In this interview, Stephen Penman shares key insights from his new book, Financial Statement Analysis for Value Investing. As the George O. May Professor Emeritus at Columbia Business School, Penman offers a rigorous critique of conventional valuation tools, arguing that forecasting distant free cash flows for a traditional DCF model is often a “fool’s errand”. He challenges the core idea that valuation models are meant to find a single, elusive “intrinsic value,” a notion even Ben Graham found problematic.

Instead, Penman argues that valuation models should be used as a “way of thinking” to reverse engineer the market’s expectations. This approach, which he frames as “negotiating with Mr. Market”, forces the analyst to quantify the growth and margin assumptions already baked into the stock price.

The foundation of this analysis, he argues, is not cash accounting but accrual accounting. Penman makes a compelling case for why balance sheets and income statements — when properly scrutinized — provide a more reliable picture of value creation. He explains that accrual accounting “brings the future forward in time”, minimizing the reliance on highly speculative terminal values that plague cash-flow models.

The discussion also delves into the practical application of these ideas. Penman details how leverage distorts common metrics like ROE and P/E, stressing the need to separate operating from financing activities. He critiques the academic search for a single cost of capital, suggesting the hurdle rate is a personal, rather than an objective, number.

The conversation explores earnings quality, quantitative factor investing, and the importance of intellectual honesty in avoiding self-deception. Enjoy!

🎧 What You’ll Learn in This Masterclass

• The New Book: Why this is an “active investing book,” not just a new edition.

• The “Fool’s Errand”: A critique of traditional DCF and long-term forecasting.

• Reverse Engineering: Using valuation models to understand the market’s thinking, not to find intrinsic value.

• Accrual vs. Cash Flow: Why accrual accounting provides a more secure valuation and reduces reliance on terminal value.

• Earnings Quality: Red flags to watch for, including gaps between earnings and cash flow.

• Conservative Accounting: How to spot it and why “aggressively conservative” accounting can distort future profits.

• Distortions from Leverage: How debt impacts ROE and P/E ratios and the importance of “unlevering” the analysis.

• Rethinking Risk: Why the CAPM is flawed and the cost of capital is a “personal matter”.

• Margin of Safety: How to apply the concept when you can’t pinpoint intrinsic value.

• The “Too Hard” Pile: Valuing high-growth, non-profitable companies like AI and biotech startups.

• Factor Investing: A critique of “data dredging” and trading on simple multiples.

• Special Situations: Applying the framework to M&A and property-casualty insurers.

• M&A Accounting: The problem with goodwill and intangible amortization.

• The Future of Value Investing: Why the core principles remain, even with AI and new information sources.

• The Investor’s Mindset: The personal attributes required for success, including discipline and avoiding self-deception.

The following transcript has been lightly edited for clarity.

John Mihaljevic: It is a great pleasure to welcome Stephen Penman, the George O. May Professor Emeritus and Special Lecturer at Columbia Business School. His books, Accounting for Value and Financial Statement Analysis for Value Investing, are truly volumes that should be on every intelligent investor’s desk and should be read carefully — because what I found is that they’re very applicable to actual investing, as opposed to a lot of accounting books that will teach you accounting but aren’t going to be as applicable to the craft of investing itself.

Stephen Penman: Yes, I think that’s right. We try to write the book in an active style, rather than just explaining investing, explaining accounting, valuation models, cookbook stuff. We put it in a very active investing style. If you want to be a fundamental value investor, here is how to approach it in an active way, and particularly with dealing with the accounting involved.

John: The new edition came out just some months ago here in 2025. What motivated you to write this new edition, to update your insights?

Stephen: Let me just correct you there. It’s not a new edition of a previous book. I have two previous books, one which is more of a textbook style called Financial Statement Analysis and Security Valuation. That’s been around for, 2001 was the first edition. That was published by McGraw Hill, who have decided not to proceed, as a textbook. They’re textbook publishers now into the big mass markets, so they didn’t want to proceed with a sixth edition. So this is instead of that. It flows on somewhat in terms of ideas from another book called Accounting for Value, also published by the, like this book, this new book, by the Columbia University Press.

But it’s not a continuation. It’s actually written much less a textbook in style, rather than an active investing book. Having said that, it is very much designed also for a textbook, in the style and the opinion that students being active about investing will grab students, not just gathering knowledge, but actually thinking about how to do this on a practical basis. So it’s also a textbook with a lot of additional materials on the website for professors and so on. I should say it’s not just my book either, it’s co-authored with Peter Pope, who’s a colleague also at Bocconi University. So it’s a joint effort here.

John: Terrific. Maybe just lay out some of the core messages, or topics that you sought to cover with the book.

Stephen: That’s going to be a long answer, but I’ll give you the one, some one-liners to help you along there. The book is about active value investing, fundamental investing as we say, but it’s about how to go about it.

When I think about value investing, as most value investors do, the first thing you think about is the business. What’s the business model? Where’s it going? What’s its strategy? How can I think about what the business is going to look like in one, two, three, four, five years ahead? That’s the most important aspect of value investing: first of all, understand the business.

But the book is not primarily about that, although it’s in the background there and refers back to it. It’s really about, then, once you understand the business, you think it’s a very good business, let’s get some quantification going to get it expressed in terms of numbers, dollar numbers, or euro numbers, whatever you want, which you can actually then employ to actually think about dollar or euro prices.

That’s the accounting. We call that accounting, pulling the information together, how you pull that information together in an efficient way to actually understand, you think it’s a good business, but I want to get an assessment of what it’s worth to understand whether actually the price at which it’s trading is the price to pay.

That’s of course all standard value investing, so there’s nothing new there. Where the book is innovative, and it is quite a different book, is in a number of ways.

The first way is, we don’t like valuation models, at least as they’re typically applied. The idea that you can forecast free cash flows for 5 years, 10 years, 20 years, discount the free cash flow value, and get a thing called intrinsic value, we think that’s rather a fool’s errand. Forecasting into the distant future is very, very difficult. The book has a wonderful quote that I took from Charlie Munger, Warren Buffett’s sidekick, or more than a sidekick, which he says, “the idea that you use valuation models to forecast the future, discount back, he says, that’s not the way to do it.” He says, he has a sentence there where he says, “That’s what they teach in business schools. Well, they’ve got to do something.”

So it actually says valuation models are really not for valuation. Valuation models are a way of thinking about valuation, to direct your thinking. And in doing that, it differs from the standard way of doing, which is discounted cash flow analysis, which we call cash accounting. It uses balance sheets and income statements. The rough model that outlines this is the residual income model, where you think about the balance sheet and adding value to the balance sheet. But it doesn’t plug in discount rates and growth rates and pretend you’re getting the intrinsic value.

In fact, we say in the book, it’s probably best to think that you cannot find the intrinsic value. It’s a very elusive notion. Benjamin Graham actually said that many, many years ago. It’s a very elusive notion.

So what we do is we adopt the approach which goes back to Rappaport and Mauboussin way back, the reverse engineering approach. We do it a little differently from them. We say, here’s the price that the market is asking you to pay today for Nvidia, for Microsoft, for any of them. Do I want to buy? Or do I want to sell?

And then, to begin a process by saying, to answer that question, I don’t go independently and try and find an intrinsic value and use a valuation model which has very doubtful inputs. What is the growth rate you’re putting in, the long-term growth rate? It’s very hard to get hold of.

So, we say, let me understand the thinking in the market price. And so it uses the valuation model to understand the thinking in the market price. This is, again, a very traditional approach in value investing. Benjamin Graham, if you go back to Security Analysis, if you go back to his books, he talks about investing as being a matter of negotiating with Mr. Market. “What do you think about it, Mr. Market? And how does that compare with how I think about it?” First, you’ve got to understand, you’ve got to understand what is his thinking.

And so that’s the approach taken. And once you understand his thinking, and using it to understand the big thing is understanding his estimation of growth in the future, then you can start your fundamental analysis by then pulling your accounting together, pulling your analysis together, doing your fundamental analysis. “He thinks that there’s likely to be a growth rate of 7%. Can I actually, knowing the business, can I actually think, yes, that’s reasonable? Because I think that the sales implied in that, the margins implied in that, are actually reasonable.” Or otherwise. And so that’s the way to approach the task.

Other themes in the book, there’s a standard theme: valuations are a matter of accounting. One accounts for value. And how you do that accounting in challenging the market price, in challenging Mr. Market’s estimate of the future, is an accounting matter. And how you do the accounting is, valuation is a matter of accounting for the value. That requires, of course, you understand accounting, but it also requires that you actually use good accounting.

So there’s a couple of chapters, more than a couple of chapters, that deal with, “If I want to use US GAAP accounting or IFRS accounting, is that good accounting?” A lot of it’s good, but here’s some things you have to watch out for. And so it instructs about how you actually do your accounting in a way with integrity that gets you on to make you secure and get you on to proper foundations. I can go on, there are many other themes, but...

John: Let’s just get into some specifics here, perhaps on the topic of earnings quality. A lot of value investors swear by cash flows, but accrual accounting could also reveal value creation, maybe even more reliably. I’m wondering if you could talk a little bit about accrual earnings, following the realization principle, and using them versus raw cash flow.

Stephen: That’s really to the point of accounting for value. Discounted cash flow analysis, using cash flows, free cash flows, is, it’s cash accounting. It’s what’s going through the cash flow statement. And as you say, accrual accounting says, “No, the focus is going to be on balance sheets and income statements. The investments you put in place and what they’re going to earn, to cover your cost of capital.”

Then it goes, it says, “Why would you want to do this?” There are a few reasons. First of all, discounted cash flow analysis forecasts free cash flows. Free cash flows are cash flows from operations—we like that stuff, cash, net cash coming in—minus investment. That’s the free cash flow after you reinvest in the firm.

From an accounting point of view, that’s rather strange, that investment is treated as a bad. Cash flow from operations minus cash investment. So the more you invest—and growth companies invest a lot—the lower your free cash flows. Ultimately that investment will turn back and generate positive cash in the future, but in the long term, we’re all dead. Forecasting what’s going to happen in the long term is very difficult. Forecasting more than 3, 4, 5, 6 years gives me severe psychological problems.

Accrual accounting says, “Hold it. Hold it. We’re not going to treat those investments as a bad. We’re going to generate a balance sheet. And we’re going to put those on the balance sheet.” We don’t do that with all assets, we don’t do that with all investments. We don’t do that with R&D, so there’s an issue.

Then, it says, “Look, when we recognize the earnings in doing that, recognize the earnings, we’ve got to use accrual accounting.” So if you’re using discounted cash flow analysis, forecasting cash flows, and you’ve got a pension scheme where the cash flows won’t happen until 30 years hence when the employees retire, that gives you a hell of a forecasting problem. Whereas the accrual accounting says, “Hold it, we’ll do this for you. We’ll actually recognize the liability to do that on the balance sheet. So it’s there already, booked for you. You don’t have to forecast it for the very long term. And at the same time, we’ll recognize the associated wages expense committed this period from actually making these promises to employees.”

That’s the way, in some sense, what it does is it brings the future forward in time. So you’re not stuck with this big problem of forecasting for the very long term or developing a valuation which rides on a terminal value, where the terminal value is a very high proportion of the—the terminal value which deals about speculation in the long term is typically, even for a mature company, is actually usually very high proportion of price. Starbucks, which is now a very regular company, if you try to value that, 90% of the valuation is in the terminal value, and you’ve got to come up with a growth rate and plug it in, and that one’s a tough one.

We want to avoid that. So we want to get to a situation where there’s more reliance on what you see now, the earnings and the book values, and maybe the near-term earnings that you can get a grasp on, and then, without that reliance on that long-term, minimize the long-term. And accrual accounting does that for you because it brings the future forward in time and gives you a more secure valuation.

John: Accrual earnings can be manipulated. Even cash flows can, for that matter. But what red flags or quality checks do you recommend investors look for in financial statements to guard against aggressive accounting? For instance, are there particular signs such as unsustainably high accruals, one-time gains, or big gaps between earnings and cash flow that would signal that earnings may not be actually translating into genuine value?

Stephen: You’re right. That there’s the rub, as we say. Yes, accrual accounting in principle, gives us a better recognition, better grasp on the value generation. However, many accruals, most accruals, are subject to estimates, and so there you have some issues.

We do have institutions to deal with that. We have auditors. We have audit committees. We have boards of directors. We have the SEC sitting there, which are some protection, but of course, these sometimes fail us. So the book then says, “Here,” there’s a couple of chapters there, it says, “Here is what you’ve got to watch out for. And here are the diagnostics to actually assess whether the accruals are good quality or not.”

Yes, the accruals versus the cash flow is one of them. If you’re putting high receivables and you’re getting little cash from your customers, you better go and check that one out. It points out also the balance sheets and income statements are, balance sheets as well as income statements are important for the quality of the accounting.

So, the way we think about the balance sheet, as a quality balance sheet, is one that cannot come back and hit you later. If you look at the residual income model, which is the basic framework here, the balance sheet goes into price one-to-one, there’s no discount for it. There’s a discount for the risk of future earnings, but not to the balance sheet. So that tells you the balance sheet has to be a safe balance sheet, a safe anchor. There’s nothing there that can come back and hit you later.

So, what can go wrong? Up to a couple of years ago, operating leases weren’t on the balance sheet. That’s going to come back and hit you later. At last, they’ve got that straight. Fair value accounting, let’s watch out for that. If they’re writing up assets and they’re recognizing things at fair value, unrealized—you mentioned the realization principle—it’s unrealized, it’s still at risk. Risk is only resolved when the asset value is realized. Off-balance sheet liabilities, leases are the example. The off-balance sheet liability for contingent equity securities, for convertible bonds.

The trick there of issuing convertible bonds, recording them at face value, and having very low or no interest on the bonds, with all the cost to the shareholders coming on a generous conversion, where the accounting doesn’t record that cost to the shareholders, that’s something that’s going to come and hit you later, because when those shareholders, when those holders of the convertible bonds or preferreds exercise, they’re going to dilute your equity. So, these are accounting issues that have to be dealt with. That’s the balance sheet.

The income statement, a quality income statement is one that, there’s nothing in the income statement that can reverse later. Under-booking allowance for bad debts or over-booking revenues has to come back and hit you later. A quality income statement is one where if, in fact, the firm is going to be exactly the same next year as this year, the reported income here now is the income you’re going to get. There’s nothing there that’s actually going to affect you. And so there’s a lot of diagnostics on that. There’s a lot of diagnostics for sales, a lot of diagnostics for warranties, a lot of diagnostics for depreciation, and so on and so forth. And so the analysis is always done with these diagnostics.

Having said that, typically GAAP, US GAAP and IFRS, is pretty good accounting with some exceptions that are pointed out in the book. Most times, everything looks okay. Or most looks okay. But it’s very important to actually understand that in your fundamental analysis, you’re anchoring on really safe accounting.

One aspect of it is, and I really believe this, you mentioned the realization principle. Yes, let’s have the realization principle. Don’t book earnings until you get a customer. Fair value accounting goes against that, of course. In fact, that’s the whole part of the history of value investing. Back in the 1920s, firms routinely wrote up assets because it was boom time. “The assets are worth much more than the accountants have on the books. We’ve got to write them up.” And then one day in October 1929, the asset values crashed.

That was the beginning of Benjamin Graham’s insight. John Maynard Keynes also, who lost a lot of money in the 1920s, he became a value investor. And what they demanded is, “No more water in the balance sheet.” You put water in the balance sheet, it can evaporate, as indeed fair values did in the global financial crisis in a lot of financial institutions, with the taxpayers left on the hook.

The demand, “Let’s stick to the realization principle. Don’t recognize value until it’s everything’s safe.” That also tells you, if it’s not recognized yet, you and I as an investor, we can anticipate that and put it into our price. Just realize that revenues and earnings not yet recognized are still at risk. You might want to think about that.

John: We often want to find the red flags, but if we wanted to actually identify businesses that are conservative in their accounting, what would we look for or what are the usual ways that managements can be very conservative and still stay within what’s allowed by GAAP?

Stephen: GAAP itself is very conservative, actually, until you got into the movement towards fair value accounting, which the regulations, both the SEC and the standard-setting boards, have withdrawn from. They’re basically only applying it to certain marketable securities and derivatives. Just be assured that the basic accounting is conservative.

But then you have to look for those firms within that, within GAAP, that are being more conservative. They have a lot of conservative allowances for loan losses, in banks. They have conservative depreciation, which writes off assets quicker and gives you lower profits.

You recognize these firms as being conservative. That’s nice, but the opposite side of conservatism is, if you’re conservative now, you’re going to be less conservative later. So if you have high depreciation now, it means the asset is going to be fully depreciated before they’re actually economically depreciated. You’re going to have higher earnings in the future. So, conservatism, excessive conservatism, is sometimes bad.

Basic conservatism is, “I want to be conservative. Yes, if in fact, I’ve got receivables, I want to make sure I discount them conservatively and not get in the situation where I’m overestimating the profits.” But I can be too conservative, too. I can be aggressively conservative, if you wish. And that’s got to be looked at also, because that means that they’re written things down.

Impairments are a very good example, when firms take impairments. They often do excessive impairments, big baths. That’s, that often happens when there’s new management in. “We’re going to change the strategy. We’re going to write down.” They write down excessively. They write down assets, which means there’s less expenses from those assets, from the inventory written down, from the plant written down, to give you higher profits in the future. This is, I wouldn’t say as bad as going the other way and being aggressive on the upside, but it’s something that has to be watched.

Fortunately, some years ago, the FASB, required firms, after excessive write-downs in the 1990s and early 2000s, required firms to have much more documentation to support their write-downs.

John: That’s a great point, because when a business writes down too much, it’s basically inflating its future return on equity metrics in a way, which is not...

Stephen: It is. Yes, and it’s actually recognizing a liability for the estimated restructuring, and this liability is something that never has to be paid, so you have to actually bleed it back into earnings to get rid of the liability. That’s the impairment bleed-backs, which increase future earnings. IBM was very good at this in the 1990s. They looked very good. And actually, in the 1990s, they were a great company, no complaints. But actually, they excessively impaired in the early 90s, and that really increased their profits subsequently.

John: Let’s talk a little bit about leverage and risk in valuation. Your residual operating income model addresses the distortion that leverage can introduce to ROE and other metrics. Tell us just a little bit about how you address leverage.

Stephen: First of all, of course, we, as value investors, understand leverage is risky. And most people understand leverage is risky. Just ask the shareholders at Lehman Brothers. They know it’s risky. And they suffered because of it. And it’s very much in the theory, finance theory, that leverage is risky.

One of the rough rules of value investors is, “Just watch you’re not buying too much leverage.” Particularly if the operations are risky. But there’s a more subtle point, you referred to, is that leverage affects a lot of the accounting measures that we typically use. So return on equity, for example, which we take as a measure of profitability for the shareholders. Leverage, increase leverage, increases the return on equity. But in theory, generally, it doesn’t increase value. You issue bonds at the market price, fair value, it doesn’t, it doesn’t change, it doesn’t add value. Just trading bonds doesn’t add value, unless of course you’re an arbitrageur, a bond trader.

It increases ROE. You’re on the board of directors, and the CEO comes to you and says, “I think my compensation should be based on return on equity, return to the shareholders.” And you say, “That sounds good. Let’s go for that.” It’s a big mistake, because just tomorrow, you’re going to get a bond issue, financing a stock repurchase, to change the equity, lever it, and the ROE is going to go up tremendously, but no value has been added.

It’s not just ROE that’s affected. P/E ratios, which we look at, very, one of the most common metrics, the P/E ratio, is affected by leverage. I tend to ask my students when I introduce P/E ratios, “If a firm issues debt, what happens to the P/E ratio? Does it go up or go down?” They don’t know, of course, but their guess is it goes up. The answer is wrong, it goes down. More leverage gives you a lower P/E ratio. The book takes you through it, it’s deterministic, it’s just how accounting works and prices work.

If you screen on P/E ratios and you look at a low P/E ratio, say, “That’s a low, that’s a low-priced stock, I’ll go and buy it.” If it’s due to leverage, then you’re just loading up on risk.

There are many other metrics in accounting. Price-to-book ratios are affected by leverage. They tend to be higher the higher the leverage. The price looks high relative to book value, but it’s only a function of the leverage.

So, you said it. Whenever you do valuation, you’ve got to unlever. Get rid of the leverage. Work with the operations, the operating activities. And this is a basic distinction in finance, of course. This is Modigliani and Miller. Leverage, except in special circumstances, leverage doesn’t affect the price of the equity. Get rid of it. And understand the, the added value comes from the business activities, the operating activities.

And so look at return on the net operating assets, look at unlevered earnings-to-price ratios, look at unlevered rates of return, and so on and so forth. And carry out everything on an unlevered basis.

As it turns out, the leverage is pretty much clear already from the financial statements. Debt assets and debt liabilities typically are very close to value. Unless there’s been a big change in creditworthiness or interest rates and so on. So the debt seems to be reasonably priced. It’s the pricing of the business that’s the important thing. And to do that, you’ve got to make sure, a very fundamental rule in value investing is, in accounting analysis and financial statement analysis, separate the financial activities from the operating activities. Don’t get them mixed up.

Yes, there’s debt there, there are, there may be a large amount of debt assets, like capital. Any shmuck can buy a bond. Any shmuck can buy a CD. That’s not where your value comes from. So that is the focus. And that gets over the mistake you can make by looking at levered accounting numbers.

John: When it gets particularly interesting is when the leverage is not your plain vanilla, straight-up leverage, but let’s say non-recourse leverage of some sort where the equity has the upside but limited downside. And then in that case, maybe it would make sense to give the equity some credit for that non-recourse leverage, given the asymmetry. How would we do that?

Stephen: I think it depends on what, in terms of generating the instrument, what you paid for it. If it’s fair value that reflected all these things, it’s going to be okay.

The case where leverage, where looking at the debt is going to be important is, in fact, when the financing transactions are not done at fair value. So, if in fact, you issue bonds and take the proceeds and buy back stock, because you think your stock is under-priced, that’s going to generate value. So any trade, or if, in fact, you think, “My bond’s mispriced,” so it’s time to actually go and do that. This is the, this is the trick of firms in the times when the Fed puts interest rates low and interest rates are very low. You’ve got very good credit ratings. You go out and issue some bonds, take advantage of that low interest rate. That generates some value. This is bond, this is actually bond arbitrage.

But if you’re issuing bonds and you’re issuing equity or repurchasing equity at fair market value, then that’s, that can’t create value. That’s a theorem in finance. But the alternative, the contrary situation, of course, is, yes, you do stock repurchases when you think your stock is under-priced. And be careful not to issue stock when you think it’s under-priced.

There’s a model there for actually gaining money from leverage. There’s another aspect to it. There’s a whole chapter on leverage. But there’s another aspect to it is, value investors say, “Be careful of leverage, don’t buy any leverage.” But there’s a time when, in fact, you might want to lever up because you’re so convinced that the stock is cheap. In trading terms, there’s alpha there. That then you might want to lever that up. You might want to go and borrow and lever that up.

That’s very risky. You’ve got to be very, very sure of your position and a real good margin of safety. You might want to lever that up. And that’s in an unlevered active investing fund, of course. But also, you might, if you’ve got two firms that are both equally attractive, and you want to invest in them, the one that has higher leverage is actually going to be more attractive because their leverage is going to give you, their leverage, the firm’s leverage, is going to give you a higher return when, in fact, it all pays off.

So the firm can, you can go into debt on private account, or the firm can go in debt on the shareholders’ benefit. Just as you can buy a cheap stock when you think it’s under-priced, but the firm also can buy back their own stock when it’s under-priced on your behalf. The benefit accrues to the shareholders. And so the analysis goes through. These are exceptions. The best place to start is there’s no value added from debt. That is the starting point. And then you look at these situations where there might be, in which case you can do some debt arbitrage.

John: And also, the tax code is another potential factor where maybe it favors some degree of leverage.

Stephen: Yes. You’ve got it. That is not recognized in the accounting. So if, in fact, you issue debt and you get a tax deduction for the debt, which is now more limited than it used to be, you get tax, then there’s a subsidy for the debt. That is potentially there.

But you do have to watch out. The firm issues debt to get the tax benefit. They’ve got to sell it to someone. Let’s say you or me. We have to pay taxes on the interest. So we might price that in. So it works both ways. It’s not automatic that you actually get the tax benefit of interest deduction as a corporation, because you actually then have to put the stuff on other people who actually have to pay tax on the interest income they receive. Who don’t get the subsidy. And that’s going to be built into the price. That’s a pretty thorny problem, actually, working that through. But it’s not automatic that, in fact, that the tax deduction is a subsidy that flows directly to the shareholders.

John: Thank you for that insight.

Stephen: That insight is not mine. That’s actually Merton Miller, who was on the original Modigliani and Miller, which talked about the tax benefit of debt. And then he came back in a later paper in, I think, 1977 and said, “Oh, hold it. I’m not sure I’m quite right on that.”

John: (Laughs) Right. Now, when it comes to accounting for risk in valuation, the traditional finance model would take a risk-adjusted discount rate, I guess with beta in there. You advocate for a slightly different approach. Could you talk a little bit about that, please?

Stephen: Yes, I do. We do in the book. And I wouldn’t call it slightly; I’d call it quite a different approach.

John: I was being diplomatic.

Stephen: (Laughs) Yes, who’s listening? Right. No, it’s very easy to take a model like the Capital Asset Pricing Model and say, “Oh, this gives me the discount rate. I’ll just plug it in and go for it.” But as Charlie Munger said, “You’ve got to be worried about all models.”

Let me start with the story, which I think is in the book.

In the Global Financial Crisis of 2008-2009, I was teaching a valuation class. Warren Buffett wrote a paper in the New York Times saying the S&P 500 had crashed. It dropped down to as low as 667, I think, at one point. This is about November 2008. He wrote a piece in the New York Times saying, “Now’s the time to buy stocks. They’re cheap.”

So I grabbed the New York Times, I walked in the class—I waddled into class—and I said, “Hey, look, it’s time to buy stocks. Are you guys buying stocks?”

And the students... no one said yes. And I said, “Well, why aren’t you buying stocks?”

“Well, Professor, we’ve just had this huge crash. We are finance graduates, investment graduates. Columbia is basically a finance school, more so in those days. We don’t think we’re going to get a job. The whole world’s going to hell. We’ve got a lot of risk. Not only that, we’ve got student debt to the ceiling. We’re very highly levered. We just cannot take the risk.”

It was a very uncertain world. “What’s going to happen?” If you can remember back to November 2008, my goodness, is this the end of the world?

So they’re basically saying, “I’m not buying stocks because my discount rate is infinite. It’s very high.”

Then they turned on me and said, “Hey, Professor, are you buying stocks?”

And I said, “Yes, I am, actually. I’m looking very closely at them all. But you’ve got to remember, first of all, I have a job. I’m not looking for a job. And Columbia University is silly enough to give me tenure. I cannot be fired unless I’m very, very naughty. I’m in a very secure situation. I’m not highly levered. So yes, it’s time for me. You and everyone else are running from stocks because of the risk. But for me, and also Warren Buffett, it’s an opportunity.”

Another thing he’s saying is, “We have a different discount rate. We have a different cost of capital. We have a different hurdle rate. We have a different hurdle rate compensation for risk.”

The first thing to recognize as a value investor is it’s a very personal matter. You have one that’s probably different from mine.

The second thing is to recognize that adopting a model that gives you the cost of capital is really a fool’s errand. We talked about “there’s no such thing as an intrinsic value.” It’s good to think there’s no such thing as intrinsic value. To think that there’s no such thing as a cost of capital that you can discover is probably a good way of thinking, too.

You think about the risk that firms face, except for your lemonade stand. There’s a complexity of risk, particularly for international firms. There are huge risks they face, varied risks. To think that you can funnel all those risks down into one number. “Hey, John, it’s 8.1%. It’s not 8.6%.” I think that’s a fool’s errand.

And they say, “Oh, well, but these academics have given us these pricing models.” One is the Capital Asset Pricing Model. Actually, that was quite a revolution in terms of thinking. That a lot of risk just comes from the sensitivity of the market portfolio, because you can get diversification through Markowitz. It was very good thinking. But then to have a model that says, “Now I can use this thinking to tell you, John, it’s 8.1%. It’s not 8.6%.” I don’t think so.

When you look at it, you start with the risk-free rate. Well, what do we use for that? We say in class, “Well, use the U.S. 10-year bond rate. Because the U.S. government has never defaulted.” Although, by the way, we’re getting a little worried about that now. But it’s not risk-free.

When the 10-year rate was below 1% at one time, you needed your mind read with all the money that was being printed to think that this was actually going to be the rate all the way through for 10 years. You’re going to get inflation. And inflation devalues your bond. It’s not risk-free, to be totally honest.

One thing we as value investors try to be, is to be honest. Honest in our way we conduct ourselves, but honest in our thinking.

Then it says, “To get the CAPM cost of capital, you’ve got to have a risk premium: the expected return on the market in the future minus the risk-free rate.” The expected return on the market? Man, if you give me that number, you’re a better man or woman than I am.

What do they do? You ask anyone, you ask the students. What is it? “It’s 5% or it’s 5.5%.” Why? “Because that’s what they teach in business school. Just use 5%. And don’t ask me about it.”

The beta’s estimated with a standard error of 0.2. So the whole thing’s very, very messy. You know from a valuation model, if you change that discount rate by just half a percent, you get very different valuations, particularly if it’s combined with a growth rate you don’t know much about.

Again, in the spirit of being honest, value investors have this creed: “Understand what you know and what you don’t know, and don’t base your valuation or your assessment on what you don’t know.” Admit that to yourself, and then think how to proceed.

The way we proceed in the book, it says, “You cannot expect the model to bail you out and say, ‘Hey, this is what I got in finance 120 course.’ No, you’ve got to go and make a business assessment of the risk. Pro forma it out on different scenarios. What’s the probability of getting this amount of sales, this amount of sales at these profit margins? Let me get the distribution.”

I can tell you in fundamental analysis, we can tell you by doing that, what the risk is, in pro forma. I can’t tell you how to map that into a number. “John, it’s 8.1%. Don’t tell me it’s 8.6%.”

Once you’ve done that, then you apply your own hurdle rate, and yours may be different from mine. I think that’s being honest about it. We just don’t know it.

It’s a dirty little secret, actually, in academia. We’ve been chasing the cost of capital, the discount rate, for, well, ever since Markowitz—80 years. Five Nobel Prizes for the effort. But the dirty little secret is we just don’t know how to calculate the cost of capital.

John: Very interesting. How should we rethink the concept of margin of safety if pinpointing an exact intrinsic value is problematic?

Stephen: That’s in the value investing creed, of course. Getting back to my notion of negotiating with Mr. Market. Here’s your price. I can do some accounting for value to give you an indication that will indicate to me what your growth rate is. To do that, I have to put in a hurdle rate, which has got to be my own hurdle rate.

However, one way of doing the margin of safety is, “If I put in a higher hurdle rate—something that I think I’d be satisfied in this environment of getting 10%, but if I put in 12% or 13%—what comes out of it is a number that tells you the market’s anticipating higher growth.” That actually makes sense, because if you have a higher discount rate, hurdle rate, you’ve got to have more growth to cover the hurdle.

If, in fact, once you’ve done your fundamental analysis and you see that Mr. Market’s assessment is very pessimistic relative to that high hurdle rate, you have a margin of safety. Use it not as something you know the hurdle rate, but use it as a tool to give you a margin of safety.

That’s one way of thinking about it. The other way to think about it: once I do this fundamental analysis and see how far I am from Mr. Market’s assessment, then let me go for the stocks where I think, indeed, there’s a margin of safety. He’s really quite wrong. Or let me avoid those stocks where I think he’s really overpriced, or short-sell them if you’re into that game.

John: On the topic of growth and value and paying for the future, I guess the basic message is that we should not pay, or certainly overpay, for growth. How does your framework help us think about companies that aren’t really generating any profits at the moment? Basically, every AI company out there, except for NVIDIA, is not generating profits at the moment. It seems highly uncertain what the future will look like for those new business models. Can we even begin to come to any intelligent assessment of value, or does that have to go into the “too hard” pile?

Stephen: The short answer is the “too hard” pile, but let me elaborate. You’re right. One of the themes of the book is the heart of investment is buying growth. Growth, because it’s growth in future earnings which are not yet realized, means those earnings are still at risk. Growth is risky. So if you have a lot of growth that you’re buying, you assess you’re buying a lot of growth in the market price, you might want to think this is a more risky firm. That’s a good way to think about it.

Now you get to a mature firm. I’ve got a history of sales and profit margins. I know the business. I can model it out with a fair degree of comfort.

But you get a firm where it’s all in the distant future. Those firms, as you say, are not making profits now.

I remember my students asked me many times when I was teaching at Berkeley during the dot-com boom. I was teaching financial statements. They said, “Professor, how do I value a Silicon Valley startup? How do I value a biotech startup?”

I have to say to you, this is just something that I cannot tell you about. Look at the balance sheet. All you’ve got is cash and cash burn. Look at the income statement. All you’ve got is expensed R&D, no revenues as yet, very little revenues as yet. I can’t tell you much at all. Here’s a good clue. Why don’t you go out and get a PhD in biochemistry and understand the science there?

This sort of analysis that we’re talking about here is not for those companies. But one thing I can tell you is that if you want to pay something for one of these companies, you must have a scenario where in the future, sometime in the future, this is going to bang. They’re going to get through phase three. It’s a very good drug, and so on and so forth.

You can model that out. But first of all, you’ve got to understand the biochemistry. That’s the primary thing. Doing financial statement analysis is not the name of the game. But I can tell you, you have to have that in the future.

If it’s a long time in the future, it’s growth. More so, if it’s growth a long time in the future, it’s going to be a long time before you’re going to get those earnings. You’ve got to recognize that that’s a very risky company. You might want to have a very high hurdle rate. It’s like a venture capitalist. What are their hurdle rates? 25%, 30%? Even if they do it that way, it’s got to be high.

I think that’s, again, a matter of being realistic. To pretend you can value a biotech startup with some analysis of accounting data is misdirected.

John: Quantitative strategies and factor investing have become quite popular. You seem to bring a critique to the idea of trading on simple multiples or smart beta schemes. What do those quant approaches miss, in your view, that an old-fashioned fundamental analysis can catch?

Stephen: You mentioned two things there. Let me deal with the latter one: trading on multiples. That is pretty easy. You look at the price, you can look up the book value or the earnings, get a P/E ratio, or price-to-book ratio, or price-to-sales ratio. As long as you can do division—you have to get at least to fifth grade—then you can do it.

You buy the ones that are low. Now, sometimes that works, but it’s a hell of a risk.

There’s a motto, again, we emphasize in the book, a tenet we emphasize in the book: “Ignore information at your peril.” Trading on just one bit of information, earnings; one bit of information, book value; two bits of information, earnings and book value—you’ve got to be very, very careful. You are in danger of trading with someone who’s really done their homework.

Here in this book, we teach how you do your homework. We’re going to try and do it parsimoniously so you don’t have to have thousands of bits of information. But you’ve got to do your homework. In some sense, the book is about what you’re missing out on, the mistakes you’re making when you do those quick-cut analyses.

They call it trading on P/E ratios, price-to-book ratios, “value versus growth” investments, for low P/Es and high P/Es and low price-to-books. It’s silly. All investing is value investing. You can buy a very high P/E ratio as a good deal.

That’s a very important point. The question, therefore, is what else do you need to pull in to actually get you a better trading strategy and to reduce the risk that you’re not trading against someone who’s done their homework.

You mentioned factor investing. I’ve read some time ago, there’s about $1 trillion under management of factor investing in the world. A lot of these factors, the very famous ones, of course, are the Fama and French factors. And the multi-factor model. “Well, the CAPM model, we see that doesn’t work. So let’s add some other factors.”

“How do we get these factors?” “We purely get them by data dredging.”

We go and see, “Oh, price-to-book predicts returns. We’ll make a factor out of that.” “Firm size predicts returns. We’ll make a factor out of that.” “ROE predicts returns. We’ll make a factor out of that.”

These factors are formed in the Fama and French five-factor, six-factor models, just simply by data dredging. There’s no theory, no understanding. Interestingly enough, they come up with accounting numbers. When you do your fundamental analysis, you understand the accounting, you understand what they’re picking up and what they’re not picking up.

In my mind, it’s a very crude approach, basically based on data dredging and not understanding the accounting. When that happens, you can run into trouble.

It turns out, I’m glad you asked this question, because what I’ve been involved in the last couple of years is research developing an accounting-based factor model, which understands the risk that’s conveyed by the accounting and building factors by the risk that the accounting is conveying.

You have a realization principle, it’s very important. “Yes, the price is high, but it’s not yet realized.” “What’s the probability that it’s going to be realized?”

I’m a bit dismayed, as I think most value investors are, about the cheapness of a lot of strategies. There are many good strategies out there, I’m sure, particularly on the buy side. We don’t observe many of them. They’re in the dark. There are many, many good strategies. There are many good fundamental strategies. There are many good quantitative strategies.

But in terms of the ones that publish, the Morningstar style box, my goodness, it’s very crude. It’s very crude. The key is, yes, you can throw the asparagus at everything. But what can you put on the table? That’s what we try to put on the table. But in doing so, we try to show what errors you can run into if you don’t get fundamental.

John: Certainly, it seems that often the tail wags the dog, or the marketing will drive the financial product that’s created and sold. It may not make the most sense from an accounting valuation standpoint.

Stephen: No, no. When you think of our industry, our finance business, which has had a lot of achievements, particularly in terms of risk-sharing instruments and so on. In some sense, it’s an industry that’s chasing AUM. Any way of getting AUM through marketing, through any device and so on, is important. If you have one good year, you display your returns.

It’s an industry which is getting in the more naive retail investor, because the retail investor doesn’t know about it, needs someone else for help. It’s all about chasing AUM, and there’s a basic notion that on average, funds don’t end better than investing in the index.

Which has given rise to this passive investing, which is a bit worrying if everyone’s a passive investor and no one’s doing the research. Then we’ve got a real random walk down Wall Street, haven’t we?

John: Absolutely. You have a chapter on special situations, which for value investors have been a mainstay ever since Joel Greenblatt’s book or even before that. Tell us what you mean by special situation in the context of financial statement analysis and a quick overview of how your approach can be applied in cases like turnarounds, restructurings, or other non-standard scenarios.

Stephen: Yes, the special situations are those particular situations. You mentioned turnarounds and restructurings. We don’t cover that there. In the chapter, we only cover two things. One is insurance: property-casualty insurers. The other is acquisitions, M&A.

It’s how to actually do the valuation in an insurer, a property-casualty insurer. The drivers are very, very different. The idea of the float, generating the float, and earning money from the float by investing that float in other assets, in other businesses like Berkshire Hathaway does, like Markel does, or buying securities. The cost of getting a float is, of course, lower premiums, which gives you a higher combined ratio, the loss ratio.

That’s what’s going on. It’s all within the same model. Work with the income statements and balance sheets. Understand the float from the balance sheet and how that float can change over time. And the income statement about how much the cost of getting the float—which is actually the loss or the slight profit you’re earning on the insurance side—is being earned.

On M&A, it’s a question of applying the same principles of the book to buying another company and how you might do that. In particular, how you split the value from an acquisition with the so-called added values, how that’s split between the target firm and the acquiring firm.

There are a lot of difficulties there. There are accounting difficulties. The accounting for acquisitions is bad. Here’s one example. What’s this goodwill number? It’s a plug. We’re supposed to impair it. What the hell’s in it?

I have done some work to generate an alternative accounting for goodwill and for acquisitions that gets to the heart of what’s being generated and what’s there to be impaired or otherwise maintained on the balance sheet.

Those are the two we look at. There’s a case there on restructurings, Coca-Cola’s restructuring, a number of restructurings at one time. It had the 49% equity in the bottlers, the 49% solution. Then it decided to acquire the bottlers. And now recently, in the last few years, it’s decided to offload those bottlers and distribution companies. There’s a restructuring going on. How do you think about the value generated in the restructuring? That’s not in the chapter; that’s in a case that goes along with the book.

John: What I’ve always found interesting when it comes to M&A is how automatic it is that investors exclude intangibles amortization from their assessment of earnings when, actually, a company paid that money above and beyond the value of the assets of the acquired company. So while it makes sense to exclude that amortization when you’re assessing the underlying business—the returns on the underlying business—it doesn’t make sense when you’re assessing the returns on your M&A necessarily. I feel like maybe there’s a deficiency there in how investors look at that.

Stephen: Yes, I think the problem here is with the accounting. As I say, this accounting needs to be completely redone. I do have a paper if people are interested on a proposal of how to do the M&A accounting differently.

But no, you recognize these intangible assets that are purchased. That’s a little bit putting your finger up to the wind. “What’s the value of the brand? What’s the value of this? And what’s the value of that?” It’s a bit of a fluffy number.

Then, if you’ve got to amortize it, and you only amortize with definite-lived intangibles booked, not with the indefinite-lived, then the amortization number is added back because it’s a fluffy number, too. This is like the old days when goodwill, before FASB standard 142 and 143, used to be amortized. The standard thing was to be amortized over 40 years. Analysts always added it back and said, “This is just an arbitrary number. Following a rule, you add it back. It doesn’t make any sense.”

You don’t want numbers that analysts say, “It’s too fluffy. I add it back.” Because one thing is that there is some amortization. If you have a copyright or you have a patent that’s going to expire in 25 years, well, it’s going to expire. There’s going to be a cost. You’ve got to recognize that. It’s a question of how you do the amortization.

