also been true.
If you just think about broadly what’s happened in the United States over the last 14 years, the place to be, the number-one place to invest pretty much in the world has been large-cap US stocks. Those stocks have rewarded investors hugely, both from a valuation perspective, but more importantly from an earnings perspective. The earnings and the profits of the “Magnificent Seven” have just grown tremendously over the last 10 years and their stock prices have grown alongside them. And small-cap companies and value companies have largely been left behind. My hunch is that there will come a point when that does reverse itself, when big-cap companies or mega-cap companies start to actually trade at a discount to the market as investor sentiment leaves them and that value stocks might have their time in the sun again.
But trying to figure out when that switch occurs, boy is that tricky. And it’s been brutal if you’ve been a value investor over the last 10-plus years because you have likely dramatically underperformed the S&P 500 over that time. This is why there’s that great saying the market can stay irrational longer than you can stay solvent. Can you imagine being a small-cap value money manager over the last 15 years and trying to tell your investors, “Yes, invest with us. Yes, we’ve underperformed for 15 years, but that turnaround is on the horizon.” This is why investing by style can just be so brutally hard.
Arnott: Looking at the investment landscape more broadly, there are a lot of people now looking at yields on cash and other cashlike assets and saying, if I can get 5% in a money market fund or a three-month Treasury with no risk and still stay ahead of inflation, that looks pretty good. Do you think that people are overinvested in cash at this point?
Feroldi: That is a good question. For the first time in 15 years, actually holding cash has not had as big of an opportunity cost as it does today. My personal brokerage account is paying me like 4% or 5% interest rate on holding my cash, whereas previously it was paying me like 0%. So yeah, just holding cash is not as painful as it used to be. However, the key question for any investor to ask before they make any investment is, when do I need this money to pay off? When do I need this investment to deliver me with the returns that I need it to? If the answer to that question is 10-plus years, even with cash rates at 4%, the most likely place that you’re going to earn a good return is still going to be in broad-based index funds and in the US stock market. That’s what history says.
If you need those capital in five years or less, you are better off keeping that money in cash or in fixed income, which has a very high chance of you returning your capital back to you, plus with some slight increase in purchasing power over that time. So, to me, while cash is a more attractive place to keep capital now than it has been in the past, if you want to grow your capital over the long term and really have a good chance of beating inflation and you can hold for 10-plus years, to me the stock market is still the place that you should put your capital regardless of where current interest rates are.
Benz: When you think of the current market environment and how investors are dealing with risk or thinking about risk today, what are some of the main pitfalls that you think investors could be running into when you’re observing other investors’ behavior in this kind of market environment?
Feroldi: Well, this gets into all of the general ways that investors can be their own worst enemies. Investing is more of a game where you’re competing against your own emotions than you are competing against the market. It is perfectly natural for humans to look at what other people are doing and feel some kind of emotion toward them. If you see somebody else making a ton of money in cryptocurrencies or in SaaS stocks or in AI stocks, it is natural for you to feel jealous, to feel left out, and to want to put your money into that even though you’ve already missed the huge runup. So, FOMO is a very real thing that a lot of investors do fall prey to.
The best way that investors can fight back against those natural tendencies is when they are in a calm, rational, and emotionless state to write down investing rules for themselves, to create an investor policy statement, and to write out what are you investing for? How are you going to invest that money? How are you going to ensure that your head stays on straight when market prices are going against you? How are you going to make sure that you make smart decisions when some part of the market seems like it’s making everybody millionaires and you are missing out? Really taking the time to think through questions like that when you’re in a calm, rational state can do wonders for you to keep your head on when market prices are going crazy. So, I think it was Aswath Damodaran that said it best: The most important investor to study isn’t Buffett or Munger or Seth Klarman. The most important investor to study thoroughly is yourself.
Arnott: We’ve also heard from a lot of investors currently, and they’re very worried about market volatility with the presidential election and geopolitical uncertainty, things like that. Do you think that those external factors are worth taking into account in any way, or should investors just try to tune out that daily news flow?
Feroldi: It can be really hard to tune out the daily news flow, especially when it comes to big political events that are predictable, such as elections. We certainly have a heated election that is likely to happen in the United States right now. But one thing that every investor should do, or that always helps me at the very least, is to pull up a long-term chart of the S&P 500 and color code it by president. There are actually some beautiful pictures of this online. What you can clearly see is that the market tends to do its thing, aka go up over time, regardless of who is in the White House and regardless of what political party is in charge of the country.
