A ‘humble investor’ opines on asset allocation, factor investing, and the limits of forecasting.
Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes. Our guest this week is Daniel Rasmussen. He’s the founder and portfolio manager of Verdad Advisors, a hedge fund. Before starting Verdad, Dan worked at Bain Capital Private Equity and Bridgewater Associates. He’s a member of the investment committee of the trustees of donations of the Episcopal Church and he’s a contributor to The Wall Street Journal. Dan is author of the new book, The Humble Investor: How to find a winning edge in a surprising world. His earlier book was American Uprising: The Untold Story of America’s Largest Slave Revolt. Dan holds a bachelor’s from Harvard and an MBA from Stanford. Dan, thanks so much for joining us on The Long View.
The Humble Investor: How to find a winning edge in a surprising world
American Uprising: The Untold Story of America’s Largest Slave Revolt
“Waves in Ship Prices and Investment,” by Sam Hanson and Robin Greenwood, Quarterly Journal of Economics, February 2014.
Superforecasting: The Art and Science of Prediction, by Philip Tetlock
“Gaining Edge by Forecasting Volatility and Correlations,” by Dan Rasmussen, Chris Satterthwaite, and Lionel Smoler Schatz, verdadcap.com, Oct. 30, 2023.
“Where the Value Investing Strategy Still Works,” by Dan Rasmussen, ft.com, May 23, 2024.
“Factors from Scratch: A Look Back, and Forward, at How, When and Why Factors Work,” by Chris Meredith, Jesse Livermore, and Patrick O’Shaughnessy, osam.com, May 2018.
“The Size Factor: Small Caps Are Trading at the Steepest Discount to Large Caps in Decades,” by Dan Rasmussen and Brian Chingono, verdadcap.com, Aug. 22, 2022.
“The Small Cap Amplifier,” by Dan Rasmussen and Brian Chingono, verdadcap.com, Oct. 21, 2024.
“Explaining International Valuations,” by Dan Rasmussen, verdadcap.com, Jan. 27, 2025.
“The ‘Fool’s Yield’ of Private Credit,” by Jamie Powell, ft.com, Jan. 28, 2020.
“Sizing Private Equity Allocations,” by Dan Rasmussen, verdadcap.com, May 13, 2024.
“The Best Macro Indicator: Why You Should Be Following High-Yield Spreads,” by Dan Rasmussen, verdadcap.com, May 17, 2021.
“Crisis Investing in Europe: The Unlikely Winners in the Most Difficult Times,” by Dan Rasmussen and Brian Chingono, verdadcap.com, May 16, 2022.
“EM Crisis Investing, A Deeper Dive: Understanding the Factors at Play in Emerging Markets,” by Verdad Research, verdadcap.com, May 3, 2022.
(Please stay tuned for important disclosure information at the conclusion of this episode.)
Dan Lefkovitz: Hi and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes. Our guest this week is Daniel Rasmussen. He’s the founder and portfolio manager of Verdad Advisors, a hedge fund. Before starting Verdad, Dan worked at Bain Capital Private Equity and Bridgewater Associates. He’s a member of the investment committee of the trustees of donations of the Episcopal Church and he’s a contributor to The Wall Street Journal. Dan is author of the new book, The Humble Investor: How to find a winning edge in a surprising world. His earlier book was American Uprising: The Untold Story of America’s Largest Slave Revolt. Dan holds a bachelor’s from Harvard and an MBA from Stanford. Dan, thanks so much for joining us on The Long View.
Daniel Rasmussen: My pleasure. Thanks for having me on.
Lefkovitz: Absolutely. So I wanted to kick off by asking you a little bit about your background. You have somewhat unusual academic background for a hedge fund manager. You studied history and literature. Maybe you can explain how you got into investment management.
Rasmussen: The short answer is I needed a job. The longer answer though is that I think what attracted me to investing is twofold. I think first, investing is a chance to bet on ideas. And I always had my head in a book. I loved the world of ideas. I loved learning. And investing seemed like a career where you just got to come up with ideas and if they were right, you made money. And if you were wrong, you lost money. But it seemed so intellectually honest and interesting. And second, as a historian or a study of history, I liked the idea that in some sense, the only thing you can draw on in making investment decisions is the past. You’re studying the past to try to make real-world decisions.
And if you think about the pitch of being a history major, it’s always that there’s something to learn from. You go study the American Revolution, not just because it’s an esoteric interest, but in some sense, it might inform you about how to act in the future, about how our country should be run. And in that sense, I loved the idea that in investing, you’re studying the past to derive the lessons that you could learn to make better decisions to be a better investor in the future. And if those lessons were right, if you were a good historian, you could profit more than others. And I love that idea. And I think that’s what got me really excited about going into investing after college, even though I was coming from a history background, not an economics or accounting one.
Lefkovitz: And I see you worked at Bridgewater and in private equity, and we’ll talk a little bit about your views on private equity later. But Bridgewater, many will be familiar with, macro hedge fund. Can you talk a little bit about your experiences there and what you took away from it?
Rasmussen: I interned at Bridgewater in college. That was my first introduction to investing. And I loved it. And Bridgewater plays such a big emphasis on long studies of history. It was a very academic place. In some sense, it was like a highly, highly paid think tank with a lot of accountability for that the ideas were good or bad. And I loved that atmosphere and that way of thinking about the world. And that sort of got me hooked on investing.
Lefkovitz: OK. And maybe talk a little bit about the hedge fund that you run today, Verdad. First of all, how did you name it? What does it mean? And what does it do?