John: Maybe we can finish by talking a little bit about the future of value investing or how it needs to adapt in this modern, knowledge-based economy, with more and more intangibles driving value. What is your view on the relevance of value investing and what, if anything, needs to change to make it more relevant?

Stephen: In some sense, I think all investing is value investing. We’re not going to escape that one. It’s a question of how you go about it. When you’re buying a stock, when you’re buying a firm, you’re buying payoffs. It’s a question of what you want to pay for those payoffs. You’ve got to get some grip on that. The question is just how you do it.

People will gamble, of course. People will gamble on all sorts of things. They’ll treat it as a casino. They’re free to do it. That’s fine. You can gamble.

But for someone who’s a little bit risk-averse and says, “Maybe if I just pull in a bit of information, I’m not going to get rid of all the risk, and maybe I’m left with a lot of risk, but I can reduce my risk by bringing in some information.” I think that’s always going to be there for those who want to put some effort into it, those who want to do some work.

Those who don’t want to do that or who feel they can’t do it, well, yes, if you want to share in the fortunes of America, just go and buy the S&P 500. You’ll share in the disappointments of America, the ups and downs. But yes, just go and do that. That’s okay. But for those who have some equipment and some understanding to actually press on it, it’s always going to be there.

You might say, “Yes, I’m going to buy the S&P 500, but let me go through and just look at a few companies. If there’s a lot of speculation around, I cannot really justify it, I may strip them out. Or I may be left with an adjusted S&P 500 with firms stripped out. I don’t have to go the full monty.”

But where’s value investing going, in answer to your question? I think the basic discipline of value investing is on the table. It’s been there for a long, long time, laid out by people like Keynes and Benjamin Graham and so on. The basic attitudes are there. I think one of the important things for an investor is just to have a lot of common sense. Bring that common sense to it, understanding the business. I think that will always be there.

In terms of technical innovations about how you might do it better, I think information is gold. The ability to grab more information about outcomes may help us improve it.

There’s a lot of difference between when I started investing; I was like Warren Buffett. I’d go to the Moody’s manuals and read what’s in the Moody’s manuals. This is way before the internet and everything else. Now we can scrape information with satellites and all sorts of things. That trend of getting more information is going to be important. But I think the basic approach to it is probably not going to change.

You’re probably going to ask about AI. I don’t know. I’m not sure it can actually do the creative thinking that a human can do when it comes to value investing, of understanding the business and combining that together with your accounting. It can do a lot in terms of bringing the information to you. But I don’t know. I’m just an observer. Let’s see what happens there.

John: Professor Penman, is there anything we have not covered that you’d still like to leave our members with before we part ways?

Stephen: I think there’s a certain person who’s adept, certain personal characteristics which are good. Keep that in mind. First of all, this is not for day traders. This requires serious long-term thinking. It requires discipline. It requires separating yourself from the herd.

Yes, you’ve got to read The Wall Street Journal and the Financial Times and pick up all the news, but do it with a distance. Be skeptical. Challenge the thinking, challenge the normal thinking. Be very thorough. Do your homework.

These are, I think, very important attributes.

In my mind, the most important attribute for a value investor is to beware of self-deception. I find this is one of my biggest problems. “Oh, I’ve written a paper. I like that paper.” You can like the paper. Let’s take it at a distance.

My kids growing up—they’re grown up now—I used to tell them, “The biggest danger is self-deception.” There’s a lot of that a teenager has. Beware of your self-deception. Test yourself. Bring the data to yourself.

Negotiate with Mr. Market. But don’t think you know everything. Say, “Well, what does he know that I don’t know? Why has he got a different opinion than I have?” Turn it back on yourself.

That is what I call being honest. Of course, it’s not just being professionally honest, which is very, very important, but it’s being honest in yourself. I think that’s a very, very important attribute to have. Don’t kid yourself.

John: On that note, Professor, thank you so much for taking the time to have this conversation. It’s been really packed with wisdom and insights. I can only warmly recommend your new book to all of our members and listeners. Truly appreciate you doing this with us. Thank you.

Stephen: Thank you very much, and it’s been good talking to you. By the way, my name is Stephen, not Professor Penman.

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I had the pleasure of sitting down with Czech superinvestor Daniel Gladiš in Brno recently to discuss insights from his new book, Hidden Investment Treasures: How to Find Great Stock Investments as the Investment World Goes Passive. Daniel is a veteran value investor, founder of Vltava Fund, and longtime member of MOI Global.

In this conversation, Daniel explains how active investors can uncover compelling opportunities even as passive investing dominates today’s market. The interview explores several themes from Hidden Investment Treasures. Daniel touches on how he finds winning ideas in an era of index funds, why capital allocation decisions are critical to value creation, and how his investment approach has continued to evolve. Daniel also dives into several real-time case studies that form the crux of his new book.

Active Opportunities in a Passive Market

One key theme Daniel discusses is the advantage for active investors in a market increasingly ruled by passive funds. With the majority of money now flowing into index-tracking investments, price discovery has become distorted, creating mispricings savvy investors can exploit.

Daniel notes that when equity markets are dominated by passive investments, it actually “creates a lot of opportunities for active investors”. He argues that investors must adapt their selection process to turn the passive trend to their advantage. He outlines how the prevalence of passive funds has made market moves more extreme and slower to reflect fundamentals, opening the door for patient, long-term value investors to find bargains.

Capital Allocation and Value Creation

Daniel emphasizes that much of a company’s value creation comes down to smart capital allocation. Several case studies in his book illustrate how repurchases and acquisitions can boost long-term shareholder value. For example, Asbury Automotive is a company growing aggressively through acquisitions while simultaneously buying back stock, leading to rapid per-share growth in earnings.

Daniel highlights buybacks as a recurring theme, but with an important caveat: not all repurchases create value. He puts strong weight on how management deploys capital, whether investing in growth, making acquisitions, or returning cash to shareholders. Buybacks only make sense when done below a stock’s intrinsic value; repurchasing shares at too high a price actually destroys value for the remaining shareholders. He prefers buybacks (when undervalued) over dividends, which he finds tax-inefficient and often inflexible. Daniel offers insight into how investors can avoid “value traps” and benefit from growth in per-share value.

Real-Time Case Studies and Investing Lessons

A distinctive aspect of Daniel’s book (and the interview) is the use of real-time case studies drawn from his actual portfolio. Daniel deliberately chose about 15 stocks he currently owns (or has owned recently), spanning a range of industries, to demonstrate that you can find value in many corners of the market. By presenting live ideas rather than only past successes, he “puts his neck on the line” to provide more credible lessons.

Each case study is crafted to illustrate broader investing principles, from an auto dealership leveraging buybacks, to a special situation in litigation finance, to an energy company with a shrewd shareholder return policy. Daniel’s structured approach to these case studies offers a view into how he analyzes businesses in different sectors, all while adhering to core value investing tenets.

An Ever-Evolving Investment Philosophy

Throughout the interview, Daniel reflects on how his philosophy has developed over the decades, and why it’s still evolving. Early in his career he was heavily influenced by Ben Graham’s teachings, focusing on statistically cheap deep value stocks. Over time, as obvious bargains grew scarce, he gravitated toward better-quality businesses and learned that “the best investments are the simplest ones”. Daniel candidly describes mistakes made when he tried to get too clever, reinforcing the value of sticking to fundamental principles.

Importantly, he views investing as a continuous learning process: “…you can always get better, you can always learn something new,” he says, stressing the need to adapt as the environment changes. Even in the passive-investing era, Daniel is adjusting his stock selection approach and remains curious how it will evolve in the next 5–10 years.

Key Themes:

• Passive Investing Era – Distortions and Opportunities for Stock Pickers

• Capital Allocation Focus – Share Buybacks, M&A, and Value Creation

• Case Study Highlights – Real-Time Investment Ideas across Industries

• Investing Philosophy – Continuous Learning and Evolution of Approach

Enjoy the converation!

The following transcript has been lightly edited for clarity.

John: Daniel, thank you so much for hosting me here in Brno. It’s a real pleasure to be where it all happens, where you manage the Vltava fund. We are here today to discuss your new book, Hidden Investment Treasures, which I can very warmly recommend to everybody listening in.

Hopefully, we get a nice preview and some insights that are in the book, but you’ve been a best-selling author in the Czech Republic before. My question to you is what motivated you to write this new book. How did it come about?

Daniel: First of all, it’s a pleasure to have you here in Brno. It’s always a pleasure talking to you, so I’d like to thank you for coming.

The idea to write this book came quite unexpectedly. It’s an interesting story. About a year ago, I was attending a conference in Denmark called Nordic Value, which is organized by my friend Ole Soeberg. This conference is not open to the public; it’s invitation-only. Every participant presents one concrete stock investment idea. In two days, you get 35 different stock ideas. This is the type of conference I like most because you can talk about various things, but the bottom line in stock picking, in active investing, is which stock you decide to buy. I find individual ideas to be the most valuable.

I was listening to those presentations and it occurred to me that it would be interesting if someone wrote a book consisting only of those investment ideas because it would be able to show readers that you can be active investor, you can find all kinds of investment ideas, and you can have fun while doing it. I tried to recall a book like that. I think I have read almost everything written about investments and relevant topics over the last 30 years, and I couldn’t remember any such books. I immediately jumped to another idea. “Why don’t I write a book like that? Why don’t I write for myself something that I look for from the others most?”

I get very enthusiastic about things quite often. That morning, if you were to ask me if I was going to write another book, I would probably have said no. In the evening, I had already sketched the list of chapters, and I was looking forward to going back home two days later and starting writing. I didn’t expect it, but I enjoyed writing the book a lot afterwards.

John: Yes, it’s quite a unique book. Maybe the reason why there are all these investment books out there but not one like yours is that a lot of folks don’t like to put their ideas out in the open, especially in real time, because people like to emphasize their winners and put the losers somewhere on the back burner. However, you did put yourself out there. As I understand it from reading the book, the case studies are indeed in real time rather than accounts of past winners.

Daniel: Yes, the book consists of about 15 individual investment ideas. When I was selecting them, the main condition was that I would only write about stocks we own. It would be easy to look at the last five years, retrospectively pick stocks that did well over that time, and recreate, ex-post a story, then and there why it was a good investment, but that doesn’t help much. I only talk about stocks we own.

You’re right. It’s not very popular among investment managers because a) you are revealing what you do, and b) you are putting your neck on the line since some of those ideas will inevitably turn out not to be that great, but I think it would have more credibility.

I also tried to pick stocks from various industries to show that you can look for value in different places in the market today. In addition, I wanted to select stocks that can be used to demonstrate some more general investment topics that could be applied to other companies in a broader way or things that are valued over time. That was my selection process.

John: You do cover a vast range of investment scenarios through the case studies you’ve picked. Did you pick them in order to illustrate the breadth, or is that a result of how you manage your portfolio and construct it for diversification?

Daniel: It’s both. There are definitely more stocks we own that I talk about in the book, but in some cases, you would be repeating yourself because they come from similar industries or have a similar investment ratio. I wanted to show the breadth of the opportunities available in the market.

Most importantly, in theory, you can write a book about investment ideas at any time, but I think this book is also quite timely because we live in a world where equity markets are dominated by passive investments, which creates a lot of opportunities for active investors. I wanted to show them and also maybe suggest how we should approach the stock selection process in order to turn to our advantage a situation where most of the money is being invested passively.

John: Yes, that’s a great point. Now, some of the case studies illustrate how share repurchases can create value. You have an example on value-accretive M&A. You have a special situation in the litigation space. We’ll get into the case studies in a moment. I think those are always of interest to everybody because they may yield good investment ideas, but let’s first talk about the opportunity for active managers like yourself in a world so dominated by passive investment flows and why that creates an opportunity for stock pickers like yourself.

Daniel: Especially in the US market, which is now more than 60% of the world capitalization, it is highly likely that the majority of the money is being invested passively, and this changes the character of the stock market in a big way.

Passive investment is a good idea in itself, but passive investors rely on the activities of active investors. Passive investors buy an index or some benchmark, and they don’t care how much they pay for individual stocks within those benchmarks or indices. They rely on the activities of active investors and hope that active investors – by their appraisal process, by their selection process, by their buying cheap stocks and selling expensive stocks – create the price discovery process. They basically make sure that stocks are approximately reasonably valued or tend to approach their fundamental values over time.

If there are a few passive investors and a lot of active investors, that works fine, but in today’s world where most of the money is being invested passively and only a fraction of the active investors do stock valuations, the price discovery process is deeply distorted.

First of all, passive investors cease to be price takers; they are now price makers. They influence the prices of individual stocks even if they don’t analyze them individually. That’s because the flow of passive money into various indices influences the composition of the indices, which, in turn, shows where the money is flowing. There are many indices, benchmarks, and ETFs, and they influence each other. Passive investors have now become price creators or price makers.

Also, the price discovery process still works, but it’s much slower because only a small percentage of active investors do stock valuation as you have a lot of algorithmic trading and momentum strategies. Among active investors, most are retail investors, and I think most of them don’t have the abilities to value stocks. People who do fundamental valuations represent only a small fraction of the market.

The dynamics of the market are such that when the money is flowing into passive funds, they have to buy stocks immediately because that’s what they do, and by definition, the sellers have to come from the active investor group. Because of passive buyers, the sellers have to be active funds. Because there’s so much passive money and so few active investors, when money is flowing into passive funds, the prices required to balance the marginal demand and marginal supply of stocks tend to go exponentially higher because, in theory, if there was one last active investor in the world, the price you have to pay to sell his or her stock would be indefinite.

Prices tend to rise exponentially in the market – in general and also in individual stocks. When money flows out of passive funds, it works the other way around because the amount of money available among active investors to buy the stocks passive funds are selling is relatively small, so prices have to go down exponentially to find the equilibrium. Market trends are now longer and more extreme both ways – up and down – both in the market as a whole and individual companies.

What also worries me is that the percentage of passive investors has a strongly negative impact on corporate governance. When you pick any single stock and look at who the largest owners are, almost everywhere, it’s Vanguard and BlackRock – passive funds. Passive funds are the biggest owners in most of the individual stocks. I think they don’t have any motivation or tendency to care much about what’s happening in those individual stocks because they don’t care how much they cost. Their business is not to manage money. Their business is to collect money and shift it to those benchmarks.

One of the smartest and most knowledgeable investors is Jim Chanos. He teaches a course on the history of financial fraud. If he says that we now live in the golden age of fraud – unfortunately, I believe that we are – a big reason for that is the prevalence of passive investors. They don’t care about what’s happening in the individual companies, and the oversight over management is very weak.

This is the environment we live in. I try to describe it in the book. I also try to describe how to approach the stock selection process if you are an active investor – not only to find good ideas but also turn the whole situation to your advantage.

John: Yes, and that’s the ultimate goal, right? I know you are finding many ways to do that. We’ll talk about some of the advantages an active investor like yourself has in a world of passive money. I believe there’s also a bigger issue around the functioning of capital markets because the whole purpose of the stock market is to allocate capital efficiently within an economy. With so much money passively invested, that function seems to be breaking down. That may not matter so much to an active investor, but it should matter to regulators and society at large.

Daniel: Yes, I agree with you 100%. You cannot measure those things, which means they go unnoticed and no one can figure out how much damage it causes. But if you are living in a world where stock markets are not efficient enough and the price incentives that would attract capital are distorted, the capital flows to different places – not to where it brings the biggest return but to where the market seems to be shifting it. This lowers the efficiency of the whole capital allocation process, which costs society as a whole a lot of money – although no one can figure it out how much that may be.

John: Yes, I think even John Bogle – the founder of Vanguard - said that at some point, if passive becomes too large, it’s detrimental.

Daniel: He said things would collapse. Of course, you will never get to a situation where all the money is invested passively. Things would get bad much earlier, but I think we’re already very far down that line. The thing is that the ability to buy an index – the passive investments, the ETFs John Bogle was instrumental in creating and all of that – is a great idea, but like almost every great idea, if it’s carried to an extreme, it ceases to be a good idea. I think this is where we are at the moment.

John: Yes. I compare passive investing to derivatives on securities where derivatives take the price of the underlying, and passive investors take the price in the market. However, if derivatives were to become the driving force, it would clearly lead to distortions. I think it’s similar with passive money.

Daniel: The whole passive investment growth is also creating certain systemic risks for those index investors – more in the US than in other markets. Other markets are less concentrated, but in the US, a handful of the top companies now make the largest percentage of the index in history – if you look at market capitalization, not earnings – and many of them are related to each other – either being in a similar business or creating business for each other. There’s a certain systemic risk. Of course, it feels great if it goes up, but if it turns around and money starts flowing out of the market for some reason, who’s going to be the buyer? I don’t see anyone.

John: Let’s talk about how you take advantage of this because everybody knows that if you have someone at the poker table who doesn’t know how to play the game, you are at an advantage. It seems to me that in the stock market, some people are falling for what I view as a fallacy – that because there’s so much passive money now, all of a sudden, active investors might be at a disadvantage since the passive money is moving things around. To me, the more “dumb money” there is in the market, the better, right?

Daniel: No, I think the environment for active investments now is extremely favorable. I’ve been doing this for more than 30 years. I don’t recall less competition among active investors than today. Some 20 to 30 years ago, it was much tougher to find good investment ideas. It’s much easier now, but you should approach it with certain qualifications.

For example, seven years ago, we noticed that passive investments were already growing very fast. We noticed there were a lot of companies in the market whose businesses were doing great. They were growing earnings. They had no troubles. They showed good business performance, but the stock prices didn’t go anywhere. For one, two, three years, the market paid zero attention to them.

We started wondering, “Why is that?” I think the main reason is that most of these companies are away from the main indices, from the large caps. Also, the passive money was not touching them at all. Maybe even worse, it was creating outflows because the concentration game was already in play. We wondered how we could use this to our advantage. I think the answer was pretty obvious. You didn’t want to get in a situation where you would buy good-performing stocks, but you would also know that nobody would pay attention for a very long time because then it’s dead money. Also, in theory, at some later point, the price may catch up with value. It may be quite frustrating to wait because the market wouldn’t pay any attention to it.

We said, “What if we find stocks that are good businesses, that are cheap, and that the market doesn’t pay any attention to, but that create the demand for the stock themselves by buying a lot of their own shares?” In that case, you don’t need the market to notice how good and cheap the businesses are and come up with a buying demand. You don’t want it. You want these companies to stay as cheap and unnoticed for as long as possible. If they can buy 5%, 6%, 7% of their own stock at six times earnings year after year after year, the final outcome would be highly favorable – probably exponential.

In the course of 2019, we completely reanalyzed the 300 companies we follow and paid a lot more attention in our analysis to the asset allocation of the companies themselves, especially to buybacks. We now basically have a portfolio where more than 90% is companies that consistently buy back their own shares.

You take advantage of the fact that passive investors don’t pay any attention to many of those companies. At the same time, you don’t need them to start paying attention because the companies are already buying themselves. If management realize that buying stocks back at six times earning is probably a much better alternative than doing anything else, and they do it year after year after year, that’s the way to go.

Things like that weren’t readily available 20 years ago. There was much more competition, the stocks didn’t go unnoticed for a long time, and managements didn’t have that opportunity to buy their own stocks cheaply for years. I think that’s one way to go.

John: As an active investor, it seems like you’re in a race with most of the competition not even trying to win.

Daniel: No, and I would – selfishly – love to see even more passive investors than today. Of course, it’s not good for society, but for active investors, it is probably the best they could wish for.

John: Yes, absolutely. I think what you mentioned on the topic of share repurchases and companies creating demand for their stock – but maybe even more importantly, increasing intrinsic value per share as they make those buybacks at a low price – that’s one way to avoid the so-called value traps. Let’s talk about that and where you look for opportunities because I know you like to look at areas that are out of favor, underfollowed, or neglected. How do you go about that aspect of the approach and idea generation?

Daniel: There’s a saying – and, by definition, it is probably also correct – that only unpopular assets can be really cheap because, if something is very popular, everyone loves it and is optimistic, so this is probably also reflected in the price, and things are expensive. On the other hand, if something is unpopular, unfollowed, underfollowed, under-researched, under-owned, boring, then there’s a good chance it is cheap. It’s not an absolute truth, but it’s a good place to start.

We tend to find a lot of good ideas in every industry, but mostly in places that are untouched by the flows of passive money, which means they’re not in the largest caps and in the most popular industries. They may be outside the US. I can’t specifically point out a country or industry or size that would seem to be ripe with opportunities.

The opportunities are definitely almost everywhere you look if you’re looking in the right places. Looking for them is a time-consuming process, of course, and that’s good because most people are not ready to do things like that. I think opportunities are almost everywhere. One of the purposes of the book was to show that you can find them in various industries, countries, and sizes.

John: You’ve been investing for decades now. How has your philosophy evolved over time, and has that evolution also been affected by the passive investment flows?

Daniel: Yes. My first portfolio was in 1993. At the time, it was only Czech stocks because we didn’t know anything else about other markets. I was a broker at that time. I was already long-term oriented, but I knew very little about valuations and stock selections. I only invested in the domestic market. In retrospect, it was very naive.

As a broker, I had a lot of hedge funds and famous investors and investment funds in the US and UK as clients. When I visited them, I listened to them, learning what they do, how they do it, and different strategies in different parts of the world. I started looking for stocks outside the Czech Republic. My horizon was broadening, but things changed a lot at the end of 1998. I think every person has certain moments in their life that they will remember forever. You hear the news or something so impactful happens to you that you remember forever what you were doing and where you were at that moment. To this day, I remember reading Benjamin Graham’s The Intelligent Investor for the first time. I know exactly when and where.

John: When and where?

Daniel: I was living in England at the time. I read the book in my study or in my bedroom. It was the last two months of 1998. I recall it very clearly because the book had an impact on me like no other book.

Today, many of its parts are a little archaic, but there are certain parts that remain fundamental – like the idea of fundamental value, the margin of safety, the Mr. Market allegory, and stuff like that. It changed my thinking completely. I started applying Graham’s teachings to my investments. I became very statistical and number-oriented after that. I had a broader portfolio of statistically cheap stocks. It worked quite well for a time, but after a while, I noticed a few things.

One, the opportunities were disappearing as the market was getting more expensive, and you couldn’t find those deep value stocks. You had to deal with smaller and smaller market caps, which is expensive and not too appealing. I was learning more about investments. I started gravitating more towards better businesses.

Then I went through a period when I thought I was already so good that I tried to do unnecessary, complicated stuff – as if I was trying to show the outside world how smart I am. I learned from that. I think the best investments are the simplest ones. The simpler, the better.

Things are evolving all the time. Over the last several years, the approach I described in a world dominated by passive investments is to change how we select stocks. I’m very curious how things will continue developing and whether – in five or 10 years from now – I would think that this was not the best and that things could be done even better.

It’s a never-ending process. You never achieve a state where you would say, “Right now, I’m a good investor, and I can just relax and stop learning.” No, because you can always get better, you can always learn something new, and you can always adapt to how the environment is changing around you. That’s what I find most fascinating about investments. Every day, you have new intellectual challenges or inputs and signals you can work on.

John: You’re running real-time experiments, but not in a controlled environment because the market is always changing.

Daniel: Exactly. You don’t have all the information. You can’t control the environment. You have to deal with uncertainty.

John: I think that’s why so many investors love investing. You can do it your whole life and keep learning, which I think is very rare.

Daniel: It is very rare. You find very few areas where you can hope to be better and better till very old age. In most other areas – business, life, sports, and anything else – you reach your peak relatively early, and then you only go down. In investing, as long as you can stay mentally sharp, you can keep getting better and better because you accumulate more and more knowledge every day, and you cannot jump over those stages. Things don’t happen faster because you want them to. You have to live through them day by day.

John: Yes, and a lot of the fallacies in markets or the boom-busts happen at least once a generation. The new folks entering the market may think they’ve discovered something.

Daniel: People who have been investing for five or 10 years know only one state of the market.

John: If you’ve survived at least a couple of these cycles, you have more of a reference point.

Daniel: Yes, you become more skeptical and more careful. The younger folks may think you are a dinosaur. They’ve been saying about Buffett for the last 40 years that he’s out of touch, but he keeps learning.

John: There the famous saying, “This time is different,” when it almost never is, but I think even a lot of experienced folks fall for that fallacy because it’s so alluring when the market is doing well to believe that maybe this time truly is different.

Daniel: The question is the definition of what is different. Some things change over time, but some things never change. People should remember that.

John: We now have AI. That’s the new new thing. It’s definitely very powerful. A lot of people will say, “This time really is different because AI truly is so transformational,” and it might be in a lot of ways. I do agree that it is, but when it comes to the basics of investing and how value is created for shareholders, that’s still the same last time I checked.

Daniel: I agree.

John: Let’s get into some of the case studies because I think a lot of the value of the book is in those case studies – both in terms of generating potential ideas to delve deeper into and of creating mental models and patterns that could lead to other ideas. Maybe we can start with the idea of share repurchases creating value. It probably applies to a few of the case studies – certainly to Asbury Automotive. Walk us through that case study or another one, if you think it’s relevant.

Daniel: Share repurchases are a recurring theme in the book. You can find it with various stock ideas. I talk about it in more detail in the Asbury Auto story.

Asbury Auto is one of the largest US auto dealers. This business has been growing amazingly fast – both by acquisitions and by stock buybacks. When I talk about growth in a business, I usually refer to growth per share because, as an investor, I don’t care how big the company gets in terms of absolute size. What I care about is how big it gets or how profitable it gets per share that I own.

Many companies grow extensively by issuing shares or making acquisitions, but if you are issuing a lot of stock-based compensation shares, the share count keeps growing and growing. Per-share growth is much slower. When I talk about growth, it means per-share growth. In the case of Asbury, it grows both in absolute terms – through acquisitions and organic growth – but also even much faster per share because the share count has been going down over time quite rapidly.

It fascinates me. You have a company that has grown maybe 20 times in size over the last 20 years or so. It will probably keep growing much faster than the market, and it keeps trading at eight times earnings. If the company can keep buying its own shares at eight times earnings, that probably is a fantastic value-enhancing transaction.

I generally like stock repurchases, but, of course, not all stock repurchases are value-creating. I tend to put a lot of emphasis on asset allocation on the side of management and on the side of how they can use the money. There’s a number of things they can do. There’s replacement capex, there’s growth capex, there’s some organic growth. You can do acquisitions. You can buy debt. You can return money to shareholders – either through dividends or stock repurchases.

I’m not a big fan of dividends because firstly, dividends are taxed, and secondly, they are usually set up in a rigid way that doesn’t pay enough attention to how efficient that allocation is. Still, I like stock repurchases if they are done on a good value.

Unfortunately, there’s probably one trillion of stock buybacks in the US per year now – a huge amount of money – but I would say at least three quarters of that is done at prices way above the intrinsic value of the stock. If management buy stock above its fair value, they basically transfer money from the selling shareholders to those who remain in the stock. If you remain a shareholder, it damages your fundamental value.

For me to like share repurchases, one of the conditions is they be done below the fundamental value of the stock. In that case, the value is transferred from those who sell the shares to those who keep owning the shares. If I keep owning a share, its fundamental value keeps going up.

We have very limited ways of judging it, but management have at least five or seven basic options of allocating capital available. We don’t know all the options available to them at any given time because we don’t see those that they reject, for example. Even if we see those that they do, very often, we cannot ex ante calculate the return on those investments. You can try to do it ex post, but not ex ante. However, if management are truly looking at all these options continuously and always trying to send money where there’s the biggest return on investment, then buying stocks at single-digit multiples often is by far the best way because acquisitions are usually more expensive. They also carry much more risk than investing in yourself, and going for absolute growth is sometimes also not very efficient.

I love stock buybacks. Some of the companies we own have decreased their share count so much that it’s unbelievable. We used to own AutoNation, a peer of Asbury. It’s another dealer, a bit larger. Its share count over the last 25 years is down maybe 90%, so your ownership of the company has gone up 10 times even if you didn’t buy any stock, and the company itself is much bigger. I like those things a lot.

John: There’s a nuance there because, as you say, if companies are buying back stock below fair value, they are accreting value on a per-share basis. With Asbury, that was the case when you invested. It still sounds cheap.

Daniel: It still is, yes.

John: Some other stories become expensive because people look at the historical stock chart, maybe when management were able to buy cheap and were cannibalizing their own shares. Now, some of those stocks get expensive and management don’t switch gears. They keep plowing free cash flow into the stock. That seems problematic, but it’s also tough for managements as their shareholders probably want them to keep repurchasing because – almost by definition – if you’re a shareholder of a company, you probably think the stock is undervalued. A couple of recent examples are O’Reilly Auto and AutoZone where I believe the stocks are now in the 30s on a PE basis. The math works differently if you keep buying back.

Daniel: Yes, these two companies are among those notorious stock cannibals. The only thing they do is buy back shares, which is okay, but if you buy at a high 20s multiple, it’s not the best use of money.

Management have to be more flexible in the asset allocation. For example, we have another stock in our portfolio you might want to talk about later. It is also mentioned the book – OSB Group. It is a small UK bank. It also does very large buybacks regularly, but the management seem to have a matrix where they compare the price on a daily basis to their notion of intrinsic value. You can see that if the stock is lower, they buy 300,000 shares a day; when the stock moves higher, they buy 30,000 shares a day. They are very price-conscious. That’s very important.

Another bank we own is JP Morgan. Jamie Dimon says that over time, they will do a lot of buybacks because they have so much excess capital and make so much money, but now – at 2.4 times price to book and maybe 2.7 times price to tangible book – it doesn’t make any sense. They might do some, but very little. I think you have to be very price-conscious because you can easily destroy value.

Another example of good allocation is Berkshire. Buffett started buying back shares seven or eight years ago. He was very active four or five years ago. They were buying back a lot of shares when the stock price was maybe 25% above book value. At the beginning of this year, it was maybe 65%, so they didn’t buy any for the last 12 months. Now it’s getting cheaper again; maybe they’ll start at some point.

A lot of managements have a short-term thinking horizon. They know they’ll be out two or three years from now. They have stock options and bonuses. Very often, it’s tied to the stock price, which I don’t think is a good criterion. They tend to do whatever it takes to keep the stock price up. Warren Buffett – of course, his own horizon is now short, but his thinking is as long-term as ever – doesn’t get any bonuses from stock price. He owns a lot of stock himself. He wants the fundamental value to keep building. He thinks long term. He knows that sooner or later, the price would get cheap enough again, and he would buy a ton of stock. Until then, he’s happy to accumulate cash.

Most investors today either don’t care – that’s the passive – or have very short-term horizons. Buybacks are not a big part of their long-term investment team because they don’t have any long-term investment team. They’re short term-oriented. As long as management keep buying shares, that keeps the stock price up in the short term, and that’s fine, but if you’re a very long-term investor and think in five years and longer terms, then the asset allocation on the side of management is absolutely essential. You can kill a good company with stupid asset allocation, and you can make an average business an extremely strong compounder if your asset allocation is highly efficient.

John: That’s such an important point with regard to buybacks because buybacks are great if done at the right price. Otherwise, they may not create value. That’s within the intelligent investor community. Then there’s the whole other category of buybacks we don’t even talk about, which are made for offsetting stock-based comp, which is a total waste of money. I think we would agree. The principle of looking at things on a per-share basis is something investors should take to heart more because if your favorite growth company is putting up 20% to 25% on the top line but the share count is growing 5% to 10% a year, you’re not ahead that much.

Daniel: I’m glad you mentioned stock-based compensation because it is a huge number in some companies. It runs in the tens of billions per year. I know why, but those companies tend to include it in operating cash flow – like they are making money – whereas I always exclude it from operating cash flow. I put it in financing cash flow because you’re basically selling stock to finance the business.

Very often, it looks like they do a lot of buybacks, but when you look at the details, two-thirds of the buybacks are buying back stocks they previously issued at much more favorable terms to shareholders. First, the free cash flow is much smaller than they show. Second, the stock buybacks are also much smaller than they show because they offset what they issued before.

Take Amazon. It has a great business, but its stock price is always a bit expensive. It’s pretty high. Amazon has been doing stock-based compensation for many years. For you as an investor, it is good to pay employees with seriously overpriced stock. That increases the fundamental value of the business.

Tesla did the same. Its stock is always extremely expensive. Many times, the company issued a lot of stock at a strongly inflated price. At times, it was questioned whether Tesla could finance itself, but because the market was awarding it a very high stock price, it was able to issue very expensive stock, which increased the fundamental value of the business. If you can issue a relatively small number of shares at five times their fundamental value – or 10 times or 20 times or whatever – it increases the value of the business. The dynamics of this is always fascinating to me.

John: Yes, it’s like the reflexivity argument. That’s also why it’s hard to short high-flying stocks because they could issue new shares at the inflated price, and that diminishes your short thesis. If they can raise a ton of money at an inflated price, all of a sudden, they can have this huge cash position that wasn’t part of the thesis before. It’s a very dicey approach, to say the least, to bet on that kind of reflexivity working out because it can also work the other way where if a stock starts going down, all of a sudden, you have to issue more shares for your stock-based comp. It’s harder to keep employees. It can also spiral downward very quickly.

Daniel: Yes, especially in the finance industry. If the stock price is depressed, the companies usually have a hard time financing themselves, so the reflexivity works negatively. There’s a negative loop.

John: Yes, definitely. You mentioned OSB Group. How did you find the idea? How does a smaller bank like that even register on your screen? You also look at bigger banks and have found value in some very large banks. What’s so special about OSB Group?

Daniel: You’ve read the book. I talk about investing in banks in general first in that chapter because I find it interesting. A lot of people avoid investing in banks per se. Some of the arguments are rational or reasonable – it’s a leveraged industry, it’s a regulated industry, there’s a lot of competition, it’s highly cyclical. That’s true, but sometimes, the arguments are less rational – like, banks are black boxes. You can even hear sometimes that there will be no need for banks in the modern world.

However, some other people have been highly successful investors and have been investing in banks for life – like Warren Buffett. There’s always something in-between. I think a well-chosen bank can be an extremely good long-term compounder. The reason is that if you look at the balance sheet of a bank, it almost entirely consists of financial items. There are no factories, no inventories, no big capex, and stuff like that. It’s all financial items. Whenever a bank makes profit, the whole profit increases the book value.

If a bank’s ROE is at a relatively high level, the book value – which is a good measure of value growth for banks – is growing very fast because you don’t have this leakage. You don’t have this capex, etc. It all grows up. Also, despite assets being depreciated at industrial companies, you don’t know what the market value is relative to the accounting value, while in banks, a lot of stuff is mark-to-market, so the book value is better.

If you find a bank that compounds capital, has high ROE, it can be a great compounder. I have two examples in the book. One is JP Morgan. When you look at banks, because of the risks I talk about, it’s probably a good idea to pick the best. It’s not a good idea to go for lower quality because it’s cheaper. You should stick with the best. I think JP Morgan is by far the best-managed large bank in the world.

Jamie Dimon took over Bank One in 2000 and later on merged it with JP Morgan. The return of the stock since he became CEO is over 12% per annum compared to maybe 7% or 8% for the S&P 500. It beats the market by far. Even if you take the JP Morgan period from 2004, it’s still better than the market. That’s because the average ROE is in the double digits, and that’s much higher than the average earnings growth of the S&P 500. This could be a great long-term compounder.

There’s another way to select among banks. That is our second example – OSB Group. It is a smaller UK bank. If you look for a bank with a special niche in the market – a segment that has been abandoned by the big players for some reason – you can also find a great compounder. That’s the case with OSB Group. It’s a UK bank with a market cap of probably 2 billion or under 2 billion pounds. It’s small, but it has a very simple, old-fashioned business – it mainly lends money to buy-to-let small businesses.

A portion of the UK housing market is occupied by people who rent apartments, and these properties are typically owned by small or medium-sized businesses. A typical owner has between one and seven properties. The bank lends them the money. It’s a very safe business. First of all, it’s collateralized by the real estate. The average loan to value is about 65%, which is pretty safe. The average cost of risk recently has been about 25 basis points. It’s very good. It’s also a well-diversified business because the loans are relatively small. There are thousands of them, maybe even tens of thousands.

There was a change in regulation in the UK market several years ago that made the large banks leave this segment. It became too cumbersome and too labor-intensive for them, so they left. This segment is now dominated by smaller players, and OSB Group has a roughly 9% market share in its main business.

The company IPO-ed about 11 years ago. The book value – if you add back the dividends it paid – has compounded by something like 17% or 18% per annum since the IPO, which is very fast growth. I would expect it to do similarly well in the next 10 years. I would expect the ROE to be at least 15% over the long term. When I wrote the book, it was trading at around 75% or 80% of book value, which I deem very cheap. OSB has been using this price to its advantage, buying all of that stock. On the top of that, it pays a lot of dividends. You could do well in a business like that.

I like investing in banks because I myself have been in the financial business for 30 years. I was in asset management brokerage. I was also on the board of a bank in Prague for a short time. I have no prejudices against banking. If you select your stocks well, you can compound your money very well.

John: It sounds like – and maybe that’s a pattern you look for – smaller banks like OSB have a strong position in a particular niche that’s maybe less competitive because the big banks don’t want to put in the effort it takes.

Daniel: Yes. In the UK, the requirement was that the bank sign off on the business plan of the property owner, which is stupid. If you’re a bank, it’s in your interest to learn about it, but why do you have to sign off on it? The big banks said, “Forget it. We’re not going to do that in order to lend two, five, or seven million to those people. We want to lend 25 million or 250 million to big businesses.” They left the segment, and smaller banks increased their market share.

When valuing a bank, you have to value it differently from valuing non-financial companies. We tend to value non-financial companies based on free cash flow. With a bank, it’s pretty much impossible to figure out what the free cash flow is. You also don’t know what a bank’s debt is because pretty much everything on the liability side is some form of debt.

However, because it’s all financial items, we tend to combine the book value and the ROE as the two key elements in valuation. The higher the ROE, the more above the book value we’re ready to pay. We tend to discount banks by 10%. If a bank has an ROE of 10% over time, we think it’s approximately worth one time book value. If it has 15%, we tend to pay above book value. We try to avoid banks with ROE of less than 10% because they can be cheap, but the correction of valuation has to happen rather fast; if it takes longer, then the low ROE has very negative effects. We tend to pick.

For JP Morgan, the return on tangible equity – which is a sibling of ROE – should be about 17% over the cycle, which is a lot. For OSB Group, I expect the ROE to be about 15% over time. If you have a 15% ROE and start at one time book value, you’re probably going to make more than 15% per annum over a long period.

John: I guess your assessment of management is crucial with banks.

Daniel: Yes, absolutely. With JP Morgan, I can’t think of a better managed bank if we’re talking about big banks. There’s a lot of smaller banks, so there’s no way you can learn about all of them, but at least you can assess the management of those you look at, and I like the management here as well. It’s a very old-fashioned banking business. You lend money to business owners. You own the loan until its expiration. You finance by retail deposits. It is pretty safe for the business.

John: Yes, that sounds very straightforward. I guess with banks it’s the net interest margin.

Daniel: Net interest margin is key. Fees and commissions. On the other hand, you have a cost of risk – bad loans and cost of your capital.

John: Another case study I find fascinating at the moment – because it’s still misunderstood even though it had some big positive news – is Burford Capital. I thought the stock was going to rerate very quickly after Argentina acknowledged there’s something there. What was the thesis when you first invested? How has it played out so far?

Daniel: It’s a UK-based company I discovered about six years ago. It’s a pioneer and by far the biggest player in litigation finance. Litigation finance is a relatively young industry. It’s a business where companies finance litigations for their customers – typically corporations or law firms – in return for a portion of the awards, if there are awards.

I selected the company for the book because, in general, I think that human capital or human work is a big value creator at the level of companies. The people create value by their work, by their ideas, by their efforts in general. It’s not always positive, but overall, it’s positive. In the case of Burford Capital, 100% of value is created by human capital.

It’s like a private equity fund where the portfolio doesn’t consist of stakes in companies but of hundreds of legal cases. They have relatively short maturity – about three years on average. When the company gets the proceeds, it reinvests them in new cases. It’s like a private equity portfolio marked close to market because it’s much shorter, and it’s being reinvested at a relatively high level. I think the IRR over the entire history of the company is in the high 20s – maybe 27. That’s the rate at which it is able to invest and reinvest the money, which is a lot. You deduct the cost of running the business, you deduct the cost of capital, you add a little because of leverage, and you come up with a theoretical expected return on equity.

I think the company is still a bit misunderstood because it’s relatively young. It’s also relatively small. It was listed in UK first and only recently in the US. The accounting is fine, but the cadence of earnings is extremely unpredictable. It’s not like a business where every quarter you book about the same revenues and profit, and it goes up 5% every year. The results of the legal cases are unpredictable, as is the timing. Quarterly results are more or less meaningless. Sometimes, they are very good; sometimes, they are poor, but that doesn’t matter and doesn’t mean much. You should take a more general, philosophical approach to that business, but this is still very cheap.

Its biggest case by far is the litigation against Argentina. In 2011 or 2012, Argentina nationalized YPF – the oil company – and expropriated the foreign investors without any compensation although it previously wrote in the articles that in case something happened, they will be compensated. There was even a formula for how compensation would be calculated, but that didn’t happen.

The two clients Burford represents went bankrupt, and the liquidators approached Burford to ask if it could finance the case because bankrupt companies have no cash. The US court has awarded $16 billion to the defendants, of which Burford would probably get about a third – about 35%. There’s still an appeal pending. Right now, the sum is over $17 billion because the interest keeps accruing. I think Argentina would have to settle sooner or later.

If the full amount is awarded, Burford would probably get about $5 billion or $6 billion. Its market cap is less than $3 billion. That’s a lot of money. Of course, the market discounts that award and believes the case will be settled for much less money. At any rate, it would be quite substantial. Besides that, Burford owns a lot of other cases. Some of them are very large. Even without the YPF case, the stock price justifies the rest of the business. We have a solid business at a fair value plus a free option for a huge upside.