So, when it comes to politics, you can have as passionate views as you want from a citizen’s perspective and from a voting perspective, but you should do your best to keep politics out of your investments. The long-term trajectory of the United States and of the United States’ stock market has a very high likelihood of continuing being up and to the right, regardless of what political party is in power. So that’s very easy to say in a calm, rational state, but tuning out that noise in real time when you’re just exposed to it day to day, boy, can that be hard to do.
Benz: You have argued that for individual investors, one of the only ways that they have an edge versus professional investors is with their time horizons, that they are able to maintain longer time horizons than professional money managers might be able to. So, can you talk about that, how that might be the key competitive advantage that individual investors have?
Feroldi: I would even go further to say it’s the only competitive advantage that individual investors have, but boy, is it a powerful competitive advantage. The biggest edge that individuals have is that they are managing their own capital. They have no principal agent risk to worry about. They’re not going to fire themselves if they underperform over a month or a quarter. They have nobody that they need to explain their investing style to. They don’t need to constantly go out and market themselves saying, “invest with me, I have great returns.” They are truly in control of their decisions, and they can invest however they see fit.
The market by its very nature does not have those same attributes working for them. If you are managing somebody else’s money, you are making decisions based on what you think that other entity will approve of. That includes not only the type of investments that you’re making, but also the time frame that you are investing over. If you are a money manager, what you are constantly trying to do is prove to your investors and to potential investors that you are doing well now. And like it or not, many investors that buy stocks or buy stock funds judge those managers over the short term, over the performance that they had over the last quarter, the six-month period, or a year. If they’re unhappy with that performance over a very short-term time period, they can pull their money out and move it into other investments. Money managers know that. And if they want to attract assets, they have to play that game where they’re showing that they’re outperforming or at least keeping up with the market over the short term. So, they cannot, cannot, in many cases, invest in companies with a long-term mindset. You do not have those same limitations as an individual investor. So, you can truly look at a stock, figure out where the company will be in five or 10 years, buy it, and you have the capacity to hold that stock and let that thesis play out and let your company compound your money for you. So that might sound like a miniscule edge. Boy, is it huge, and every individual investor should do everything in their power to take full advantage of it.
Arnott: Are there certain areas that you think are more fruitful for individual stock investors? For example, should they be looking at smaller and midsized companies that might be not as well followed by Wall Street analysts?
Feroldi: Yeah, I’ll mimic Peter Lynch here and he says, buy what you know. Everybody that has a job knows some sector of the economy or some industry far better than even seasoned Wall Street investors do. So, you know which products or services are the best for your industry. You know as a consumer what products and services you enjoy. So, you should definitely start your research with companies where you have an edge, where you know the industries better than outside observers do. That could mean putting your money into smaller companies, like some investors advocate for investing in small caps or even micro-caps that are likely to be undiscovered, that are likely to be uncovered by Wall Street. That is certainly one strategy that you can pursue.
Another is to look to the big companies that you think you know well and simply invest in them with a different time horizon than the rest of the market. For example, it didn’t take a genius to figure out that the iPhone was doing pretty well way back in 2015. It had been on the market for seven years. They’ve come to selling hundreds of millions of them per year. And yet if you bought Apple stock seven years after the iPhone came out, when it was readily apparent and millions of people had them around the world, you still could have made multiples on multiples of your money in Apple simply by identifying that company and holding it. So, I don’t think that investors have to look in micro-caps or small-cap spaces to find undiscovered stocks in order to do very well. I think you can do that with large caps so long as you invest with a differentiated time horizon than the rest of the market.
Benz: Warren Buffett has been a huge influence on the way that you think about investing and talk to other investors about investing. When did you discover Buffett and what have been his key contributions to how you think about investing in companies?
Feroldi: I think at some point everybody that researches individual stocks eventually stumbles into Warren Buffett and how he thinks. So, I first discovered Buffett way back in like 2005 or 2006 when somebody wrote about him in a book that I was reading. He said, “This guy Warren Buffett, he’s worth like, I don’t know, $50 billion, $100 billion, something like that.” And that was the first time I ever heard that name before. That led me to research him. And when you Google the name Warren Buffett, an explosion of results come at you. There are books about him. You can of course read his wonderful shareholder letters. There are even videos now that you can watch of him at Berkshire Hathaway meetings. But he is somebody that every investor, regardless of your current investing style, should totally take the time to watch.