Rasmussen: We manage a little over $1 billion. We have a variety of different strategies. We do microcap deep value internationally. We do a lot in Japan, betting a lot on corporate governance reform there. We do a lot of high-yield credit. We have a crisis investing strategy where we have a strategy for what to do when the world blows up. So one problem with bubbles, as you never know when you’re in one, but you always know when you’re in a crisis. So we work with our clients to prepare for that and to figure out what to do when the crisis strikes. And then our final, our newest product is a market-neutral multistrategy, multi-asset fund that probably looks more similar to a Bridgewater-type thing than to a private equity-type vehicle.
Lefkovitz: And the name Verdad, how did you come up with it?
Rasmussen: It’s funny. Naming a hedge fund is very hard because every possible name that you can think of is taken, every combination of a color and a rock or a body of water or a different vacation spot on the island of Nantucket has been taken 10 years ago. So I think it was probably my 100th choice, but Verdad is truth in Spanish. So I don’t know how that ended up on the list, but it was the first of about 50 that I tried that worked. And so we’re off to the races with it.
Lefkovitz: And we’ll talk about your book, The Humble Investor in a second, but I wanted to ask you about your previous book, American Uprising: The Untold Story of America’s Largest Slave Revolt. How did writing that book come about?
Rasmussen: So this was my junior paper and then my senior thesis at Harvard. I was very interested in early American history from the founding to the Civil War. And this was a fascinating story. It’s the largest slave revolt in American history. It happened in New Orleans in 1811, but very, very little had been written about it in part because New Orleans was sort of the fringes of America. It was French. It was Spanish. It was only very recently American at the time, and very much on the periphery. So very little attention was paid in Washington, which is how the story got lost. But the story of it was incredible. About 500 slaves rose up in the plantations outside of New Orleans, and they marched into the city to try to overthrow it. A reminder of what had happened in the Haitian Revolution. They were defeated. They were either put on trial or executed without trial. And then their heads were chopped off and they were put on poles that lined the river, Mississippi River, for miles outside of the city. So it was a really brutal moment in American history, but a fascinating story of resistance to slavery.
Lefkovitz: So interesting. Not many people publish their undergrad thesis. So that’s a real credit to you. I think that’s the first time that slave revolts have been discussed on this podcast.
Rasmussen: Trying to keep things interesting.
Lefkovitz: Yes, yes. And it’s one of the reasons you’re on. So we’ll turn to your most recent book, which I thought was really, really interesting, very well written. Well, maybe you can talk a little bit about what’s behind the title. Why do you think humility is such an important trait for investors?
Rasmussen: I’ll tell two stories that I think are so relevant to thinking about humility in the context of investing. The first is the story of Greek shipowners. My colleague here, Sam Hanson, wrote a beautiful paper about Greek shipowners. And what it turns out is that when shipping prices are very high and profits are big in the shipping industry, Greek shipping companies go out and order new ships at the South Korean and Japanese shipyards and Chinese shipyards. And the reason they do so is that the IRR on those ships looks very high. They take current profits and the cost to build a ship, and you do the math, and you say, holy smokes, I should build a bunch of new ships. This is a great market. The problem is that it takes two or three years for the ships to get built. And when the ships get built, the ships arrive and all of a sudden shipping prices drop. And all of a sudden, those ships are looking very unprofitable. And there’s a downcycle in the shipping market. And the reason for that, they call it competition neglect. And the idea of competition neglect is that all of the Greek shipowners are thinking only of themselves. They’re thinking, I see high profits, I’m going to order new ships. And they don’t anticipate that all of their peers, all of their competitors are seeing the same high profits and are also ordering ships.
And so at that very time, when the ships arrive, there’s always a glut of new ships that drives the prices down. That’s competition neglect. And I think investing, if you think of Fama’s brilliant idea of efficient-market hypothesis, the efficient-market hypothesis is a wonderful way to think about competition neglect. We’re always thinking about our analysis. So I think the market’s doing this or I like the stock for that reason. But we’re so rarely thinking, do other people like it for the same reason, or do other people of the same view? So one of my favorite mottos about investing is that investing is not a game of analysis. It’s a game of meta-analysis. You can’t neglect your competition. You have to be holding efficient-markets hypothesis in your mind and considering how your actions are influenced by the same ideas that everyone else’s actions are influenced by. And if that’s the case, how are your results going to be surprising by virtue of your competitors’ actions?
And I think the second story, in addition to my Greek shipping story, goes back to World War II. Ken Arrow was the youngest economist to win the Nobel Prize, and he was in the weather service during World War II. And he was tasked with putting together long-range weather forecasts for the military. And after looking and spending some time on these long-range weather forecasts, he found that these forecasts were terrible, that the weather service had no ability to predict whether it was going to rain a month from now. And so he wrote a memo to his superior officer saying, these forecasts are crazy. We should just use an almanac or some long-term average rather than having us make these silly forecasts. And he received a telegraph from his commanding officer, and it said the commanding officer knows that the forecasts are crap, but he needs them for planning purposes. And I think there’s a wonderful lesson in there because even as we admit that the future is very hard to predict, that it’s hard to know, that we need to be humble. We need to not neglect our competition. We need to embrace efficient-markets theory. At the same time, we also have a need for plans.
We have a need for planning. For example, you can say, market-timing is a bad thing. But on the other hand, we all know that when you get your paycheck, when you get some new lump sum to invest, or you have to take money out of the market, you’re in some sense making a timing decision in the sense that you’re having to then decide, well, which of my investments are the best or the worst, or how should I add to them or subtract from them? And no one keeps their investments constant for very, very long periods of time, although they should. And so what we need to think about in that context is not just competition neglect. We can’t neglect our competition. We can’t neglect being cognizant of the efficient-market hypothesis. And we also can’t neglect the idea that forecasting is very difficult. And yet at the same time, we need to find a way to deal with uncertainty and to plan for the future.