I think it’s a great – almost textbook – case of a company where pretty much the complete value of the business is created by human capital and human work because the core of the business is 70 lawyers who have to be able to assess cases, express them in time, probability, and monetary terms, and decide whether they do them or not.

John: To me, it looks like a classic case of investors framing the investment thesis wrong. The Argentina case is almost like an overhang on the stock when it should be the opposite.

Daniel: Exactly.

John: As you say, the rest of the business already justifies the valuation. Fundamentally, from the IRRs it’s been able to get on the portfolio of its litigations, it’s a good business.

Daniel: The YPF case is excluded from this IRR because the IRR is only calculated from the cases already concluded and paid for.

I think there’s a lot of misconception about this business because it doesn’t initiate the legal cases. It doesn’t take them over. When a corporation approaches Burford and says, “We want you to finance our portfolio of legal cases,” it look at it and maybe does that. The law firms do the same because they don’t have the capital to finance it themselves. Burford doesn’t initiate the legal cases and doesn’t take them over. Sometimes, it is looked upon negatively, as if it’s a vulture fund that tries to feast on poor delinquents, but no, it doesn’t initiate the cases.

John: Do you think there are any legitimate concerns or risks around Burford on the competitive front? If the IRRs are so attractive, maybe some bigger law firms would say, “We will do the case.”

Daniel: The competition is much smaller. There are a couple of other listed firms, but they are probably one order smaller. There are some private equity funds or specialized hedge funds that compete with Burford as well, but it has achieved a reputation and a size that leaves it with almost no competition.

For example, it can finance whole portfolios of legal cases for a corporation. It recently purchased such a portfolio from a Fortune 50 corporation and then invested $250 million, which is a transaction that very few competitors can do.

If you look at Berkshire’s insurance business, in the history of insurance, I think there are maybe seven or 10 transactions in total where the insurance premium was $1 billion or higher, and all of them were done by Berkshire because no other insurance company can take so much risk on its books. I think there was even a case a couple of years ago where Berkshire sold reinsurance to AIB and the insurance premium was $10 billion. There’s no one in the world that could do a transaction of that size.

In its own business, I think Burford is in a similar position. It’s at a level where it has very limited competition.

John: Yes, definitely a fascinating case. What kind of timeline do you expect on Argentina? Is there a way to tell how the negotiations are going?

Daniel: No. There’s still one appeal pending, which I’m pretty sure Argentina would lose. Unfortunately, it’s not the fault of the current administration but the previous ones. It has had a lot of litigations and lost many of them, eventually paying in pretty much all of them. It tries to fight and delay, which eventually costs it more, but it has to pay.

There was also litigation regarding some GDP-linked bonds in the UK where it lost the final appeal and has to pay about 1.5 billion. There’s no further appeal. That case now appears in the documentation of IMF that’s lending money to Argentina. At some point, Argentina has to recognize this as a liability.

In the YPF case, there’s still one more appeal pending. I think the government doesn’t want to recognize it until every other option is recognized. Of course, it will become more expensive for it, but countries like Argentina and Brazil have a history of imprisoning previous presidents. You don’t want to be in a situation where the next president put you in jail because you signed a settlement and didn’t exhaust all cases.

I think the time will come – probably later this year or next year – when the appeals would be exhausted. Of course, it would be smarter for Argentina to negotiate a settlement much earlier in the process because the further it goes, the more it loses, and the less leverage it has. We’ll see. It’s an interesting story to watch.

John: Shifting gears, you also profile an energy company. That’s a whole different sector, but – from both a macro standpoint and the company-specific thesis – it’s a very interesting one.

Daniel: Yes, the company I talk about is Cenovus Energy, but there’s another chapter preceding this one that talks about the oil industry in general. I think there’s a misconception among many investors that the demand for oil will go down fast for some reason. Some agencies even project very fast declining demand for oil.

However, when I travel around the world, I see a completely different story. I see a lot of growth ambitions in the poorer 5 billion people in parts of the world where the demand for energy is very low right now, but these people have ambitions and desires to live a much better life than they do. They want to get closer to what we are used to. If they succeed, this will come together with a lot of increasing demand for all types of energy, including oil.

I see oil demand growing continuously for many years down the road. If you look at the supply and demand, the more likely scenario is for oil to go higher over time or in the next 10 years. Of course, to a certain extent, oil price and gas price are the key elements when you analyze an oil company because they are all price takers. If you try to figure out what the future cash flow is for an oil company, and if you try to build a model or even do a rough estimate, oil price is always the first line. You have to have some expectations about it. My expectations are on the upward side, not the downward side.

We used to invest in oil a long time ago – before 2008 – when there was a period of globalization and China was rising. Oil was growing very fast, but maybe two years later, we left the industry because we didn’t like the asset allocation of oil companies. At that time, it was like, “Drill, baby, drill.” They were trying to acquire as many assets as possible, acquire other companies, grow production, and whatever it took because their expectations for oil prices were very optimistic.

In this industry, you are a price taker. You have very long investment horizons. You have huge upfront costs. You work with a debt load, and it’s a highly cyclical industry. The asset allocation process was very distracting. However, things changed over time. The oil companies were being pressured to stop producing oil – by society, by politicians, and sometimes by their own shareholders. They ventured into other industries and other activities. Most of all, they stopped investing in oil production because it was unpopular.

Put yourself in the shoes of the CEO of a large oil company. Your chief geologist comes to you and tells you, “I’ve got a great discovery offshore of Brazil. It will require $9 billion to invest. We might start producing five years from now, and we will be producing for another 15 years. Probably five years from the start, we’ll recover the initial capital.” The CEO will tell you, “Forget it” because in today’s environment, he would be facing society pressure, so why take the risk?

Companies have cut dramatically their investment in new production. Instead, they are returning money to shareholders, which for them is less controversial and less risky. In the short run, it may be beneficial for shareholders. The outcome of all of that would be that the price of oil will be higher than it could be because you will not have sufficient investment. That’s the macro story.

When you think about how to express that in stock selection, there’s a lot of choice. There are many oil-producing companies. What we do is cluster them into four groups. One group are the national oil companies, like Saudi Aramco, but most of them are not publicly traded. Saudi Aramco might be the only exception, but you wouldn’t invest in that, so we put it aside. They produce about a quarter of the oil.

Then you have the supermajors like Exxon, BP, Shell, and Petrobras. We don’t invest in them as well because their size is their disadvantage. They have to spend a lot of money on developing new reserves and finding new oil, and growth for them is very difficult to achieve. Also, because they’re so big, they are in the front line of politicians’ anger or pushbacks.

On the other end, you have junior oil companies. Some of them are not even producing. Some of them rely on one or two key sources. You can make a lot of money in some of them, but it’s a very risky area. You have to be deeply specialized.

We try to look for something in the middle. We look for companies that are highly profitable, have established production, have low finding cost and low production cost, and are in predictable jurisdictions. That leaves you with only very few option – some in US and some in Canada. We picked one of the three large Canadian players – Cenovus Energy – because Canada may not always be predictable, but it is one of the more stable environments.

The company has all its oil in place, so the finding costs are very low. Its development costs are also very low because of the type of production it does. The production costs are low because the main cost is gas, which is cheap in that part of the world. The asset allocation policy is very good. The company basically returns all the free cash flow to investors by some dividends but mostly by buying back stock. I expect the share count to continue going down over time.

If my assumptions about the future price of oil are more or less okay, then Cenovus should be able to generate a double-digit free cash flow yield and will return most of it to shareholders year after year. That’s explains the position. Also, if you own all these oil reserves in the ground – in this case, it’s for more than 30 years of production – it creates a hedge against certain extreme scenarios in general, for example, high inflation, commodity shortages, or even geopolitical risks. I think a position like that has a place in our portfolio.

John: Very interesting. Obviously, it is a commodity business, not the traditional high-quality business. Cenovus in particular sounds more like a predictable production story than an exploration story.

Daniel: Yes, and it’s not only being able to produce oil cheaply. You also have to be able to transport it and refine it. Cenovus is well-connected to pipelines and has some refineries. As long as its asset allocation priorities remain as they are, we’ll be happy to own the stock.

When the modus operandi changes in the whole industry, and they start acquiring each other or start acquiring reserves regardless of the price, we would reconsider it, but as long as they keep growing at a reasonably modest pace and return free cash to shareholders, that’s the ideal situation. It’s an ideal situation for us as shareholders, but it’s not ideal for consumers because that makes the oil price higher than it could be, but we’re not going to change that.

John: Let’s talk about Berkshire because that’s the big one and an inspiration for a lot of things, including the last chapter of your book entitled “Berkshire Park.” It has a lot of parallels to investing, and I was fortunate to see it and experience it. Thank you for that.

When did you first invest in Berkshire? How do you view it in terms of the position it has in your portfolio because it’s a special company?

Daniel: I first bought Berkshire in 1995 or 1996 – years before we started the fund. In the fund, it’s been our largest position by far for maybe 13 years. It’s a benchmark stock within our portfolio because it has probably the most predictable future results among all the stocks we own. It develops in a very predictable way. It also has the least business risks of all the stocks we own. That’s because of the balance sheet, asset allocation, and quality of assets.

At today’s price, you can probably earn 10% or 11% per annum over the long run from this stock with minimum risk. When we look at any other company, we want higher return because every other company has higher business risk. We can always buy more Berkshire to a certain point, so we always use it as a benchmark. Every other stock we own has a higher business risk, but most of them – at least when you buy them – have a higher expected return. For us, it’s a good benchmark that keeps us disciplined.

I included it in the first chapter of the book because what I find fascinating is that it’s one of the best long-term stories in the world – or at least in the US. It’s been visible to everyone for decades, yet still so few people understand the company that I’m baffled. If you’re a professional investor and see a story that’s been so successful, you should learn a lot about it. You don’t have to invest in it, but you should understand why it’s been so successful. People don’t understand it.

Last Saturday, it reported quarterly earnings. You can see from the headlines that the journalists don’t really understand the figures. Our mutual friend Chris Bloomstran got angry on Twitter. He said, “I spent two hours talking to journalists, trying to explain to them what the results are, and then they misrepresent them in the story anyway.” I find it fascinating. A lot of investors don’t understand Berkshire. Many people still think it’s an investment fund.

Among the big mega caps, it’s the only one today that I consider undervalued. That’s why we still own it. It’s an example of a boring company in the sense that its development is very steady. You don’t expect there to be any excitement. Yes, every 10 years, it does a big acquisition, but then it’s a reasonably steady and boring business.

People tend to find boring businesses unattractive, which I think is a mistake. People have a tendency to undervalue the impact of long-term compounding, which is exactly what this business is about. Every company has a certain life cycle because it has a certain product that experiences a boom but is eventually replaced or dies down. However, Berkshire’s business is not some product or service. Its business is compounding capital, and that compounding can run forever and can be very fast on a per-share basis.

John: What’s most misunderstood seems to be this aspect that it’s not an investment fund. It’s a collection of operating businesses.

Daniel: A conglomerate.

John: With a great capital allocator at the helm.

Daniel: Cheap leverage. Your built-in leverage, which is non-recourse, is for free and has indefinite maturity.

John: How do you think about the fact that it’s so big now and the rate at which it can keep compounding given the size?

Daniel: Yes, it’s a disadvantage. Size is always a disadvantage in investments. I think it should be a lot more aggressive on buybacks because that takes a portion of that problem away.

It was very active several years ago. Around March or April this year, for the first time since 2002 – at least in our calculations – the stock got above its fundamental value. I understand why Berkshire doesn’t buy right now, but over time, it should get more aggressive. Right now, I think it’s about 14% to 15% below its fundamental value. Maybe it’s not cheap enough for Berkshire yet, but with that much cash and this problem growing over time, it should maybe be more aggressive.

That’s one reason why we have Markel in our portfolio and also as a chapter in the book. Another thing I find fascinating is that the Berkshire business model has been in place and visible for decades, but almost no one has been able to replicate it. That’s because it’s not easy. That’s why one of the durable advantages is the business model put in place at Berkshire. Markel is one of the very few companies that at least tries to do things in a similar way and got somewhere in a successful way.

Over the last 25 to 35 years, the stock performance might be even better. I remember when Tom Gayner joined Markel around 1990. I think the stock price was $20. Now, it’s $2,000. It’s a 100-bagger, which probably might be better than Berkshire over that period. Of course, it’s not the same quality. Markel is not there yet, but it’s going in a similar direction. Markel’s biggest advantage is that it’s much smaller – the market cap being maybe $25 billion. Size is definitely not a disadvantage for Markel. t will have an easier time growing faster.

However, it’s extremely difficult to replicate Berkshire’s model because – among other things – it takes a lot of time. There’s a great book about Berkshire by Adam Mead published a couple of years ago that gives you the entire history of Berkshire’s transactions. When you look at the late 1960s or early 1970s – soon after Buffett became CEO and started turning the textile company into what it is today – you realize how long it takes. Even 10 years after he started, it was still a very small company. These things take a very long time, and no one has the patience to keep building something for 30 years and waiting for the results. That’s why it won’t get replicated easily.

John: Yes, it’s the nature of that exponential curve which – for quite a lot of years – looks almost flat, and then it goes up. There’s that statistic around how much value or personal wealth Buffett has created after even his 80th birthday, and it’s a lot.

Daniel: Yes, I think he was in his 50s when he became a billionaire. One billion today is not a lot of money, of course, but at that time, it was. If he didn’t distribute a lot of his shares to charity, he would probably be now over $200 billion – maybe $300 billion. About 99% of his wealth was created after he turned 50. That’s the exponential curve. In absolute terms, the biggest numbers of Berkshire are still ahead, not in per-share terms or in percentage terms – that’s almost impossible – but in absolute terms.

John: Where’s the stock price today?

Daniel: It’s about $700,000.

John: How about when you first invested in 1995?

Daniel: Personally? It was $45,000 maybe. When we first bought it in the fund, it was $110,000. I don’t own it personally now – only through the fund – but for me, it would have been 15 times. For the fund, it’s about seven times.

John: Yes, I don’t think we’ll have that story repeated. As you say, there aren’t even many trying to repeat it. Markel is one, and maybe a few others.

Daniel: Yes, very few.

John: It’s truly remarkable. I wonder what will happen with Berkshire after Buffett is no longer at the helm – whether it continues as one entity.

Daniel: I don’t expect any major changes. De facto, a very large part of Berkshire has been run by Greg Abel for some time. He’s been in charge of the private part for some time. At the end of this year, he would be in charge of the whole business. He would become CEO.

The longer I watch him, the more I like him. I think he’s an extremely smart guy. Buffett is Buffett. There’s no one else like him, but Greg might have certain advantages over Buffett. First of all, he was running real businesses for some time. True, Buffett is the CEO of a large conglomerate, but he’s more of a money shuffler/asset allocator – a great one, to be sure, but Greg Abel was running businesses himself. That may be an advantage to a certain extent. Also, he seems to have less inertia vis-à-vis some of these private businesses. Buffett bought all of them, and some in the private section of Berkshire are probably not performing well enough. I think Greg Abel would be tougher on them. He has been already. He might be even more disposed to get rid of some of them.

I don’t have any problems with him running the show. Of course, I would love to be reading Buffett’s writing and listening to him for many years to come, but that can’t happen.

John: In the book, you also talk about a couple of mistakes – which I think is also instructive to include – and their different nature.

Daniel: I mentioned two specifically. I mentioned CVS as an example of a company we should have never bought and Microsoft as an example of a company we should have never sold. I don’t have much emotional attachment to those mistakes, but I try to analyze them in an intellectual way and figure out what the mistake was, why it happened, and how to make sure it won’t repeat very often. I think it’s important to be learning from the mistakes.

John: What was the mistake with CVS?

Daniel: CVS used to be an extremely popular stock until about some time in the middle of the last decade. It made the huge acquisition of Aetna – a health insurance company that was hugely overpriced – and the stock started to go down. CVS incurred a lot of debt and had a lot of interest to pay down. It had to stop buying back shares and had to continue reusing the debt. The valuation kept getting lower and lower because the market didn’t like what the company did.

Then it replaced the CEO. The one responsible for Aetna was gone. CVS brought on the one previously running Aetna to be its new CEO. She said the priority would be not to do acquisitions anymore. The company would buy back stock and focus on improving the business.

After COVID, the stock was pretty cheap. We said, “This looks like an attractive opportunity.” We based it on our faith that the asset allocation would be okay. For a while, it was okay, and the stock was moving higher, but the company did two acquisitions in short succession that were a complete waste of money. It wasted maybe at least half of the purchase price. Again, increase the debt, stop buying back shares, and the rest. The market didn’t like the acquisitions, and the stock started going down.

We realized that if a company has a history of poor asset allocation, the fact that the CEO changes – especially when she comes from within the company – is not enough. We sold it because there’s no point in owning a company that is doing reasonably well but from time to time destroys the value by paying too much for a large acquisition. That was a mistake.

I talk about base case versus case rates. We knew that expensive acquisitions are the red flag we want to avoid, but we tended to overweight the case rate – like believing things here would turn out to be better – but that was a mistake.

In the case of Microsoft, it’s a stock we should never have sold. We bought it in 2010 or 2011. It was extremely unpopular. It’s hard to imagine that today when it’s one of the Mag Seven, but back then, people saw Microsoft as a business of the past that had nothing to do or nothing to say for the future. It traded at 10 times earnings.

We had a different opinion of the company. We bought it and had to explain to our investors for two years why we bought a stock that everyone knows is on its way out of business slowly. Then it started to go up and we didn’t have to explain anymore, but the thing was that it started to do much better than anyone thought.

Our mistake was when we paid 10 times earnings for an unloved stock. That was our anchor price or anchor valuation. The earnings started to rise. The multiple started to go higher. After several years, we felt it was expensive because we bought it at 10 times earnings. Now it’s several times higher, but these multiples are very expensive, so we sold the stock. We made a lot of money, but the stock went up much higher after that.

On CVS, we lost maybe half a percent of the fund – almost inconsequential because we initially bought it very cheaply. It doesn’t bother us that much. It’s a good lesson, but it doesn’t really matter. On Microsoft, we made a lot of money, but we left so much money on the table by selling it too early that I’m still kind of bothered about it.

We try to be more general about letting the good stories run because, usually, when you have something working very well, you just let it go for a while more because when good companies start running, they tend to go for longer than people think. Also, the market rewards them with bigger multiples although this is a sensitive theme because you don’t want to get caught in the growth trap. Sometimes, you let go, but it was a mistake no one forced upon us. We decided to sell.

John: What is a growth trap, in your view?

Daniel: People talk about value traps a lot. A value trap is a situation where you find a cheap stock – the value opportunity – but over time, you realize that the value in the business is not as high as you thought. It may be lower. It may be going down, and the stock keeps going down with it. It keeps being cheap relative to value, but because the value keeps going down, you are trapped. In the end, you might sell the stock – still at a discount – but you know that the discount is not really there because the value is questionable.

There’s a mirror situation which I call a growth trap, where you pay too much for too high potential future growth, then you realize the growth won’t be there and you overpaid, and the stock collapses dramatically. In value traps, it’s like a continuous process. It’s only a matter of how fast you come to the realization that this is the case. With growth traps, it tends to happen very fast.

We’re living one case right now with a Danish company called Novo Nordisk. A year ago, the stock was above $1,000 because everyone was extremely bullish about the potential of the obesity drugs. Then came the realization that the growth might be there, but way more modest, and the stock is now 70% lower, which is highly unusual for a very well-known, large company like that.

This is probably a typical case of a growth trap. A lot of people got trapped in their expectation of potential growth. The stock was trading at 50 times earnings at its peak, which is a lot even if you are growing fast. Now, it’s priced at 12 times earnings over the next 12 months, which are much lower growth expectations. The future will tell what the case is and whether this is a value trap or a value opportunity. It’s certainly not a growth trap anymore.

John: Yes, it’s very tricky, and that’s where judgment comes in on this issue of selling too early a company like Microsoft. It certainly hurts a lot, but as you say, some companies turn into growth traps. For Novo shareholders, it would have been smart to sell at some point, maybe even a little early. I think that’s where valuation does need to come in although as value investors, we often underestimate how high valuation can go on those growing companies.

Daniel: Yes, it can. We were buying Microsoft at 10 times earnings. You could say that at that time, it was a great opportunity because it’s a very strong, established company. Its growth after that was much faster than people expected, but now you’re paying a high 30s multiple for a stock like that. Can it grow fast enough to justify this? I don’t know. The market thinks it can, but I’m not convinced. It’s not growing that fast. It’s decent growth, but not super high growth.

You can find companies growing at least that fast at much lower multiples, but I didn’t expect 15 years ago that the stock would go to 35 to 37 times earnings. No one did. Otherwise, the stock wouldn’t have traded at 10 times earnings.

It’s easy to explain and justify everything ex post, but we don’t know whether the multiples for Microsoft or Novo Nordisk today are too high or too low or just about okay. That’s the good thing about investing. You can never arrive at a situation where you would say, “I know this is the way it’s going to be.” It’s always assumption, estimate, uncertainty, incomplete information, dynamic environment. Everything is changing. It’s very stimulating.

John: If you were to synthesize it all, what’s your advice for finding hidden investment treasures in today’s market?

Daniel: I’m not very good at making bold statements, but I try to explain two things in the book – that the environment for active investors today is very favorable if you understand it and approach it in the right way and that there are opportunities out there.

There’s plenty of them although the US market may be at one of its highest valuation levels in history. It’s partially held up by a handful of top stocks. If you go below the surface of the market, you can see a lot of opportunities everywhere – in other countries, emerging markets, and other developed markets. I think you can have a lot of fun and make a lot of money if you do the work. It requires a lot of effort. That’s true. Those opportunities will not present themselves every morning, but they’re there.

John: In parting, tell us what lasting principles you want readers to take from your book.

Daniel: As we said earlier, some things change, but some things don’t. Something that doesn’t change – and that I think will not change in the future – is that you should look at investments as a transaction where you exchange money for some value.

You have to always think in terms of price and value and always try to make investments where the price is much lower than the value. It doesn’t apply only to stocks. It applies for any type of investment. Many people don’t think about these things at all. If you have the discipline and select investments in this way, you can have a much better combination of return and risk than the market offers today.

John: Yes, people seem to know price versus value intuitively in the rest of their lives, but not in the stock market for some reason, which is interesting.

Daniel: Yes. When you do your regular shopping, you wouldn’t pay an exorbitant price for something ordinary or just good. You’re always price-conscious. However, when some people look at stocks, they forget about it completely. That’s a mistake.

John: Thank you for this conversation, Daniel.

Featured Events

• Latticework 2025 (FULLY BOOKED), New York City (Oct. 7)

• Ideaweek 2026, St. Moritz, Switzerland (Jan. 26-29, 2026)

• Best Ideas Omaha 2026, Omaha, Nebraska (May 1, 2026)

• The Zurich Project 2026, Zurich, Switzerland (Jun. 2-4, 2026)

Share Latticework by MOI Global

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• Share Latticework (simply click the above button!)

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Volunteer by reaching out directly to John (john@moiglobal.com).

In this interview, Larry Cunningham shares key insights from his book, The Essays of Warren Buffett: Lessons for Corporate America. Cunningham, a distinguished scholar on corporate governance and a trusted commentator on Buffett’s philosophy, reveals the essential wisdom distilled from decades of Buffett’s letters. By carefully curating and synthesizing Buffett's annual letters into coherent themes, Cunningham illuminates Buffett's timeless principles on investing, business management, and leadership.

Throughout the discussion, Cunningham emphasizes the underlying consistency of Buffett's investment philosophy—particularly his focus on intrinsic value, the critical distinction between price and value, and the unwavering importance of trust in corporate culture. He sheds light on the distinctive trust-based operational structure at Berkshire Hathaway, explaining how autonomy granted to subsidiary managers fosters exceptional performance and long-term value creation.

Cunningham also provides compelling insights into Buffett’s approach to modern issues such as ESG, shareholder activism, and corporate governance, highlighting Buffett's unconventional yet deeply principled stance. Experienced investors seeking to deepen their understanding of Buffett’s methods will find Cunningham’s analysis particularly valuable, offering clarity and perspective beyond superficial interpretations of Buffett’s widely publicized comments.

Insights you’ll gain in this conversation:

• The Evolution and Importance of Buffett's Essays

• Intrinsic Value: Price versus Value

• Trust-Based Corporate Culture at Berkshire

• Berkshire's Unique Governance Model

• Buffett’s Approach to ESG and Corporate Responsibility

• Identifying and Attracting Quality Shareholders

• Buffett's Exceptional Communication Skills

• Index Investing vs. Active Value Investing

• Insights into Buffett’s Personal Investment Philosophy

• Warren Buffett's Vision for Long-term Value Creation

Enjoy the conversation!

A small number of seats at our event of the year, Latticework 2025, will be made available soon to our Substack subscribers. Stay tuned!

Latticework 2025 will be held in New York City on October 7th. In fireside chats with audience participation, the summit will explore intelligent investing in a rapidly changing world. Keynote speakers include:

• Chris Bloomstran, President of Semper Augustus Investments Group

• Tom Gayner, CEO of Markel and Director of The Coca-Cola Company

• Saurabh Madaan, Managing Member of Manveen Asset Management

• Bob Robotti, President and CIO of Robotti & Company Advisors

• Tom Russo, Managing Member of Gardner Russo & Quinn

• Will Thomson, Managing Partner of Massif Capital

• Christopher Tsai, President of Tsai Capital Corporation

• Ed Wachenheim III, Chairman of Greenhaven Associates

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In this interview, Professor Baruch Lev shares key insights from his book, The End of Accounting and the Path Forward for Investors and Managers. Lev argues compellingly that traditional financial reports — once the cornerstone of investment decisions — have increasingly lost relevance, particularly in an economy dominated by intangible assets such as patents, brands, and human capital. Drawing upon extensive empirical research, Lev reveals why conventional accounting methods fail to capture the true value drivers of modern businesses, often misleading investors rather than guiding them.

Throughout the conversation, Lev highlights the paradoxes inherent in current financial reporting practices, particularly how investments in critical intangible assets frequently appear as losses rather than valuable contributions. Investors relying solely on traditional earnings metrics can be significantly misled about a company’s prospects. Instead, Lev proposes a fresh analytical approach, encouraging investors to focus on strategic assets — unique, scarce, and difficult-to-imitate resources that genuinely drive long-term corporate success.

For seasoned investors who recognize the limitations of standard financial metrics, this interview offers a thoughtful exploration of alternative frameworks for assessing value creation. Lev’s insights promise to reshape how investors evaluate companies and make informed, strategic decisions.

Insights you’ll gain in this conversation:

• The Relevance Crisis of Traditional Accounting

• The Rise and Impact of Intangible Assets

• Strategic Assets and How to Identify Them

• Industry-Specific Reporting Solutions

• Practical Insights for Investors: Oil & Gas, Insurance, Pharma, Biotech, and Subscription Services

• The Pitfalls of Quarterly Earnings Predictions

• Moving Beyond Earnings: What Investors Should Really Watch

Let’s dive in.

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We are pleased to share this conversation between John Mihaljevic and MOI Global member Laurence Endersen, highlighting key insights from the book, The Compounder’s Element: A Patient Path to Prosperity.

Drawing on his deep understanding of long-term investing, Laurence delves into the essential qualities that distinguish truly exceptional compounders from merely good companies. Throughout the conversation, he emphasizes the importance of patience, disciplined capital allocation, and the relentless pursuit of durable competitive advantages — attributes he identifies as foundational for sustained wealth creation.

Listeners will particularly appreciate Laurence’s nuanced discussion on how investors can effectively identify these exceptional compounders early in their lifecycle and hold them for extended periods, reaping exponential returns over decades rather than quarters. He underscores why typical investment behaviors — such as chasing short-term gains or timing market fluctuations — can undermine long-term portfolio performance, advocating instead for a strategic approach rooted in conviction and patience.

Additionally, Laurence addresses common misconceptions about compounding and provides examples of companies that exemplify these qualities. Experienced investors seeking to refine their approach to selecting enduring winners will find Laurence’s insights illuminating and actionable.

Insights you’ll gain in this conversation:

• Understanding the True Nature of Compounders

• Why Patience Is an Investor’s Greatest Asset

• Identifying Durable Competitive Advantages

• The Pitfalls of Short-termism in Investing

• Real-world Examples of Exceptional Compounders

• Building a Portfolio for Multi-decade Success

Enjoy the conversation!

This installment of MOI’s Meet-the-Author Forum was recorded in 2025.

Laurence Endersen originally studied law as a pathway to practicing taxation while also training as a chartered accountant. A move to Sydney, Australia in 1994 facilitated a career change to corporate advisory and project finance, before returning to Ireland in 1998 where he subsequently held a series of investment management roles across venture capital, structured securities, leveraged loans and listed equities. Laurence founded a private investment firm in 2015. He currently lives with his family in Dublin. Laurence has published two other books, Pebbles of Perception: How a Few Good Choices Make all the Difference and What Owen Didn’t Know: A Philosophical Fable.

Featured Events

• Latticework 2025, The Yale Club of New York City (Oct. 7)

• Ideaweek 2026, St. Moritz, Switzerland (Jan. 26-29, 2026)

• Best Ideas Omaha 2026, Omaha, Nebraska (May 1, 2026)

• The Zurich Project 2026, Zurich, Switzerland (Jun. 2-4, 2026)

Share Latticework by MOI Global

Enjoying Latticework? Help us make it even more special.

• Share Latticework (simply click the above button!)

• Introduce us to a thoughtful speaker or podcast guest

• Be considered for an interview or idea presentation

• Volunteer to host a small group dinner in your city

• Become a sponsor of Latticework / MOI Global

Volunteer by reaching out directly to John (john@moiglobal.com).

In this interview, longtime Brooks Running CEO Jim Weber shares key insights from his book, Running with Purpose: How Brooks Outpaced Goliath Competitors to Lead the Pack. Jim details the compelling journey of how a niche running brand successfully competed against larger global players by focusing on its purpose, product excellence, and customer connection.

From a value investor’s standpoint, Brooks has been on a fascinating journey: It was acquired by Russell Athletic in 2004. Fruit of the Loom purchased Russell in 2006 and Brooks became a subsidiary of Fruit of the Loom’s parent company, Berkshire Hathaway. It became an independent subsidiary of Berkshire in 2011.

Throughout this conversation with Alex Gilchrist of MOI Global, Jim emphasizes the importance of clarity and discipline in business strategy. He shares how Brooks strategically abandoned its broader athletic apparel lines to concentrate solely on performance running shoes, a decision driven by deep consumer insights and unwavering commitment to runners. This intense focus allowed Brooks to build a powerful brand identity and loyalty among dedicated customers.

Jim also explores critical moments in Brooks’ evolution — such as navigating through industry disruptions, adapting to changing consumer preferences, and strategically utilizing grassroots marketing to authentically engage with the running community. Jim’s insights into building a purpose-driven culture and leveraging genuine consumer trust will resonate with long-term-oriented investors who value resilience and authenticity.

Members will find value in Weber’s reflections on leadership, strategic focus, and the disciplined execution that has allowed Brooks Running to thrive amid challenging market conditions.

Insights you’ll gain in this conversation:

• Jim Weber's Professional Journey and Leadership Philosophy

• Pivoting Brooks to a Dedicated Running Brand

• Building and Executing a Focused Business Strategy

• Product Excellence and Authentic Customer Connections

• Navigating Industry Disruption and Competition

• Grassroots Marketing and Community Engagement

• Lessons in Niche Brand Dominance

• Leveraging a Purpose-Driven Corporate Culture

• The Importance of Trust and Consistency in Branding

• Insights on Sustaining Long-Term Growth and Resilience

Enjoy the conversation!

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In this interview, Richard Lawrence shares key insights from his book, The Model: 37 Years Investing in Asian Equities. As founder of Overlook Investments, Richard offers an exploration of value investing within the dynamic and often misunderstood Asian markets. Overlook’s impressive track record — compounding investor capital at more than 14% annually over 30 years — frames Richard’s reflections, which cover everything from handling crises to engaging constructively with corporate management.

Richard emphasizes the role of disciplined investment practices, the significance of dividends over buybacks, and the art of quietly effective activism in improving corporate governance. His detailed anecdotes from the Asian Financial Crisis of 1997-98 reveal how enduring such periods provides invaluable lessons, not only about risk management but also about seizing long-term opportunities when others flee the market.

The conversation also explores the evolution of Overlook’s business model, including its self-imposed limits on capital growth and a succession structure designed to ensure long-term stability. Long term-oriented investors will find Richard’s approach to ESG particularly intriguing, as he integrates environmental and governance factors deeply into his investment thesis, focusing on genuine impact rather than mere box-ticking.

Insights you’ll gain in this conversation:

• The Origins of "The Model"

• Lessons from Investing through Asian Crises

• The Importance of Long-Term Capital and Discipline

• Effective Corporate Engagement and Quiet Activism

• Preference for Dividends over Share Buybacks

• Building Sustainable Investment Structures

• Navigating Cultural Differences in Asian Markets

• The Role of ESG in Long-Term Investing

• Climate Change and Investment Implications

• Ensuring Effective Succession and Longevity at Overlook

Enjoy the conversation!

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In this conversation Larry Cunningham shares key insights from his book, Quality Shareholders. Widely recognized as a leading authority on corporate governance and Berkshire Hathaway, Larry explores the concept of quality shareholders — investors who focus deeply on individual companies and adopt a patient, long-term holding approach. Throughout the discussion, Larry reveals how attracting quality shareholders can profoundly impact corporate performance, strategic flexibility, and overall governance quality.

Using Berkshire as a foundational example, Cunningham highlights the underestimated benefits companies gain from cultivating investors who think and act like committed business partners. He contrasts quality shareholders with index investors and short-term traders, clarifying how the former enable companies to pursue intelligent long-term strategies without the constant pressure to meet quarterly expectations.

The conversation delves into how companies can attract and maintain quality shareholders, including practical strategies such as clear communication, effective board composition, thoughtful capital allocation, and transparent annual letters. Long term-oriented investors will appreciate Larry’s empirical insights and real-world examples, from Unilever's pivot away from quarterly guidance to shareholder engagement practices employed by leading firms.

Insights you’ll gain in this conversation:

• Understanding the Quality Shareholder Concept

• Benefits of a Quality Shareholder Base

• The Impact of Short-Termism on Corporate Strategy

• Strategies for Attracting Quality Shareholders

• Effective Shareholder Communication Techniques

• Board Composition and Shareholder Alignment

• Real-World Case Studies: Unilever and Beyond

• Innovative Approaches to Capital Allocation

• Evaluating Dual-Class Share Structures

• The Future of Shareholder-Centric Governance

Enjoy the conversation!

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In this exclusive conversation, former Medtronic CEO Bill George delves into what it means to lead with authenticity in times of uncertainty. With a proven track record — having grown Medtronic’s market cap from $1 billion to $60 billion — Bill explores how genuine leadership, rooted in clear values and long-term vision, can drive exceptional performance.

Bill addresses the tension CEOs face between short-term market pressures and long-term strategic vision, illustrating the pitfalls of chasing charisma over character, and short-term gains over sustainable growth in shareholder value. His insights on why the best leaders maintain transparency with investors, manage risk intelligently, and foster a culture of innovation will resonate with value-oriented investors.

Bill emphasizes the necessity of aligning personal integrity with corporate strategy, particularly in how CEOs communicate with shareholders and allocate capital. His examples from top corporations such as Microsoft, Merck, and General Motors bring these lessons to life, offering practical wisdom on building resilient businesses capable of thriving amid disruptions. Bill is the author of the book, True North.

Insights you’ll gain in this conversation:

• From Intrapreneur to CEO: Bill’s Journey at Medtronic

• Balancing Innovation with Financial Prudence

• The Importance of Transparent Communication with Investors

• Long-Term Strategic Thinking and Risk Management

• Distinguishing Authentic Leadership from Charismatic Leadership

• Defining and Pursuing Your True North

• Building Inclusive and Resilient Organizational Cultures

• Preparing the Next Generation of Authentic Leaders

• Leading with Integrity Through Crisis and Uncertainty

Enjoy the conversation!

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We had the pleasure of speaking with James Emanuel, author of Fabric Of Success: The Golden Threads Running Through The Tapestry Of Every Great Business. James discussed the book with Alex Gilchrist of MOI Global.

A lawyer turned investor, James improves the fortunes of the companies in which he has a financial interest. His book captures the essence of a great investment. James is also the author of the highly recommended Rock & Turner substack and a contributor to Latticework.

In this exclusive interview, James shares insights from his book, Fabric of Success. Drawing from his extensive experience as a long-term equity investor, James provides a unique vantage point on what differentiates truly exceptional businesses from the rest. He delves deeply into the common traits shared by standout CEOs — those visionary leaders who consistently deliver extraordinary long-term value.

James argues that investors frequently overlook the crucial role played by top executives, often distracted by fleeting narratives or superficial metrics. He illustrates his points with compelling examples, including stories of Sam Walton at Walmart, Steve Jobs at Apple, and the striking contrast between short-term managerial thinking and genuine long-term stewardship.

Throughout the discussion, James emphasizes the importance of looking beyond conventional measures of success — highlighting why aspects like company culture, capital allocation strategies, and alignment of incentives can be pivotal to long-term outperformance. By identifying what he refers to as “golden threads” woven through history’s greatest companies, James provides valuable tools for investors aiming to spot hidden gems and avoid costly pitfalls.

Experienced investors and fund managers will find James’ insights deeply thought-provoking, challenging traditional investment paradigms.

Discussion overview:

• The Critical Role of Leadership

• Common Traits of Exceptional CEOs

• Long-term Thinking and Incentive Alignment

• Unconventional Approaches to Capital Allocation

• Dividend Policy: Myths and Realities

• Spotting Hidden Gems and Red Flags

• Why Location Matters in Business

• Culture as a Competitive Advantage

• Learning from History's Greatest Companies

Enjoy the conversation!

The following transcript has been edited for space and clarity.

Alex: Today’s guest is James Emanuel. He is an investor with a multi-decade career in the finance and banking industry who runs a private long-only equity fund that aims to have permanent capital invested in exceptional businesses. James is here to talk to us about his second book, Fabric of Success, which is available on Amazon. Welcome, James.

James: As part of my investing career, I regularly engage with C-suite executives, and I raise constructive challenges where decisions or a course of action makes little or no sense to me. This has happened countless times over the decades.

It often feels like Groundhog Day. I raise the same challenges again and again, albeit with different CEOs and CFOs. The interesting part is the response I receive. Most of the time, they’ll say something like, “Wow! I’ve never looked at it like that before,” or “That’s an interesting perspective.” Even more interesting is that this kind of discourse often brings about change and a beneficial pivot in the direction of the company. Don’t get me wrong: I don’t claim to be a guru of business administration. Everything I know, I have learned from others – from reading, from watching, from discovering what success looks like.

The advantage an investor has over a corporate CEO is peripheral vision. A CEO knows everything about their own company, is – one would hope – an expert on the industry, and may have limited knowledge about the business of their competitors. Think about that for a moment. That’s an extremely narrow field of focus. Now, contrast that to an investor like myself who constantly analyzes all sorts of businesses in different industries and countries. As an investor, I’ll be reading quarterly and annual reports and engaging with other investors. I come to learn what success looks like, what works and what doesn’t work. My field of focus is far broader, so I can introduce these challenges from what I’ve learned from others.

It’s no surprise that an investor can introduce new perspectives to corporate management. That’s when I thought to myself, “How valuable would it be to capture these perspectives in a book that I could share with corporate executives, particularly those running the companies in which I myself am invested? That way, I can see the benefit.”

I thought about the structure of the book. One of my favorite books is The Outsiders by Will Thorndike, who focuses on eight exceptional CEOs. He takes them one chapter at a time. What I have done instead is look thematically in 53 chapters at various aspects of running a business – whether it’s cost management or capital allocation, decentralization of operations, avoiding bureaucracy, succession planning, dividend policy, aligning the interests of insiders and outsiders, and so on. Each one of those themes is dealt with in its own chapter.

Then I look at how each of these exceptional CEOs have dealt with each of those themes, and I compare and contrast the approach. What I found fascinating is that these fantastic CEOs – I focus on about 150 of them in total – despite being located in different geographies, working in different industries, and some operating in very different eras, they all seem to converge on a strikingly similar approach to dealing with each of these topics.

Even more importantly, while they didn’t all start with a similar methodology, that’s where they all ended up. They all learned what worked throughout their careers. They learned from each other as well. Some have the same mentors and the same people who inspire them. They all seemed to converge – through trial and error – on a very similar approach. It would be silly for anybody running a business today to ignore this approach. By reading the book and learning a little more about how these people have achieved such outstanding success, a CEO can almost skip a few stages in the evolutionary process and hone in on some of those things.

One of the key things is that none of these people are afraid to break from convention. They understand that being better means doing things differently. Yet, despite being unconventional, they’ve all converged on a remarkably similar operating model. When writing the book, the objective was to pull on these golden threads running through the fabric of every great business, and I am exceptionally pleased with the result. Crucial to our discussion today, by identifying these golden threads, it becomes possible for me as an investor to spot them in other companies, which is how I find hidden gems in which to invest.

Alex: You mentioned the importance of the leaders of a company. Why do you think this is so often overlooked by other investors?

James: It’s interesting. Too many investors buy into a narrative. They don’t ask about the quality of the business and its management. By way of example, let’s consider the dot-com boom at the turn of the millennium.