For me, the biggest things that I’ve learned from Buffett are about the importance of business fundamentals. How looking at a company’s income statement, balance sheet, and cash flow statement really dictate how well the company does over the long term, how you should own those companies and think like an owner, operator, how to tell good companies apart from bad ones—good companies being companies that require very little capital and throw off lots of cash; bad companies being those that require a huge amount of capital and are consumers of capital and never have any cash. I’ve learned about mental models and valuation from Buffett. So, it’s kind of unbelievable the amount of lessons that I’ve learned, even though I’m primarily a growth investor from Warren Buffett. So, he is an investor that every investor should study thoroughly.
Arnott: There’s also been some research. There’s a professor at Arizona State University, Hendrik Bessembinder, who found that about 57% of US stocks actually underperformed T-bills over a longer time period. So, thinking about a statistic like that, do you think that the deck is kind of stacked against an individual investor who wants to try to emulate Buffett or try to choose the best stocks?
Feroldi: I think the odds are stacked against any individual company, period. I’ve seen similar studies that actually show that 66%, roughly two out of every three stocks, underperform their benchmark over time, which means that, if you flip that around, only about one in three stocks that are out there will outperform their benchmark. And moreover, if you think about the companies that drive the lion’s share of the index’s return, so 80%-plus of the index’s return, they are only about 7% of stocks that are out there.
Larning that was actually pretty revolutionary for me, because prior to learning that statistic, I thought if a company beat the market or lost to the market, it was basically a coin flip, like a good company, a bad company. It turns out that Pareto’s law, the 80/20 principle, is actually in full display in here. So, if you are going to buy individual stocks, knowing that general framework for yourself is very important. And this is why so many investors, myself included, recommend having at least 10 stocks in your portfolio, if not 20. And then when you’re analyzing the performance of those—let’s say you have 20 stocks in there—what you can expect is you make 20 investments, about 10 to 15 of them will actually lose you money in real terms. Either the stocks will go down or those stocks will underperform the index. Another three or four will keep up with the index or even slightly beat it. But of those 20, you can expect one or two to be such mega winners that they drive the lion’s share of the gains of your portfolio.
I experienced that myself when I look back at my portfolio and I own companies like Netflix and Nvidia and Mercado Libre and Tesla and those companies—the gains that I had from those companies, dwarfed the gains that I had in my 10th investment and beyond when combined. I thought that I just got lucky by buying those stocks and I just bought a fluke business that went up, but when you actually dive into the data and look at index funds, that’s how the market works. A minority of companies drive the majority of the results of the index in general, which is why index investing works so well. While you are guaranteed to get all the losers, if you index invest, you’re guaranteed to get all those mega winners as well. So, I don’t think individual investors have the numbers stacked against them anymore than professional money managers do, but I think it’s incredibly important that you know what the odds are of making an investment before you make the investment. That will humble you a little bit and hopefully convince you to diversify more than you naturally would.
Benz: For our last question, I wanted to ask about Charlie Munger. You wrote a tribute to him after he passed away late in 2023. I’m wondering if you can talk about some of the main lessons you learned from him and also whether you ever had the chance to meet him?
Feroldi: I sadly have never gotten the chance to meet him. Boy, that would have been an absolute treat. But when I think about Charlie Munger, he’s probably one of the wisest people I’ve ever come across. Not only was he a fabulous investor, I just think he was a fabulous human being. And while Warren Buffett is the person you should study if you want to become a better investor, Charlie Munger is the person you should study if you want to become a better human.
The most important thing that I ever learned from Charlie Munger was this talk that he did, I want to say 20 years ago, maybe 30 years at this point, called The Psychology of Human Misjudgment. And that was the first time when I heard that talk that he went through many of the mental models and the logical fallacies that go on in the human brain that cause us to make bad decisions. For example, taking our cues from other people or doing mental math to make investing decisions. When I listened to that talk and I talked about those misjudgments, every single one I ticked off and was like, Yup, I’ve done that. Yup, I’ve done that. Yup, I’ve done that. And it’s really from studying Munger that I understand all the ways that your brain can work against you as an investor. So, of all the wonderful lessons that he has shared over the years, that’s the one that I think has stuck with me the most.
Benz: Well, Brian, as always, it’s so great to hear from you, to hear your insights, get your perspective on various things. Thank you so much for taking the time to be here today.
Feroldi: Amy and Christine, thank you so much for having me. I look forward to coming back again.
Arnott: Thanks, Brian.
Benz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
You can follow me on social media @Christine_Benz on X or at Christine Benz on LinkedIn.
Arnott: And at Amy Arnott on LinkedIn.
Benz: 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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