Lefkovitz: Yeah. And you make the point that there are certain things that are easier to forecast than others. What are some of the things that you determine are unforecastable, are just not worth the effort? And what have you determined is easier to forecast?
Rasmussen: So, I think the way to evaluate. So, first, Philip Tetlock is a famous scholar who was publishing his original work around the time I graduated from college and entered the workforce. So now his ideas are probably familiar to many of your listeners. And his idea was that he wanted to test how good people were at forecasting. And so he ran these huge experiments where he’d give people in all different fields the challenges to forecast events—will the Soviet Union dissolve next year and so on. And then he compared the forecast to the actual results. And what it turned out is that first of all, the forecasts were pretty close to random chance. So, people just weren’t very good at forecasting generally. But even more striking, expertise in a field did not make someone better at predicting it. In fact, it only made them more confident, but not more accurate, which is doubly bad. And he went further than that though, and said, well, what’s the definition of a good forecast? How do you approach that?
And what he came to is this idea of base rates, that you should look at the historical probabilities. And if you say, take an analogous situation—so if you’re thinking about, say is the US going to go to war next year, you might take all the years in which the United States had existed, subset to the years when it wasn’t at war, and then said of those years, how many years did it go to war? And that would be your probability. And often that method comes to very different assumptions. You might use that method and come to the number like 4% or something like that.
Where, on the other hand, if you said, well, is the US going to go to war, you’d immediately think, well, Taiwan could get invaded, or Russia could attack. And you’d come up with all these salient examples and come up with a number much, much higher than what base rates would imply. And so what you’re looking for is to try to identify, use base rates and then identify places where base rates are predictive of outcomes and where you can develop a model that has some level of predictive accuracy. And so, one area which, for example, is completely unforecastable, obviously, is the direction of the equity market. It’s impossible to know whether the S&P is going to go up or down next month, or what the percentage return is going to be on the equity market as a whole. It’s just impossible. And it should be intuitively obvious that it’s impossible. Nobody can do it.
And so we shouldn’t even try. And I think if the efficient-markets hypothesis holds, predicting returns should be next to impossible. Now, there’s been some revision in that and that certain factors do seem to predict returns in the cross-section of equities. And so, we know some things about returns. For example, we know that over the long term stocks have a higher average return than bonds, which have a higher return than cash. So we maybe can come up with long average forecasts that end up being OK. But predicting month-over-month or day-over-day variations is a near impossibility. On the other hand, if you think about volatility, how volatile is the market going to be next month? And it’s not intuitive why people should care about this, but I’ll get to that. How risky the market is going to be, that actually is quite predictable. So it turns out that last month’s volatility predicts next month’s volatility pretty well. And options markets’ price volatility, and that’s a pretty good prediction, too.
So we can actually know the volatility with some degree of accuracy one month out. And another very forecastable thing in markets is the correlation structure. So correlations change a lot. So for example, whether stocks and bonds are correlated or not, it’s a series that changes a lot. Sometimes stocks and bonds are positively correlated. Sometimes they’re negatively correlated. But you can predict their correlations with a fair degree of accuracy, even more than you can predict volatility. And so now you might be asking, why is that useful to me? As an investor, shouldn’t all I care about be returns? All I care about is returns. But actually, all you care about isn’t returns. Every investor also cares about volatility or correlations or should. And I’ll walk through the logic of why. So volatility, first we have this idea of Sharpe ratio, which is return divided by risk, essentially. And it turns out that volatility and the idea of a Sharpe ratio matters.
Higher-volatility assets produce something called volatility drag. If you have an asset that goes down 10 and then up 10, you then have $0.99 on the dollar. You’ve lost 1% because of that 10% volatility. If the asset went down 20 and then up 20, you’ve actually lost 4%. If it goes down 30 and up 30, you’ve lost 9%. So the more volatile your series is, your losses go up by the square of the volatility. So volatility is actually very detrimental to long-term returns. So if you think about taking two different asset classes or even take the US stock market and you say, OK, let’s assume I have no view on returns of the US stock market. I think the market’s going to return 70 basis points a month forever on average. That’s always going to be my assumption.
Well, a month in which it has a 10% annualized volatility is a distinctly better month to be invested than a month when it has a 20% annualized volatility. A Sharpe ratio is materially better. The risk to return is materially better and your volatility drag will be materially lower. If you then think about holding a portfolio because no one just owns one asset, we all own a mix of assets, the correlation structure starts to matter too. If you’re thinking about safe assets, you want to own a lot of equities, but you want to have some safe assets, some money that’s going to be negatively correlated when the equity market goes down, these are going to go up. During periods of inflation, bonds become highly positively correlated to stocks. And so you need another safe haven asset. The bonds aren’t going to work. You might need gold, and gold might turn out to be a very good safe haven asset when the stock/bond correlation goes high. So I think there’s ways in which you can use the more predictable things—volatility and correlations, for example—to make better portfolio decisions and deemphasize a focus purely on returns.
Lefkovitz: That’s really interesting. I wanted to go back to that concept of meta-analysis that you mentioned. So analyzing the forecasts that are embedded in markets, you talk about betting against hubris. Can you explain what you mean and how you go about doing this kind of meta-analysis?