Every top tech company back then was considered golden. As long as it had dot-com after its name, people were happy to throw money at it regardless of the fact that it wasn’t profitable, and a lot of them were highly unlikely to ever be profitable. Very few investors considered the ability of the CEO to deliver. To me, that’s back-to-front, upside-down thinking. They invest blindly, and, frankly, they deserve to lose money when the bubble bursts. There are parallels to be drawn with what’s happening today in the AI sector. Everybody’s throwing money at AI. Evaluations have gone crazy. A lot of it makes absolutely no sense.

Rather than investing in a theme, investors need to learn what ingredients make a great business, and then look for those ingredients. Some of these are in very dull, unfashionable industries. For me, the key ingredients – I’ll call out five of them now, though there are certainly more – are people, culture, capital allocation, time scales, and aligned incentives. I could certainly speak for hours on all this stuff, and that’s why I’ve written the book, but I’ll try and narrow it down.

Let’s start with people because I see that as the most important factor. It goes to the question you just asked me. The person steering the ship is so much more important than the ship itself. How many equity analysts value a business based on peer comparisons or peer company multiples? In my opinion, they’re barking up the wrong tree. Just because Company X trades at 30 times earning doesn’t mean that every company in its industry can justify the same multiple. It’s flawed logic. There are lots of e-commerce businesses, but there’s only one Jeff Bezos.

Let me give you some historical examples that hammer this point home. Consider Sam Walton, who created Walmart – probably the most successful grocery store on the planet. If you don’t know much about his life and career, I highly recommend his book Made in America – it’s a fantastic read. He set up his first store in Newport, Arkansas. It was running for about five years, and it was the most successful grocery store in the state, but he made a critical error, which he calls out in the book. It was a regret throughout his life.

The error was that he didn’t include a lease renewal clause in his rent agreement for the store premises. The landlord was a greedy man. He noticed how successful the store was. At the end of the five-year term, he told Sam Walton, “I’m not going to renew your lease.” Sam Walton had all of the key ingredients that had made the store such a huge success, and he lost everything because the landlord wouldn’t renew. Instead, this greedy person gifted the store as a going concern to his son. Sam Walton was knocked down, but he got back up and set up other stores in other states and locations. It wasn’t until 10 years later, when he got to his eighth or ninth store, that he came back to Newport, Arkansas. He opened that eighth or ninth store there.

What’s critically important here is that Sam Walton got knocked down, the first five years of his career were effectively wiped out, but he got up and built the incredibly successful franchise we know today as Walmart. The store he opened eight or nine years later in Arkansas also cleaned up. Now, the critical thing is that the hugely successful store the landlord had gifted to his son came to absolutely nothing. What does that tell you? It’s exactly the same business in the same location; all the key ingredients Sam Walton had introduced were there, but the change in ownership made all the difference. One was a failure; one became incredibly successful.

There are other examples. You can look at the McDonald brothers – Dick and Mac McDonald. They were happy with a single restaurant location. It wasn’t until Ray Kroc came along and persuaded them to scale up that McDonald’s became what it is today. Had it not been for Ray Kroc, McDonald’s probably wouldn’t have been anything except for one diner in San Bernardino, California. Again, it’s the person that makes a difference, not the business.

Warren Buffett, who’s a great example, says the single most important decision in evaluating a business is the management. He said he looks for people with talent, character, and a high degree of integrity. He says that if you have those three things, you’ve got a tremendous business. However, most equity analysts don’t put any kind of thought into the quality of the leadership. They become obsessed with quantitative analysis. They plug numbers into DCF spreadsheets and miss the most important qualitative part. Don’t get me wrong – I use a host of models and spreadsheets, but they’re never my starting point. I need to identify the quality of the business first before I waste my time analyzing the numbers.

Let me give you one other fantastic example. Consider a company we all know well – Apple. Steve Jobs is what I call a circumstantial CEO. If you look at his academic background and what he did before he started Apple, he never set out to be a businessman. That wasn’t what he was all about. He never set out to be the CEO of a public company, either. It happened by chance. He was pursuing his passion, which at that time was to democratize technology by creating accessible and user-friendly digital tools that could change the world. He didn’t set out to create a trillion-dollar company. Apple was simply the vehicle he established with Steve Wozniak to realize his dream.

The fascinating thing is that at an early stage, the writing was on the wall about how successful he was likely to become. We’re all very familiar with Henry Singleton. He’s one of the great CEOs that Will Thorndike wrote about in The Outsiders. Not many people know this, but he was a very early-stage investor in Apple. This is when personal computers were just coming into being. Hundreds of computer company startups appeared, but very few of them succeeded. Most withered and died. Singleton was subsequently asked how it was that he chose to invest in Apple over all of the others and how it happened that Apple turned out to be the winner. His response was simply that he’d been hugely impressed by Steve Jobs. It was the person, not the company. To Singleton, Jobs appeared to be a man on a mission. He was evidently committing everything he had to achieving that objective, and this distinguished him from all the others.

To hammer the point home about him being a circumstantial CEO, establishing a company and raising seed finance was the easy part, but the skill set to create a successful business is rarely the same skill set required to drive the company forward. None of us would jump behind the wheel of a car without taking driving lessons, but many people jump behind the steering wheel of a company equally ill-prepared, which obviously leads to poor decisions – particularly in relation to capital allocation and corporate strategy – and this is where most businesses falter. They essentially have the wrong person steering the ship.

Handing over control to someone else is never easy, especially for somebody who built the business themselves from scratch, with a major portion of their personal wealth invested. To Jobs’ credit, he recognized that he knew nothing about business administration, so he brought in a seasoned executive – John Sculley from Pepsi. The problem was that he selected the wrong man. Sculley clashed with Jobs and fired him. We know the story. The most valuable asset the company had was Steve Jobs. Scully disposed of that asset, which was one of a host of bad decisions he made during his tenure.

Apple’s fortunes declined under Sculley, taking it almost to the brink of bankruptcy in 1997. Allegedly, it was 90 days away from running out of cash, but Sculley was removed from the board, and Steve Jobs was brought back in, rescuing Apple from the jaws of insolvency and putting it on a trajectory to where it is today – a trillion-dollar company. What does that tell us? Same company, same target market, same industry – the difference was the person steering the ship. The outcome could not have been more different.

As an investor, the first thing you need to look at is the management. Who’s in charge? How passionate are they? What’s their mission? What’s incentivizing them? The lesson to be learned is that, as investors, we are not looking for the next Apple. We’re looking for the next Steve Jobs.

Let me take that a stage further. After Sculley kicked him out of Apple, Jobs founded the software business, which eventually became the Apple iOS operating system. He was also instrumental in the success of animation studio Pixar. Later in his career, when Pixar was acquired by Disney, Jobs became Disney’s largest shareholder. He joined the board and helped transform Disney’s fortunes as well. He influenced its strategy and also played a role in the appointment of Bob Iger as CEO. If you’d been able to invest in everything Steve Jobs touched, you would have done incredibly well.

Once again, the takeaway here is you’ve got to invest in the people, not the narrative. It’s not about the ideas. I don’t know if you’ve read the book Creativity, Inc. by Ed Catmull, the CEO of Pixar. He insisted that ideas come from people, so the people are always more important than the ideas. He always said that getting the team right is the necessary precursor to getting the ideas right. He stressed that a good idea in the hands of a mediocre team is like giving a bottle of champagne to a child. Didn’t we see that with Apple and Sculley? It was a fantastic idea, a fantastic company, but Sculley was a mediocre manager and nearly crashed the company. However, if you give a mediocre idea to a brilliant team, they’ll either fix it or throw it away and come up with something better.

This repeats again and again through history. Think about Intel under Bob Noyce, Gordon Moore, and Andrew Grove. They initially started a memory business in a commoditized market, which was a mediocre idea, but they realized it was mediocre, so they discarded it and came up with something better. That resulted in a pivot into semiconductors, and the rest is history.

To hammer the point home with one more example, consider Xerox PARC, PARC was the Palo Alto Research Center, which was established by the Xerox Corporation in 1970. It was responsible for pioneering many groundbreaking computer technologies. Those included the GUI (graphical user interface), the computer mouse we all use today, Ethernet networking, laser printing, and even the first personal computer, which was called the Alto.

However, Xerox failed to capitalize on many of PARC’s inventions commercially. The GUI is a great case study. I focus on this in the book, but I’ll tell you a bit about it. The graphical user interface was introduced at a time when everything before that was command line DOS. Introducing a graphical interface made computing more approachable for the average person, but Xerox didn’t do anything with it.

Steve Jobs was inspired by the work that had been done at Xerox PARC. He developed the first commercial GUI at Apple for his Lisa computer. That was in the early 1980s. He was focused on hardware sales rather than software and didn’t commercialize the operating system and the GUI. He made it available exclusively on Apple machines as a means to propel sales of the hardware. That very much opened the door for Bill Gates to come along, but it wasn’t for another five years.

Bill Gates had witnessed the power of Apple’s GUI, so he developed Windows. He took a very different approach. He wasn’t interested in selling hardware. Instead, he was focused on software. He made Windows available to anyone, whatever computer system they were operating on, and that opened the floodgates for widespread adoption of Microsoft’s operating system. By 1994, it had grabbed 90% of the market.

The GUI was a springboard for both Apple and Microsoft to succeed, albeit they were pushing in different directions. Apple used it as a means to sell hardware; Microsoft used it to succeed in software. The critical thing here is that you have three CEOs. The CEO of Xerox developed the technology but failed to commercialize it and do anything with it. On the other hand, Bill Gates and Steve Jobs built fabulous trillion-dollar companies on the back of that GUI idea developed by somebody else.

Once again, it’s not the idea, and it’s not the narrative. It’s the person. It’s all about the captain of ship. It’s all about the CEO.

Alex: You’ve mentioned these different characters. Can we pull on some of these golden threads, particularly from an investor’s perspective?

James: Sure. One of the other golden threads is time scales. This links up very neatly with people and also with incentives. Let’s talk about time scales for a bit.

As the famous saying goes, Rome wasn’t built in a day. Decisions need to be made with a bias towards the long term. Perhaps you’re familiar with the semi-reclusive investor Anthony Deden, who’s based in Switzerland. He has deliberately almost cut himself off from the financial world because he doesn’t want to be corrupted by all the white noise. It’s probably why Buffett is out in Omaha.

Anthony Deden tells a wonderful story. In the course of his investing career, he meets up with all sorts of businesses. On one particular occasion, he was traveling to meet with an Arab date farmer who was happily planting saplings in his orchard. Deden asked him, “How long will it be before these trees yield commercially valuable fruit?” Much to Deden’s surprise, the date farmer told him it was going to be 40 years, and it was almost certainly not in the lifetime of this farmer, who was already in his late 50s.

The important thing to bear in mind is that this date farmer was happily planting trees that weren’t going to benefit him in his lifetime. He could instead have extracted today’s earnings to enrich himself and chosen not to invest in these saplings, but his mindset was that his job, his duty, was to protect, preserve, and enhance what he was given to manage – effectively the date farm. He saw his role as being the trustee of assets owned largely by others. In this case, it was a family, but in the case of a public company, it’s clearly the shareholders. That was his mission. He was deeply grateful to the generations before him that had planted the trees yielding the fruit that was providing him with a living today, and he saw it as his duty to do the same. He was making decisions based on multi-decade outcomes. Isn’t that the kind of business you would like to apply permanent capital to?

Think about great CEOs we’re more familiar with, people like Jeff Bezos at Amazon. You can read his inaugural shareholder letter from back in 1997, in particular a section under the heading “It’s All About the Long Term.” He said there, “We believe that a fundamental measure of our success will be the value we create over the long term. We make decisions and weigh trade-offs differently from other companies. We make investment decisions in light of long-term market leadership considerations rather than short-term Wall Street reactions.”

Isn’t that the same kind of mindset as the date farmer’s? Just like Apple from day one, the clues were there. Amazon had the key ingredients. That letter was written in 1997, the year of the IPO. Henry Singleton realized Steve Jobs was someone exceptional, someone he wanted to invest in. Similarly, in that inaugural shareholder letter Bezos wrote for Amazon, the clues were all there. He had those key ingredients to build a great company, and so it was.

Essentially, whether you’re looking at Bezos, Jobs, Sam Walton, or even Thomas Edison, none of them were in it for the money. They were all on a mission, and wealth was an indirect consequence of a job well done. Unfortunately, these great leaders are in the minority. Most CEOs are mercenaries. They’ve got no passion for what they’re doing. They’re in it only to enrich themselves, but chasing wealth is the wrong way to do things, and it leads to making poor decisions and to unfavorable outcomes.

The best example I could probably give you is Twitter. Look at what happened to Twitter. It had an IPO in 2013 and was taken private by Elon Musk a decade later at almost exactly the same share price. Bear in mind that Twitter never paid a dividend throughout its existence. In real terms, accounting for inflation, the price paid per share by Elon Musk was lower than the IPO price, so it was a miserable time for investors. They had invested for a decade with a negative total return on their investment. Meanwhile, Jack Dorsey – the CEO – propelled his personal net worth over the period from zero to $4.5 billion. That was all on the back of stock-based compensation and all sorts of other means of extracting value from the business.

Twitter was the right idea. It launched at the right time with a huge addressable market, but it failed commercially because it was being driven by the wrong people with the wrong mindset and the wrong incentives. That’s probably why Mark Zuckerberg described Dorsey as driving a clown car into a gold mine. That’s effectively what he was doing.

Too many investors bought into the narrative. Twitter launched at a time when social media was truly coming into its own. They bought into the narrative, invested in Twitter, and put their money on the wrong horse. They paid no attention to the quality of the jockey. However, the writing was on the wall all along. The stock-based compensation was egregious. It was outrageous. You can see the company was making absolutely no progress. It ended where it ended, and investors suffered as a consequence.

A company in the right hands would compound in value; in the wrong hands, time would simply afford more damage to be done. That was summed up nicely by Buffett when he said, “Time is the friend of the wonderful company but the enemy of the mediocre.”

That’s one of the key ingredients. We’re talking about time scales – looking not to appease Wall Street and fixate on short-term metrics like earnings per share but instead investing for the long term. A lot of people misread Jeff Bezos. He took a very similar approach to John Malone, who reinvested most of his earnings back in the company and deliberately tried to keep earnings as low as possible because earnings attract the taxman, and taxes are a bleed on corporate capital.

Instead, Malone resolved that you’re far better off reinvesting as much of your earnings as possible into growing the business, and you’re effectively growing at the expense of the taxman. Bezos did exactly the same. There were so many equity analysts over the years who said, “I can’t invest in this company because the earnings multiple is way too high.” The earnings multiple was only way too high because Bezos was deliberately suppressing earnings. He was deliberately reapplying all of the capital he could into the growth of the business. Over the course of the last 20 to 25 years, we’ve seen the results of that.

Alex: You mentioned all these amazing CEOs. What would you say are the traits they share?

James: They are all on a mission. They are all focused on the long term. Interestingly, McKinsey did a piece of analysis where it resolved that the most successful CEOs have an average tenure of about 11.5 years. Contrast that to the average tenure of a public company CEO in America at the moment – it’s little more than four years.

Think about that. Why should it make such a huge difference? Think about what Charlie Munger always used to say. He was always so focused on incentives. He would say, “Show me the incentives, and I’ll tell you the outcome.” Most companies are run by what I call career CEOs. They jump from one company to the next every few years, collecting big payouts along the way. They’re very much like coaches of sports teams but with one critical difference.

If you think about it, a sports coach is focused on the short term. They’re only looking at the current season. They want to win a trophy this year. Building a company is a long-term endeavor for a CEO. It’s completely different. This is what I spoke about when we discussed the date farmer and Jeff Bezos. To put that in context, if the average CEO is only in office for four years, do you think they’re motivated to do what’s best for the company and its shareholders for decades to come, or do you think it’s more likely they’re focused on doing whatever’s necessary to hit short-term remuneration targets to enrich themselves?

I’d like to lean into this and give you a fantastic example. You’re probably very familiar with Lou Gerstner – the CEO of IBM over the turn of the millennium. He’s always praised for being such a wonderful CEO, but I think the narrative around Lou Gerstner is completely wrong, and his tenure was completely misunderstood. Let me give you an example because this truly hammers home the point about incentives and why this is so important when evaluating companies.

Thomas Watson effectively founded IBM after leaving the NCR – the National Cash Register business – which was another wonderful business well worth studying and one Charlie Munger was always very focused on. Watson moved from NCR to what became IBM (International Business Machines) around 1924. For the best part of a century, he and his son built IBM into the most valuable company in the world. By 1991, its market cap was approximately $105 billion, which then was about as big as you could get.

What’s critical – and why I would like to focus on Lou Gerstner – is that all of that success built over 80 years was undone in the next nine. Lou Gerstner was appointed CEO of IBM in 1993. Like Sculley at Apple, he was the wrong man for the job. He’d come from RJR Nabisco – a biscuit company. Sculley had come from PepsiCo – a soft drink company. What do these people know about technology companies? They don’t know anything. It’s a completely different skill set. Still, Gerstner was brought in, and his incentives were all wrong. The incentives he was offered were pegged to the share price of IBM.

So many companies do this, and it’s completely wrong. The focus of the CEO becomes boosting the share price, even if that’s at the expense of the long-term prospects of the business. Under Gerstner, debt ballooned from $10 billion to $29 billion. More importantly, that debt was primarily used for share buybacks, not for investing in the growth of the business.

During his tenure, he repurchased 25% of the shares of IBM, mostly at overinflated prices, which destroyed shareholder equity. As the share price inflated through this forced demand through all the repurchase activity, shareholder equity was being destroyed. Investors were focused on completely the wrong things and were reaching the wrong conclusions. Of course, as the number of shares goes down, earnings per share inflate. It’s not because the earnings are necessarily going up. It’s not the numerator in the equation that’s changing – it’s the denominator. Similarly, the return on equity will be boosted because by buying back shares at overinflated prices, he is effectively destroying shareholder equity.

Once again, you’re looking at return on equity. It’s the denominator that’s contracting. It’s making these metrics look great. All the while, sales decline. Between 1998 and 2001, IBM’s sales declined significantly, but the share price doubled over that period. Go make sense of that. Again, it’s because investors focus on the wrong metrics. They’re looking at EPS and return on equity. The foolish investors were ignoring fundamentals. Fear of missing out resulted in herd mentality. People jumped in and were chasing the share price. It was all about momentum, which was very similar to what we saw with Tesla over the COVID period.

During Lou Gerstner’s tenure, the dividend yield fell from 7.2% in 1992 to 0.4% by 2000. Blinded by share price gains, investors completely overlooked the collapse in dividends. Gerstner also sold core assets at IBM. He effectively asset-stripped the business. The data delivery network was sold to AT&T. Lexmark – the printer division – was sold to a private investor. The iconic ThinkPad PC division was sold to Lenovo in China. Software assets – including Lotus Notes and Domino – were sold to HCL Technologies. All the while, Gerstner slashed research and development.

He was selling off core assets, and there wasn’t much research and development going on, so the company wasn’t developing anything new in-house. Tax credits from stock options flattened net profits. Then he set up a special purpose vehicle called IBM Global Financing to securitize all of the debt he had taken on. This allowed IBM to move a lot of that debt off the balance sheet, which was naughty. It wasn’t the right thing to do. He was effectively disguising what was happening there. Now, more of the debt was being used to finance customer spending with low interest loans, but Gerstner booked all of that revenue and profit upfront, and he was using off-balance sheet debt to boost revenue and profit numbers. He leased lots of equipment to customers, which was a major source of revenue, but that also was effectively debt financing which, again, was concealed off balance sheet.

Pension plan value changes were counted as income. Accounting irregularities eventually attracted the attention of the SEC, which summoned IBM top brass to Washington. One of the things they looked at, for instance, is when the data delivery network was sold to AT&T for $4 billion, instead of that sale income being booked as extraordinary income, which is how it should have been, what they did was reduce SG&A opex by $4 billion. They were playing with the numbers. Gerstner’s tenure at IBM was more about financial engineering than about computer engineering.

There were many more things he did, but you get the idea. All of these things provided a short-term financial boost at the expense of the long-term prospects of IBM, which had taken 80 years to build under Thomas Watson. It was all about the poorly devised incentive scheme, which encouraged Gerstner to think short term in order to qualify for huge bonuses. When he left IBM, his personal wealth had ballooned to $630 million, but IBM was a shadow of its former self. He caused irreparable damage that continues to this day.

Gerstner left IBM in 2003, if I’m not mistaken. The company’s market cap had reached $208 billion because of all of the accounting alchemy he engaged in. After he left and it became clear what he’d done, the market cap collapsed to $98 billion. Two decades later, it still hasn’t recovered. The market cap is now only $128 billion – almost half of what it was at its peak. All of that was because of the way Gerstner managed IBM. Meanwhile, you pick up umpteen books written about Gerstner being a model to be followed as a CEO. I simply don’t understand it.

It’s all about incentives. It’s all about the long-term objective. It’s all about acting as a trustee of the assets you’re handed to manage as a CEO. It’s all about being on a mission. You can’t be a mercenary. If you’re invested in a company and see any evidence of the CEO being a mercenary, my advice would be to get out fast and transfer your money elsewhere.

Alex: What do you makes the CEO care about what happens to other shareholders and not just themselves?

James: It’s self-interest. If somebody dangles a carrot under your nose and offers you the opportunity to make hundreds of millions – if not billions, as in the case of Twitter – it’s very tempting for some people to take that.

Others see shareholders as an inconvenience. You might be a software engineer, for instance. You create a fantastic app that goes viral. You decide to build on that success. You want to expand and hire other software developers. You sell part of your company’s equity. Lo and behold, you find yourself the CEO of a public company. In that context, you see those shareholders as a necessary evil. You needed to sell some of your equity to raise capital – you didn’t do it because you wanted those shareholders to be partners.

If you look at Berkshire Hathaway, its investor manual is effectively its constitution. The company says that although it’s effectively a body corporate, it considers itself to be almost a partnership, and it considers its shareholders partners. Munger is no longer with us, but both he and Buffett invested most of their personal wealth in Berkshire, so that their fortunes would move in lockstep with shareholders. That’s the right way to go about it. Most other CEOs do see shareholders as an inconvenience, as a necessary evil, and they’re focused on themselves.

Alex: Do you think the CEO is almost more important than the business itself?

James: The CEO is absolutely more important than the business itself. I have given you many examples today of the same company in the same market with the same product effectively having an entirely different outcome in the hands of a different person. The person is the key to success.

Before researching anything about a company, a deep dive on the CEO is the most important thing. It’s one of the reasons why some of the most successful companies in history have founder CEOs who are passionate and have stuck with the business for the long term. It was always their intention to stick with it for the long term, which is why they always made decisions that were in the long-term interests of the company itself.

Alex: I found it particularly interesting when you said that good managers are willing to either make good use of an idea or chuck it away if it’s the wrong idea. It makes me think that a good CEO will be willing to abandon projects that don’t yield enough return and favor those that do and think outside of the box.

James: It’s not always the way. Effectively, what we’ve been talking about is the exception rather than the rule. Exceptional leaders will recognize that they’ve got a mediocre idea and that it needs to be improved.

I gave you the example of Intel, which is a textbook case study. If you want to look at others as a contrast, look at Kodak. It was the market leaders in silver halide film. Wherever you went in the world in the 1970s or the 1980s, you could be sure you’d see billboards for two companies – Coca-Cola and Kodak. It was one of the biggest brands globally and a hugely successful company. It was one of the Nifty 50 as well. It went bankrupt. Why? Because it didn’t recognize what was happening in its industry. It rested on its laurels. It knew it was doing very well in silver halide film, so it didn’t embrace digital photography. That was the death knell for the business.

It was a similar thing with Blockbuster Video, which was a rental business. It saw streaming coming over the hill, but either didn’t see it as a threat or didn’t want to disrupt its own business model. If you analyze any of the financials from Blockbuster, you’ll notice that the lion’s share of its earnings came from late fees.

For those young enough not to remember movie rental businesses like Blockbuster, before streaming, we had to go to a local store, select a movie from the shelf, and take home either a video cassette or a DVD. We’d have that movie for 24 hours. We had to return it the next day, and if we were late, we’d have to pay a late fee – very much like a late fee on a book borrowed from a library. Blockbuster made a lot of money on those late fees. It saw that streaming was a threat to this revenue stream. For that reason, it didn’t want to embrace it, which enabled Netflix to come in and claim its crown. Blockbuster effectively died.

There are countless more examples, but most companies and most CEOs are so married to a successful idea, even if it is mediocre or becoming mediocre. It may have been successful in the past but is becoming mediocre, yet they won’t relinquish that idea.

Another fantastic example is Blackberry. It was enormously successful. Anybody in the financial sector in the early 2000s had a Blackberry. It was not only a status symbol; it was also an immensely useful tool because, for the first time, you could pick up emails on the go. You didn’t have to be sitting behind your desktop. It had a tiny keyboard that most of us used with our thumbs. When Steve Jobs introduced the concept of a touchscreen, Blackberry refused to accept it. Of course, the iPhone took over and claimed all share in that particular market from BlackBerry.

I’d say most managements are mediocre, and they’re not prepared to discard bad ideas or cannibalize their existing business. The problem is that if you are not prepared to cannibalize your own business, somebody else will come along and cannibalize it for you.

Alex: If managements don’t recognize these threats despite operating in that business and doing that every day, how should investors – who are, in a sense, a step removed – recognize them?

James: The themes are there for all to see. You don’t have to be inside Kodak to see that digital photography is gaining traction and that it presents a threat to silver halide. You didn’t have to be a genius to see that streaming movies could be a threat to video rentals.

One of the primary drawbacks in video rentals was limited supply. You go down to your video rental store and it may only have one or two copies of every movie. If both have been rented out by someone else, that’s a movie you can’t watch. With streaming, there are no such limitations. It’s quite obvious that kind of thing is likely to be disruptive. I think investors can spot these things, certainly raise them with management at shareholder meetings and try and gauge the response. If management don’t want to listen or don’t want to change, then perhaps it’s time to bail out and put your money somewhere else.

Alex: In some sense, it seems to be coming back to the idea of the mission. Is the company out on a mission to make things better for its customers? If you’re Blockbuster and live off late-fee payments, it seems inherently bad for your customers. Not only won’t they be fans, but you’re doing something wrong. If you were interested in seeing how to use whatever new technology is coming along to improve things for customers, that might be a better way to approach it.

James: Absolutely. Customer-first is so important. Anybody who has studied the retail industry and read anything about Sol Price and Sam Walton will know they always put the customer first. Jim Sinegal at Costco is exactly the same. They have all said in the past that the boss is the customer. The customer has the ability to effectively fire everyone in the company – from the chairman down – by taking their business elsewhere and spending their money elsewhere. You have to be customer-centric and customer-focused.

All of the super successful businesses put their customers first. That’s another theme in the book, and I dedicate a chapter to that one as well.

Alex: Could you share some of your thoughts on other key ingredients for success?

James: Absolutely. Let me throw in a curveball, something that a lot of people perhaps don’t think about. Location is another key ingredient that many investors will never consider. It’s critical.

Let’s think about Walt Disney. He established his first animation studio in Kansas City, which is where he grew up. It failed. It became insolvent. Did that mean Walt Disney was no good at animation? Absolutely not. Did it mean animation was a bad idea? Again, no. Did it mean you shouldn’t have invested in the nascent animation industry? Again, the answer is no.

Anybody who does gardening knows that some plants will thrive in full sunshine. Others like the shade. Some like wet conditions, while others prefer drier, arid conditions. It is the same with businesses – the same business in different locations will lead to an entirely different outcome. Kansas City wasn’t fertile soil for animation in the 1920s and probably still isn’t today, but as we know, Walt Disney was on a mission. He had a passion for animation, so he moved to California, where all the big movie studios were located and where venture capital focused on animation and movies was looking to put money to work in this new, rapidly-evolving industry. As they say, the rest is history. You’ve got the same person with the same company and the same idea in a different location. The result was totally different.

Another example is the automotive industry. We all think that the electric car is a relatively new invention, but – believe it or not – Robert Anderson of Scotland invented the first-ever electric carriage in 1832 in an attempt to move away from horsepower. Up until then, human beings were reliant on horses pulling carriages along. Effectively, the first car was invented in the UK in the 1830s. The roads in Britain were second only to those in France. Britain also had plenty of skilled mechanics and engineering ability. In essence, the automotive industry ought to have been dominated by the British. They had the first car, they had the roads, and they had the engineering ability, but that’s not what happened. Karl Benz in Germany and Henry Ford in the US effectively captured the market decades later.

What went wrong for the car industry in the UK? The answer is the UK government. It stifled all innovation. It effectively enacted legislation designed to protect vested financial interests in the railways, which were the dominant means of travel back then. Of critical importance here is that many government officials were personally invested in the railways, which helps us understand why they were against competition from road travel.

As far as the invention of the car, it was certainly a case of having the right idea, the right technology, and the right people, but it was all in the wrong location because the UK at that time was hostile to automotive technology. Karl Benz invented the petrol engine in the 1870s or 1880s, about 50 years after the car had been invented in the UK. Henry Ford didn’t start his first car company until 1904. He set up Cadillac and then went on to found Ford a few years later.

Another wonderful example is Silicon Valley. Its fascinating history is explored in more detail in the book, so I won’t go into that here, but there’s an extremely high concentration of skill, expertise, and knowledge in one place that makes wonderful things happen in technology. If two technology companies were identical in every way, but one was being established in Silicon Valley and the other in Europe, the odds would be very heavily skewed in favor of the US-based business because that’s where the skill set, the expertise, and the technology exist at the moment.

As a result, if I were an investor who knows nothing else about these companies, I would be more tempted to put my money into the same technology company based in Silicon Valley. Again, location is critically important, but when analyzing companies, how many people factor that into their equity analysis? Very, very few.

Alex: Maybe they think more about where their sales are than where their operations are.

James: Yes, absolutely. I could give you another example.

Think about Coco Chanel. She was in Paris at a time when couture was prevalent there. She had all the couturiers, very technically skilled with needlework. She had access to the most luxurious fabrics. Chanel established a fashion empire because the soil was fertile in Paris at the time. Had she tried to establish a fashion empire anywhere else, it would have almost certainly failed. Location is so critically important.

Alex: It seems that part of the idea of the CEO falling in love with the mission is that they need to have the right ingredients around.

James: That’s really a chicken-and-egg type thing. In my mind, having the right CEO will lead to the other ingredients being right. Walt Disney was the right CEO for Disney. He founded the company. He realized that he was in the wrong location and that because of his passion he had to move, so he did. The rest is history.

Similarly with Jeff Bezos at Amazon. He’s certainly the right man for the job. He knew he would have to make decisions that were in the long-term interests of the company. If that didn’t make Wall Street happy, he was prepared to take it on the chin. In that inaugural shareholder letter, he said to investors, “I just want to set up my store. This is how I’m going to be effectively steering the ship. If you’re aligned with my thinking, great – you’re welcome to get onboard. If you’re not, there are plenty of other places you can invest.” He made it clear from the outset.

It was all about quality. You can read plenty about Steve Jobs and the number of times he rejected technology being developed in-house because it didn’t quite meet his criteria of quality, esthetics, and usability. He told his design team to go away and change either the user interface or the look and feel. He was always searching for inspiration from others. If you look at Apple Stores and the way they are laid out, they have got a very Japanese feel to them. That’s no coincidence. Jobs was greatly inspired by Akio Morita – the founder of Sony – and often traveled to Japan because Morita was one of his mentors.

As an aside, the black turtleneck Jobs always wore was designed by Issey Miyake, who was the designer for Akio Morita at Sony. After the Second World War, when Sony was founded, Japan was on its knees. Not only was it in recession, but almost half of Japan was homeless. The country had been absolutely destroyed in the war. It wasn’t a great time to launch a tech startup, but Akio Morita did it anyway.

Back then, if companies wanted to employ people, they had to provide clothing for them to wear because people didn’t have the means to pay for their own work attire. They were literally on the breadline. Even today, a lot of Japanese companies still provide workwear for their staff, and Sony is no exception. Sony has Issey Miyake – the fashion designer – design all of its in-house workwear. It was Akio Morita who introduced him to Steve Jobs. That’s why Jobs always wore that turtleneck.

All I’m saying here is that if you find the right CEO, if you’ve got the right person steering the ship, all of these other things should flow. If the other things aren’t flowing and any of these other ingredients appear to be out of place, chances are that you’ve got the wrong person steering the ship. These aren’t separate components. They’re all inextricably linked.

You’ve got to look at long-term decision-making. You’ve got to look at incentives. You’ve got to look at whether decisions are being made in the long-term interests of the company. Is the location of the business optimal for success? Is the company evolving? Is it prepared to cannibalize its own business to evolve with the changing landscape?

There are so many other factors. A lot of the most successful companies nurture talent within. That’s a hugely important factor as well. If you are looking to promote internally, ultimately to the top of the shop, that changes your mindset on the kind of people you’re recruiting for entry-level jobs. The Taylors, who developed Enterprise Rent-A-Car, only promote internally. As a result, the people they hire to sit at the front desk and hand over the keys to a rental car are the caliber of people they believe will ultimately be able to progress through the hierarchy and perhaps one day run the company. This means that even in entry-level jobs, the person serving the customer will be of much higher than at a rival company, which gives you a competitive advantage.

You see similar themes at Costco. It does exactly the same. All three of its CEOs started at the bottom. In fact, Jim Sinegal – who was co-founder – started as a bag packer. At Gen Elec, one of the most recent CEOs was a forklift truck driver and worked his way up to CEO 30 or 40 years later.

You see these patterns emerging time and time again. Even Mark Leonard at Constellation Software – which is an entirely different kind of business because he’s a serial acquirer – says that his hit rate hiring externally is no better than 50%. He says, “Why would you roll the dice and take a risk with a 50% success rate and hire external people when you could promote from within?” He always tries to promote from within for that particular reason.

I pull these golden threads out in the book in these vastly different industries. We’ve spoken about serial acquires in the vertically integrated software business. We’ve spoken about Costco, which is a grocery-type store. We’ve spoken about car rentals with Enterprise. They all gravitate towards the same kind of model. It’s all about nurturing talent from within, giving people a career path, allowing employees to think like owners so they have to believe that they’ll benefit from the success of the business. It involves all other types of incentives – profit-sharing and that sort of thing.

These are golden threads that run through every successful business. Only the kind of golden CEO you want to invest in will understand these subtle nuances that have to be introduced to a business. It’s all about culture. I gave the example of Lou Gerstner. He was the opposite kind of CEO. He wasn’t interested in the well-being of IBM and its shareholders; he was only interested in hitting short-term remuneration targets. He became very wealthy as a result, and his shareholders suffered. I think these are the most important things to focus on when making long-term investments.

Alex: You told me a story about Patagonia earlier. I thought that was very interesting, especially given how it departs from the conventional idea about ESG.

James: Yes, Patagonia is a wonderful company. Yvon Chouinard – who founded Patagonia – wrote a book called Let My People Go Surfing. It’s well worth the read. Even when Chouinard has achieved incredible success, he has always put the planet, the environment first. It’s the way he runs his business.

He very famously ran an advert in the New York Times on Black Friday with a picture of one of his jackets and a big caption above it saying, “Don’t buy this jacket.” What kind of person tells consumers not to buy their products? He did, and it was an incredibly successful advertising campaign. He was very much against consumerism, against people buying cheap clothes and disposing of them. He believed in making quality garments that people could use effectively over a lifetime because that’s so much better for the environment. Although they would cost more, he saw it as more economical because you’re far better off paying a bit more for a quality item than buying cheap items which need to be replaced very frequently.

The critical thing with Yvon Chouinard is that he refused to take his company public. One of the reasons was that he didn’t want to be answerable to shareholders. He wanted to be focused on long-term objectives rather than quarterly earnings targets. More importantly, he was laser-focused on the environment and the planet. Bit by bit, he has put the company into a trust, and all of the profits that flow from it now go to environmental causes. Critically important is that he never publicizes that. It never features in his advertising material. He’s not looking for a pat on the back. He’s not looking to win customers necessarily because of his own environmental ambitions.

Contrast this to the crazy wave of ESG investing we’ve seen in recent years. Most CEOs regard ESG as a tick-box exercise. They want to tick the right boxes because they know there are all sorts of managed funds out there that will only invest in companies meeting ESG criteria. These companies aren’t particularly interested in doing the right thing for the environment. It is just a tick-box exercise. Their approach is in stark contrast with the approach of Chouinard at Patagonia.

I could call out Elon Musk as an interesting example. He holds himself out as being a champion of the environment. He introduced Tesla cars. It wasn’t his company. He acquired it, but he built it up into what it is today. He’s always pushed that environmental line, selling electric cars as being fantastic for the environment. Meanwhile, what else is he doing? He’s got SpaceX. He’s almost gratuitously launching rockets. God knows what that’s doing for greenhouse gas emissions.

Moreover, he was a huge promoter of Bitcoin. Bitcoin mining is an activity that consumes more power than Belgium or Austria. The carbon footprint of Bitcoin is enormous. How does someone like Elon Musk square that circle? How does he hold himself out to be a champion of the environment, pushing Tesla and while at the same time promoting a technology incredibly detrimental to the environment? I can’t reconcile that. I find Elon Musk to be a very difficult character to understand. Personally, I would never invest in his companies for that reason, among others. However, Yvon Chouinard is truly a model for other CEOs to aspire to. If anybody hasn’t read his book, I would highly recommend it.

Alex: You have some strong views about capital allocation and dividend policy. Would you like to share some of your thoughts?

James: So far, we’ve been discussing – from an investment perspective – how the people running the business are more important than the business itself, but the question becomes how to identify a great CEO. This is where the golden threads identified in the book become so valuable.

Essentially, when all the best CEOs do something in a particular way, you can look for others who adopt a similar approach. In answer to your question, capital allocation is arguably the most important task for a CEO, but most make awful decisions without fully grasping the implications.

Take dividends. Many CEOs feel compelled to pay them, not understanding that doing so is often harmful to their business. Compounding this issue is a widespread myth that a large part of an investor’s return on equities stems from reinvesting dividends. Shareholders demand dividends unaware of the flaw in their logic. In combination, these two factors cause many companies to fall short of realizing their full potential.

Capital allocation decisions should always be guided by opportunity costs. That was something Charlie Munger always harped on about, and I believe that’s quite right. A business is subject to a large number of outside influences, and the vast majority of them can’t be predicted. Henry Singleton always preached about remaining flexible. He said he deliberately avoided making plans. Instead, he would steer the boat each day based on prevailing circumstances, which has to be the right way to run a business. Yet, most CEOs default to blindly following some kind of a playbook regardless of circumstances and without any critical thinking. Effectively, they’re replacing management discretion with a codified approach that avoids the need to make difficult decisions. Do you want someone like that running a company in which you’re invested? I certainly don’t.

Dividends sit at the heart of the capital allocation issue. As you’re aware, neither Warren Buffett nor Jeff Bezos pays a dividend. Ask yourself why. If you’re not sure of the answer, allow me to offer some insights and explanations.

Back in 1972, there was a group of 50 top-performing US stocks, including McDonald’s, Coca-Cola, Walt Disney, American Express, Gillette, and General Electric. Collectively, they were known as the Nifty 50. They were heralded as the best investment opportunities. They were considered elite companies one could buy and hold almost forever. Half a century later, many of them remain industry leaders.

Here’s the really interesting part. If an investor in 1972 had evenly distributed $5,000 across all 50 companies – $100 in each – and held them until the end of 2022, that $5,000 investment would have grown to $609,000 through a combination of capital growth and dividends – not a bad return. However, instead of investing in the Nifty 50, that investor back in 1972 could have put the $5,000 into Berkshire Hathaway. The amusing thing here is that back in 1972, Berkshire Hathaway was a turnaround situation. It was emerging out of a failed textile business and wasn’t considered worthy of being included in the Nifty 50. Yet, over time, $5,000 invested in Berkshire Hathaway would have grown to a cool $28.7 million. The Nifty 50 – $609,000; Berkshire Hathaway – $28.7 million. I’m sure you’ll agree it’s quite a difference.

This demonstrates the magic that Buffett discovered very early on in his investing career. That’s the extraordinary power of compounding retained earnings. Buffett achieved an astonishing annualized return of just under 19% on a CAGR basis, while the Nifty 50 compounded an annual rate just over 10%. The key truly is in optimizing growth by avoiding the payment of dividends. It’s not rocket science; it’s just basic mathematics. Let me give you an example.

If a company achieves 20% return on invested capital and reinvests all of that back into the business, then – all else being equal – the value of the business will compound at that same 20% rate. However, if the company distributes 50% of its earnings as dividends, the compounded growth rate is cut in half to just 10%. To put numbers on it, $5 million invested in a business with a 50% payout ratio compounding for 15 years at 10% will grow to $23 million, plus $16 million in gross dividends – a total of $39 million on a $5 million investment. Without dividends, compounding at the full 20%, it will have grown to $77 million.

The only difference is that in one scenario there was a dividend, and in the other scenario there wasn’t. The outcome is almost double. This is why Buffett realized that paying dividends is foolish. He explains why Berkshire Hathaway outperformed the Nifty 50 by a factor of 47 times over that 50-year period. The longer the compounding period is, the more pronounced the effect will be. This is probably why Albert Einstein famously referred to compounding as the eighth wonder of the world. He said, “He who understands it earns it.” Buffett certainly understood it.

Those who don’t get it underperform, which is why I said earlier that it’s foolish, but a lot of CEOs just don’t get capital allocation properly. They pay out huge dividends, sometimes because shareholders demand it. Again, shareholders lose out. Not only are you underperforming, but by not reinvesting all of your capital in growth, you’re allowing competitors to capture market share that remains unclaimed due to the slower growth rate of your business. This doesn’t make any sense at all.

Alex: Given this, why are companies and investors so often fixated on dividends?

James: That’s an interesting question. To answer it, we need to look back in time.

Prior to the 1950s, there was a prevailing belief that if a company generated regular cash for its investors, that signaled its quality and reliability as a business. During that era, companies were heavy with tangible assets, meaning that organic growth was slow. Acquisitions were rare at that time, and share repurchases weren’t yet a thing. With excess capital accumulating, returning it to shareholders became a default choice. It made a lot of sense, and it was ethically sound.

We now live in a completely different world. Many of the leading companies today have an intangible asset base that’s very easy to scale. Mergers and acquisitions are commonplace, and share buybacks done properly are incredibly accretive to shareholder returns. Despite changing times, so many CEOs are still using their grandfather’s playbook and still doing it the way it was done back in the 1950s.

Although I’ve framed it in a historic context, the debate about whether or not to pay dividends isn’t new. We’re going a long way back now. In the 1870s, Sam Andrews was an early investor and a director in Standard Oil. He believed the consistently high dividend payouts would make Standard Oil’s stock a hugely attractive investment, but JD Rockefeller disagreed. He argued that profits should be reinvested to fuel growth and to strengthen the company’s competitive position. This disagreement was a source of ongoing tension within Standard Oil. It culminated in Andrews being ousted. Rockefeller went on to become the richest man on the planet at one time, and his approach was fully validated by the success of Standard Oil.

From an investor’s standpoint, unlike other asset classes, a company can compound in value. This is what makes equity investing so attractive. By reinvesting earnings, it becomes possible to create a long-term reinvestment spiral that accelerates growth. It amazes me that so many CEOs and investors simply don’t get it.

The next person to consider in this narrative is John Malone – the legendary CEO of TCI. He served there from 1973 until 1999 – just over 25 years. It’s important to understand that when he joined in the 1970s, the prevailing trend among public companies was to focus on the optimization of net earnings. To be honest, that mindset continues today, but Malone recognized back then that this approach was fundamentally flawed. He recognized that earnings are taxed, which drained capital from the company. He asked himself, “Why bleed capital to the taxman when it can instead be reinvested in a tax-efficient manner that will compound for the benefit of both the business and its shareholders?”

With little or no net earnings, there would be no dividends. Still, under Malone’s leadership, TCI became a financial powerhouse. He delivered remarkable returns for shareholders, averaging over 30% year-on-year for a straight quarter of a century. In fact, every dollar invested in TCI at the beginning of his reign grew to be worth $900 by the time he stood down. As an investor, if you’ve seen a dollar of your investment turn into $900, would you be bothered about not receiving a dividend? By comparison, over the same period, the S&P 500, which comprises companies mostly fixated on maximizing quarterly earnings – the opposite to Malone – and favoring dividends over reinvestment, turned the same dollar into $22. Talk about a stark contrast.

Back in the 1970s, Malone created a real headache for Wall Street analysts. They struggled with his approach, which was so novel. They’d always valued businesses on earnings multiples, so optimizing earnings was the holy grail. Malone tried to help them through their malaise. He was doing the complete opposite. He emphasized that they needed to divert their attention from the bottom line and instead focus on the earnings power of the business. Reinvested capital is not a cost of running a business. It’s a means of optimizing future cash flows through investment, which is where the real value of the business could be unlocked. Reinvested capital reduces bottom-line earnings, which makes net earnings an unreliable indicator of the true worth of a business.

The important metric is how much cash the business is capable of generating in the absence of that reinvestment. What Malone advocated was that analysts ought to look further up the income statement, which is the way to reveal the true earnings power of the business. This is how John Malone introduced the now ubiquitous term EBITDA into the business lexicon back in the 1970s. Effectively, “earnings before interest, tax, depreciation, and amortization” is a variation on operating earnings right the way up the income statement. Unfortunately, EBITDA is used today for all sorts of nefarious purposes, which is why Charlie Munger referred to it as bullshit earnings, but its purpose is entirely legitimate if used properly, the way John Malone intended it to be used.

Like Buffett and Bezos, Malone understood that the intrinsic value of the business lies in the net present value of future cash flows, not the current earnings. That was reinforced in Amazon’s 1997 inaugural shareholder letter. In it, Bezos emphasized that his was a long-term approach prioritizing future cash flows over short-term Wall Street earning expectations. That strategy – combined with his refusal to bleed capital in the form of dividends – saw Amazon’s market cap grow from $438 million around the time of the IPO in 1997 to $1.7 trillion by the time Bezos stepped down in 2021. It’s worth even more than that now. While Bezos was in office, he achieved a 43% compound annual growth rate. That’s quite incredible.

It also explains the danger of using earnings metrics to screen investments. How many investors look for PE ratios as a means of screening investments? For this reason, it’s flawed. How many investors were deterred from investing in Amazon over the years because its PE multiple appeared to be high in the 70s? It only appeared high because of the incredibly high levels of reinvestment in the business, which distorted the denominator. That’s a critical mistake. It caused so many investors to miss out on one of the greatest investments of the century. Even today, Wall Street obsesses over earnings metrics and earnings per share. Analysts still don’t seem to get it. This leads me to an incredibly interesting story.

There’s a lesson to be gleaned from the Federal Republic of Germany. After World War Two, the German economy was in ruins. In 1947, industrial output was only a third of its 1938 level, and a large percentage of Germany’s working age men had been killed in battle. However, a mere 20 years later, Germany’s economy had transformed into a powerhouse and become the envy of the world. It was referred to as the German economic miracle. In fact, Germany’s economy has consistently remained Europe’s strongest economy since the 1980s – even before the reunification of East and West – but the real relevance here is how they achieved it.

Germany introduced a 95% corporate tax rate. You didn’t mishear – that’s 95%. It’s not clear whether this was done to raise public money to be used to rebuild Germany after the war or whether it was devised by an economic genius who was thinking about second- and third-level consequences of the policy, but it worked out well.

Think about this for a minute. How might a 95% tax rate influence corporate behavior? If you were running a company at that time and knew that your profits would be taxed at 95%, why maximize earnings when almost all of it was going to be taken away in tax? What happened instead is that every company sought to minimize earnings by reinvesting heavily in growth. With little or no corporate earnings, investors were neither motivated nor distracted by dividend income. This approach led to rapid economic expansion, the German economic miracle.

The country effectively achieved great success in exactly the same way that Berkshire Hathaway, Amazon, and TCI achieved their own economic miracles. It’s all about taking the long-term view and preserving corporate capital, reinvesting in the business, and enjoying the power of compound growth instead of bleeding capital in the form of dividends.

A stark example of what happens when a truly great company deviates from this approach is the unfortunate story of what went on at Intel. Once a darling of the stock market, it was the undisputed leader in the semiconductor industry. It was known for its cutting-edge microprocessors and continuous innovation. However, Intel saw its competitive edge diminish due to a shift in the management strategy. This decline can be traced back to the leadership of CEO Brian Krzanich, who took over in 2013.

Instead of focusing on long-term growth – as Buffett, Bezos, and others do – Krzanich prioritized short-term financial metrics, particularly those related to earnings, because that’s what his poorly designed remuneration package incentivized him to do. To boost earnings per share, Krzanich made a controversial decision to cut opex, particularly in research and development, which is absolutely incredible and even more remarkable since Intel’s co-founder Gordon Moore famously observed that the number of transistors in an integrated circuit doubles roughly every two years, which we now refer to as Moore’s law and underscores the rapid pace of innovation required in the industry.

Against that backdrop, Krzanich decided to cut R&D, which makes absolutely no sense at all. Rather than investing in R&D to maintain Intel’s leadership, he redirected resources towards share repurchases, which does nothing for the underlying business at all, but it artificially inflates earnings per share. All of this was at the expense of the long-term prospects of the business. The other thing he did was to delay transitioning to a more advanced manufacturing process in order to reduce capex. This decision allowed competitors like TSMC and Samsung to surpass Intel in manufacturing technology, leading to a loss in Intel’s market leadership.

The delayed innovation resulted in a talent drain as top engineers left Intel to join its more advanced rivals. Compounding these strategic missteps, Intel adopted – relevant to our discussion – a progressive dividend policy. Not only was Krzanich deliberately restricting reinvestment in the business, but he chose to distribute the capital that should have been reinvested as dividends instead. What he did throughout his term was increase the dividend payment sequentially, regardless of opportunity cost. The sum paid as dividends per share more than doubled throughout his tenure despite the fortunes of the company declining over the same period.

He inflicted such damage on the business that by 2024, its market cap stood at $84 billion versus $108 billion when he was named CEO over a decade earlier. It was a disastrous 11 years for Intel investors; they’d been receiving dividends all the way through, but taking a huge capital hit as a result. Intel has since been working to reverse course under the leadership of Pat Gelsinger. The company has seen the error of its ways and has begun scaling back its dividends. Whether it can ever recover from the setbacks of the Krzanich era remains to be seen, but its efforts to refocus on the long-term strategy is certainly a step in the right direction.

Before I wrap up the answer to this question, I’d like to contrast the strategies of two companies – Publix and McDonald’s. US listeners, particularly in the southern states, will be very familiar with Publix – the grocery chain founded back in the 1930s. It is a challenger to Walmart, particularly in those southern states and its domestic market. The company owes its phenomenal growth to the power of retained earnings.

Ed Crenshaw – the CEO and grandson of founder George Jenkins – affirmed that profits were the fuel for rapid expansion and helped it to succeed. He confirmed that it was years before they ever even considered declaring a dividend. Had Publix opted to pay dividends from the outset, it couldn’t have grown as quickly as it did, and it wouldn’t have been as successful as it has been. Shareholders may have received regular income, but the investment would have resembled a high-yield bond rather than a growth-oriented equity, which is how it turned out.

In stark contrast – in recent years, at least – McDonald’s took the high-yield bond approach, and its business has stagnated as a result. Quarterly revenues in 2024 are pretty much at the level they were in 2010. In a 14-year period, quarterly revenues have pretty much been stable. There’s been no growth at all.

Why has this happened? During that period, McDonald’s dividend payout ratio has been as high as 80%. If you’re giving away 80% of your earnings rather than reinvesting them in the business, you have cause and effect, which is why the business has stagnated. Metaphorically, if you consider Publix a thoroughbred racehorse nurtured for high performance, McDonald’s is a cow that’s been milked to the point of exhaustion through the payment of dividends. I hope that answers the question.

Alex: Although there are strong arguments in favor of not paying dividends, how do you serve investors who require income?

James: That’s interesting. It goes back to what I said at the beginning about investors who don’t see the flaw in their logic when demanding dividends.

Many corporate boards will argue that they must pay dividends because a significant number of their investors require income, but that’s flawed thinking on two counts. First, it misunderstands the real issue. Second, it proposes an ineffective solution.

I accept that some investors require income, but I would also state – and it will be difficult to refute – that many other investors don’t want income and would prefer instead to optimize capital growth. Why should a company favor one group of investors over another? Additionally, why should a company dictate the timing and the amount of cash distributed to investors? Not all shareholders have the same needs at the same time. On that basis, it’s an undeniable truth that dividends are an attempt to provide a “one size fits all” solution, which is inherently impossible.

Ironically, not paying a dividend actually offers the flexibility to meet the needs of all shareholders. I’ll explain why. Through the liquidity of the stock market, those who need income can choose if, when, and how much cash to draw down from their investment instead of relying on dividend income. If the amount they withdraw from their investment is less than the growth rate of the business, their investment still continues to grow in value. If they choose to draw down large sums, causing the value of their investment to stagnate, it’s without prejudice to the growth aspirations of the other shareholders. This is much fairer than the way McDonald’s has done it and paid out 80% of its earnings regardless, which has punished anybody looking for growth.

Not paying dividends and letting instead shareholders manage their own needs through drawing down their investment allows them to manage their income streams more efficiently and control better the timing of their cash flows to mitigate personal tax liabilities. Interestingly, this is why Warren Buffett has always advocated for this approach when questioned about why he refuses to pay dividends.

Another common argument from corporate boards is that dividends are necessary to attract institutional investors. It’s certainly true that pension funds and the like do favor dividend-yielding stocks for income generation and liability matching purposes, but income-chasing investors aren’t the ideal shareholders a company should seek to attract. The reason is that they tend to prioritize their own commercial objectives and often switch investments based on prevailing dividend yields, and they show little commitment to the long-term goals of the business. Allowing self-serving shareholders such as those to influence capital allocation decisions reflects poor management, in my opinion.

To give you a good example of this, back in 2008, Microsoft explored acquiring Yahoo. It was a deal valued back then at around $44 billion, but the acquisition ultimately fell through for various reasons. Following that, pressured by income-seeking shareholders, Microsoft distributed the capital that had been earmarked for that deal as dividends. The decision prevented the company from using those funds for another strategic acquisition or, indeed, reinvesting in its own search technology development.

As a result, Microsoft struggled to compete in the search and online advertising markets, which is where Google came to dominate. Crucially, many of the shareholders that pressed Microsoft to pay that dividend when the Yahoo deal fell through received a huge windfall, but they soon exited. They moved on to the next company paying out a big dividend. They had no interest in the long-term prosperity of the business. They viewed Microsoft purely as an opportunistic source of short-term income. Microsoft suffered because it arguably allowed the tail to wag the dog.

You must never lose sight of the fact that the company will always have shareholders. This is a given in the stock market because for every seller, there’s a buyer. The real challenge lies in attracting the right type of shareholders, which is those aligned with the company’s long-term objectives. This is why Charlie Munger once said, “Run a company well, allocate capital intelligently, and the business will attract the shareholders it deserves.” The example of Microsoft sums that up very well.

The other interesting thing to point out is that despite not paying dividends, companies like Berkshire Hathaway and Amazon have never struggled to attract institutional investors. Some will say, “Their size and provenance afford them a unique status,” but it’s extremely important to remember that both of these companies started small and both achieved their success without the payment of dividends from the outset.

Does that answer the question?

Alex: Yes, but if companies do take this approach and move away from paying dividends, what’s the best way for them to convince their investors that this approach is indeed in their best interests?

James: That’s interesting. I think Henry Singleton addressed this issue. He was another outstanding CEO. In fact, Warren Buffett once referred to him as the best capital allocator of all time. He always resisted paying dividends as well. We’ve got this golden thread again. We’ve got Jeff Bezos, Warren Buffett, John Malone, and now Henry Singleton. They all resisted paying dividends. JD Rockefeller was another one.

When Henry Singleton was questioned on the matter, he responded, “What would stockholders do with the money? Would they spend it? Teledyne isn’t an income stock. Would they reinvest it?” He noted, “Since Teledyne earns 33% on equity, we can reinvest it better for them than they can reinvest it for themselves.” Then he pointed out something crucial. He said the profits had already been taxed. Paid out as a dividend, they get taxed a second time as income. Why subject stockholders’ money to double taxation?

Singleton shifted the debate to the investor’s viewpoint, highlighting the numerous disadvantages of receiving dividends. He emphasized the issue of double taxation, which is highly significant. Consider this. You’re a company with a dollar of pre-tax earnings. That gets reduced to 75 cents after a 25% corporate tax rate. If those 75 cents are paid out as dividend, it may be subject to a 40% income tax in certain jurisdictions, leaving the investor with a net 45 cents of the initial dollar in their pocket.

It doesn’t end there. That money needs to be reinvested, and after factoring the market bid-offer spread, transaction fees, and all other frictional costs, the investor might end up with 38 cents in the dollar reinvested. In that scenario, the only real beneficiaries are the tax authorities and stock brokers. Why would an investor favor such an outcome? In contrast, if the company had optimized reinvestment and minimized taxable earnings – as John Malone and Henry Singleton did – almost all of that original dollar could have been reinvested to accelerate future compound growth. It doesn’t take a genius to work out which is the superior approach.

It’s essential to stress that there’s a prevailing myth that the lion’s share of an investor’s returns flows from the reinvestment of dividends, but let’s think about this mathematically. Dividends are reinvested by investors at stock market prices, which is often a multiple of book value, while retained capital is reinvested by the company at book value. This distinction is critical. What does it mean?

Essentially, the return on retained capital will be the same as the return on equity being achieved by the business because it’s being reinvested at book value rather than being only a fraction of that number if paid out to the shareholder and reinvested by the stock market at a premium – multiples of book value. The company can reinvest on behalf of its shareholders at a preferential price. It’s the reinvestment of those retained earnings – not the dividends – that drives exceptional shareholder returns, which explains why Buffett, Bezos, Singleton, and Malone have achieved so much.

As discussed earlier, a company is capable of compounding in value. This is what makes equity investing so attractive. By reinvesting earnings, it becomes possible to create a tax-efficient, long-term cycle of capital growth. Investors preferring income over capital growth should – with few exceptions – be active in other asset classes or else take Warren Buffett’s advice and invest in growth stocks that don’t pay dividends, then simply draw down on a stock that’s rapidly growing in capital value due to this reinvestment process.

From a shareholder’s perspective, one more point to consider is the administrative burden of reclaiming withholding taxes on dividends paid by companies in foreign jurisdictions. We don’t all invest in our domestic market. Withholding taxes could be a real nuisance. As I’ve found, trying to reclaim withholding taxes is a process that could be incredibly difficult, if not entirely impossible in some circumstances. That’s another reason to view dividends unfavorably. There are far more accretive means of allocating capital.

Alex: How do you think about dividend payments in the context of capital allocation more generally?

James: Let’s look at this through a slightly different lens. If a business becomes unsustainable or no longer economically viable, it will wind down its operations, pay off its debts, and distribute the remaining assets to shareholders – what we call liquidation of a business.

Similarly, if the return on marginal capital declines, the logical strategy might be to shrink the balance sheet, thereby reducing the business’s capital base back to a profitable core. This is what we’ve seen in some industries – for instance, the tobacco industry. It makes perfect sense in a declining industry. This is effectively a partial liquidation of the business where you’re liquidating some of the asset base.

Now ask yourself, “Is the payment of a dividend not a partial distribution of the company’s accumulated asset base?” Of course it is. Effectively, are the terms “partial liquidation” and “dividend” not entirely synonymous? They both refer to exactly the same process. Both involve the reduction of a company’s net assets, shrinking the balance sheet, and decreasing the capital deployed by the business. This raises the question of why a company with opportunity to grow should intentionally shrink its asset base through the payment of dividends. Why partially liquidate a business with good growth prospects? It makes no sense at all.

To make matters worse, some CEOs deplete cash reserves through dividend payments and then seek to raise growth capital via the debt or equity markets. In my mind, that’s not only irrational but borders on complete incompetence. Borrowing money to deploy in the business in order to generate returns on investment makes sense, but borrowing money to facilitate the payment of dividends is plain stupid. Many CEOs would not have previously contemplated dividends in these terms before, but they’d be well advised to do so in the future because it shifts the perspective and could lead to a more coherent capital allocation strategy.

In terms of capital allocation strategies, the process you can see in the most successful companies is structured like a waterfall. Decisions are made in a specific order of priority. First and foremost, a good company will always focus on reinvesting in the business or building cash reserves for future investment. If no profitable reinvestment opportunities are foreseen, the next step is to consider reducing debt or repurchasing undervalued equity – both of which benefit the business and its shareholders. Only when all of these options have been exhausted and cash reserves start to accumulate to the point of excess should the company consider distributing surplus capital as dividends, which implies the return of capital to shareholders will at most be an ad hoc activity, that is, special dividends. It makes no sense to have regular dividend policy and still less a progressive dividend policy.

Let’s explore each section of that waterfall in some more detail. Even when investment opportunities are not immediately apparent, building a cash reserve in anticipation of future opportunities is a valid reason to refrain from paying dividends. A cash war chest provides flexibility for strategic initiatives and maintains the ability to weather economic downturns. Berkshire Hathaway is the perfect example of this. It has built a cash war chest which – at present, given its recent sell down of its Apple stake – stands at over $250 billion, and the company still has no intention of paying dividends. Crucially, shareholders have such confidence in Buffett’s ability to allocate that capital accretively that they don’t even demand a dividend.

As Buffett explained, “We have no interest in cash – except to the extent that it gives us opportunities,” which is how he’s grown the business so successfully. He says, “The only reason for having cash is if you think you’re going to need it.” He says that cash combined with the courage in time of crisis is priceless. He has proven that time and time again. He allocated his excess cash extremely well after the dot-com crash and the credit crisis of 2008, and it’s paid huge dividends. He’s always said – as have most other good investors – that you’ve got to be courageous when all others are fearful. That’s exactly what he’s done. He’s only been able to do that by having these big cash reserves he can deploy strategically when the opportunity presents itself.

He runs a conglomerate. He’s got those acquisition opportunities, and not all companies work on that basis. If you don’t have those kind of reinvestment opportunities, the next level of the waterfall involves considerations around debt and equity financing. Share repurchases are a huge topic in their own right. I won’t go into too much detail here, but it’s important to briefly touch on them.

We all know that debt is typically a cheaper form of financing because lenders face lower risks. There are repayments scheduled at regular intervals, and debt holders also have a senior claim on assets in case of insolvency. On the other hand, equity financing involves offering investors a stake in the business’s future success, leading to a perpetual dilution of earnings on a per share basis and of the value of the business across a broader base of owners, which arguably makes equity financing less desirable.

Yet the peculiar thing is that many companies will focus on paying down debt while showing less urgency to reduce the more expensive and less desirable equity financing, which has never made sense to me at all. The situation becomes even more puzzling if one considers that a dividend is a one-time payment to investors – the short-term windfall – while reducing the share count through buybacks will provide remaining shareholders with a larger share of future earnings and capital appreciation on the basis of the value of the business, benefiting them in perpetuity. Share reductions are far more beneficial and accretive to shareholders than dividends. Meanwhile, most CEOs will favor dividends over buybacks, which doesn’t make a whole lot of sense to me.

There’s also a paradox to consider. A CEO will spend a significant amount of time presenting to investors – in person, by video link, through publishing written reports. The aim is to retain existing investors, to give them reassurance, and to attract new ones. In that context, does it not seem contradictory for a company to promote itself as a sound investment when it’s opted to distribute its capital rather than investing it in itself through buybacks? It doesn’t make any sense at all.

Buffett, Bezos, Singleton, and Malone never seem to exhaust in this waterfall approach the first four steps. They’ve never exhausted their primary options for accretively allocating capital. They’ve never found themselves in a position where the distribution of assets as a dividend made any sense. In other words, they never reached the bottom of their waterfall, which explains why they’ve never paid dividends. Arguably, it’s why others shouldn’t pay dividends, either.

Eventually, CEOs see the light. Let’s take another great CEO – Mark Leonard of Constellation Software. He’s an exemplary CEO. I’m sure everyone will agree. In his 2021 shareholder letter, he said, “One of our directors has been calling me irresponsible for years. His thesis goes like this: CSI can invest capital more effectively than the vast majority of CSI shareholders. Hence, we should stop paying dividends and invest all of the cash we produce. We have paid three special dividends. For the last decade, we’ve also paid a regular quarterly dividend.” Then he said, “I’ve stopped arguing. I’ve converted, and with the fervor of the newly converted, I’m busy demonstrating my newfound fate.” He came around to the same way of thinking as the other great CEOs.

Wrapping up, I will ask you, “Is it not uncanny how all of the best CEOs eventually see the light and converge on a very similar approach to capital allocation and dividend policy?” These are CEOs who operated over completely different time scales. We saw Mark Leonard convert in 2021. We had Singleton and Malone deploying this strategy back in the 1960s, 1970s, and 1980s. Bezos didn’t start until the early 2000s. Back in the 1870s, this was exactly the strategy Rockefeller deployed. In my mind, this is no coincidence. This is one of the golden threads that runs through all great businesses. This is why I pull this one out in my book, in the chapter on dividends.

Ultimately, companies that pay dividends typically either lack viable reinvestment opportunities – possibly due to operating in a declining industry – or they have management that lack the creativity and financial acumen to fully realize the company’s full potential. That explains why many high-performing investors – I like to include myself in that number – use a company’s approach to dividends as a leading indicator of its quality as an investment. When I’m analyzing a business, one of the things I’ll look at in detail is its approach to dividends. If I see a company paying regular dividends, having a progressive dividend policy, and ignoring the opportunity cast, that’s usually a huge red flag for me.

Alex: James Emanuel, thank you so much for taking the time to talk to us today about your new book.

James Emanuel lives and works in London, England. He is happily married and has three children. He qualified in English law having achieved a Bachelor of Laws degree with Honours (and several academic prizes along the way). He subsequently secured a post graduate Legal Practice Certificate from the Law Society of England and Wales. However, having enjoyed the academic side of law, practicing law was not what excited him. Sharing a family aptitude for mathematics and economics — his father, being a retired stockbroker and his brother an actuary — he was drawn into the world of finance, particularly investing in businesses. As an investor in some of the world’s leading businesses, he has engaged with corporate leaders and learned what success looks like. He constantly introduces constructive challenges to inform corporate decision making and has improved the fortunes of the companies in which he has a financial interest. He has also served as a special advisor to the U.K. Government in matters relating to business policy.

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I am delighted to share this new recording with you, as Capital Returns has been hugely influential in shaping my investment philosophy. The book is truly a “must read” for every investor aspiring to long-term greatness.

In Part One of our two-part series, I took you on a journey through capital cycle theory, as masterfully articulated by Edward Chancellor and London-based Marathon Asset Management.

In this Part Two, we apply capital cycle theory to today’s market environment, seeking to identify exceptional opportunities in capital-starved industries. The discussion applies the capital cycle framework to several asset-heavy sectors that have seen dramatic booms and busts — energy, oil services, shipping, metals & mining, and real estate.

Each of these sectors recently experienced the aftermath of a deep downturn. Years of low investment have strained supply, improving economics for the survivors. This creates potential opportunities for value investors — though timing and careful selection remain key. Below, we preview the major themes of Part Two and how capital cycle thinking is being applied to current industries.

Energy (Oil & Gas): Underinvestment Comes Home to Roost

Oil is a textbook capital-cycle commodity. After years of $100+ oil spurred a spending boom, the cycle turned in 2014: prices plunged and companies slashed upstream capital expenditures by about 50%. Investment stayed depressed through the late 2010s, exacerbated by the 2020 crash. By 2022, demand had recovered but supply couldn’t catch up — global oil inventories fell and OPEC’s spare capacity dwindled. The world faced a structural oil shortage, sending prices back above $100. Yet producers remain cautious: even at these prices, 2022 CapEx was still far below 2014 levels. Instead of chasing volume, companies are returning cash to shareholders. This unusual restraint suggests the upswing could persist until new investment eventually floods back. As value investor Bob Robotti notes, with every existing well depleting and few new ones drilled, a production decline was inevitable — and now it’s playing out in higher prices. For investors, energy firms today enjoy strong cash flows and improving returns on capital.

Oilfield Services: A Brutal Cleansing and Rebound

The oilfield services industry (rig contractors, equipment providers) went through a harrowing downcycle alongside energy. Overcapacity was rife in the last boom, and when oil prices collapsed, service companies collapsed too. Between 2014 and 2018 an average of 40+ offshore rigs were scrapped each year, and nearly every major drilling firm went bankrupt. This cleansing of excess capacity means that now, with oil activity picking up, far fewer rigs and crews are available. Day-rates for drilling have jumped, and surviving companies are finally regaining pricing power. Their stocks have begun to recover from extreme lows, yet the cycle may still be young – virtually no one is financing new rigs (it takes years to add capacity), so incumbents have a wide-open window of opportunity. After this near-death bust, oil services appear to be at the start of a major capital-cycle upswing as demand returns to a shrunken industry.

Shipping: Orderbook Signals in Booms and Busts

Dry bulk shipping offers a prime example of the capital cycle. A China-driven commodities boom in the mid-2000s sent freight rates skyrocketing, leading owners to order too many new ships. When demand tailed off in 2008, the market crashed 90%+, kicking off a long bust in which many vessels were scrapped and investors fled. By 2016, new ship orders had dropped to multi-decade lows, paving the way for a recovery. As global trade rebounded in 2021, freight rates surged and leaner shipping firms earned windfall profits. Crucially, shipowners exercised restraint this time – they did not binge on new vessels, so the upcycle has lasted longer instead of being cut short by oversupply.

Container shipping, in contrast, saw a rapid boom-bust. The pandemic supply-chain crunch drove container freight rates up five- to tenfold, yielding record profits for liners (some earned their entire market cap in profit in one year). But flush with cash, the industry over-ordered new mega-ships, swelling the orderbook to ~25% of the fleet. Now those ships are arriving just as demand normalizes, causing spot rates to collapse over 80% from the peak. This whiplash underscores the capital cycle mantra: when future supply surges, price relief is only temporary. Today, segments with little new capacity on the horizon (like bulk carriers or oil tankers) appear more favorable, whereas those with a glut of ships coming (containers) face a tougher road ahead.

Metals & Mining: Caution Pays Off After the Bust

Mining shows how capital cycle discipline can pay dividends. After the 2000s commodity “supercycle” peaked around 2011, the big miners drastically pulled back – they cut exploration and shelved projects, opting to repair balance sheets. A decade of scant investment left the industry with few new mines in the pipeline. Now demand is rising again (the green energy transition, for example, is boosting need for copper, nickel, lithium, etc.), but supply remains constrained. Analysts at Goehring & Rozencwajg warn of a looming copper shortage – inventories are near record lows and new projects are scarce. In other words, the seeds of a potential upcycle have been planted. Miners are still showing restraint despite higher prices. When iron ore prices doubled to records in 2021, companies did not rush to build new mines, remembering the oversupply lesson. As a result, many mining firms are gushing cash today and trade at low valuations (partly due to ESG concerns and skepticism about demand). The key will be to watch for a resurgence of CapEx: as long as management teams remain cautious, returns on capital in mining could stay elevated. But if they slip back into expansion-at-all-costs mode, that will signal the cycle’s next turn.

Real Estate: Undersupply vs. Oversupply

Real estate cycles often hinge on whether developers overbuilt or underbuilt. In U.S. housing, the 2008 crash was followed by a decade of underbuilding — far fewer homes were built than new households formed. By the 2020s, this left an acute housing shortage. Home prices and rents surged until 2022, and builders enjoyed record profits. Even after interest rates jumped, prices dipped only modestly because inventory remained so tight. The capital cycle logic is clear: the bust (2008) sowed the seeds for the next boom by curtailing supply for years. In contrast, China’s housing market massively overbuilt. Decades of construction led to entire “ghost cities” of empty apartments — China has an estimated 65 million empty units. When the bubble finally popped, major developers defaulted and new building came to a halt. China is now enduring a protracted bust as it works through excess supply — a stark reminder that oversupply can take a long time to fix.

Commercial real estate is seeing its own harsh correction. Offices, in particular, face sky-high vacancies after the shift to remote work, especially in older buildings. Property values have plummeted and financing has dried up. Essentially, no one is funding new office construction now. Over time, this lack of new supply (and the conversion of some offices to other uses) will help the survivors. Some contrarian investors like David Einhorn are even buying distressed offices at around 30% of replacement cost, betting that with no new projects being built, any future pickup in demand will sharply boost the value of existing assets. More broadly, rising interest rates have raised the cost of capital and slammed the brakes on development across many real estate segments. At an 8% cap rate, no new apartment projects make financial sense – development has essentially collapsed. This environment ultimately sets the stage for a recovery: markets that were underbuilt (like U.S. housing or logistics warehouses) remain healthy, while those that overbuilt (downtown offices, etc.) are struggling. Real estate once again shows that when capital is abundant and builds too much, lean times follow – but when capital investment dries up, the groundwork is laid for better days ahead.

Conclusion

Part Two demonstrates that the capital cycle framework remains as relevant as ever. Across industries, the same pattern emerges: where capital was scarce and capacity was cut, conditions are now improving; where capital was overabundant, oversupply has led to pain. The key question for any sector is, “Are investors funding new growth, or are they cutting back and fleeing?” The answer often predicts the future.

Part Two concludes with practical advice for applying this framework — for example, monitor supply indicators (orderbooks, CapEx levels, inventory trends), examine management’s capital allocation discipline, and be willing to go against the crowd during extremes. Value investors who heed these signals can better time when to lean into an unloved industry or to step away from an overhyped one.

Podcast Part Two: Key Segments

• Introduction & Context – Recap of capital cycle lessons from Part One; recent macro cycles setting the stage

• Energy (Oil & Gas Upstream) – From investment glut to supply shortage, and the new discipline of producers

• Oilfield Services – How a wipeout in drilling capacity is turning into a rebound for surviving contractors

• Shipping – Wild swings in freight markets; why low orderbooks signaled opportunity (and gluts signaled danger)

• Metals & Mining – Post-supercycle retrenchment leading to tight supply (e.g. copper) and strong cash generation

• Real Estate – Regional contrasts: U.S. undersupply vs. China oversupply; offices adjusting to higher rates

• Takeaways & Conclusion – Applying the capital cycle lens in practice (supply metrics, contrarian strategy, etc.)

This Part Two of our two-part series was recorded in March 2025.

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I first read Peter Lynch’s One Up on Wall Street early in my investing journey, and its impact on my investment philosophy was profound. Lynch’s wisdom not only demystified the world of stock investing for me but also instilled a lasting confidence that, as an individual investor, I could indeed compete with — and even outperform — the professionals on Wall Street. His down-to-earth insights and emphasis on understanding the businesses behind the stocks resonated deeply, shaping my perspective and approach profoundly.

Today, I’m delighted to share the timeless insights from Lynch’s classic with you. I distill Lynch’s principles, explore his categorization of stocks, and highlight how his ideas continue to apply in today’s market environment. My goal is to share not only an abiding appreciation of Lynch’s strategies but also practical guidance for applying his methods today.

In revisiting this influential text, we’ll see how his approach holds up — and even thrives — in the context of today’s investment landscape. I hope to equip you with the wisdom and perspective needed to identify promising opportunities and avoid debilitating losses.

Here’s an “executive summary” of my in-depth survey of the book:

The core principles articulated by Lynch in One Up on Wall Street revolve around practical insight, rigorous analysis, and disciplined emotional control — key tenets for navigating financial markets successfully.

Lynch, who famously achieved annualized returns of approximately 29% while managing Fidelity’s Magellan Fund from 1977 to 1990, strongly advocates for individual investors’ capability to outperform large institutional investors. He argues that retail investors possess distinct advantages: agility, the ability to invest meaningfully in smaller, overlooked companies, and firsthand knowledge of emerging market trends through direct personal and professional experiences. In contrast, institutional investors, constrained by size and market visibility, often miss these early indicators, providing opportunities for attentive retail investors.

Central to Lynch’s investing philosophy is the critical importance of genuinely understanding the companies in which one invests. He insists investors must clearly articulate why they own each stock, warning against investing based solely on speculation, hype, or overly complex narratives. His famous advice, "If you can’t explain it to a ten-year-old in two minutes or less, you probably shouldn’t own it," underscores his emphasis on clarity and simplicity. Lynch’s historical investment successes in straightforward businesses like Dunkin’ Donuts illustrate how mundane, easily comprehensible businesses often yield robust long-term returns, as their simple operations and predictability help investors identify sustained competitive advantages.

Lynch also stresses diligent research — “doing your homework” — to verify investment hypotheses. He encourages investors to closely monitor tangible, industry-specific metrics such as commodity prices for resource firms, occupancy rates for hospitality stocks, or subscriber growth for technology companies. These metrics, grounded in business fundamentals rather than macroeconomic speculation, form the cornerstone of informed investment decisions. Lynch humorously dismisses attempts at economic forecasting as futile, advising investors instead to focus on concrete data directly relevant to company performance.

An essential aspect of Lynch’s method involves capitalizing on market volatility rather than fearing it. He advises investors to view market corrections and downturns as opportunities to purchase quality companies at discounted prices. Historically, Lynch points out that market corrections are frequent occurrences and should be expected, not feared. His ability to maintain emotional discipline during volatility is a hallmark of his investment style, reinforcing his assertion that “your stomach is more important than your brain” when investing. Investors who can emotionally handle market fluctuations and remain patient often reap substantial rewards.

Lynch’s distinctive contribution to investment literature includes categorizing stocks into six distinct types, each with specific strategies and expectations:

1. Slow Growers: Typically mature companies with modest earnings growth rates (2-5%) and stable dividends. Lynch advises caution, recommending slow growers primarily when they are undervalued and offer attractive dividend yields. Telecom giants such as AT&T and Verizon exemplify contemporary slow growers, offering steady dividends but limited growth prospects.

2. Stalwarts: Blue-chip companies with moderate growth rates (10-12%), providing stability and resilience. Examples include Coca-Cola, Johnson & Johnson, and Procter & Gamble. While not likely to deliver rapid growth, stalwarts offer dependable returns and resilience during economic downturns. Lynch’s methodology highlights the importance of buying stalwarts when temporarily out of favor, as these moments provide attractive entry points. Microsoft’s evolution from stagnation to renewed growth under Satya Nadella exemplifies how stalwarts can transition into turnaround and growth opportunities, providing substantial rewards to investors who identify positive strategic shifts early.

3. Fast Growers: Smaller, rapidly expanding companies with potential earnings growth rates of 20-30% annually. This category is Lynch’s preferred hunting ground for "tenbaggers," stocks that appreciate tenfold or more. He emphasizes cautious optimism, advising investors to focus on moderately rapid growth (around 20-25%) in industries less scrutinized by the broader market. Historical successes include Wal-Mart, which replicated its efficient retail model nationwide, and Taco Bell, whose rapid expansion in the 1980s provided significant investor returns. Contemporary parallels include Monster Beverage, Shopify, and Domino’s Pizza, companies which experienced phenomenal growth from simple but highly effective business strategies.

4. Cyclicals: Companies whose earnings fluctuate significantly with economic cycles. Lynch emphasizes the critical importance of timing when investing in cyclicals, recommending purchases when sentiment and valuations reflect pessimism near the bottom of the cycle. He suggests targeting cyclicals with robust balance sheets capable of enduring downturns. Historical examples include Chrysler and Ford during economic recoveries. Recently, energy companies such as ExxonMobil and Chevron provided profitable investment opportunities during cyclical downturns triggered by the COVID-19 pandemic’s impact on oil prices.

5. Turnarounds: Distressed or challenged companies with potential for recovery due to managerial or strategic improvements. Lynch sees these as high-risk but potentially lucrative investments, advising a disciplined approach that includes verifying solid balance sheets and concrete signs of operational improvement. Historical examples like Chrysler in the 1980s and more recent examples like Best Buy and Microsoft illustrate successful turnarounds, where strategic pivots revitalized stagnant or declining businesses. Investors must remain vigilant, however, as many turnarounds fail — highlighting the importance of strong balance sheets and clear evidence of business improvement before investing.

6. Asset Plays: Companies significantly undervalued due to overlooked tangible or intangible assets. These might include real estate, cash holdings, patents, or intellectual property whose value exceeds the market’s current assessment of the entire business. Historical examples include Crown Cork & Seal, while modern cases feature Nintendo and various conglomerate spinoffs like General Electric’s recent restructuring into separate entities to unlock value. Asset plays require investor patience, as the market may take considerable time to recognize underlying asset value.

Lynch’s frameworks adapt remarkably well to today’s market conditions. Although contemporary investing involves challenges such as heightened market speed, algorithmic trading, and rapid information dissemination, these factors underscore Lynch’s argument for patient, disciplined, fundamental-based investing rather than speculative chasing of fleeting trends.

For instance, Lynch’s skepticism towards excessively hyped industries remains relevant. Recent speculative frenzies, such as cannabis stocks or cryptocurrency, validate his warnings about “hot stocks in hot industries.” Many such speculative investments collapsed when reality failed to meet sky-high expectations, reaffirming Lynch’s wisdom in avoiding trendy but fundamentally unsupported businesses.

Additionally, Lynch’s advocacy of valuation discipline through tools like the Price-to-Earnings-Growth (PEG) ratio proves essential in today’s volatile and rapidly shifting interest rate environment. Companies with inflated valuations but limited profitability — typical of many recent high-flying tech stocks — experienced sharp corrections, illustrating Lynch’s warning against overpaying for growth. Conversely, companies in less glamorous sectors but with robust earnings growth and reasonable valuations have offered superior and more stable returns.

Lynch also champions the value of insider buying and meaningful share buybacks as positive indicators of company health, aligning management interests with shareholders. He highlights the need for careful analysis of management actions: share buybacks at reasonable valuations signal confidence and shareholder alignment, exemplified historically by Ford and contemporarily by Apple.

Emotional discipline, particularly critical in turbulent periods, is another enduring Lynch principle. Recent events, including the COVID-19-related market decline in March 2020, illustrate the necessity of maintaining composure, as investors who resisted panic selling often experienced substantial recoveries shortly thereafter. Lynch’s guidance — maintaining a focus on underlying company strength rather than reacting impulsively to market fluctuations—is crucial for investment success.

Ultimately, Lynch’s work emphasizes that sound investing is fundamentally about identifying strong, understandable companies at reasonable valuations and maintaining conviction through inevitable fluctuations. His blend of practical insight, rigorous analysis, and disciplined emotional control provides a robust framework that continues to guide value investors and fund managers toward long-term success.

This podcast episode was recorded in March 2025.

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• Ideaweek 2026, St. Moritz, Switzerland (Jan. 26-29, 2026)

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I am delighted to share this new recording with you, as Capital Returns has been hugely influential in shaping my investment philosophy. The book is truly a “must read” for every investor aspiring to long-term greatness.

In this Part One of our two-part series, I take you on a journey through capital cycle theory, as masterfully articulated by Edward Chancellor and London-based Marathon Asset Management.