Rasmussen: So the idea is that if the future is unpredictable and if it’s always unpredictable, and yet we know there’s a human need to plan and to make forecasts, how can we find a way to profit by betting against people’s hubris, betting that other people are going to try to make predictions in areas which are inherently unpredictable? And they’re going to be too confident that their forecasts are right. And I think that’s sort of my first meta-analytic approach for thinking about strategies that should work. And I think the most obvious strategy here when you think about that type of meta-analysis is value investing. Value investing, which means to buy stocks that have low prices and to short stocks or avoid stocks that are very high prices relative to their current fundamentals, because the valuation of each stock is pricing in a forecast. So the very expensive stocks are pricing in a very optimistic forecast that future cash flows are going to be much higher tomorrow than they are today, versus the stock people are most pessimistic about the trade at the lowest-valuation multiples tend to be stocks that people have very pessimistic observations. Future cash flows are going to be the same or negative growth relative to today.
And what that means is that there’s a wonderful paper by the folks over at O’Shaughnessy Asset Management called “Factors from Scratch” that show that when you put these things into motion, what you see is that you take a set of things that are very expensive and set of things that are very cheap. Over the next year, the very expensive things will actually grow faster and do better on a fundamental basis than the things that are very cheap. Nvidia will probably have higher growth next year than some tissue manufacturer or soda can manufacturer, some boring business like that that trades at very low multiples. But although they have better fundamentals, the expensive companies have better fundamentals one year out, those fundamentals often underperform the expectations that are embedded in the valuation multiple. And when you reset that a year from now after that one year of growth or one year of decline, the forecast for the following year or the following set of years, which is what then becomes the valuation multiple is often quite random.
Yes, we might have a view on 2025 growth, but do we have a view on 2026 growth? Or more importantly, do we have a view of what—at the end of 2025, our view of 2026 will be relative to what happened in 2025. You’re getting into these degrees of complexity that are so hard to anticipate, and so they end up unfolding randomly. And therefore, the expensive stocks, their valuation multiples come down, and the cheap stocks’ valuation multiples go up. And it turns out that that multiple change is bigger than the fundamental difference. And so value stocks end up doing better over the long term than growth stocks. It’s an arbitrage of betting against the hubris of other people’s predictions. There are other areas in which you can think about making those types of meta-analytic investment decisions, but value investing, I think, is the most obvious example of a place where you’re so clearly betting against the hubris embedded in other people’s growth forecasts.
Lefkovitz: I wonder, has the most recent period where value has underperformed growth, at least in the US, so badly, has that tested your faith at all in the factor?
Rasmussen: Yes. That’s why it’s called the humble investor instead of the arrogant investor. It’s because I’ve been a value investor through a horrid period for being a value investor. And so I think it’s taught me a few lessons about being too confident in your forecasts. So I think a few observations about the value factor. I think first, yes, value hasn’t worked in the US, but it’s worked fine internationally. And so if you’ve been a value investor in Japan or a value investor in Europe, you’ve actually done quite well relative to the market, even though in the US, actually, it’s been a horrible investing strategy. And so we have to explore the historical contingencies. Why is it that value investing hasn’t done well in the United States?
And I think the reality is that it’s because of historically unique and rare circumstances, which is that the US has been through an innovation wave, the likes of which has been seen only roughly every 50 years in this country, where these large-cap tech companies have so dramatically performed in terms of their fundamentals, such as to be in the top 1% of the historical sample in terms of growth rates of earnings and profits and revenues, and to have done that on such a massive scale that was unprecedented. And so that usual mean reversion where you say, well, gee, the things that people are optimistic about should underperform those optimistic forecasts. In fact, tech companies have outperformed those optimistic forecasts, they’ve done better than anybody thought they could have done, because nobody had really seen growth at this scale before. And that’s really what drove the success of the US stock market. And simultaneously, you’ve seen a rerating upward of those stocks. People, as they outperformed expectations, increased those expectations, so valuation multiples rose.
And then second, people were searching for the next Google or the next Meta or the next Microsoft. And so you had many of these small-cap growth companies, which normally is the worst place to be in the market, actually do quite well as people attempted to pick the winners. And so that’s been the dynamic that’s defined the US for a number of years, the dominance of these big growers. The question is, is that historically, those types of innovations, first, the rewards go to the innovators, and second, they go to the customers. And I think what my question is, is when will that transition occur, where the winners of this technology wave start to have essentially those results priced in, and the true winners become those who gain more from buying the technology than the builders did.
Lefkovitz: Interesting. And the size premium, you’re a fan of small caps or small-cap value, I should say?
Rasmussen: Yeah, I don’t have as much of a strong view on the size factor in the sense that, I don’t know that intrinsically, a company should do better because it’s smaller. I don’t think there’s necessarily a great rationale for that. I think you could make a risk-based argument that smaller companies are more likely to go bankrupt and more risky, and so they should command a return premium, perhaps. But I think what’s more interesting to me about small caps is that there are so many more small caps than large caps. In the US, there’s the S&P 500, and there’s the Russell 2000—there are almost four times as many small caps as there are large caps. And that’s true, and especially go abroad. International markets are just full of small and micro caps for a whole variety of reasons, and there are many fewer large caps.
And so what makes it interesting is if you’re looking for extremes, if you’re saying, hey, I want to own the cheapest 10% of companies, or I want to short the most expensive 10% of companies, almost all of those companies are going to be very small. And so I think that I like small caps, and I like investing in small and micro caps because they give you a way to make more extreme bets on the factors that you’re interested in betting on. If you think that you want to bet on areas of the market that are not followed by analysts that are more inefficient, of course you’re going to end up in small caps. You want to buy the cheapest companies while they’re out there, they’re all going to be in the small-cap line. You want to buy the highest-growth companies until recently, they were all in small caps. Now, of course, Nvidia obviously isn’t, but for every one Nvidia that’s growing up, those rates are probably five or six or seven or 10 small caps that have grown at the same rate over the past few years. And so I think that that’s what attracts me to the small- and micro-cap market.
The other thing that attracts me to it, frankly, is that I grew up in the Vanguard world. I graduated from college and passive was already taking a large amount of share. And so as I thought about active management, what should active management be? I sort of thought, if I’m going to build a business in active management, it has to be in areas of the market that Vanguard can’t or won’t compete. And so yes, Vanguard does small caps, but it’s going to be impossible for them or any index provider to do micro caps at scale because micro caps are sort of inherently too illiquid to be put into a large-capacity product. The same is followed in my attempt to build, say, crisis-investing strategies where market timing is a place where passive can’t necessarily do, or thinking about market-neutral hedge funds. This is another area where passive is not a threat in some sense. And so I’ve thought also about the business logic of what I’m trying to build, of having that meta-analytic approach, knowing my competition, knowing how hard it is to win and saying, let’s find areas that might be more inefficient or just simply be difficult for very large competitors or passive to compete in.
Lefkovitz: You also mentioned you’re a global investor. The US equity market has really been the place to be for over a decade now. Why have you maintained your conviction in global investing? I know you’re a little less interested in emerging markets.
Rasmussen: I think international investing has attracted me because, first, initially, because I’m a value investor and international markets have been cheaper than the US for the last few years when I’ve been building my firm and starting my career in investing. I’ve to understand the sources of that valuation difference. And so what I did is I took all the equity style factors and region and style factors like quality or profitability or growth or utilities and ran a regression that tried to predict valuation. And of course, that regression is pretty good. You can predict what a company is valued at by knowing its growth rate and its sector and its quality and profitability statistics. So you have a pretty high-powered regression.
And then I threw into that regression two additional variables. One was whether the company was listed in the United States. And second, what percentage of the company’s revenue was in the United States? And the share of a company’s revenue that’s in the United States is actually a slight negative in their regression, which is interesting. It’s not statistically significant, but it’s a slight negative. In other words, companies with higher percent of their revenue in the US tend to be cheaper than companies with a higher percent of their revenue abroad. One of the reasons for this is that globally diversified companies trade at premium. So companies like Meta or Nvidia or Microsoft are global businesses, whereas companies that have 100% share of their business in the United States tend to be smaller, less diversified, less interesting in some sense.
But the US listing was a massive, highly statistically significant boost to valuations, even controlling for all of these other factors. And that’s to me, in some sense, in a nutshell, why I’m interested in international stocks, because I think they’re irrationally undervalued, irrationally in the sense that it’s not justified by the fundamentals, any fundamentals I can think of. Yes, there’s some percentage of the gap. International structurally should probably trade at a 20% discount to the US. But it trades at a much bigger discount than that, and that’s almost all attributable to this listing dynamic. And that’s, I think, what’s gotten me excited about international investing. And I think this sort of relates to passive investing, which again is a wonderful thing and a big success for investors. But one of the negatives of passive investing is that most people, when they think about passive, they don’t think, the FTSE Mid-Cap Europe Index, they think, no, I’m going to put my money in either the S&P 500 or the Vanguard Total Market Index. And so they end up with an implicit big US bias. And I think that the liquidity that’s been driven by that into US markets has been one of the factors that’s kept US valuations higher than the rest of the world.
Lefkovitz: And EM, can you talk about your skepticism toward emerging markets?
Rasmussen: Yes. I think my skepticism toward emerging markets is, I spent a lot of time studying crises. It’s an area of deep interest to me. And one of the things that I would observe is that when developed markets go into crisis, they recover the vast majority of the time. We’re talking in the ‘90s. Certainly in the US, we’ve recovered from 100% of economic crises. You go to other markets like England, 100% recovery rate, and so on. But you start to go into the emerging markets. And you see not only do emerging markets have about four times as many crises as developed markets, but the probability of recovery is meaningfully lower. There are some emerging markets that elect the wrong government. That government seizes all assets. And the market essentially goes to zero and never recovers, which doesn’t happen in developed markets. And so my skepticism about emerging markets is simply that our ability to rely on the nonmarket rule of law and the guarantee of property rights is materially lower than developed markets. And that’s what gives me a lot of skepticism about being a long-run buy and hold investor in emerging markets. I think there are times when you want to load up on EM. There are certainly great opportunities in individual equities or certain time periods in emerging markets. But as a long-run buy and hold or as an asset allocation, those property rights questions and the risk, the much higher probability risk of a crisis and the higher probability given a crisis of a nonrecovery, are what make me quite worried about developing markets.
Lefkovitz: Well, I wanted to turn to private equity because I thought your views here were really interesting. You worked in the private equity space as an investor, but you write in your book that private equity is the single biggest mistake that investors are making in markets today. Could you explain what you mean?
Rasmussen: I think that one of the elements of meta-analysis is to look for correlated beliefs. What are places where everybody seems to agree, but where they might not be right, and where maybe logic and first principle suggests that they aren’t right. And private equity is a place where, if you think about the profit share of private equity companies, the share of the total aggregate profit created by private firms relative to publicly listed firms, they’re probably about 2% to 4% of the aggregate profit pool. Right now, private equity folks will always say, well, there are huge infinite number of private companies and very few public companies. And so the opportunity set is much bigger outside of the public markets. The problem with that is that the private companies are much, much, much smaller than public companies. And it takes, yes, there are thousands and thousands of dry cleaners, but add up all the dry cleaners in the world. You don’t even get to one Facebook.