In Part Two, we apply capital cycle theory to the recent market environment, seeking to identify exceptional opportunities in capital-starved industries.

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Experienced investors know that markets are more than just numbers on a screen — they are living cycles of boom and bust. Capital Returns: Investing Through the Capital Cycle, edited by renowned financial historian Edward Chancellor, shines a spotlight on one of the most fundamental yet underappreciated forces behind those cycles.

The book compiles a decade’s worth of investment essays from Marathon Asset Management, a London-based value firm, offering an insider’s look at how capital flows within industries can make or break investment returns. Far from a typical market chronicle, Capital Returns provides a rigorous framework for investors seeking an edge in understanding market dynamics. Its significance lies in distilling how the ebb and flow of capital — into steel mills, oil wells, tech startups, you name it — ultimately governs competition, profitability, and long-term value creation.

For portfolio managers and value aficionados, the capital cycle framework isn’t just theory; it’s a practical lens for spotting opportunities and risks that traditional analysis might overlook.

At the heart of the book (and our podcast discussion) is the capital cycle concept. Put simply, the capital cycle theory observes that high returns attract excessive capital, which eventually drives returns down, while poor returns repel capital, sowing the seeds of a future recovery. In other words, when an industry is enjoying fat profits and rosy growth projections, companies and investors tend to flood it with money — new entrants, expanded capacity, ambitious projects — until competition and overcapacity inevitably erode those profits. Conversely, when an industry is in the doldrums with abysmal returns, capital investment dries up: weaker players exit, projects get canceled, and supply shrinks, paving the way for the survivors’ fortunes to improve.

This supply-driven feedback loop leads to a powerful mean reversion in economic outcomes. Excess success plants the seeds of its own demise, just as hardship plants the seeds of resurgence. It’s a sophisticated twist on classic boom-bust wisdom, rooted in supply-side economics for investors. Chancellor quips that many analysts fixate on demand trends while ignoring supply, “which is what drives the capital cycle.” By refocusing on metrics like industry capacity, capital expenditure, and competition, investors can anticipate inflection points that others miss. Think of Joseph Schumpeter’s “creative destruction,” but with a balance sheet twist — capital rushing in where it shouldn’t and fleeing where it’s most needed, time and again.

Why should intelligent investors care about this framework? Capital cycle analysis offers a contrarian roadmap to navigate market manias and slumps. Traditional value investing often emphasizes buying cheap and avoiding hype, and the capital cycle provides tangible criteria to do just that. For example, Chancellor notes that following the “trail of investment” can help identify bubbles before they burst. History bears this out: the late-1990s dot-com frenzy and the mid-2000s housing boom were each marked by a surge in capital spending (on telecom networks, new homes, etc.), foreshadowing eventual glut and collapse.

Marathon’s insight was to “avoid sectors where investment is unduly elevated and competition is fierce, and instead seek out areas where capital is scarce and conditions are favorable.” In practice, this meant often being early — venturing into out-of-favor industries that everyone else had given up on — and steering clear of the hot sectors du jour. It’s a strategy requiring patience and independent thinking.

Capital Returns is particularly relevant now, after a long era of cheap money and expansion. As the cost of capital rises again, we’re witnessing the pendulum swing: previously neglected sectors (energy, shipping, basic materials) are becoming attractive as capital expenditure there remains cautious, while some once-booming corners of the market face sobering realities. The book’s lessons serve as a timely reminder that fundamentals eventually matter — exuberance fades, and industries with disciplined investment tend to reward investors in the long run.

In our podcast discussion, we delve deep into these themes, unpacking both the theory and its real-world implications. You’ll hear how Marathon Asset Management applied the capital cycle lens across a range of industries and market regimes, and what they learned over years of trial and error. Key themes include the universality of the capital cycle (from beer breweries consolidating globally, to banks overeagerly expanding credit, to even the rise and fall of cod fishing and wind farms), and how recognizing those patterns can give investors an edge.

We explore why growth vs. value is not a black-and-white distinction — a fast-growing company can still be a great investment if industry supply remains constrained, just as a statistically “cheap” stock can be a trap in an overcapitalized sector.

Another focal point is the role of management: capital cycle investing isn’t just about industries in the abstract, but also about CEOs and boards making savvy (or foolish) capital allocation decisions. Good management can resist the siren song of empire-building and return cash when projects don’t promise adequate returns, whereas bad management may squander advantage by chasing scale at the wrong time.

The episode also touches on how this framework shed light on financial crises — for instance, how surging loan growth and balance-sheet expansion in mid-2000s banking was a red flag well before 2008. We discuss the aftermath of that crisis too, examining the era of “living dead” zombie companies propped up by low rates, and how an investor might distinguish temporary distortions from permanent impairments.

We connect the dots to emerging markets, investigating the paradox of why regions with rapid economic growth (like China in the 2000s) often delivered poor stock returns because endless capital funding kept competition high and returns low.

Below is a breakdown of the major discussion segments in the podcast:

• Why Capital Returns Matters: Background on the book’s origins and why understanding the capital cycle is crucial for savvy investors. We set the stage by highlighting Chancellor’s involvement and Marathon’s unique perspective, framing the capital cycle as an indispensable tool in a value investor’s toolkit.

• Defining the Capital Cycle: An explanation of the capital cycle framework. We discuss how capital flowing into booming industries eventually undermines returns, and how capital exiting distressed sectors plants the seeds for recovery. This segment uses simple examples (including Chancellor’s “widget manufacturer” story) to illustrate the boom-bust mechanism from a supply-side angle.

• Marathon’s Lens and the Supply-Side Focus: Insight into Marathon Asset Management’s contrarian approach. We talk about how Marathon “followed the money” — tracking industry capital expenditures and capacity — to spot bubbles and opportunities. Real historical cues, like 1990s tech capex and 2000s housing construction, are mentioned as evidence of why this lens works when traditional demand-focused analysis falls short.

• Revisiting Growth vs. Value Through Cycle Dynamics: An exploration of how capital cycle thinking blurs the line between growth and value investing. Here we examine Marathon’s argument that what really matters is industry economics and competitive behavior, not the usual growth/value labels. For example, a high-growth company in a disciplined industry might earn superior returns (and be worth a premium), whereas a “cheap” company in a hot, crowded sector can disappoint.

• Case Studies Across Industries: A tour through diverse industries to see the capital cycle in action. We highlight stories from the book’s essays – such as the global beer brewery consolidation saga that initially hurt returns before rationalizing, the cyclical swings in commodities and mining, and even niche cases like cod fisheries or wind turbine manufacturing. These cases demonstrate that the capital cycle is a universal phenomenon, cropping up in any sector where investment surges or evaporates.

• Management Matters — Capital Allocation in Practice: Discussion of the human element in the capital cycle. Using examples like Finland’s Sampo under CEO Björn Wahlroos (a Marathon favorite), we illustrate how astute management can navigate cycles by curbing expansion at the peak and deploying capital at the trough. Conversely, we look at cautionary tales of CEOs who became overconfident empire-builders, only to destroy shareholder value when the cycle turned. This segment reinforces why evaluating management’s capital allocation discipline is a critical part of the investor’s analysis.

• Financial Sector Cycles and “Accidents Waiting to Happen”: An analysis of how the capital cycle framework applies to banks and financial services. We recount how Marathon’s letters warned of excessive loan growth and leverage in the mid-2000s (especially in European banks) as an “accident waiting to happen.” In this segment, the discussion shows that rapid balance sheet expansion in banking follows the same boom-bust logic: easy credit and aggressive growth precede credit busts and losses. By viewing the 2008 financial crisis through a capital cycle lens, we gain a deeper understanding of how to spot systemic risks early.

• Post-Crisis Aftermath – The Living Dead: Examination of the unusual post-2008 environment, where massive monetary easing kept many struggling companies alive (the “living dead” or zombie firms). We discuss Marathon’s observations on how ultra-low interest rates and bailouts distorted the natural capital cycle, preventing the usual cleansing of the bust. This part of the conversation tackles the challenge for value investors in distinguishing between temporary market distortions and true value opportunities in the aftermath of a bust.

• Emerging Markets and the China Syndrome: A deep dive into emerging market growth stories through the capital cycle perspective. Focusing on China as a prime example, we explore the puzzle of high GDP growth paired with poor equity returns. The segment explains how relentless capital investment in booming economies can lead to overcapacity and low returns on equity, underscoring the book’s lesson that economic growth alone doesn’t guarantee investor profits. We also touch on historical parallels in other emerging markets to show this is a recurring theme.

• Wall Street’s Role at Cycle Extremes: A lighter but insightful look at how market euphoria manifests in corporate finance activity. Drawing on the book’s satirical essay about Wall Street, we discuss signals like flurries of IPOs, frenzied M&A deals, and even the pace of share buybacks as markers of where we might be in the cycle. When investment bankers are busily taking companies public or orchestrating mega-deals, it often coincides with market tops, whereas shareholder-friendly actions like buybacks tend to appear after downturns. Recognizing these patterns can help investors gauge sentiment and avoid being swept up in late-cycle hubris.

In Part Two, we apply capital cycle theory to the recent market environment. We highlight sectors (such as energy and shipping) that appear to be on the favorable side of the capital cycle — where years of underinvestment may be setting the stage for strong returns. We also express caution about areas where capital has been pouring in aggressively.

This Part One of our two-part series was recorded on March 13, 2025.

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Volunteer by reaching out directly to John (john@moiglobal.com).

We had the pleasure of speaking with fund manager Dan Rasmussen about his new book, The Humble Investor: How to Find a Winning Edge in a Surprising World.

The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Dan.)

John Mihaljevic: It is a great pleasure to have with me best-selling author Dan Rasmussen, founder and portfolio manager at Verdad. He has a new book out, The Humble Investor: How to Find a Winning Edge in a Surprising World. It will be the subject of our conversation today.

Before starting Verdad, Dan was at Bain Capital Private Equity as well as Bridgewater Associates. He earned an AB from Harvard College summa cum laude and Phi Beta Kappa and an MBA from the Stanford Business School. He also is a contributor to The Wall Street Journal, and his research has been featured in multiple volumes of The Best Investment Writing. In 2017, he was included in the Forbes 30 under 30 list.

Dan, what inspired you to write the book?

Dan Rasmussen: Since I started Verdad, I have been writing a weekly research note that we send out to about 30,000 subscribers. The essence of those research notes is what we are thinking about, working on, and studying internally at Verdad. Whatever the number one problem of the day is that we study and research, we share it with our readers.

After doing that for about 10 years, I thought, “Why don’t I take these and put them together into a book that summarizes everything I have learned in the first 10 years of writing and running this hedge fund?” That’s what the book is. It’s trying to distill my philosophy and share 10 years of original research with a broader audience.

John: You curated and edited some of your writings that resonated the most so far. Is that how a reader should think about the format?

Dan: That is where I started, but ultimately, it is not just a compilation of notes. It is a book that runs from start to finish, with a constant idea but covers all of our most read and best-received research.

John: The book is structured in three parts – laying the groundwork, putting your theories to work, and then investing through the tests of time. Maybe you can talk about what you mean by laying the groundwork.

Dan: In college, I was a historian. I love studying history. The history of financial theory has totally gotten me. I am deeply interested in trying to figure out where the ideas that dominate Wall Street today come from. Why do we think what we think? Why do we learn what we learn in business schools? What are those core ideas? What do we make of them?

I started with trying to understand modern finance theory. I think the essence of modern finance theory goes back to the discounted cash flow model. It’s the first step in the thought process. The discounted cash flow model says that a company’s value is the sum of all of its future cash flows discounted back to the present. Starting in 1930, you can build on that. You start and say, “That’s the essence of valuation.” The next stage was people saying, “If that was true, why wouldn’t everyone just put all of their money in the asset with the highest expected return?”

The idea of risk was then introduced. You don’t put all of your eggs into one basket because there’s risk. That risk can be measured by volatility, so you need to focus not only on returns but also on the Sharpe ratio, which is optimized through diversification. Through there, you are onto the essence of modern portfolio theory. I think the theory is weakest at its very foundation, which is that discounted cash flow model. It is for two reasons, and these are the reasons why I call my book The Humble Investor. It’s a critique of some of these ideas.

The first idea is that you can predict cash flows years into the future, which is the first premise of the discounted cash flow model. If you don’t know future cash flows, then you don’t know the valuation of a firm. The second one is the idea of discount rates – that we can predict discount rates far into the future. If you discount back to the present, then you’ll get the accurate valuation. I have the perhaps radical but eminently commonsense position that you can’t predict cash flows and discount rates years from the future, so the whole theory is a bit of bunkum.

Much of the book is saying, “If we can’t predict the future, if we can’t predict these important financial variables, what do we do? What do we make of that? How do we react? How do we build an investing strategy on more firm foundations?”

The other key component of this is the idea for which Robert Shiller won the Nobel Prize – excess volatility. The idea is that even if we could predict future cash flows and discount rates, the volatility of those time series is only able to explain about 10% to 20% of equity market volatility. The rest is inexplainable by discount rates and earnings. In other words, there is something else beyond earnings and volatility driving the market most of the time.

What I try to argue here is that excessive volatility is the result of the way markets work – markets are driven by humans, and humans have erroneous forecasts about the future. We all go and place a set of trades. We make our predictions about the future. The future happens, and most of us turn out to be wrong in their predictions. Then all of those bets get reset, and that happens on an ever-evolving basis. The volatility of the market is driven by expectation errors. It is driven by investing mistakes, by forecasting mistakes. Yet, when you read finance textbooks or go to an MBA program or whatever it may be, the word “mistake” hardly ever comes up. The idea that our forecasts are going to be wrong most of the time never comes up.

What I’m trying to do with The Humble Investor is say, “How do we react to this? How do we incorporate the idea of the unpredictability of the future, of the certainty of investing mistakes, of the certainty of forecasting mistakes into building a better investment strategy that doesn’t rely on brittle, likely-to-be-wrong forecasting?”

John: One obviously big item is how to build an edge in equity investing. Given what you just described, what were some of your thoughts around finding an edge? How has that evolved over time?

Dan: If you approach equities from the perspective of just building discounted cash flow models, this book is an argument against it – that it’s not the right strategy because it’s built on the wrong theory and it makes the arrogant assumption that you can predict future cash flows and discount rates with a degree of accuracy that I don’t think is justified.

I did a major update of a famous study done in 2004. I updated it with 20 years of new data that looked at the question of the persistence of growth. Do companies that have grown at a certain rate continue growing at that same rate into the future? If you divide companies by their historic growth, does that predict future growth? The answer is not at all. Whether a company has grown fast or slow doesn’t mean anything about how it will grow in the future.

When you talk about stocks, people say, “This company is growing at 6%,” or something like that. I always say, “You don’t know that. You know it has grown at 6%, but the fact that it has grown at 6% doesn’t imply anything about its future growth.” This is probably one of the most interesting or provocative findings from quantitative finance. It has been replicated over and over again. You can’t derive any information about future profits from the historic series of profits – it simply doesn’t predict anything.

That leads me to the next idea. We then say, “What about using a guidance or estimates to predict the future?” One thing we find there is that you first have to segment out short-term and long-term forecasts. Some work by Andrei Shleifer and others has found that long-term forecasts tend to be so wrong that they’re contrarian signals. The higher the long-run forecast, the worse the returns; the worse the long-run forecast, the better the returns. Short-term growth forecasts are more interesting. They get you within the right range 50% of the time; 50% of the time, they are wrong. Growth ends up being way slower or way faster.

When you do a sum product where you say, “What happens when a company predicts its growth rate and then hits that growth number?” It turns out the stock does about average. If you do what you said you were going to do, you earn about an average return. What happens if you say you’re going to grow and then you grow less than that? Obviously, you get punished for it. What happens if you grow much faster? Your stock does much better than the market.

Given that the accuracy rate is about 50%, what ends up happening is firms that predict low growth have about a 50% chance of being right. When they achieve low growth, their stock does about average. The other 50% of the time, the forecast ends up being too conservative; the company does better, and the stock does better than average. Conversely, very high-growth firms are right about 50% of the time, and the stock does about average. However, most of the time they’re too optimistic, and the stock does so badly when they disappoint that the growth forecast doesn’t provide any information because when it’s wrong, the market reaction is big enough to punish your erroneous prediction so much that when you’re right, it was priced in anyways.

What you start to see is that with equities, you’re playing in a world where you’re betting against expectations. I like to say that investing isn’t a game of analysis – it’s a game of meta-analysis. It doesn’t matter what you know or what you’ve figured out; it matters what you know and have figured out relative to what the market has figured out. In this case, we find that buying stocks that have lower expectations, that are priced for more disappointing outcomes, ends up leading to systematically better returns because when the forecasts are wrong, it accrues to your benefit versus when the forecasts are wrong at punishing you. That’s what has happened over long periods in equity markets.

As a caveat, we should say this dynamic has not played out in the US for about 10 years, but internationally and in the history of the US market, this phenomenon or pattern has been very much true.

My idea is that if you want to build a winning edge in equities, the first thing you need to do is look at valuation and focus your attention on the places where the forecasts or what’s priced into the stock valuation is an easy bar to pass rather than focusing on those where expectations are high and consensus optimism is too great.

There’s a second idea, which is, “What does predict future earnings if not prior growth?” It turns out there’s a wonderful metric – gross profit divided by assets, which is a proxy for return on assets or very highly correlated with return on assets or ROIC. You can think of this as among a family of different metrics, generally calculated by dividing an income statement or cash flow item by a balance sheet item, and you’ll get something in this realm.

It turns out that companies with higher gross profit divided by assets, higher return on assets, do tend to exhibit higher long-term future growth, especially higher long-term future growth than what’s priced in. Buying very high-quality businesses as measured by ROIC or gross profit to assets turns out to be another path to achieving the same outcome. Relying on growth projections by discounted cash flow models or on historic growth will lead you astray, whereas relying on these metrics will push you constantly in the right direction in terms of looking for firms that are undervalued, where expectations are too pessimistic, and that are quite high quality, where the fundamental businesses are strong and likely to generate sustainable cash flows years into the future.

John: How does this relate to the idea of base rates?

Dan: The idea is that when you’re thinking about a company, one way to make forecasts – which is the way we experts traditionally do it – is to say, “I’ll analyze this company. I’ll study everything I can possibly figure out about it. Once I know all of that, I’ll develop a forecast.”

Base rates are different. They say, “Rather than doing it that way, you want to look at the historic probabilities.” Take a company, or a tech company, or a big tech company, or whatever set of categorical distinctions you want to make about the company, then say, “What has been the historic distribution of outcomes for companies like this – whether for revenue growth, earnings growth, or stock price return?” Then base your forecast on that categorical set of historical probabilities rather than on your own expert judgment based on detailed analysis of the individual example.

That’s what drives me towards trying to figure out and say, “Rather than looking at DCF models, let’s look at the predictive value of some of these categorizations or things that help us separate stocks into categories.” I argue in the book that two of the most meaningful ones are valuation, that low-valuation stocks do perform quite differently from high-valuation stocks – most of the time better, not in the United States in the last 10 years, but mostly better – and then hot stocks with high profitability or high quality as measured by gross profit assets or any set of those related metrics – which also have done very well over time, including in the US recently – and that by looking therefore for stocks that fit a pattern of stocks which end up doing well rather than trying to use your own individual analysis to understand a company in isolation, you end up doing better.

John: How should we understand the experience of the US over the past decade?

Dan: I love thinking and writing about history. History doesn’t follow an arc. It doesn’t bend in any particular direction. There is no end of history. There are no great forces that will drive it in a specific direction. Marx is wrong. There are no laws of history.

I think history is always and everywhere contingent on human action and human events. We have to look at the last decade with that in mind. We can have all of these base rates and ideas about how the world generally works, but there are also moments in history where great events happen and great people act and shape the future of nations and of the world.

In the past decade of economic history, that has indeed been true. We have gone through a period of technological innovation that seems to happen once a century, maybe even less frequently than that. The confluence of events that have happened – the adoption of the cloud, the rise of mobile computing, SaaS software, social media – all of these related technologies blossomed in the 2010s and since the financial crisis when people had widespread high-speed internet access and high-speed internet access on their phones. We have seen YouTube launch. We have seen the iPhone. Think of Salesforce and the tremendous rise of Nvidia more recently. There has been a huge boom in technological innovation.

The innovators have been rewarded for their innovation. They have earned massive profits that have been growing very rapidly as these new technologies have grown and expanded. Because of that, the traditional relationships between growth and value have not worked since these companies – these innovators – have beaten expectations year after year to a shocking degree.

Ten or 15 years ago, nobody could have predicted how profitable Amazon was going to be in 2024, or Apple, or Facebook, or any of these stocks. They have outperformed what anyone imagined and rather than mean-reverting down, their stocks have kept going up and up, and the valuation multiples have been reset upwards to the point where these are colossal, world-beating companies whose CEOs were invited to the presidential inauguration yesterday.

You therefore say, “What happens next? Is that innovation likely to continue? Will these companies continue to be as dominant forever as they were over the last few years? What is priced in and how does that relate to the future?” As unprofitable as it has been to be a pessimist about technological innovation, the right stance perhaps isn’t pessimism about technological innovation but rather agnosticism, like saying, “I don’t know because, traditionally, when new technological products have been released, the customers need to benefit more than the sellers.” As these adoptions get more widespread, not only does new competition arise, but these new innovations are commoditized and their use to the customers becomes greater and greater as the revenues to the companies become greater and greater.

In the second wave of technological innovation, the rewards don’t go to the innovators – they go to the early adopters and the customers of these companies. That’s likely what we will see. As all these exciting technological innovations spread, widen, and dissipate, we will see rising productivity and rising margins among normal companies that were not innovators but have simply adopted these technologies.

At the same time, the central investment question of 2025 is quite clear. “What is the future of AI?” I think we have two futures – one in which AI is equally or more impactful as an innovation as cloud and mobile and SaaS were in the 2010s, so we see another tech boom, an innovation wave happening in the 2020s just like it happened in the 2010s. The second alternative is that we have some combination of trajectories and things don’t turn out as great as anticipated. I’ll offer three possible paths for AI not being quite as exciting.

The first is that, quite simply, the technology works and is great, but it takes longer than people expect to roll out and be adopted in a widespread way – just like the internet did. Amazon was founded in the 1990s, but it didn’t become the colossus it is for quite a while. Between the 1990s and the time Amazon became a powerhouse, we had a 10-year drought where everything tech was a horrible investment in the stock market. That’s one possibility.

The second possibility relates to the idea of competition neglect, which is that all the big tech companies seem to be building the same thing, without perhaps acknowledging that only one of them will be the real winner. Yes, there will be winners in AI – like there was a winner in search or a winner in social networking – but the also-rans will be burned by their excessive investment in AI as the winners come to dominate.

A third potential future is one in which AI doesn’t work out – we have seen a tremendous moderation in the business cycle in the United States, a strong stabilization of economic growth that has come from a transition from a manufacturing-based economy to a services economy. If AI pans out as everyone says it will, we’ll see the transition of a services economy back into a manufacturing economy where the services and the knowledge are what’s being manufactured, but in every other way, it looks like a traditional manufacturing-type investment where you’re putting a massive amount of costs in – whether that’s buying servers, building out data centers, or investing in the LLM – and those investments are tremendously energy-intensive.

They require a massive investment, for example, in electricity or a power in order to function. Therefore, we see a return to some of the more traditional things we saw on a business cycle where you have booms of overinvestment and then busts as that overinvestment gets burned out, where you have huge capex swings, and where a certain level of cyclicality returns to business in a way that people weren’t anticipating.

Those are only three potential futures – none of which might occur or all of which might in some way – but all of which are to say that history is contingent. We don’t know what will happen, yet the markets are pricing in a great degree of certainty about it. My argument in The Humble Investor is that when other people are certain, we should try to take the other ends of the trade. That’s where the best odds are likely to be.

John: Since we’re on the topic of AI, I am also wondering whether there is a scenario where AI succeeds so much that it ends up obsoleting or crushing the business models of a lot of the players that sell software because AI could theoretically create software at an extremely low cost. How will these companies keep their pricing power if there is all this deflationary pressure from AI-generated competing products?

Dan: That is a brilliant point. You can think about some of the classic arguments for SaaS companies. “The switching costs are too high. It would cost someone so much money to extract our database and turn it into something.”

AI could do that pretty quickly. Switching costs are likely to come down at the very least. To your point, I think AI is most obvious. We use a lot of AI tools internally, primarily for coding. It’s great for coding. It can do a lot of that for you. It can check your code and even write a first draft. It will dramatically accelerate people’s ability to build software.

If software is the number one valued thing where excessive profits are being earned – or at least great profits relative to the investment – what does this mean for it? The argument that AI could contribute to those profits getting competed away seems a pretty sensible one.

John: Let’s talk about geographic diversification and investing globally. Some of the analogous argument to the US experience over the past decade also applies to US equities in general as compared to non-US equities where I think the concentration of market value today in the US is probably quite high historically. What does that tell you about going-forward returns – US versus international?

Dan: It’s wrapped up in exactly the same logic because right now, the US is the high-valuation country, and everywhere else in the world is low valuation, with the exception of India or something. Broadly, Europe, Japan, even China – anywhere outside of the US you want to go – you are buying much lower valuations.

The tension between the two arguments – on the one hand, folks are saying, “The great world-beating companies, the Mag Seven, are all in the United States. That’s why US corporate earnings have been so much higher than anywhere else in the world, and that’s likely to remain so with the US continuing to dominate the world in innovation, continuing in its deregulatory abilities to offer the best place for businesses to be headquartered, and attracting the best talent because of its low-tax regime.”

On the other hand, international markets have gone so cheap that if the US is 65% of the ACWI and international stocks are 35%, by revenue, the US is probably 35% and the ex-US portion is 65%. It’s almost reversed, which gives you a sense of the magnitude of the difference in valuation multiples between the two.

We’re also faced with the same argument we had over value and growth, which is that international diversification hasn’t worked for a long time, and being 100% in the US has. I relate the reasons for that to the historical contingency where the set of companies that drove all the US outperformance are technology companies in the same sector building on the same innovations that are making the same bet on AI – all of them at the same time.

We’re left with the US-international debate as a value-growth debate. I am here making the argument for value and for international, which is really the same argument in the face of being wrong, of losing that bet for 10 or 15 years now, where the only right answer has been the US, and the only answer within the US has been growth. However, just because something has been true even for quite a long time, it doesn’t mean things have changed forever and it will always be true. The base rates would imply that low expectation stocks will do better and high expectation stocks will do worse. The gap in expectations between the US and international is so clear right now, but I think it’s prudent to be more diversified than one might normally be.

As a side note, I was looking recently at the correlations between major indices. US value stocks now have about the same correlation to US growth stocks as international stocks have to US growth stocks, which gives you a sense of how much the market is dominated by one set of stocks, by one trade, by one bet, and everything else is falling to the wayside.

John: Is there a historic analogy here? Have we seen this movie before?

Dan: In various ways, it is said that history rhymes but doesn’t repeat. There are certainly times that rhyme, and I’ll give a few. One is the Nifty 50 bubble where a set of great American companies in the 1960s were thought to be true world-beaters and huge amounts of capital flowed into those stocks. You only had to own a few of them to win. Then you had this period over the next 10 or 15 years of zero-percent equity returns. Many of those companies ended up doing well over the long term. They were great companies, but they got way too overvalued during that period.

A more extreme analogy would be Japan in the 1980s, with people saying the way the Japanese run companies and the Japanese management style is so much better than anywhere else in the world, so why shouldn’t you have all this capital in Japan? Even if 30% of the ACWI is now Japan, it makes sense because Japan’s so great. That could be another analog.

The 1990s could be another one where the dominance of technology and innovation as themes is recurring, but there are counterpoints to each of those. No analogy is perfect. An important point is that even if you say today rhymes with those periods, it’s extremely hard to know. For example, are we in 1995? Are we in 1999? How does our current situation match?

I tend to think that one of the most important things to know about our current environment is simply how low risk everyone thinks it is as measured by high-yield spreads, which is one of my favorite macroeconomic indicators and now pretty much near all-time lows where the market is essentially pricing in that we’ll never have defaults again. That’s probably wrong,

John: That’s the spread between high-yield borrowing costs and AAA?

Dan: And duration-matched Treasuries – yes, exactly.

John: Have we ever been this low or close to this low on the spread?

Dan: The late 1990s and 2007.

John: Do you think there’s anything different – either structurally or in the Fed or whatever the appropriate intervention force would be – that would render defaults a thing of the past?

Dan: We saw a very aggressive reaction from the Fed to COVID. In some ways, it was a brilliant reaction to very explicitly try to prevent the blowing out of the high-yield spread and to prevent defaults by even buying corporate bonds, by buying high-yield bonds. A lot of people seemed to take it as a signal that the Fed was willing to expand its arsenal of tools and be very aggressive to prevent default cycles from getting out of hand, to stop what Ben Bernanke called “the financial accelerator” from getting off and going.

However, lending has been around for a very long time in human history, and we’ve always had default cycles. I don’t think we’ve reached the end of history. There will be default cycles in the future. There would have to be. Capital does get misallocated during certain periods, and bond holders do demand the money back. It seems inevitable that defaults will return. The Fed can’t beat the lending markets forever, but I do think we’re in a period where risk has been building up into the system because the belief that defaults will be so low for so long or will never come back has become so prominent.

John: You have a chapter in the book on bond investing – “Chase Quality, Not Yield.” That would seem to relate to the notion of those spreads being so low that people will just chase that last bit of yield and not focus on quality at all.

Dan: Yes, what people most commonly seem to get wrong about fixed-income markets is that they take off their efficient market hat when they leave the equity market and arrive in the wild world of fixed income because yields seem like such an obvious and compelling story. If one bond offers a 5% yield and the other an 8% yield, they are both contracts that, in theory, guarantee you that coupon payment. It’s logical to say, “The 8% yielding bond should return 8%, and the 5% yielding bond should return 5%.”

In the well-behaved corners of the bond market, that’s true. If you start from AAA government securities and go down to BBB corporate securities, as you walk from the US Treasury bond at 4% to the Microsoft bond at 4.5% to the Exxon or Ford bond at 5%, you generally do earn a little more for taking on a bit of corporate credit risk. However, once you get into a wilder and woolier world where you start to see below-investment grade, you see this concept of a fool’s yield, which is that as yields rise, total realized returns go down so that if you are offered a 6% yielding bond and a 16% yielding bond, history and base rates would show that the 6% yielding bond usually does better than the 16% yielding bond because the magnitude of defaults and downgrades In the latter case is enough to bring down expected returns.

The markets are efficient. If you have to borrow at 16%, you’re probably not a very good borrower. You’re probably pretty risky. By the way, we’ve been lending money to companies for hundreds and hundreds of years, so we’re pretty good now at pricing that risk – even better than we are at pricing equity risk. It’s such an efficient market that you don’t earn an incremental return by being fooled into investing in companies with much higher yields.

Yet, the sexiest thing on Wall Street these days is private credit, which is basically high-interest rate loans banks wouldn’t touch that offer a huge premium to what, say, Treasuries would offer. That story is probably the tip of the spear of excessive promiscuity in corporate lending. It’s probably the place – private equity, private credit – that will be hit the worst if we are to see a default cycle.

John: The Fed has intervened aggressively, which has most likely led to the inflation we’ve seen. I’d love to talk to you about inflation and how investors stay afloat in such an environment.

Dan: We’ve learned a few lessons over the past few years. One of my favorite metrics is this idea of inflation beta. How does an asset react when inflation goes up or down? If you’re trying to build a diversified portfolio, what assets do you need to incorporate in order to survive inflationary environments?

Interestingly enough, a lot of people talk about TIPS (Treasury Inflation-Protected Securities), but one contrarian argument I’d make is that they’re pretty lousy most of the time at protecting against inflation. The reason TIPS are lousy at protecting against inflation is because they are comprised of both a bet on interest rates and a bet on inflation. You earn a specific interest rate and then you earn inflation spread on top of that, so the market is pricing in both. When there’s a lot of inflation, interest rates go up, so the interest rate component of your TIPS goes up, and you lose money. Your inflation component obviously does better, so you make money, but you end up about even. Theoretically, TIPS end up being a rather lousy way for people to protect their money against inflation.

It turns out commodities work much better, especially gold and oil. Both come with their own challenges. Oil in particular is highly volatile and dependent on the business cycle, so gold probably becomes the best option on a Sharpe-adjusted basis for protecting your money against inflation. Think of gold and bonds as your almost equivalents where they’re both low-risk assets, but gold does well in inflationary environments, and bonds do badly in inflationary environments and the opposite in a deflationary environment. Incorporating some element of commodity trading into a broader portfolio and especially thinking about gold is quite important for surviving inflationary times.

John: When it comes to gold, how do you think about its continued relevance going forward in light of Bitcoin and crypto capturing so much mindshare and seemingly being increasingly adopted by institutions? There is now even talk of the US government possibly doing something that would legitimize Bitcoin. Does that affect the attractiveness of gold?

Dan: I don’t think so. They are two very different things. They certainly trade in a highly uncorrelated way.

Gold has two attributes that distinguish it from Bitcoin and crypto. The first is its longevity. There’s a famous paper by Campbell Harvey that shows the amount in gold you pay a Roman centurion is the same amount in gold you pay a US Army captain today. There’s such a long history of gold as a currency. Gold has maintained its value over literally thousands of years. It has a history Bitcoin just cannot rival.

The second is looking at the way these things trade. Gold has about the volatility of bonds – a little more than bonds, but thereabout. Crypto has the volatility of a crazy meme stock. I think of the role of gold as a bond equivalent or a bond alternative, whereas I think of crypto as equities on steroids. They are very different roles these might play in your portfolio.

You could say, “I want to protect some legacy investment that I need to survive for 30, 40, or 100 years. I want to make sure it stays protected from inflation and retains its value, so I’ll put it in gold.” That logic makes a lot of sense, while saying, “I’ll put all of that in Bitcoin for the next 100 years” sounds like putting all of your money in Nvidia for 100 years. It might be an incredible investment for the next one, two, or three years, but how do we know Bitcoin will still be around 100 years from now? We can be fairly confident that gold will.

John: When it comes to equities that would protect against inflation, there is the perception out there you should just invest in the highest-quality businesses that have pricing power and basically run on intangibles. On the other hand, historically, a lot of the assets that have protected well against inflation are, in fact, capital-intensive – like real estate or mining. How do you think about the best sectors for inflation protection?

Dan: Both arguments can be true. You never know which will prevail at any given time, but it’s enough to say that equities won’t necessarily be hurt by inflation and won’t necessarily benefit. It’s very contingent.

There are certain periods where there’s been high inflation and equities have been walloped, and there are other periods where there’s high inflation and equities have done quite well. I wouldn’t spend a huge amount of time thinking about inflation when I’m thinking about my equity portfolio. It doesn’t seem like a huge driver day-to-day, but it’s a massive driver for the bond market.

That’s why I think gold fits as a fixed-income alternative. It belongs in the conversation about what I do with my safe assets, not necessarily the conversation about what I do with my risk assets or what I do with my equity assets, which I think depends far less on inflation than what’s happening in the bond market.

John: You end the book with a chapter on designing a counter-cyclical asset allocation strategy. I’d love to hear about that.

Dan: This has been the great whale of an idea I’ve been pursuing – how to build more robust, counter-cyclical portfolios that work regardless of economic scenario and incorporate a lot of the ideas in the book and ideas I’ve been working on for the last few years.

Where I’ve gotten on the topic of portfolio construction is that if you think about efficient markets – and I love going back to efficient markets as a North Star – they say predicting expected returns is quite hard, maybe even impossible, but it doesn’t say anything about predicting volatility or predicting the correlations between different assets. We have found that volatility and correlations as a result are much more predictable than returns. It’s much easier to predict whether stocks and bonds will be correlated next month than whether stocks or bonds will outperform each other. It’s much easier to predict that bonds will be less volatile than stocks, for example, than it is to predict that stocks will return better than bonds in any given short horizon period.

It also turns out that both volatility and correlations are widely variable. For example, we’ve gone through periods where stocks and bonds are negatively correlated and periods where they’re positively correlated. During those periods, if you took last month’s correlation and forecast it to be next month’s correlation, you would have done relatively well at predicting the correlations between those assets.

The argument I make in this chapter and the type of logic I’ve been working on is that if you’re building a portfolio, yes, you need to have a prediction about expected returns, but a prediction about volatility and a prediction about correlations are also equally important to portfolio optimization and are much more predictable. What I have been trying to do is to code that logic into software and say, “Let’s build Sharpe-optimized portfolios that incorporate multiple asset classes and then factors within the asset classes so we could trade value as an asset, or gold as an asset, or Treasuries as an asset, or momentum as an asset.”

If you can look at what the correlation of each of those is, what the volatility of each of those is, even if your expected return is simply the long-term average of each of those things, you should be able to build more robust portfolios that are reacting in real time to changing macroeconomic conditions, changing correlation structures, changing volatility environments. If you can do all of that consistently and intelligently and get all those basics right, you should be able to build portfolios that work better, have higher Sharpe ratios, and can be optimized to achieve whatever target return or target volatility you’re looking for.

That’s what I’ve been working on. It builds on a lot of the foundations of the work I’ve been talking about in equities and fixed income.

John: What has been the experience so far in terms of success and what you still regard as any big questions to answer or issues to resolve?

Dan: It has become quite clear from trading these types of strategies that the insight about correlations and volatility is right. You can build more diversified, lower-risk portfolios by incorporating a broader set of assets. You can achieve a higher Sharpe ratio through doing this. It’s clear, and there’s a whole variety of assets that a lot of people don’t trade. They think only about stocks or about bonds and stocks, not about commodities, currencies, and the factors.

Once you expand your horizon to consider those things, you start to see that you have a much broader set of tools to diversify your portfolio if you’re willing to use leverage, go short, and do all the other fancy things hedge funds love to do to achieve a smoother path to hopefully equity or equity plus returns.

John: I know you base a lot of your conclusions on quantitative work that you do internally. To what extent would you describe yours as a quant-first firm versus bringing in qualitative judgment as well?

Dan: We’re probably 70% or 80% quantitative, but we try to be logical. We don’t want to unleash machine learning and say that whatever the machine finds is right. We want to build up logical structures and make sure everything we’re doing and everything we’re telling the computer to do makes sense and follows logical economic principles. In that sense, we are perhaps more fundamental than your average quantitative investment firm.

John: Who do you hope to reach with this book?

Dan: I think of the audience as your readers of The Wall Street Journal, The Financial Times, or The Economist – people interested in an in-depth dive into how markets work and the quantitative research on financial markets in an applied way; people interested in behavioral finance and the science of prediction, which hopefully is a large audience.

John: Dan, thank you so much for taking the time to sit down with me for this conversation. I would recommend the book to all of our members. It is a terrific read – The Humble Investor.

This conversation was recorded in January 2025.

Daniel Rasmussen is the founder and portfolio manager of Verdad Advisers, a ~$900M hedge fund. Before starting Verdad, Dan worked at Bain Capital Private Equity and Bridgewater Associates. He is a member of the investment committee of the Trustees of Donations of the Episcopal Church, is the New York Times bestselling author of American Uprising: The Untold Story of America’s Largest Slave Revolt, and in 2017, was named to the Forbes 30 under 30 list. Dan is a contributor to the Wall Street Journal and his investment research has been featured in multiple volumes of The Best Investment Writing. Dan earned an AB from Harvard College summa cum laude and Phi Beta Kappa and an MBA from the Stanford Graduate School of Business.

We had the pleasure of speaking with Dr. Howard M. Schilit, PhD, CPA, the founder and CEO of Schilit Forensics, an investment research consultancy. Howard is a pioneer in the field of detecting accounting chicanery and has testified before Congress and the SEC. He is often referred to as the “Sherlock Holmes of Accounting”.

Howard discussed his book, Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports, with Alex Gilchrist of MOI Global. The latest edition of this bestselling classic focuses on case studies from the past quarter century and brings the reader up to date on accounting chicanery in global markets. Howard and his team of forensic accounting experts reveal frauds, expose financial reporting miscreants, and reveal the latest methods companies use to mislead investors.

In this conversation, Alex and Howard dig deep into some of the most illuminating case studies and ways public companies fool gullible investors.

Let’s take a closer look.

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We had the pleasure of chatting with Christopher Mayer, portfolio manager at Woodlock House Family Capital.

Chris discussed his book, 100 Baggers: Stocks that Return 100-to-1 and How to Find Them, with Alex Gilchrist of MOI Global.

The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Chris.)

Alex Gilchrist: What led you to write this book — how did it come about?

Chris Mayer: It started with Chuck Akre, a very well-known investor with a great track record. In 2011, he delivered a speech called “An Investor’s Odyssey.” In this speech, he went through his approach and mentioned a book by Thomas Phelps called 100 to 1 in the Stock Market as being a big influence on him.

I love reading investment books. At that point, I thought I had read every investment book there was, but I had never heard of this one, so I got a copy of it. It came out in 1972. Phelps had a varied career in finance, doing a number of different things. This book studied all the stocks that had gone up at least 100 times. I think his study starts in 1932 and runs to the end of the book.

He’s a great writer, very quotable, with a folksy manner. That book was super interesting, so I started to quote from it. I would tell people about it, and this went on for a little while. Finally, someone suggested to me, “Why don’t you update it?” A little light bulb went on. I said, “Wow! That’s a great idea. I should do that.” That’s how it came about. I went ahead and got research on stocks that have gone up at least 100 to 1 from 1962. That was as far back as I could get data at the time – from 1962 to about 2014. The book was published in 2015, but the data ends in 2014. That’s how I started the process of updating Phelps’ insights.