So, the number of companies doesn’t matter. It’s the aggregate profit share. And that’s again, quite small. And private equity deals are micro caps generally. The median market cap is less than $200 million, about $180 million. And again, micro caps as a corner of the public equity market are tiny, tiny, tiny. Single-digit percentages. And yet you’re seeing very sophisticated investors—endowments, foundations, even pension funds—putting 40% of their money in private markets. This is a massive, massive overweight of micro-cap companies in their portfolios. So first of all, there’s a flood of money, an excessive amount of money relative to the opportunity set flowing into this space. The second part is around risk. If there’s one thing we know about really small companies is that they’re distinctly more risky, distinctly more risky than large companies. They’re more likely to go bankrupt. They’re less diversified. They’re more volatile. And the next thing that we know is that private equity deals are leveraged. They borrow a lot of money.
And so, you’re looking at leveraged companies, very leveraged companies that are very small. You’re looking at a very, very, very risky set of companies. And so to take 40% of your portfolio and put it in these very small, very leveraged, very risky companies is a very, very risky decision to do. Now, if you’re going to take that risky decision, you must have a view that private equity is going to somehow dramatically outperform public equity markets for you to take on this incremental risk. And by the way, incremental illiquidity. But I would argue that it’s unreasonable to have that assumption for a few reasons. I think one is that the valuations today in private equity are actually higher than public markets. It doesn’t always look like that from the statistics, but what the statistics that are quoted are often missing is that private equity reports pro forma numbers, pro forma, EBITDA. Pro forma EBITDA is often very different from GAAP if there was a GAAP concept of EBITDA, but the way public companies would calculate EBITDA. And so those adjustments are often about a third of the difference.
And so what you’re seeing is these very inflated valuations in private markets funded by massive amounts of borrowing from private credit. And with allocators putting huge percentages of their endowments or pension funds into this asset class. And by the way, they’re doing so at very high fees and with illiquidity. And so my view is that that’s the tremendous amount of correlated risk. Everybody’s doing it. Everybody’s doing it in way bigger proportion than the actual economic substance of what they’re investing in would justify all with the same correlated belief that private equity will outperform. And I think it’s not going to end well. Debt-fueled, illiquid asset over allocation rarely does. And this is, I think, one of the biggest risks that large, sophisticated investors face today.
Lefkovitz: What about the trend that so much capital formation is happening in private markets these days? We have all these unicorns that are staying private for so long. And so much of their growth is happening off of public markets. And so investors just to get exposure to the entire opportunity set need to include private markets.
Rasmussen: Yeah, again, it’s often pitched that way. But as a percentage of the actual amount of profits or even revenue in the economy, it’s very, very small. So yes, they’re salient examples. There are few of these companies that stay private for very long periods of time. But for every one of those, there are often unicorns that lose their horns or whatever that you don’t hear about that seemed like they were going to become massive winners that go bankrupt or whatever it might be. And those salient examples are often lost. And so I think that people have to be very, very wary of these illiquid asset classes and make the meta-analytic judgment of why is this opportunity so much better than public markets is to justify the fees and the illiquidity. And if your answer is that the markets are less efficient, well, I’m sorry, if everybody’s putting 40% of their money into this, it’s not inefficient. Or if your argument is that private equity operators improve the companies they own, well, 40 or 50% of deals are sponsor to sponsor. So if BlackRock didn’t and Blackstone didn’t improve it, when KKR buys it from them, they’re going to improve it again.
How could this kind of constant improvement be some constant edge for the asset class? I think a lot of these stories are concealing the realities that this is leveraged microcap and technology these days. It’s very heavily technology focused, leveraged microcap tech investing in an asset class that has seen massive inflows. And by the way, those inflows seem to have stopped all the tailwinds from the increased fundraising, at least for now, seem on pause. And what you’re seeing is that it’s also very, very hard to exit. These companies are having a lot of trouble selling their portfolio companies, in fact, and probably because they’re not getting the valuations they want from them. Or the public markets don’t like companies that are 8x leveraged or whatever these companies are. And so all those, I think, point to a moment where private equity, probably since the financial crisis has been roughly equal to the S&P 500’s returns over the last two or three years, however, you’ve started to see the S&P have higher returns on private equity.
And so therefore those endowments that chose not to have large private allocations have been doing better. And so you’ll start to see people wondering why did I take on this illiquidity risk? Why am I paying these fees for something that’s not outperforming the public equity markets? And when the fund inflows turn to fund outflows, everything in financial markets is recursive. It’s going to have a very negative impact on the asset class.
Lefkovitz: And you mentioned private credit. This is a really hot asset class these days, but you call private credit fools’ yield. Why do you characterize it that way?
Rasmussen: So markets are efficient. We need to have a healthy respect for efficient markets. And so you have to ask yourself, what are yield’s price? So, why do Treasuries have a 4% yield and private credit has a 10% or 12% yield? What’s the reason? And the reason is that the only thing that incremental yield can be pricing is bankruptcy risk, the risk of nonrepayment. And so private credit is making an interesting marketing pitch. They’re saying, on the one hand, we earn higher yields. And then on the other hand, they’re saying, but default risk is very low. We’re going to say, well, if default risk was very low, why wouldn’t you lend money at 5% instead of 12%? Surely these borrowers, if they were so high quality, and so unlikely to default, could access capital markets at much lower yields. Because the only thing really that yield can be pricing is default risk. And I think that what I would argue is that yields are actually a very efficient way of pricing default risk, that lending markets have been around as long as humans have been around.