Alex: You’ve met up with the Oracle of Middleburg since then. How did that mark your conversion to this approach?

Chris: It was a slow process. I first reached out to Chuck to interview him for the book. I went out to Middleburg and met with him. He was very generous with this time. Ever since then, I have stayed in touch with him. I would see him at least once a year, for example, in Omaha at the Berkshire meeting.

I started to study his approach more and how he sits on these high-quality businesses he owns – like Visa, MasterCard, Constellation Software, Roper Industries, and a bunch of others. He has a great track record and a great nose for finding these things. Akre himself has had 200 baggers to his credit – one in Berkshire and one in American Tower, which are these otherwise big holdings he’s held forever.

I remember talking to him about this on several occasions. Over time, I started to see more of the wisdom in his approach. I would be in and out of different names, or my portfolio might turn entirely over five or six years, and he’d be sitting there with mostly the same names. I started to move more towards that style. Now, I would say I’m 100% in it, but it has taken a while to get there.

Alex: What have been some of the upsides and perhaps some of the downsides of this conversion?

Chris: The upside is easy. There’s a number of them. One, I would say you have less work to do in terms of finding new names. With the old approach, valuation was first for me. It was the thing I always focused on. If valuation is the number one part of your thesis, when the valuation closes, you have to find something else. There’s not necessarily any other reason for you to hang on. There’s more natural turnover in a portfolio that’s valuation-focused.

With this style, you allow stocks to run. Even when they become overvalued, you sit on them – as long as the growth, returns on capital, and so forth are still there. There’s a lot less turnover. It makes for a less frenetic existence. It’s more of a peaceful, calm portfolio. I like that aspect of it. Obviously, it’s much more tax-efficient because there’s lower turnover inherently. That’s not to say you couldn’t run a value-based portfolio with low turnover, but it’s easier and more inherent in this style. You learn more about businesses because you own them for a lot longer. Those are some of the upsides.

The downsides are hard to point at. It’s maybe more psychological because you pass on a lot of ideas and then some of them work out very well. Sometimes, you find something you know is really cheap and undervalued, but maybe the business isn’t all that good. It’s not something you would hold on to for a decade. You’ve got to let those go. That may be the downside – that it does requires a little more discipline to stay and have that quality bar and not go under it, no matter how tempting certain setups might be.

Alex: A lot of the time you must end up reading quite deeply different ideas and then not pursuing.

Chris: Yes, that’s one of the tougher things. There’s a lot of reading and a lot of passing on ideas.

Alex: Do you feel like, “I’ve put so much work into this now that I want to invest just because of the work I’ve done”?

Chris: Yes, I have that feeling – all the time. It happens a lot, but I think back to the exemplar of how Chuck Akre runs his portfolio, the way Phelps talks about it in his book, and even the research I’ve done in my book. It’s better to go ahead and ride those horses you’ve selected – assuming you’ve done a good job assessing the business – than constantly trying to catch the next opportunity.

Alex: What is the math of a 100 bagger? What are the tell-tale mathematics that lead to one?

Chris: That’s an interesting question because when I started doing the study, I thought it would be much more of a statistical-driven thing where I would show the correlation between two variables – these are the correlations here, so these are the things you want to look for. I learned very quickly it wasn’t going to work because the diversity of businesses that have returned 100 to 1 is absolutely amazing. It’s everything.

That’s another thing that came out of the book. There’s no industry concentration. There are tech companies, but there are railroads, banks, and chemical companies. They are from all over. There are a lot of different paths up the mountain, but when you get down to the basic essential ingredients, I think number one is you have to have a lot of growth. The companies that return more than 100 to 1 have grown by leaps and bounds, and they have eventually earned very high returns on their capital. Third, they have the ability to reinvest.

There are always exceptions, but in the main, most of those ideas were able to do this. Some exceptions might be companies that were so outstanding in their capital allocation that they gobbled up their own shares at a great clip or at just the right time. Their underlying business maybe wasn’t so great, but they were still able to get there.

In general, that’s the formula. You want high returns on capital, a lot of growth, and the ability to reinvest. Those are the three essentials. What follows off that is that you must have a very strong competitive position because once you find these three things, you have to apply them year after year after year. It’s a long haul. To get a 20-year run of earning high returns on capital implies you have a robust moat. A lot of the companies had good management teams. Like I say in the book, there’s Charles Schwab, and then there’s Josh Schwab – the man. There’s Walmart, and there’s a name – everybody knows Sam Walton. If I say McDonald’s, you think Ray Kroc. If I say Apple, you think Steve Jobs. There was often an entrepreneur who drove it. That would be another thing you could look for.

Alex: In terms of looking at growth, can it be hard to visualize in the sense that companies might have lumpy growth, so you wouldn’t think of it averaging out over a long period of time?

Chris: Yes, those make it tough. Sometimes, they’re lumpy; sometimes, they’re just completely unpredictable.

I like to use the example of Apple because it created markets no one would have guessed or foreseen. Who could have predicted it would create the iPhone? In the early days of Amazon, when it was a bookseller, who could have imagined AWS? You can’t.

There’s some luck involved, and that’s one of the points I make in the book, too. When I talk about the 10 different things you want to look for, I have to admit that one of the elements of 100 baggers is luck. It’s easier when you can find a company that’s more consistent compounding and you can see it has big markets, but every once a while, you’ll get some lumpy compounders. You’ll get some that surprise you by coming with up new products and entering new markets.

Alex: That’s something I want to touch on with Apple. I think there was a similarity with Gillette, and not just that Warren Buffett invested in both. You mentioned Gillette went from having a PE ratio of 10X at some point to 30X.

Chris: Yes, Gillette. There are other examples like that. I remember the Pepsi example because these companies were initially domestic, then they would expand overseas. That’s another element that gets it. Gillette created different razor blades and what we now call the razor-razorblade model because it was so successful in making that transition. There are lots of ways for businesses to get there.

Alex: When one of these companies is trading at a relatively small multiple, it’s easy to think it’s not that certain. All these other things could happen. Nokia phones got disrupted. Something else could come along. With Gillette, it’s just another shaving thing. You have Wilkinson and all these other brands. There are always arguments of thinking and not wanting to recognize that moat.

Chris: That’s right. When you look at the 100 baggers, those are the ones we dream about – where you can pick out something trading at 10 times earnings and then it goes to 35, so you get that tailwind of not only growing but a huge uplift in valuation. However, many 100 baggers were expensive most of the time. You’re buying something that’s generally well-regarded and you’re paying up. We all have examples of businesses we love that always look expensive. That’s more typical.

I like this analysis. If I ever do a second edition, I think I would do this. I have seen money managers like Terry Smith and other people do this where they will say, “Look at L’Oreal. It’s compounded at this rate for the last decade, or 15 years, or 20 years.” They’ll go back and say, “What’s the maximum PE you could have paid and still gotten a 15% return?” or whatever the number is. It’s always surprising how much you could have paid and still come out ahead. The PEs are very high, which makes you think that somehow, in some way, the market consistently underestimates these high-growth compounders.

Alex: Over time, return on equity or return on invested capital – whichever is the best metric to assess the return on owner’s equity – trumps price to earning or trumps the pricing.

Chris: Over the long term, yes, it does. That’s one of the things, too. I’ve been talking to people about the book since it’s come out, and if I did another one, I would probably emphasize this point more – that it’s extremely important to have the “business-first, valuation-second” kind of idea.

It’s not that pricing doesn’t matter; it is still important, but you have a lot more leeway there than you think. It’s much more important to be right on the business than to be right about the valuation in this particular style of investing. That’s where Munger makes a point. I forget how he says it exactly, but in the long run, you earn the return of the business – even if you pay an okay-looking price, you’re going to get the return of the business in the long term. That’s the point he’s making, too.

Alex: There’s another one I saw through Chuck Akre about how you have a constant valuation model. If you assume you’re buying at an expensive PE but that PE stays the same over a long period, you’ll get in the price the full expansion in earnings.

Chris: That’s right. You will. Many times, what I like to do now is model in some decline in the multiple over time. Even then, the math will work in your favor if the returns on capital are high enough and the reinvestment opportunity is plentiful enough.

Alex: Could you tell us about the average time period for these companies? Was it just between 16 and 30 years – a median of 26?

Chris: Yes, that’s about right. They formed a little bell curve. In the middle, there was about 25 to 26 years, and then they fell off between 16 and 30. It was interesting how that happened.

Alex: Does such a long-time horizon exclude a lot of professional money managers?

Chris: It probably does. Few managers are in a position to make a bet that goes that long. The book is about 100 baggers. These are the top best-performing stocks. Even these had extended periods where they did nothing or went down. Berkshire Hathaway was the number one stock in the study, but it had one seven-year stretch where it went nowhere. How many professional managers are in a position or in a structure where they could hold on to a stock in size and have it go nowhere for seven years? Can you imagine the pressure?

Multiple drawdowns are part of the life of a 100 bagger as well. All these names have had gut-wrenching declines, even the ones that do it in a short amount of time, like Monster Beverage. It’s among those that I think did it in about a decade. It had drawdowns of 40% fairly regularly.

It’s not for everyone, that’s for sure, but this is where the individual investor may have a bit of an edge because you can take a position like that, forget about it, and let it roll. That said, if you have the right structure, it’s certainly worth it to carve out a piece of your portfolio and try to go after these long-term compounders. That’s all I’m interested in now, and I think it will work out.

Alex: Maybe if you’re investing in such high-quality companies, it makes you more discerning about everything else.

Chris: It definitely makes you more discerning. It makes it easy to say no. There are a lot of ideas I see and I can say no within seconds. I can say, “No, I’m not going to do that.” The investable universe is maybe a little more manageable. That might be a positive. You can go through ideas a lot more quickly.

Alex: Let’s go to Monster Beverage. I thought it was quite interesting because the company had a point where it experienced very strong top-line growth. As it gained more and more market share, that started to taper off, but it was still able to expand margins even after that.

Chris: Yes, Monster Beverage is an interesting case study for a couple of reasons. One is because it got there so quickly, but the other was because it was among the ones where it was there in the numbers. You could see it, and you had plenty of opportunities to buy it and still make 100 times your money.

As you mentioned, even when it grew to a fairly good size, the gross profit over a five-year span went from like 34% to 52%, and the ROE greatly improved. That’s why I like that case study. It’s over such a compressed time horizon. You’re not talking about holding something for 25 years, which will be extremely difficult for most people. This was just a decade, and you were up 100X. It’s a pretty remarkable story. There are several of them. It wasn’t like this was the only one.

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My colleague Alex Gilchrist had the pleasure of hosting Aswath Damodaran for a discussion of his book, The Dark Side of Valuation: Valuing Young, Distressed, and Complex Businesses.

Professor Damodaran teaches corporate finance and valuation at the Stern School of Business at New York University. Due to his pioneering work in equity valuation, Prof. Damodaran is often called the “Dean of Valuation”.

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The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Prof. Damodaran.)

Alex Gilchrist: Known as the “Dean of Valuation,” Professor Damodaran needs little introduction. Suffice it to say that he is exceptionally generous with his knowledge and shares a lot of his courses on his NYU Stern page, his blog, and his YouTube channel where the content is organized in such a way that one can take an evening class in almost any aspect of valuation. It’s tremendously generous when we don’t have the privilege to attend a live session with Professor Damodaran. He’s here to discuss his book The Dark Side Valuation. Thank you very much for taking your time.

Aswath Damodaran: Glad to be here. To start, though, I know CNBC somehow hoisted this Dean of Valuation moniker on me, and I’ve never been able to live it down. I prefer to think of myself as a dabbler in valuation. All you’re going to do in valuation, even if you spend the rest of your life in it, is get to the surface of things. You’re never going to get that deep.

Gilchrist: When you started your class, it was originally called security analysis. Doesn’t that make you the pioneer?

Damodaran: I don’t think it makes me the pioneer. People have always valued stocks, but for a long time, security analysis was the name for it because Ben Graham was the first to teach this class at Columbia University. He wrote the book Security Analysis in 1934. It’s one of the first books written on systematically thinking about how you value stocks. The title of the class came from his book. Once it got the title, inertia took over, and for a long time, I simply collected other material to go along. By the time I started teaching this class in 1986, it was called security analysis. It was getting a lot of debris from 35 years of adding on stuff without anybody systematically asking if it even made sense. It was merely a collection of topics, which is one reason I said, “Okay, we need to rethink this and think about a better way of organizing it. It’s not like we’re starting from scratch — people have always valued companies — but let’s focus on valuation specifically rather than get distracted by institutional information.” It’s what a lot of the class had become because it was about how to get stocks listed. Essentially, it was about things that had nothing to do with valuation.

Gilchrist: At that time, multiples were much more widely used than even discounted cash flows, weren’t they?

Damodaran: They still are – 95% of everything that passes for valuation is still multiples. You might see a discounted cash flow valuation, but often, these are what I call Kabuki DCFs, where you start by attaching a price to something based on a multiple, say, 15x earnings. Then, because it doesn’t look sophisticated enough, you do a fake discounted cash flow valuation to make it seem as if deep thought went into coming up with this number. There’s a lot of fake DCF out there. I tell people it’s better to do an honest pricing using multiples and comparables than a dishonest DCF. All banking DCFs are a waste of time. I don’t even know why they bother. Bankers shouldn’t be using DCFs. Their job is to price stocks. Just do an honest pricing. Say you’re using 10x EBITDA and leave it at that. Don’t give me this delusional DCF where you plug numbers and then go through the motions just to make it look like you’re interested in intrinsic valuation.

Gilchrist: There are two quotes in the book I especially like: “Pricing is driven by supply and demand” and “Value is driven by the discounted value of cash flows.”

Damodaran: They’re not independent, right? If demand and supply were driven purely by fundamentals, the price and the value should converge. In fact, it remains the faith of every investor that price and value will converge. The problem is that in addition to being affected by fundamentals, demand and supply are affected by mood, momentum, liquidity, and sometimes revenge. Take a look at GameStop. A lot of the trading in that stock was driven by Redditors wanting to take revenge on hedge funds. That’s not a fundamental, but it’s a human emotion. Pricing reflects our humanity. I don’t think of it as a good thing or a bad thing. As human beings, we’re going to let emotions drive some of the choices we make, and they’ll all show up in the price.

Gilchrist: It can also be reflected in what you call the storytelling in valuation. Tesla comes to mind, telling a story that is affecting the price in the market at that time.

Damodaran: Stories affect both values and prices. The difference is valuation reflects bounded stories, stories you test and make sure they pass the test of not being a fairytale. This is a story that can happen. Pricing stories are unbounded because there’s essentially nobody stopping anything. Does that even make sense? Can you really pull that off? In a pricing story, you can get carried away and push the price of a stock up to whatever number you want because you’re telling a story which is not being checked. Take NIO, a Chinese electric car company. Electric cars are the future, and that’s the extent of your analysis. You’re going to push the price up to whatever level you want. All investing is driven by storytelling. The question is whether it’s bounded, rational storytelling or whether it’s just storytelling for the sake of it.

Gilchrist: Also, if story that starts with some bounded rationality is extended on and on, maybe a person has to keep doing creative things to keep the story up.

Damodaran: The problem with telling an unbounded story is that you now have to try to deliver on that story, and in the process, you could destroy what might have been a great business. One of the things managers have to learn is to not build up a story, not tell a big story for the sake of telling a big story because sometimes, the best thing to do is keep your story bounded. Keep your story smaller. Deliver on that story, and if you can deliver on it, maybe you can move to the next phase and think about making the story bigger.

In Silicon Valley, there are now storytelling classes where founders are taught how to tell really big stories because the bigger the story you can tell, the higher the price you can get as a company. These founders go out there and promise everything but the sun and the moon to their investors. They tell really big stories. If they’re good storytellers, they might succeed in getting people to push the pricing up, but at what cost? You now have to deliver on that story, and the delivery might destroy you as a business because you’re trying to do things you shouldn’t be doing to build a good business. I don’t think that’s going to stop because as long as you can push the pricing up and get out before the dust settles, what does it matter to you whether you’re building a good business? If you’re a VC, why would you care about whether you build a good business? You make money by building up the story and flipping it to somebody else.

Gilchrist: And you satisfy your own limited partners because they’re also going to be happy.

Damodaran: That’s right. It’s not a bad thing. I don’t have a problem with VCs doing it. That’s exactly what defines success for a VC. A VC is not measured by the quality of the business they build but by how much money they make on the deals they do. If you can get in and out at the right time as a VC, you’re a hero. What does it matter that the business you got out of crashed and burned? That doesn’t make it their fault. They’re doing what they’re supposed to do. Let’s face it, self-interest is going to drive how people behave. It’s not the VC’s job to protect me as a public market investor. It’s my job to do that. I can’t expect VCs to think about my interest when they build up the business. People have to stop outsourcing and blaming others for their mistakes and start taking responsibility for their own actions. No banker or venture capitalist forces you to buy a company, so stop whining about the fact that you bought a company that dropped 50%. That’s your decision. You need to take responsibility for that.

Gilchrist: One of the themes in The Dark Side of Valuation is that when we approach complexity, we have a tendency to hide it. We try to imagine it’s not there, but I think you say it’s best to face it head on.

Damodaran: Do you mean uncertainty or complexity? Uncertainty is what we hide from. Complexity is what we build as a barrier to even take a look at uncertainty. Uncertainty makes all of us uncomfortable. As human beings, our first reaction to uncertainty is try to make it go away. We do lots of unhealthy things to make it go away. We go into denial, outsource it, and look for consultants and experts to tell us what to do. My advice with uncertainty is not to hide from it. It’s a feature, not a bug. It’s the nature of the beast. Let’s take 2020 as an example. Did we learn how uncertainty can upend the best of plans? Absolutely. But does closing our eyes make it go away? No. We have to face up to the fact that we’re surrounded by things we don’t control. Because of that, we have to make our best judgment with the data we have right now and then move on, accepting the fact that we’re going to be wrong 100% of the time, and that’s okay. All you have to do is be less wrong than everybody else. That’s the nature of investing. It’s not being right. It’s being less wrong than everybody else.

Gilchrist: In terms of valuation, many people think that you couldn’t valuate emerging markets or it’s extremely hard to. I think you were approached at one point by a gentleman from Syria who came here and said, “I’ve got a business in Syria, and I need some hurdle rate for it. How can I go about it?” You can’t do away with it. It does end up being a real-life issue.

Damodaran: I think that’s the point. Let’s face it, as investors in the US and Europe, we’ve been coddled for a long time, especially in the US, by the fact that we’ve lived in the most stable mean reverting economy of all time. Things always reverted to the way they used to be, which allows you to do a lot of lazy things in investing and get away with them, which is assuming things would revert to the way they used to be five or 10 years ago. You live in a macro environment where everything is changing. The reality is that’s not just emerging markets anymore. That’s all of us. This is going to be par for the course. Mean reversion, assuming things would revert to the way they used to be, is not going to give you any kind of answer. It does make us all uncomfortable. We wish we could go back to the 1980s or 1990s in the US, but we’re not going to. This is how it’s going to be, and we need to accept that and adjust our behavior accordingly.

Gilchrist: That’s something very timely today. People thought commercial real estate had a very predictable future ahead of it with contractual cash flows and so on, but even businesses we think of as very stable get upended. You have to be able to adapt and maybe have an opinion.

Damodaran: There are fewer and fewer safe places to hide. Fifty years ago, we said, “Are there any safe businesses?” We pointed to quite a few. Regulated utilities used to be safe. Think of a phone company. How can you lose money on that? Everybody needs a phone. Unfortunately, technology has upended that business. When you buy into a phone company now, you’re buying more of a technology company than a phone company. In a sense, the world has shifted, and this is the dark side of disruption. We talk about disruption, especially in the last decade, as a good thing, and it is for those who make money on it. Uber upended the car service business. It was a disrupter. We like to talk about how successful it’s been, but whenever there’s disruption, there’s damage. Go talk to cab drivers in New York City. Ask them what Uber has done for them and how disruption has upended their life, and you’re going to see the dark side of it. Every business is now open for disruption, which means there are no safe businesses or very few of them left on the face of the earth.

Gilchrist: You mention some special topics in the book, for instance, interest rates and exchange risks, which are not well accounted for. Could you tell us more about these?

Damodaran: These are macro risks. When you sit down to value a company, the first thing to remember is that if you immerse yourself in macro risks, you’ll never get to your company. There are things you control and things you don’t. What’s the point of worrying about the things you don’t control? When you sit down to value a company, your job is to do that, not tell me what’s going to happen to interest rates, exchange rates, or the political setup in that country, unless it affects your company directly. Analysts spend too much time worrying about the rest of the world and too little time valuing the companies they have to value. It’s tough enough valuing a company, so why become an interest rate forecaster, exchange rate forecaster, and political analyst all rolled into one? It’s impossible to do. My advice on macro risks is to accept that they are what they are. You have to live in the world you’re in, not the world you wish you were in. You’ve got to bring in whatever you can find about those risks into your analysis, charge a reasonable premium to cover them, and move on.

Gilchrist: Looking at different countries, you generally add an equity risk premium on top of the risk-free rate, but the risk-free rate can be quite different from one country to another.

Damodaran: No, the risk-free rates are not different across countries. They’re different across currencies. Countries and currencies sometimes go together, but often they don’t. Look at Europe. There’s only one currency, the euro, but you could be investing in Germany or Greece. The risk-free rate is the same in euros in both countries, but the risk premium you charge will be higher in Greece than in Germany. The notion that risk-free rates vary across countries is not true. Risk-free rates vary across currencies. Risk premiums vary across countries.

Gilchrist: How about inflation?

Damodaran: That’s in the currency. Inflation is entirely a currency issue.

Gilchrist: Then wouldn’t the inflation of, say, Greece and Germany be different?

Damodaran: Not if you have the same currency. The Greeks eat a lot of olives, and if the price of olives goes up relative to the price of gasoline, they will feel more inflation. That’s like saying the inflation rate in Texas can be very different from the inflation rate in New Hampshire. It can be because the basket of goods of the average Texan consumer might have items that have gone up more in price, but the inflation rate in US dollars is the inflation rate in US dollars. When you have inflation rates, it’s a purely currency phenomenon. To the extent that it affects countries, it’s going to show up in your cash flow. Greece is going to grow more slowly because the items it produces are disproportionately represented in the basket of goods that create that inflation. It is going to affect your cash flows and your growth rates, but your discount rate will still have the same expected inflation rate, and it always comes from the currency.

Gilchrist: Because you’re going to be paid back in that currency, and that’s connected to the value of the inflation of the currency at the time.

Damodaran: Yes. Currency is a choice you make. I can value a Russian company in rubles or in dollars. The risk-free rate is going to be very different, but the risk premiums are going to be the same. Here’s what’s going to also be different: if I value a Russian company in rubles, my cash flows have to be in rubles as well. The inflation rate in rubles is much higher than the inflation rate in dollars, but my growth rate in rubles will also be much higher than the growth rate in dollars for exactly the same reason. Inflation gives you in one place and takes away in the other. The key with currencies is to be consistent, meaning that if you decide to value a company in a currency, your risk-free rate has to be in that currency, and everything else also has to be in that currency, like your cash flows and growth rates. If you stay consistent, you’re going to be okay. If you mix and match, all bets are off.

Gilchrist: That’s something you’ve mentioned a lot, that people can introduce inconsistencies into valuation without being aware of them. One topic I found particularly interesting was creating possible scenarios for cash flows in the future. I think you mentioned Monte Carlo simulations, assigning a probability to different scenarios to come up with a different valuation.

Damodaran: In simulation, you don’t attach a probability. You do in scenarios. In simulation, you attach distributions to your variables. You get a distribution of value, which is actually reality. You don’t value a company at a particular number; you have a distribution. All simulations do is let you take the uncertainty you face in the future and be explicit about it rather than only talk about it. You say, “I’m uncertain because my margins could be different.” My answer is, “Okay, tell me how uncertain you’ll be, and I’ll build it into the valuation.” What it effectively does is take the uncertainty you face out there and force you to be explicit about it. What you get as output will be a distribution of value. It’s the best counter to hubris because you will never say, “The value of my stock is $35.” You’ll say, “The expected value or the median value is $35, but you know what? Based on the uncertainty I feel about the stock, its value could be as low as $28 or $42.” That is reality. That’s what we face in every investment. A simulation simply forces you to be explicit about that reality.

Gilchrist: When performing either this kind of scenario analysis or a simulation, did I understand well that you shouldn’t adjust the denominator you’re using?

Damodaran: Adjust for what?

Gilchrist: For risk. Normally, you’d add some kind of equity risk premium.

Damodaran: You still have to add a risk premium because doing a simulation is not going to risk-adjust the cash flow. It’s merely going to give you an expected cash flow. Risk premium is for something different. If we lived in a risk-neutral world, we’d accept expected cash flows. I tell people to watch the show Let’s Make a Deal with Howie Mandel. In that show, contestants are offered either a guaranteed amount or a choice between two suitcases, one having $1 million and the other having zero. The contestant will be offered $400,000. The reason I’d pick $400,000 is the expected value across the two suitcases is $500,000, but human beings are risk-averse. They will accept a lower guaranteed amount instead of an expected cash flow that is higher. That’s what we’re trying to do here. When we risk-adjust the cash flows, we are essentially bringing down the value below the expected cash flows. In simulations and scenario analysis, you still have to risk-adjust the discount rate.

Gilchrist: Isn’t there any risk of double counting because you’ve already assigned a probability to a specific scenario?

Damodaran: No, probabilities are not risk-adjusting; they are expected cash flows. In the example I gave you, there’s a 50% probability that you’ll get zero and 50% that you’ll get a million. The expected cash flow is $500,000. That’s not risk-adjusted; it’s only your expected cash flow. A risk-adjusted version of that would say, “I’ll take $400,000 for that $500,000 because you’re guaranteeing me.” That’s what Howie Mandel offers – a guaranteed cash flow. The notion that probability adjusting the cash flows gives you a risk adjustment is misplaced. Analysts do it all the time. I think they’ve forgotten their basic statistics when they do that. All you’re getting is an expected cash flow, and an expected cash flow is not risk-adjusting the cash flow.

Gilchrist: When you discount the cash flow in the future, in your denominator, you might build risk in by using a higher denominator, which would reduce the value.

Damodaran: That’s a good point. If we lived in a risk-neutral world, we would never do that. We’d discount everything at the risk-free rate.

Gilchrist: But if we add in the probability, aren’t we counting twice?

Damodaran: How? To go back to the example I gave you, you have the two suitcases, one with zero and one with $1 million. Let’s suppose I gave you the choice of $450,000 guaranteed instead of making that bet. You think a lot of people are going to take the $450,000?

Gilchrist: If they’re risk-averse.

Damodaran: We have a very simple test. If investors were not risk-averse, there’d be no need for risk-adjusting any number. This is not a hypothetical. This is reality. If we were risk-averse, stocks, in the long term, should earn the risk-free rate. If we were risk-averse, no participant in that Let’s Make a Deal show would take it because the guaranteed amount is always less than the expected value. Howie Mandel never offers $600,000. He offers $400,000 or $350,000, and 75% of the time, people take it. You see it right there. This is not some hypothetical economic exercise, and it’s for a simple reason. You’ll want to take a guaranteed amount rather than risk getting nothing. There’s a 50% chance you get nothing. That’s risk aversion. When you think about that chance and say you’ll take the guaranteed amount, you’re thinking about that 50% chance of getting nothing. The minute you think about it, you’ve told me you’re risk-averse because it’s weighing more than the expected value. There is this chance you will get nothing.

Gilchrist: Is that why risk often comes down to volatility in the sense that we know stocks outperform in the long run, but we’re very uncertain about it?

Damodaran: If we lived in a risk-neutral world, we wouldn’t care. That, again, is the example. We wouldn’t care about the volatility because we’d say that on an expected basis, it’s all going to average out, and therefore, we don’t need a risk premium. The fact that we demand a premium for the volatility is an indication that, collectively at least, investors are risk-averse. Are there some of us who are less risk-averse than others? Absolutely. In fact, a few of us might even be risk-loving, and we are the ones who will be willing to take that $500,000. Even if I offered you $600,000, you might say, “I’ll go for the expected value because there’s a chance I’ll make $1 million.” That’s what gambling is because in gambling, the expected value is negative. When you gamble, you’re essentially saying, “I’m going to go for this gamble even though my expected value is negative,” because walking in, you know that the casino takes 5% or 10%. Your expected value is already minus 5% or minus 10%, but you go in anyway. Some of us do it as entertainment, but others think that’s okay because they want that small chance of making $300,000, $500,000, or $1 million. A few of us are risk lovers, but in the aggregate, investors are risk-averse, so they demand a premium for being exposed to that uncertainty.

Gilchrist: So, should the expected value be calculated separately from the risk?

Damodaran: How can you separate it from the risk? We could compute an expected value as if you are risk-neutral. In other words, we could discount the cash flows with the risk-free rate, but then what am I going to do with that number? I still have to adjust it for risk, right? I’d have to do a Howie Mandel equivalent and say, “What would you pay for what I came up with Tesla? My expected value for the stock if I don’t use the risk-free rate is, let’s say, $1 trillion, but there’s a lot of risk.” You’d still have to make that judgment of how much less than $1 trillion you’re willing to pay. You can’t put off dealing with risk. You might as well bring in the discount rate rather than do it in two steps because all you’d be doing is computing an expected value using the risk-free rate and then trying to risk-adjust that value, in which case, you’ll be faced with exactly the same challenges you faced if you only adjust the discount rate for risk.

Gilchrist: Haven’t the probabilities we’ve assigned to different scenarios in the future already told us how we feel about the risk?

Damodaran: No. Think about it. What does it do? Think statistically – 50% chance of zero, 50% of $1 million. There’s no feeling in there. The expected value is $500,00. Up till now, it’s pure statistics. It’s whether you will accept less than $500,000 for that expected value that tells me about risk aversion. The very act of attaching probabilities is completely antiseptic. There is no risk premium. This is the expected value, $500,000. A hundred of us could do it, and we’ll all get $500,000, but about 80 of us will require at least $300,000. Ten of us might need $400,000. As you go through, this is where the differences from one person to the next will come across, what they will accept as a guaranteed amount instead of their expected value of $500,000.

Gilchrist: Isn’t one of the complications that it’s unobservable?

Damodaran: Yes, and that’s why we struggle. If you take a stock like Tesla, you might have hundreds of thousands of shareholders, each of them bringing in very different risk aversions. That’s why we compute estimates of what collectively, at least in the aggregate, you’re getting. That’s what all risk and return models try to do. It’s not easy, but there’s no choice other than do it, right? What alternative do you have? You have to try to come up with a consensus estimate. The expected return you end up using as your discount rate becomes a reflection of that consensus estimate, at least as you see it.

Gilchrist: You gave an example of Warren Buffett, saying that he presumably limits the number of companies he looks at to one where future cash is highly predictable. He’s highly conservative in that.

Damodaran: And it’s worked really well for him in the last 20 years, right? It shows you that even the very best investors are a function of the times they’re investing with. The strategy of finding stable companies with predictable earnings made Warren Buffett what he was. But remember, we talked about disruption making every business unstable. When Warren Buffett invested in Kraft Heinz in 2015, he was assuming that we will forever want those 57 types of ketchup and cheese that stays liquid until the next nuclear war. The problem is we don’t, so guess what? Kraft Heinz crashed and burned. Why? Because the assumption that things are predictable simply because they’ve been predictable in the past is an assumption. When the word shifts under you, that assumption breaks down. There’s a simple reason Buffett has become an average investor in the last 20 years – the world has changed under him. Who can blame him, though? The man is 92. It’s extremely difficult to change when you’re 92. I don’t have a problem with Warren Buffett. I have a problem with wannabe Warren Buffetts who are 40 or 50 years old and who blindly ape him, then complain about the world being unfair to them because it’s not delivering the returns it delivered to Warren Buffett.

Gilchrist: The only choice people have today is to make that leap, to try and make their best assessment of things.

Damodaran: Either that or they get pushed out of the market, and they’ve got to find something else to invest, and God help you with that because uncertainty is everywhere.

Gilchrist: How does that fit in the sense of an investor having a circle of competence, in the sense of saying, “I feel like I understand this”?

Damodaran: You don’t need a circle of competence. Just buy ETFs. Let’s face it, for 95% of people, this act of going out and trying to find stocks that beat the market will deliver nothing other than pain and cost. There is an easy way out, and circle of competence is vastly overrated. The only person who thinks they have a circle of competence is the person who claims to have it. What circle of competence are you going to bring? Unless you’re a PhD in biochemistry and you’re doing young biotech companies, there are very few businesses where your circle of competence will take you further than the one-yard line. For the majority of people, the most sensible thing is to not try to get rich through investing. Investing is not about getting rich. It’s about preserving and growing your wealth. Go back and live the rest of your life. Do your jobs. Be a good doctor. Be a good engineer. Be a good teacher. Take the income you make and save it. My only advice for saving is if you truly enjoy picking stocks, do so, but don’t do it in the expectation that you’re somehow going to beat the market. If you beat the market, think of it as the icing on the cake. If you don’t, don’t do too much damage to yourself. Don’t put your money in three stocks. Don’t overreach. Don’t try to get rich overnight. Don’t buy cryptos simply because everybody else is making money. The pathway to sensible investing is to not try too hard.

Gilchrist: How about when people say, “Well, I haven’t done as well as the market, but I’ve taken on less risk than the market”?

Damodaran: That’s plausible. I mean, it’s easy to check, right? If I look at your portfolio and find that it has been more volatile than the market, I’m going to present you with the facts and say, “Are you lying to yourself or are you lying to me?” The biggest enemy in investing looks at you in the mirror every morning when you’re getting dressed. It’s you. Our capacity for self-delusion is deep and won’t go away. My advice to people is to stop lying to themselves. Stop coming up with excuses, and for God’s sake, stop blaming the rest of the world for everything that goes wrong with your portfolio. People have a tendency to think that the Fed did it or the hedge funds did it. No, it’s you who did it to yourself. Let it go. If you invest out of frustration and out of anger, the only person you’re hurting is yourself.

Gilchrist: One of the very interesting topics in the book is how intangibles have become much more prevalent and have made it harder to think about companies as accounting statements don’t reflect them very well.

Damodaran: I don’t think it’s made it harder. The problem is with the accountants. They have this thing about physicality, tangibility. Part of the reason is that accounting as we know it was designed for the old-time manufacturing firm. If you think about the origins of accounting, they were in the 20th century for the Smokestack America, the GMs, the Fords, the GEs. The problem for accountants is that they’re about 50 years behind the times. They create investments in things they cannot see, like technology, R&D, and operating expenses. It’s stupidity, but it plays out as financial statements for these companies that don’t mean what they claim to mean. The earnings for Microsoft are not comparable to the earnings for GM because the earnings for Microsoft are after R&D expenses, which are really capital expenses. It’s not difficult to do, but you have to start with the accounting statements, not end with them. You’ve got to redo the accounting, and it’s not difficult. Nothing is rocket science. You can redo it to bring in the intangibles, and once you do it, you’re on firmer ground. It does add a layer of work when you value a Microsoft or an Apple or a Google, but it’s not difficult to do. I’m not going to sit here and complain about accounting not keeping up. Frankly, I’m not going to wait for accountants to come to their senses. It takes them a long time. I’m going to do it on my own. And guess what? I feel more in control when I do it on my own than when accountants do it for me. I have mixed feelings about what exactly accountants do when they come to their senses because I’m not sure they’re helping me out by trying to do the right thing.

Gilchrist: Unless the company explains, it can be quite difficult to figure out what portion of its expenses it needs just to cover its operations and what for growth for the future, such as research and development – it doesn’t need it for today, but it does need it for the future.

Damodaran: R&D is not difficult. Nothing is for today. More difficult are things like advertising expenses to build a brand name. That’s truly an investment for the future. R&D is the easiest of the items. I wouldn’t worry about it. The question is whether it will pay off in two, three, or five years. Customer acquisitions are much more difficult because you don’t know how long a customer stays on, but it’s difficult only because we don’t have the capacity to ask the follow-up questions. Uber claims that customer acquisition costs are capital expenditures. The question I’d have to ask is what the churn rate is. What percentage of riders stay on? When the churn rate is 50% or 80%, the customers keep turning over, customer acquisition costs go back to being an operating expense. We need to ask companies the right follow-up questions. We might not as investors, but analysts should be doing this. Why aren’t they doing their jobs? Why isn’t somebody getting up and asking Netflix, “You added all these users. Where in the world are they?” An Indian Netflix subscriber is worth about 1/5 of a US Netflix subscriber because they pay a lot less per month. Also, how long do they stay on as subscribers? Until we start asking the questions, we won’t be dealing with intangibles the right way. We have a template for what we need to do. We just seem unwilling or too lazy to do it.

Gilchrist: With Netflix, another thing I find quite interesting is that it counts as operational expense some of its movie development. It capitalizes some of it, but then on one level, the company does need to keep on making movies to sustain its current base of users.

Damodaran: That’s like a manufacturing company. Does a manufacturing company build a factory and just leave it? It’s got to go in and replace equipment. Think of existing content being renewed as equipment being replaced. It’s got to build new factories, which is like building new content. I don’t think it’s that different from a manufacturing company. It’s just that our frame of reference doesn’t include stuff like this. It’s more a failure of the imagination than a failure of the data, where our vision is still clouded by what used to be so that we’re not rethinking what a capex is, that when Netflix invests in a new show, it’s very much like Coca-Cola coming out with a new beverage. When it goes and maintains an old show, it’s like Coca-Cola going in and spending money to build up an existing brand. I don’t think it’s any different from a tangible investment. We simply need to think about it in more creative ways and not have this notion of “Show me something physical this company has done for it to be a capex.”

Gilchrist: What advice could you offer people to make that transition?

Damodaran: I think it’s hard work because the first company you do it in, it will be like pulling teeth. It’s like everything else in valuation. It’s a craft you keep working at, and it will get easier. The first technology company you value will give you all kinds of headaches. The second one will be easier. By the time you get to the 10th or 12th, you won’t even notice it’s a technology company. My advice is start with a company. Don’t go reading more about it because that seems to be the tendency for people now – they want to read up as much as they can before they try. It’s a waste of time. Just go start on a company. If you run into a roadblock, read up on it, and then keep working. Every time you value a company, it’s only going to get easier.

Gilchrist: Then there are factors such as total addressable market that can be quite hard to estimate.

Damodaran: Yes. Okay, it’s hard, but is it only you facing this challenge? We said uncertainty is a feature, not a bug. Does Airbnb know with certainty what its total accessible market is? No. It’s estimating. You’re estimating. We’re all trying to estimate something that none of us know, so why make this just about you?

Gilchrist: How would you think about the quality of management entering valuation?

Damodaran: It’s in your numbers, right? If it’s not in your numbers, you haven’t done your job. I’ve never seen a company pay dividends with management quality. Management quality has to show up somewhere. It’s got to show up in earnings and cash flows. If you tell me you have a quality management, but you keep losing money and I get no cash flows, I’m going to question your definition of quality. Ultimately, quality is simply a means to an end. If you tell me you have great management, show me where. What number is showing it? If you can’t show me a number, my response is, “I don’t believe you when you say you have quality management.” Often, people brand a management as high quality. You know how they branded it, right? They look at your history. Why is Amazon considered a great company? Because it’s delivered results and done so much better than expected. I think quality of management is one of these things people like to use as buzzwords. I blame the Oracle from Omaha for this because they have a fetish about quality of management. Do I think management matters? Absolutely. If it does, it’s got to be in the numbers. If it’s not in the numbers, let’s move on. There are more critical things to talk about than how much you like the manager and how great they are in terms of dealing with people. If they are that good at doing all of this stuff, why isn’t it showing up in the numbers?

Gilchrist: Could it be that they’re pursuing a long-term vision that hasn’t shown up as yet?

Damodaran: Right. How long term do we wait for this vision to show up? People think that management are some superhuman beings. They’re your employees as stockholders. If every year you come in and they say, “Just wait,” and you wait one, two, five, seven years, at some point, you’d say, “How long term is long term?” The Keynesian statement comes to mind. We are all dead in the long term.

Gilchrist: If we wait too long, it might get reflected in the prices.

Damodaran: Let’s face it, the average management team in a company is very average. I’d wager that you could replace the management team in most companies by a bunch of robots and get pretty much the same results. The reality is managers vastly overrate themselves. They think they’re all special. You ever talk to a management team that doesn’t think it’s a quality management team? I never have. Everyone claims to be high quality. This is like every parent thinking their kid is above average, at which point you’ve got to ask where the heck is the average if everybody’s above average.

Two-thirds of management teams around the world destroy value as they grow – two-thirds! Out of 45,000 companies, 30,000 managers destroy value when they come into work, not add value. The median management team is not a high-quality management team. It’s a below-quality management. If somebody claims to be high quality, then I need to see some tangible backing for that, otherwise it’s just words. Why would I pay a premium for words?

Gilchrist: You’ve also said that growth is one of the harder areas because a lot of growth is value-destroying, not value-creating.

Damodaran: That’s because companies get old. You get old and your business turns bad. It’s not your fault. There’s just nothing there. Find me an airline that grows and creates value. They’re in a bad business. It will be extremely difficult for you to create value. The sensible thing to do is shrink or at least don’t grow. You know how many management teams will take that advice? As a manager, you’re told that good managers grow their companies. When was the last time you saw a movie about a CEO who made his company smaller? I’ve seen a lot of movies about CEOs who made their companies bigger, the Steve Jobs movie about how he made Apple go from $10 billion to $1 trillion. I’d love to see a movie about a CEO who comes into a $100 billion company that’s past its best days and then finds a way to shrink it over time to reflect the fact that it’s way past its prime. We’re not going to see that movie made.