There are wonderful series, like Moody’s has great, great, great lending data back to like the 1920s, where you can see the default rates of all different companies by every different statistic. So the idea that pricing the yield at which you should lend to a company is a new field, or that there’s been innovations, is probably hubris. And rather, we should have a healthy respect that most likely yields are efficiently pricing default rates. And what we’ve actually found by looking over the last, call it 30 years of market history, is that yields are not returns. Returns are yields minus default rates. What you’ve seen is that as you go from AAA, Treasuries up to about BB bonds, sort of a fallen angel range, where a company like Ford, for example, today might sit. As yields go up, returns also go up. So realized returns are higher for BBB corporates than for US treasuries over long periods of time. You’re earning some incremental risk by taking on corporate credit risk, which makes sense.
But after about that BB point, yields go up and returns go down, because essentially, people don’t really have as good of a handle, 25% yield. It’s very hard to price the default risk. You’re just sort of saying, well, it’s a really high default risk. So I really need a really high yield. But it ends up being that most often the default rates exceed that money. And part of it is people are just attracted to high yields. They think they’re going to earn it, which is why I call it fool’s yield. And there are enough idiots that are willing to lend at that rate that it pulls down the end total returns. And you can see this across so many wonderful examples like lending club, where people were lending at 25% yields and earning 5% results, where they could have lent at 5.5% to GM and earned 5.5% back, rather than lending at 25 and getting a 5% return.
And so I think what the problem with private credit, is that I think it’s a classic case of fool’s yield. These are risky borrowers. You just haven’t realized the risk yet. And when you do, you’re going to do it all at the same time, which is what happens in default cycles. And you’re going to realize why all of these companies had to borrow at 12%. The sort of a Venn diagram of high-quality companies that are never going to go bankrupt and companies that have to borrow at 12% is virtually nonexistent. And that’s because again, lending is such an inefficient market. And of course, the private credit folks are telling you this themselves in some sense. They’re saying, well, the banks thought this was too risky. And I sort of say, well, if the banks thought it was too risky, it’s not like those guys at Goldman are shrinking away from great profit opportunities. There must have been reason they thought it was too risky and most likely it’s that the banks had been around for a few cycles and private credit really emerged after the big financial crisis.
Lefkovitz: You mentioned the level and trend of high-yield spreads as a predictive tool. Can you talk about how you came to discover that and exactly how you use it?
Rasmussen: I like to say that the high-yield spread is the best macroeconomic indicator. And by the way, you can test this in any different variety of asset classes or ways that you want to look at it. And you’ll find that when you’re trying to predict returns, and again, predicting returns is a very noisy, hard problem. In terms of macroeconomic variables that are going to give you insight, the level and direction of the high-yield spread is a pretty darn good one. And it’s a pretty darn good one because high-yield spreads, which measure the difference between the yield on risky high-yield borrowers or below-investment-grade borrowers and the equivalent duration match treasuries are, first of all, they’re measuring how lenders perceive bankruptcy risk.
Again, bankruptcy risk is pretty efficiently priced. And so when that yield spread starts to rise, it means that lenders are getting more pessimistic about the likelihood of bankruptcies. But high-yield spreads are cool in another way and that those spreads are also a self-fulfilling prophecy because if you think about today when high-yield spreads are at 300 basis points, any company with a pulse can refinance their debt. I mean, it’s just the credit markets are wide open. If you can’t refinance now with spreads at 300, your company is in really dire straits. But when spreads go out to 700 basis points over, it’s really hard to refinance. Only the best companies can get access to credit, which means if you’re a mediocre company that needs to refinance and are having a liquidity crunch and spreads are at 700, I’m sorry, but you’re going to go bankrupt. You’re going to have to default. Whereas in an environment like tonight, you could extend and pretend. And so there’s an element in which spreads are self-fulfilling. They play a role in exactly the phenomenon they’re trying to predict.
And that’s, I think, why they’re such a wonderful macroeconomic indicator because they’re not just an indicator. They have predictive power because they are themselves an important variable in the economy. And so you can see that spreads are predictive across a wide range of things. When spreads are very wide, which is true in times of crisis, what you see is that the forward returns to taking on liquidity risk are very high. If you’re willing to go buy smaller micro caps when spreads are very high, wide, you do very well. Interestingly enough, momentum as a phenomenon is very dependent on high-yield spreads. When spreads are very tight, momentum does really well. When spreads are really wide, momentum reverses and reversals actually work well. So there are all these interesting factor-type relationships that are very dependent on high-yield spreads.
Not to mention different asset classes. Like high-yield spreads are a very good predictor of economic growth. Oil is very dependent on economic growth. When high-yield spreads start to widen, oil sells off. When spreads come in, oil prices go up. There are all sorts of interesting macroeconomic relationships that are predicted by the high-yield spread, which is why I think investors, especially in liquid markets, should watch this spread very closely.
Lefkovitz: Extend and pretend. I like that one. I’ll have to use that. Well, crisis investing is something you’ve mentioned. You have a strategy at Verdad that’s focused on that. Can you explain exactly how it works?
Rasmussen: So we define a crisis as a period in which high-yield spreads go above 600 basis points. You might be unfamiliar with spreads, but you’d not be unfamiliar with every one of the periods in which high-yield spreads have crossed 600 basis points. Recently, it’s during covid. Then before that, in 2015-16, when the shale oil boom turned into a bust; before that, the eurozone debt crisis; the great financial crisis; the 2001 technology bubble bursting—those are the periods. These are big moments in economic history when spreads have gone above 600 basis points. I like crises because, again, everybody knows when you’re in a crisis. There’s no controversy like with bubbles—are we in a bubble or not? Who knows? You know when you’re in a crisis. So you can take these moments and say, hey, do things to happen differently during crises?
Are returns differently? Like what should I do in a crisis? And you think it’s also the moment of max behavioral pain. Crises are the moment where everyone’s saying, well, maybe I should sell all my stocks and go to cash. People make horrible decisions during these times. And so the idea was, why don’t we plan? Let’s come up with a plan of if a crisis strikes. And if you go back to 2008 or March of 2020, or any one of these periods, what would you have wanted to buy? Let’s say you had cash, you had bonds and cash, you had some safe assets, and so you could have gone and bought stuff. What should you have bought? And is what you should have bought the same across all of these crises? And so can we derive lessons for the next time a crisis comes, rather than saying, oh, gee, I’m going to go to cash and I’m going to panic and I’m going to be destroyed by all my behavioral biases. Instead, you come in and say, well, gee, I prepared for this. I know exactly what I’m going to do. I’m going to go buy X, Y, and Z. Well, what are X, Y, and Z? And so I spent two years studying that question and came to some really interesting conclusions.
One is that equity factors are about 4X as much predictive power during crisis. Because there are so many behavioral biases at play, these systematic, rational ways of making decisions work better. And specifically, what you see is that size, value, and negative momentum work very powerfully in crises. So if you think about when a crisis happens, liquidity gets withdrawn from the market. Think of it like a beach. The tide goes out. At the percentage of reduction of water is greatest at the shallowest parts of the beach and the least at the most liquid portions of the beach. And markets are like that too. And liquidity gets withdrawn. Small and micro caps get absolutely destroyed. Mid-caps get less destroyed. And large caps are even less affected.
Now, when the flood comes back, when the tides come back in, the exact reverse happens. Large caps benefit a little bit from the return of liquidity, but they were never that at risk of losing their liquidity. Mid-caps benefit a little bit more, but small and micro caps, it’s just like, ah, I can breathe again. There’s liquidity again. Oh my gosh, then the market totally reprices those things upward. So liquidity, when high-yield spreads go really wide, which is high-yield spreads measure in some sense the cost of liquidity, buying really illiquid things in public markets ends up very profitable. Similarly value. Things that are very cheap or become very cheap, unsurprisingly offer the best returns out of a crisis. And you can think of that as the problem that most people make is trend extrapolation.
And so they tend to say, well, the things that have been the worst hit are going to be the worst, if this recession or crisis continues are going to go to zero. And the things that haven’t been hit as bad are going to be fine. And so what happens during crisis is that there’s this huge spread where some things get really cheap and other things aren’t anywhere near as affected. And if you can go buy the really cheap things, which are often also the really illiquid things, when all of a sudden, the market comes back and revenues were down 10 and now they’re up 20 in order to get back to normal. Profits were down 50 and are now up 100. Those stocks that you bought that were the very cheap ones are often the ones that have actually the highest growth coming out of the crisis, which is counterintuitive because they’re also the place where the reversals are happening. And again, reversals are another one where the stock that’s down 90 to get back to where it was prior to the crisis, has to go up 10X.
Whereas the stock that was down 50 only has to go up 2X. And so, the stocks that are really beaten up end up doing much better coming out of a crisis when you control for bankruptcy risk and quality. And so, a lot of what I write about is how to take advantage of these crises and how to plan for them. And in some sense, I think, beyond even specifically targeting these things that are the most profitable in crises, I think I encourage every investor to take a moment and think about, what am I going to do when a crisis strikes? Because it’s inevitable that one will. And I think it’s again the time that people make the biggest investing mistakes because they’re not prepared. And so, having a plan and ideally a plan to go on offense and to buy when others are selling is, I think, the best and most sophisticated thing an investor can do when contemplating the macroeconomic conditions.
Lefkovitz: That’s interesting. Do you worry at all in writing a book like this, Dan, that you’re kind of giving away your secret sauce?
Rasmussen: I’d like to hope that I have some secret sauce. I think that my view is that so many great investors write down what they think and it’s a wonderful exercise. And I think if anyone, I’ll be flattered if anyone tries to copy anything that I do, but ideally the complexity of implementing some of these strategies and the time it takes to do that in a great way is a barrier to entry all in and of itself.
Lefkovitz: And I’m curious, in the process of writing the book, did events cause you to change anything?
Rasmussen: That’s interesting. I think that the advantage of having the perspective that one should be humble and because you’re going to be surprised by events, in some sense prepares you better for the real world because then events don’t surprise you all that much or when you are surprised, it was part of your worldview anyway. So I’d say that probably the biggest thing relative to my views and the challenge, frankly, has been the underperformance of international relative to the United States, which I know has been a challenge for everybody who does international investing or even tries to be internationally diversified. But the magnitude of the spread between the US and international results over the past few years have been just absolutely astonishing. And I think for me, you can see all these things in a backtest, you can say, oh, there are long periods where X underperforms Y. And I know that and that’s true. And I anticipate that that could happen again.
But living through it is another thing. And I think realizing why behavioral biases exist and seeing it in action, observing people dump their international stocks last fall, thinking that international is dead and will never outperform and then international starts to outperform again or whatever it may be. It’s just been fascinating. It also makes me gain an appreciation for talking to older investors that have been investing in the markets for 50 years, because there’s something about living through some of these things that gives you a unique perspective. I can look at it in the data myself and make judgments based on that. And of course, I am a historian and love studying that. But there’s something that lived experience, especially these big behavioral things, there’s a wisdom you can get from talking to older investors, let’s say, oh, this is a fad, it’ll likely pass. And they know that because they’ve seen so many fads before.
Lefkovitz: Yeah. I guess getting old has some benefits. All right, Dan, thank you so much for joining us on The Long View. Super insightful.
Rasmussen: My pleasure. Thanks for having me on.
Lefkovitz: 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 on socials at Dan Lefkovitz on LinkedIn. 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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