Gilchrist: How do you think about ESG, which is becoming much more prevalent?

Damodaran: I think it’s the most overhyped, oversold concept in the history of business. I don’t hold back. I’ve never ever seen a concept with so little behind it being adopted and hyped by so many people, and here’s why. A lot of people are making money on ESG. None of them are investors or company employees. These are consultants and advisors to portfolio managers. A lot of people are making money from this concept, but there’s very little there. Do you truly want your companies to become churches? Is that what this is going to be about? You know what happens when companies try to be churches? They’re neither good as companies nor as churches. That’s what we’re heading towards – companies that sound good but don’t do good. We all want companies to do good for society. Do we want them to operate with constraints? Absolutely. That’s why we have legislators to pass laws.

You know what this is? This is a complete abdication of responsibility by everybody. In the case of consumers, they want the convenience of shopping from Amazon, but they don’t want to think about the fact that every time a package arrives, it brings with it 15 tons of recycling. We want the convenience of going to Walmart and buying things cheap, so we’ve decided that because it’s too much work for us to be good, we should make companies do it for us. It’s the job of our politicians to pass laws that prevent social costs, but politicians are either too lazy or unable to do it. Guess what? They tell companies to be voluntarily good. Nothing good will come out of this. Ten years from now, you’ll only have a lot of ESG consultants who have gotten rich off this phenomenon. Companies will all sound good. When you open up their annual reports, it would be like reading the Bible. If you think about whether companies are actually doing more for society, I can almost guarantee you that 10 years from now, the answer will be no.

Gilchrist: In terms of valuation, is this part of the same problem of people wanting to go back to a simple time where everything seems to have a simple answer?

Damodaran: No, this is far worse because as a society, I think we have decided that all the things we need to do for goodness are too much work. We’ve decided that we’ll just pass on the responsibility to companies. This is a reflection of wanting to have our cake and eat it too. That’s the ESG promise. You will be good, and the companies will get valuable. It’s cake for all, calories for nobody. That’s never been a pitch that works out.

Gilchrist: Is there some kind of continuing advice you could offer in terms of developing the right mindset with valuation and being able to evolve over time?

Damodaran: My only advice to people is to be okay with being wrong. If you’re okay with it, your mindset will develop on its own. The problem is that people dig themselves into trenches. Once they’ve dug themselves in, they cannot admit that they’re wrong. If you’re okay being wrong, you’re going to be creative because being creative means you’ve got to take steps that will make you more wrong. I think people are looking for precision when they should be looking for accuracy. Precision basically means you have a model that delivers the same answer over and over again. Accuracy means you’re trying to get the right answer even if your model is all over the place. We need accuracy, not precision.

Gilchrist: Professor, thank you very much for taking the time to speak to us. I highly recommend your book, The Dark Side of Valuation, and all the other bits of knowledge you put out and generously share.

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I had the pleasure of speaking with Lauren C. Templeton about her book, Investing the Templeton Way: The Market-Beating Strategies of Value Investing’s Legendary Bargain Hunter.

Lauren is the founder and CEO of Templeton & Phillips Capital Management. She also serves on the Board of Directors of Fairfax Financial Holdings, Fairfax India, and Canadian Solar. Lauren is active in the non-profit community, serving as Chair for the Board of Trustees of the John Templeton Foundation and as a member of the Board of Trustees for the Baylor School.

The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Lauren.)

John Mihaljevic: What inspired you to write Investing the Templeton Way?

Lauren Templeton: I had an unusual relationship with my great-uncle in that he seeded my first fund to the tune of $30 million when I was 24 years old, and I had the opportunity to work with him up until he died. I decided I would write a book describing his most well-known trades and the historical context around them. As investors, it’s very easy for us to look back on some of these trades and think, “Oh, that was just common sense. I would have done the same thing.” However, we all know we have behavioral biases and other behavioral aspects which prevent us from doing it. I wanted to describe the historical context in which he made these trades so that we could better imagine ourselves in the same position, to give thoughtful analysis on whether or not we could have placed the same trade, and if you would have, how to position ourselves better going forward.

Mihaljevic: How would you summarize the core message of the book?

Templeton: It is definitely that if you want better performance than the crowd, you must do things differently from the crowd. Every single chapter talks about a specific trade of his that was very contrarian in nature. His contrarian trait is what helped distinguish his investment returns, in my view. I think it is very important. There are only two ways to get a bargain. One is to buy when there are no other buyers left and only sellers, and the other is to focus on neglected stocks, but it’s that behavioral aspect we find to be the easiest to take advantage of. At our firm, we are focused on buying at points of maximum pessimism, as my uncle called it. We believe this is to be a very easy way to pick up a bargain-price security.

Mihaljevic: What was it about Sir John Templeton that allowed him to pursue such a contrarian approach?

Templeton: He was a strongly disciplined person and liked discipline in all areas of his life. I think it helped him have this value bias and execute his strategy well. He also had a unique childhood and upbringing, as well as some personal experiences which taught him about buying at the point of maximum pessimism. His father was a lawyer and had an office facing the town square in Tennessee. In the Great Depression, when farms came up for auction, he would look down across the town square. If he saw that the auction produced no buyers, he would go there and buy the farm for cents on the dollar. Uncle John witnessed this over and over again, and he saw the accumulation of wealth.

That’s a highly specific experience for a child to witness, and I think that’s where he learned the art of buying a bargain and buying at the point of maximum pessimism. His investment discipline helped him execute that strategy. When you interview the greatest value investors out there, you find they are all strongly disciplined people. An investment discipline to adhere to is important for saving you from yourself. It’s extremely hard to go in and buy at the bottom of the market when no one else is buying, be it in a stock, a country, or an industry. We’ve learned to anticipate these bouts of maximum pessimism, but there are times when we get nervous, too. If you rely on investment discipline, it allows you to easily execute your strategy.

Mihaljevic: How did Sir John get started in investing? Tell us about his first forays or give us an example of an investment he made at the point of maximum pessimism early on.

Templeton: Uncle John attended Yale University, which he graduated in 1934. He remarked that a lot of the wealthier students at Yale had investments, but their families were invested in US companies only. He decided very early on that he would have a global outlook. After Yale, he received a Rhodes Scholarship and went to Oxford, where he attended Balliol College. When he graduated from Balliol, he left with a roommate on a round-the-world trip where they would visit 35 countries.

He exercised strict discipline with his expenditures as well. He had budgeted £200 for the trip and even went so far as to divide the money and mail it to himself at different points in the itinerary so that he would maintain financial discipline. This is remarkable when you think of a young person doing it back then, what coordination and thought this would have taken. When he finished the trip, he came back to the United States and entered the investment business in 1937.

His first trade in maximum pessimism occurred in 1939, when the world was on the brink of a full-blown war. The Nazis invaded Poland, which was going to lead Europe into World War II. Uncle John anticipated that the US would be dragged into it, and he thought that US industrial firms would be pushed to supply commodities and goods to support the country’s entry into the war. What’s really interesting about the whole thing is that he was correct, but he didn’t focus on the most profitable firms. He was a student of history – he had studied the civil war and World War I, and he knew there was a tendency for governments to instigate excess profit taxes. Those taxes were levied on profitable businesses before the war, so if a company was profitable prior to World War II, its excess profits coming out of the war were taxed at 85.5%. Uncle John did not want to focus on those companies; instead, he focused on the bottom of the barrel because he correctly anticipated that the war would lift all companies.

On the eve of World War II, he borrowed $10,000 from a previous employer, which is also remarkable, and bought 104 companies, 37 of which were already in bankruptcy. He held those positions for a number of years, turning the $10,000 into $40,000. Out of the 104 companies, only four investments did not work out. One of his most notable investments from that trade was the Missouri Pacific Railroad, which he purchased for 12.5 cents per share. When he sold the stock, it was trading at $5 per share, which is a 3,900% return. He had some amazing returns coming out of that, but this was what we call his first trade in maximum pessimism.

Mihaljevic: Tel us a little more about that trade. What was it that attracted him to it?

Templeton: Stocks were already depressed. If I recall correctly, the stock market was down about 49% in 12 months in 1939, so people already had a deeply pessimistic view of it. His careful analysis of history, including the civil war and World War I, led him to believe that the activities surrounding the US entrance into World War II would benefit all companies, particularly companies like railroads and specifically companies which would not be subject to the excess profit tax of 85.5%. What is common in many of the trades you’ll read about in the book, Investing the Templeton Way, is that they all have a historical component to them. He was a great student of history and liked to read a lot about it. I think in all of his trades, there was a component where he was taking something from the past and applying it to the present. That’s probably a good thing for investors to remember. History doesn’t exactly repeat itself, but it does rhyme, so there is a tendency to have quite similar events happen over and over again.

Mihaljevic: It seems quite prescient that even though he had interest in global investing, he opted for US-listed companies just before the full outbreak of World War II. I assume he branched out into global markets after the war was over. Is that correct?

Templeton: He did. He’s known as the pioneer of global and international investing. He always remarked to me that he found the students at Yale, their families that only invested in US companies, to have a very arrogant way of looking at the world. Why not have a larger universe of stocks to choose from? When you think about the time he was investing internationally, it was amazing because even now, international markets are less efficient, and emerging or frontier markets are even more inefficient. It’s harder to get information, and when he was doing it, it was exceptionally hard to get information.

He was well-known for being an early investor in Japan. He was allocating personal capital to Japan in the 1950s, and then he was investing clients’ capital in the country in the 1960s. Of course, he reached those returns in the 1970s. During the 1970s, the Templeton Growth Fund was compounding at 22% versus, I think, 4% or thereabout for the Dow. He had three bad years (1970, 1971, and 1975), but he did a good job of outperforming the market during that period because he was investing in these Japanese companies a decade before that. He recognized that these firms were low-priced based on the P/E ratio, but by being a good student of accounting, he also realized there was an anomaly and that the Japanese firms were not consolidating their subsidiaries on the balance sheet. He was able to buy companies like Hitachi, which appeared to be trading at around 16x earnings, but when you consolidated the subsidiaries, it was trading at 6x earnings. Of course, some of the things he saw in Japan in the 1960s would have been that it was growing at about 10% per year, or about 2.5x faster than the US at that time. The stocks in Japan cost 80% less than the stocks in the US, and they were trading at around 4x P/E versus 19.5x or something like that for the US.

Very often, people think of my uncle as this great macro investor, and that’s probably because he used to come on shows like Wall Street Week with Louis Rukeyser. He would make a broad call like, “I’m investing in the US. I’m investing in Japan or South Korea,” but he was so bottoms-up focused. He allowed the valuation of stocks to show him where to invest. He invested in Japan in the 1950s, 1960s, and the 1970s. Then in 1979, around the same time that Newsweek magazine proclaimed the death of equities and nobody would go near the US stock market, he transitioned from Japan into the US and put over 60% of his capital in the US around 1980. He’s well-known for going on Wall Street Week in about 1982 and predicting that the Dow would reach 3,000 in the next 10 years. The Dow was trading at 800 at the time, and by 1991, it had hit 3,000. Everybody thought he was crazy. I actually remember him going on that show and declaring so. People did think he’d lost his mind, but people usually say things like that when good investors come out and do stuff like that, so it’s fun to watch.

Mihaljevic: What do we know about his analysis of businesses? Did he prefer certain industries over others?

Templeton: He did not like heavily regulated industries, and there are some industries which are hard to value, for example, biotech. Other than that, he was pretty agnostic to industry and country. When I was investing for him, he had a rule that I could have no more than 50% in any industry, country, or currency. He had broad risk constraints on portfolios.

Mihaljevic: Did he also short securities?

Templeton: He did. It’s so funny. He would often tell people not to use leverage and not to short securities, but he did both personally. He never did it for other investors, and he always advised against using leverage and shorting securities, but I certainly knew him to do both. It’s been 12 years since my husband and I wrote the book on our honeymoon, and when I was preparing for this interview, I thought I wasn’t going to remember any of these details, but I was reminded of his strategy and the tech boom of the late 1990s, early 2000s where he was shorting IPO stocks. I graduated from college in 1998, so I remember this clearly because that is the environment I went to work in. I remember the tech boom and investors saying Julian Robertson, Warren Buffett, and Sir John Templeton had lost their touch.

Uncle John had devised a strategy where he was shorting tech stocks about 11 days prior to their IPO lockup expiration. The crazy thing is that he was covering the stocks if they fell by 95% or below historical P/E ratio at 30x. Those were the measures he used during that period, and he put $2.2 million in 84 stocks, so he had about $185 million invested in that trade. The NASDAQ would have reached an all-time high in March of 2000, and during that period, NASDAQ stocks were trading at about 151x next year’s earnings. They had incredible valuation, and there were lots of IPOs coming to market. I think there was something like $78 billion worth of IPOs hitting the market in the first quarter of 2000, and there was more than that in initial public offerings where the lock-up expiration was occurring. He knew these insiders were aware that their companies were not worth what the stocks were trading for in the market and that they would be the first to run to the exits. He found out when their IPO lock-up expirations where and shorted the stocks about 10 days before that, covering them when they fell 95% or started trading at less than 20x, which is simply remarkable. He made a gob of money doing it.

Mihaljevic: That certainly sounds like a high-conviction trade when you want to wait until they drop 95%…

Templeton: I know. Also, if you remember what the market was like back then, being short $185 million of tech stocks would have been like standing in front of a train going straight towards you. My father, who is a great investor himself and has taught me a lot, received a letter from uncle John advising him to do the same thing. Dad put on some of these short positions, and he ended up covering on them. He said, “I just can’t handle it. This isn’t for me. It’s too stressful.” It wasn’t worth it to him, but uncle John stood pat and believed in the strategy, and it worked well for him.

Mihaljevic: That’s probably why it works – it’s really hard to invest at the point of maximum pessimism or, in this case, to short at the point of maximum optimism.

Templeton: True, and he also would have had large margin calls that most investors probably couldn’t have handled because few have that much excess capital around to meet those margin calls. That was a unique trade. There are websites which track this IPO lock-up expiration, and I’ve recently pulled up one just to see the companies whose lock-ups expire this quarter. I didn’t see anything I was particularly interested in, but it’s something for investors to remember. The data’s out there. You can see which companies have their lock-ups expiring, and if they’re overvalued, it’s not unreasonable to believe the insiders will take the first opportunity to sell.

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I had the pleasure of chatting with renowned investment strategist Michael Mauboussin, Head of Consilient Research at Counterpoint Global (Morgan Stanley Investment Management), about his book, More Than You Know: Finding Financial Wisdom in Unconventional Places.

The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Michael.)

John Mihaljevic: What inspired you to write More Than You Know?

Michael Mauboussin: The main theme of More Than You Know is that thinking about the world through a multidisciplinary lens will make you a better thinker. It will make you a better person, a better parent, a better spouse. The metaphor I always like to use, which has been well used, is that of a toolkit. If you have a full toolkit containing different types of tools, no matter what problem you face, you’ll have the appropriate tool to try solve that problem. If you have just one tool or a couple of blunt tools, you’ll be using the wrong tools to try solve problems.

That kind of research — that mindset — has been deeply influenced by a number of sources, and there’s a lot of scientific support for the virtues of a multidisciplinary point of view. I’ll mention work by two scientists. One is Scott Page at the University of Michigan, who wrote a book that came out in 2007, after More Than You Know, called The Difference. More recently, he wrote a book called The Diversity Bonus. Both of those demonstrate the mathematics — the quantitative case — for why cognitive diversity helps solve difficult problems. This is not just a “wave our hands” concept. There’s good evidence that it works.

The second researcher I’ll mention is Phil Tetlock at the University of Pennsylvania. In 2006, he wrote an outstanding book called Expert Political Judgement about how difficult it is for experts to make quality forecasts. There was an interesting piece of research in there about how there are different kinds of thinkers, which he called hedgehogs and foxes. This is based on the Isaiah Berlin essay. Hedgehogs are people who have one big idea and they fit their world view into that, while foxes are people who know a bit about many different things and tend not to be wedded to any particular point of view. Tetlock showed that foxes are better forecasters, and are generally better thinkers. Following on from that, he wrote a book called Superforecasters about people who are great forecasters. It turns out that one of the key characteristics of those people is that they are actively open minded. They are thinking about a variety of things and are willing to take on different points of view.

Another big influence is Charlie Munger and his mental models approach. You can read about this — and I’m sure all your members have read it — in Poor Charlie’s Almanack, which is a great read and something that every serious investor should go back to read periodically. By the way, I met Charlie Munger for the first time in December. It was a real bucket-list moment for me, and it was awesome. Munger’s got a quote which I’ve always loved, which is if you want to be a good thinker, you must develop a mind that jumps jurisdictional boundaries. That very much is an animating concept.

The last thing I will mention as an influence is the Santa Fe Institute. I’m actually in Santa Fe, New Mexico now. You mentioned I’m chairman of the Board of Trustees. The Santa Fe Institute is an interesting place. It was started about 35 years ago by a number of academics who felt that academia had become too siloed, and that many of the most vexing and interesting problems in our world were at the intersection of disciplines, so they started an institute to transcend these jurisdictional boundaries and have people work on these difficult problems.

That’s a bit of background on the influences. This way of thinking about the world is not everybody’s cup of tea, but it’s very much in the bones of More Than You Know.

To answer your question more directly in terms of how this book came about, I’m one of those people, — which can be slightly annoying — who when they read something or watch something or see something, are always thinking about connections or corrections. I would find myself talking back to my books or talking to my TV, which is not an effective way to go through life. I thought that I should start writing about these connections that I see, or how ideas can spill over from one to the other.

There was also a specific catalyzing moment for me. My wife had a beloved grandfather — a great guy — who, in the summer of 2000, handed me a copy of Time magazine which had Tiger Woods on the cover. Tiger Woods, of course, is a famous golfer, but the story here was that in 1997, so three years prior, he had won the Masters golf tournament at the age of 21. He won it by 12 strokes. It was an extraordinary story. Woods watched the tape of his performance, and he came to the conclusion that his swing was no good. He called his coach and they revamped the swing, and the initial reaction was that he became less effective as a golfer. Then he came roaring back and had a spectacular string of victories with this revamped swing. That immediately conjured in my mind something I had learned about at the Santa Fe Institute, which is a concept called fitness landscapes. Imagine looking out at a landscape with mountains of different heights. Think of the height of each mountain as some measure of fitness or goodness. You go up to a mountain and you’re at the peak, but there may be a mountain with a higher peak out there. For you to get to the higher peak, you have to sometimes go into the valley to climb back up to the peak. I thought what Tiger Woods was doing was an excellent illustration of this idea: he was at a local peak — he was the best golfer in the world at the time — but he thought he could be even better, so he degraded his performance for a short period of time to be even better.

That launched me into these essays in the early 2000s. We wrote them every two weeks. I targeted 1,500 words, which is enough to allow you to develop an idea, but fairly short so people would read it. We called it “The Consilient Observer” — that was the name of the original essays. I was inspired by E. O. Wilson’s book Consilience, which came out in 1998 and is a book I’d recommend. Consilience is an unusual word. It’s about 150 years old, and it means the unification of knowledge. In this book, Wilson argues that for us to advance in the scientific world, we need to appeal to consilience — again, this transdisciplinary effort.

A publisher approached me and suggested we put the essays together, with introductions to various sections, and that became More Than You Know. That’s the long intellectual journey behind it, but that’s what inspired me to do it in the first place. A lot of it is this idea that we are better people if we think about lots of different disciplines.

John: The book covers a lot of ground and does that masterfully. You organized it into four sections: investment philosophy; psychology; innovation and competitive strategy; and finally, science and complexity theory. To start on the investment philosophy side, you draw a distinction between profession and business when it comes to investing. What do you mean by that?

Michael: This is an important point. This was inspired by an essay written by Charley Ellis in 2001. The argument is if you think about investing, there are two components. The profession component is all about generating excess returns for your investors. Presumably, as a leader of an organization or a portfolio manager, you are invested in that yourself. The key to the profession is it has a certain cadence. In most cases, you want to take the long view. You want to be, as Buffett would say, fearful when others are greedy and greedy when others are fearful. In a sense, you’re working counter to the broad world.

The business of investing is ultimately just like any other business, which is revenues and costs. The business of investing would presume that your business is better if you gather more assets, so the business side is about gathering assets.

You certainly need a good business to support a profession — you need to be able to compensate people, hire the right people, and have the right organization and resources, for example, to do your research in a quality fashion, but the argument that Ellis made, to which I was sympathetic, was that a lot of investment organizations had tilted more toward the business side than the profession side. (By the way, the other person who wrote elegantly about this was Jack Bogle.) For example, if a particular asset class or a particular product is hot, it is the investment organization’s focus on the business that will launch products in that area because they’re satiating a demand, whereas an organization focused on the profession might say, “We’re not going to do that because we think that the prospective returns are not very attractive,” and may even go a step further and say, “The products we want to launch are going to be in areas that are ignored today but where we think we can plant seeds that will bear fruit down the road.” As I said, a good business is important to a good profession, but it’s about what becomes the most important thing as an organization.

I’ll tell you a side story about a conversation that I had with Wally Weitz who’s a great investor based in Omaha. I think he won’t mind that I mention this. Wally’s got a great track record and has built a nice business for himself. He said to me one day, “You know, I think to myself, if I really wanted to crank this thing, if I really wanted to grow my business rapidly, there would be ways for me to do this in certain distribution channels, but every time I think about it, I look at the plan and then I put it back in my drawer and close it and say we’re really here to methodically deliver excess returns.” I thought that was a great example of someone who overtly thought about this profession versus business thing and came down on the side of the profession, which is great.

John: What parallels would you draw between investing as a profession and sports as a profession?

Michael: I think there are a lot of parallels, and I’d even go beyond sports. When you say sports, I don’t know if you mean sports team management, like GMs or–

John: I’m referring more to top athletes and how they approach their craft.

Michael: This is not in the book, but I’ve always been enamored with this concept of athletes. In sports, we have physical athletes. In our business, they’re not physical athletes, but they’re mental athletes. What does a physical athlete have to do to be at his or her peak performance? You want to have an appropriate training program — deliberate practice, operating at the limit of your performance, things that are relevant in the context of the game you play. The other side of it is you want to make sure you’re doing other things properly, for example, rest, nutrition, sleep. These are essential ingredients to performing well as a physical athlete. As a mental athlete — as an investor — what do you want to do? Incidentally, those other things — rest, sleep and nutrition — are also important for an investor. I’m on a big kick on sleep. I think sleep is vastly underestimated. You can get an important cognitive boost just by sleeping the appropriate amount and making sure that’s built into your routine.

Training for me would be mostly reading. We’ll call it learning in general, but mostly reading. Many of the great investors that I’ve been around — and I’ve had the fortune to be around a lot of great investors — spend a lot of their days just reading and thinking. What’s interesting about that is there’s no expectation for an immediate payoff. You’re not reading something in order to do something specific. You’re reading to gather and build your knowledge base so that when an opportunity presents itself, you’re in a position to take advantage of it because you’ve prepared your mind, just like an athlete has prepared him or herself for a particular situation.

For example, people are surprised when someone sends a business proposal to Warren Buffett and he acts on it in fairly short order, and they wonder how he could understand it so quickly. The answer is that he’s preparing every single day. He’s made a career of preparing himself for these kinds of situations so when they appear, he knows what to do with them quickly. I think there are a lot of parallels between those things. A lot of it boils down to the simple concept of preparation, but other components like rest and time away and sleep are also essential to being a successful mental athlete just as you want to be a successful physical athlete.

John: I’m glad you mentioned sleep, because it’s a bit of a contrarian view these days, it seems. We read so much about successful entrepreneurs waking up at all hours of the night and squeezing the last minute out of sleep as it were. It sounds like you come down on the side of not trying to economize too much when it comes to sleep.

Michael: There’s a wonderful book by Matthew Walker called Why We Sleep. Before reading it, I thought I knew the overall story, and I had the basic idea, but that book is not only fascinating, being grounded in science, but also compelling. I found myself talking about it with everyone I encountered. There’s a lot of research that demonstrates that a deficiency of sleep will impede your cognitive performance — that’s learning and memory, et cetera. There are certain extreme times when you may not be able to get the sleep that you hope for, but for most of us, in our day-to-day routine, there is no excuse for not getting the appropriate amount of sleep.

John: Tell us about the Babe Ruth effect, please.

Michael: The background story on this is that I knew a money manager who was in charge of the funds for a particular state pension. They got a new treasurer who went through all the money managers and looked at what percent of their investments beat the market, and he fired the ones that were at the bottom, save one, which was the guy I knew. This one manager had a preponderance of investments that did not beat the market, but his overall portfolio did much better than the market.

On Wall Street, you will often hear people say things like, “You know, if I can be right 53% of the time, I’m going to be great. I’ll make lots of money.” That statement is accurate in the context of trading. If you’re trading all day and you’re slightly more right than you’re wrong, you’ll do fine. The Babe Ruth effect says that the frequency of correctness doesn’t matter. It’s how much money you make when you’re right — it’s the magnitude — that matters. It is often the case that even great money managers are wrong a majority of the time on their investments. They lose money most of the time, but when they make money , they make so much that it compensates for those losses and then some. One example is George Soros. One of his colleagues reported that Soros made money on 30% or less of his trades, but of course, the guy is a multibillionaire.

Why did I call it the Babe Ruth effect? When Babe Ruth retired, he had the all-time record for homeruns, but he also had the all-time record for strikeouts. The magnitude of his homeruns more than compensated for the strikeouts that he had over time. That’s the big lesson. It’s not the frequency of correctness that matters. It’s the magnitude. It’s how much money you make when you’re right versus how much money you lose when you’re wrong.

I’ll mention one other interesting thing. There is a trading strategy called trend following, which has a formulaic approach. If you look at the payoffs of trend followers, what you find is that they lose money on a majority of trades, but they have a right-tailed payoff that allows this strategy to be fruitful overall. That’s the Babe Ruth effect.

John: Tell us a little about how you think about expertise and experts.

Michael: This is a hot topic. In particular, there’s a back and forth between Danny Kahneman, the eminent psychologist who won the Nobel Prize in Economics in 2002, and Gary Klein, who’s an outstanding social psychologist and a very interesting guy in his own right. Gary’s argument was a lot about what’s called naturalistic decision-making: you put people in certain environments and they very quickly solve problems. He talked about firefighters and emergency healthcare providers and so forth. The question becomes what is expertise and how does it work.

The way I would come down on this is expertise or intuition tends to work when you’ve trained yourself thoroughly in a stable and linear environment. The canonical example would be chess, but you could think of people such as expert drivers or even athletes or soldiers, who are trained in a specific set of environments that are sufficiently stable and linear that their actions always lead to the right outcomes. That’s where things like expertise truly can develop. If you introduce non-linear environments or unstable environments, it’s difficult to achieve so-called expertise.

This experience and expertise idea is important because there are often industries where people have lots of experience, but they don’t really have expertise. Experts are much less prevalent than people tend to think. Expertise tends to work in fairly narrow domains, and we can sketch out what those domains look like.

John: Does it make sense to think about expertise also in terms of what a machine could emulate versus what human experts are uniquely capable of doing?

Michael: If you are doing something that can be written down in a formula that is applied consistently, then a machine would likely be able to do your job. If you think about chess and Go, these games are computationally very difficult, so they lend themselves to machine power. But the rules are changing, for example, in chess, instead of us having an 8×8 board, if we change it to 12×12, and change the way the pieces move, there would be no machine that could beat it. There would be no humans that would be good at it either, but it would take a long time for the machines to be able to beat humans in that. If you can write down the rules and everything is bounded fairly well, machines are going to do well. That’s not general intelligence, to state the obvious. Those are machines that are developed to do specific tasks. This relates to how we can use machines or technology to help us in the world of investing, which is a hot and fascinating area. A lot of the applications are not that easy because markets themselves tend to be unstable and non-stationary, so it’s difficult to extrapolate the past into the future.

John: Let’s shift gears a bit to the psychology of investing. Why did you give it such prominence in the book, and what do you think is the crux of that topic?

Michael: I’ll mention a couple of things. One is I think I opened the introduction to that section with a quote from Puggy Pearson, who himself was a colorful gambler, and he had this line which was awesome. He said, “Ain’t only three things to gambling: knowing the 60-40 end of a proposition, money management and knowing yourself.” That pretty much encapsulates almost everything we need to know about investing, and the knowing yourself part is important. The point of emphasis in that section was how do we think about collective behavior, which we find all around us, but certainly is important in the context of markets.

I want to come back to that in a second, but there’s a chapter in there that’s a bit controversial, called something like “Beware of Behavioral Finance.” This is an important argument for people to take into consideration. A lot of the literature on behavioral finance deals with individual mistakes that you and I make. We tend to be overconfident. We tend to fall for anchoring, reframing, loss aversion. These are all things that we could demonstrate in a laboratory or in the classroom, and are certainly real, but it’s important to distinguish between those behaviors and what we actually see in markets, because markets are collectives. They’re people interacting with one another. The nature of collective behavior is different from individual behavior. Some people simply argue that humans are not rational, and since markets are made up of humans, that means markets are not rational. My argument is that the last thing doesn’t follow from the first two. The aggregation of even suboptimal individuals can lead to optimal results. Part of the point is that we’re not really talking about psychology when we think about markets. We’re talking about sociology, which is how groups behave in a group setting.

That was one of the big things I wanted to emphasize in that section, which was almost like a psychological or sociological approach to how to think about markets. It’s often left out in much of our discussions. If you study finance formally in the classroom, we typically start with simple models of rational agents and optimal behaviors and so forth, and you depart from that in terms of the real world. My point of emphasis is that this idea of psychology of investing and understanding how collectives operate is incredibly important to understanding how markets work, and ultimately, the ability to generate excess returns if that’s your objective.

John: How do you look at that in terms of the market at different points, meaning the aggregation of individual humans in normal times, let’s say, versus at points of extreme market stress?

Michael: The basic idea would be that markets tend to be efficient, and we’ll call it the wisdom of crowds. The wisdom of crowds is operative when three conditions are in place. Firstly, the underlying agents — in this case, investors — come to the market with diverse points of view. Some people are optimistic, some are pessimistic. There are technical traders, fundamental traders, short term, long term, etc. The second condition is that there’s a properly functioning aggregation mechanism. The information that is out in the world is reflected, in this case in particular, in prices. Exchanges do that very well, but I would note that sometimes aggregation falls down because people simply do not participate. The third is incentives, which are rewards for being right and penalties for being wrong. The argument [inaudible 00:28:35] to support this, is that when those three conditions are operative, you get an efficient market, even when the underlying agents have limitations themselves. A trivial example is the jellybean jar example, where if you have a jar of jellybeans and you pass it around to a group of people and ask them how many beans are in the jar, the individual guesses are usually not that good, but if you aggregate the guesses, you get an extremely accurate answer. Again, no individual is particularly good at it, but collectively, they’re extremely good at it.

The flipside of that is when the markets become interesting, and that is when one or more of those conditions are violated. By far, the most likely to be violated is diversity. Rather than each of us operating independently or with our own views, we correlate our behaviors. Humans are social, and investing is inherently a social exercise, so from time to time, it happens that people’s views collapse upon one another, and people all start to believe the same thing. By the way, even if you take an extreme example, such as the dot com bubble in the late 1990s through 2000s, not only were there a lot of enthusiasts buying these types of companies, but there were also a lot of naysayers who did not believe the values were appropriate, but they simply sat on their hands. They sat out. They didn’t do anything to change that narrative. They didn’t inject some diversity into the markets, which is tantamount to allowing that particular diversity breakdown to continue.

There’s a line I love from Seth Klarman at Baupost, where he says value investing is, at its core, the marriage of a contrarian streak and a calculator. The contrarian streak says when others are bullish or bearish, examine the other side of the case. That need not be a simple way to make money, because sometimes the consensus is correct, and by the way, positive feedback is something that we see a lot in nature in order to survive. So it’s not just being contrarian — the second component is essential, and that’s the calculator. Because everyone is uniformly bullish or uniformly bearish, that’s led us to a set of expectations that are unduly high or unduly low, and that company or that industry simply cannot satisfy that set of expectations that’s priced into that particular stock. As a consequence, there’s going to be a reversal. To me, that’s the package: let’s think about market efficiency, let’s use this wisdom of crowds framework and the conditions, and then introduce the Klarman thing which is this contrarian streak plus a calculator. It seems like everybody has a uniform point of view, which seems to be what’s expressed in the security price, and through an expectations approach, I’m going to reverse engineer and say it’s a good bet to be on the other side of the argument.

John: Shifting to part three of the book, innovation and competitive strategy, what do you mean when you say that creative destruction is here to stay?

Michael: Paul Romer recently won the Nobel Prize in Economics for his work on exogenous growth theory. What I learned from Romer’s work is that innovation essentially is the recombination of building blocks. You could think about certain chunks of ideas or technologies as building blocks, and by recombining them, we can solve problems in the future. The degree to which we have more building blocks available at our disposal, and we have tools to manipulate that, such as computing power, that means we should not only have steady rates of innovation, but even potentially exploding rates of innovation. That, to me, is this argument on creative destruction or innovation: because the building blocks are there, we are going to continue to see innovation. There may be complicating features, such as policy or regulation or things like that, that may accelerate or stall the rate of innovation, but the core idea that Romer laid out in terms of exogenous growth is a powerful construct. That was the argument I was trying to make.

John: Perhaps more generally, how do you think about the impact of innovation — in particular what we’re seeing today in terms of disruption across industries from technology-driven innovation —on the sustainability of competitive advantage?

Michael: This is a tricky one. I think there’s a bit of an arm wrestle going on between two sides of this argument. The first side, which has been the argument of impeding innovation, speaks mostly from the point of view of the United States, although to a degree it’s relevant in other markets as well. In the United States, certainly in the last 20 or 25 years, we’ve seen a substantial consolidation of industries. If we look at the Herfindahl Index, which is a measure of industry concentration, it has been going up, which means industries are becoming more concentrated. Most of that is a consequence of mergers and acquisitions. In the United States, the Justice Department and FTC allow companies to merge. With fewer participants, that is likely to lead to easier coordination on pricing, etc.

Many would argue that to some degree, that has blunted innovation. I alluded to this a moment ago, but to reiterate, things like regulation, which are meant to control the behaviors of incumbents, often can become a barrier to competitors. Regulatory adherence can sometimes be a cost that’s too onerous for an upstart to deal with. Financial services is an area where that’s a consideration — think about the amount of money that the large banks, certainly in the States but also elsewhere, spend on compliance. It’s a difficult thing to tackle.

On the other hand, it’s what I mentioned a moment ago, which is the recombination or putting together of technologies in a way that is fairly novel and that should lead to new solutions to problems. Amazon.com is a good example. At the time it came along, it was able to tap into things like the internet, obviously, but also a distribution system in the form of the postal service or UPS, different types of software, technology for warehouses, and so forth. These things all came together in a way that would clearly have not been possible 10, 15 or 20 years before. I think that kind of theme is going to continue as well: what resources do we have at our disposal.

To answer your question more specifically — and this is an ongoing thread of research in terms of thinking about competitive advantage — there are some thoughtful papers (the main ones are by Wiggins and Ruefli) on the argument that competitive advantage has been shrinking. You measure that specifically by looking at excess returns, so excess rents that are being earned, but it is difficult to measure. We can certainly look at the past, but it’s difficult to look at things today. My own sense is it’s difficult for certain companies to stay on top. On the flipside, if you look at, for example, margins of businesses, what we’re seeing is that in the top 20% — the top quintile, or really, the top decile — certain types of businesses are very strong, and you think about certain businesses that have strong network effects. It’s not super clear how those network effects will be eroded by competition.

The long and short of it is I don’t really know. I do think as an investor, when you buy any particular stock, you should think about what kind of competitive advantage you’re paying for, and whether that’s plausible given a thoughtful and thorough competitive strategy analysis. To come up with a concrete judgment for any particular company or industry or sector is a tricky task.

John: In the book, you ask the question, “Is there a fly in your portfolio?” Tell us about the metaphor of fruit flies.

Michael: That’s related to the question you just posed. The metaphor there was about this fly called Drosophila, which is a particular type of fly which geneticists have studied because they reproduce quickly. You get lots of generations that happen, so you can analyze how various things happen. It’s almost like it speeds up the world. The question I thought about or mused about out loud — and there are certain academics who certainly hold this view — is whether we’re simply speeding up. The world is speeding up and we’re becoming more a world of Drosophila, where things are happening faster and faster. There’s a professor, Charles Fine, who has done work on certain cycles of speed for various industries and makes the claim that the clock speed has been accelerating. That is the basic argument.

These are all things that investors should take into consideration when they’re looking at a particular company or product. What is the likely life of this product? How do I think about that? What could unseat it? Certain companies have to create new products rapidly even if it’s in the same business. Think about the evolution, for example, of disk drives, where product lives are short and you have to have a new product behind the old one in order to continue your competitive positioning. That’s the idea behind the Drosophila.

John: Is there a link to profit margins, which have been near historical highs? How do you think about reversion to mean there in light of innovation?

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We had the pleasure of chatting with Texas-based investor Tom Jacobs, a senior investment advisor at Maridea Wealth and Huckleberry Capital.

Tom discussed Maurece Schiller’s books on special situations, including How to Profit from Special Situations in the Stock Market. Tom has edited and republished the books with authorization of Schiller’s descendents.

The following transcript has been edited for space and clarity. (MOI Global members, access all features, including ways to follow up with Tom.)

John Mihaljevic: Tell us how this project came about, with you taking on the editing and republishing of Maurece Schiller’s books on special situations.

Tom Jacobs: It was quite accidental and, in some ways, ironic. I was the adviser on a special situations research project at The Motley Fool. My senior analyst, Jim Royal, and I were devotees of Joel Greenblatt’s highly influential You Can Be a Stock Market Genius. We wondered where this came from. Was this invented out of whole cloth? One day Jim Royal, my associate, sent me a PDF with no comment; this is typical of Jim and me. I opened the PDF and it said Investor’s Guide to Special Situations in the Stock Market by Maurece Schiller. Where Jim is quiet, I am not. I began jumping up and down. I told him we have this book from 1966. I went through the table of contents where I found every special situation you could imagine 31 years before You Can Be a Stock Market Genius was published.

John: How did these books get lost to history prior to you finding them again?

Tom: It’s somewhat of a mystery. In 2014, I located Schillers’ two adult children who are both in their 80s. I told them this is great stuff. It’s been lost. They initially responded, “Who is this guy?” These books were on their father’s shelf, and he never talked about them. They didn’t understand their significance. I asked, “How many others are there? What do you think about republishing them since they’re out of print?” These books might have been out of print and unknown because Schiller was an extraordinarily private man, according to his children. He was not self-promotional. Also, the big reputations in our world accrue to the hedge fund managers with demonstrable investment partnership records. Schiller was a registered representative. He was the equivalent of today’s investment adviser. He wasn’t out there. He wasn’t running Graham-Newman.

John: Do you know whether Joel Greenblatt had read the books originally? Have you spoken with him since the project?

Tom: Yes, he knew of the books. For example, you might have seen the notes from Joel’s course floating around the internet in the early 2000s in which he clearly identified Schiller’s 1959 book. When I started and thought this would take half of the time or a third of the time that it took, Joel was more than willing. He was wonderful, and he spoke with me for a bit. He was pleased this was happening.

I must tell a related story. How did I get to speak with Joel Greenblatt, who is a god to me and all of us in the special situations field? It turns out I was involved organizing my 40th high school reunion. I got in touch with Blake Darcy, who was Greenblatt’s right-hand man in launching the mutual funds. Can you believe that? I played with Blake in elementary school. Anyway, he said, “Of course I’ll connect you with Joel.” Joel was extremely gracious and supportive. He hands these around in his classes, he told me.

John: Let’s delve into the books. Why are there five? How are they structured?

Tom: Schiller kept a scrapbook. For example, he had reviews of the books. He had this little essay – I don’t know if it was a speech or something like that – and he talked about why he wrote and published the first book, Special Situations in Stocks and Bonds, published in 1955. He said he knew no one else in the field. He had been employed in the securities business since 1920 when he was about 20 years old. At that point, he started as a runner.

Also, he was a terrible student. He spent a year at Dartmouth and then tried a year at NYU. I got his transcript from NYU, and he didn’t get a grade above C. They were all Cs, Ds, and Fs. It’s clear to me he got the Wall Street bug. He reported he was an intern one summer and said, “To heck with school.” Then worked his way up. He clearly had great research skills.

He wrote in this unpublished essay how he watched the securities world grow pre-SEC and post-SEC. He wrote about how he devoted his career to helping the individual investor, whom he thought the system ripped off, certainly pre-SEC. Then he committed to individual investors in the fee-based world. He began developing special situations. He didn’t invent the field. This was in the late 1930s, a period we associate with public utility and railroad reorgs and arbitrage, distressed debt, Heine, and with Michael Price. He worked on special situations into the 1940s, but he didn’t know people who specialized in it as a field. They do this part or that part. We know, for example, Graham only wrote maybe a page-and-a-half on the subject. These were discussed, and Schiller said, “This has been my life’s work. I know all about it. I have file folders full of trade records showing special situations in practice, special situations I recommended to clients. I will write a book in part to satisfy my own ego.”

John: How does the sequence of the books go in terms of what’s covered in each one?

Tom: I hear that question often because the books are sold individually, not as a set. I want to create a boxed set sometime. People ask, “Which one should I read first?” John, from your excellent work at Manual of Ideas, you and I share a certain mindset where we love reading investment history. I love reading the Schiller books and seeing developments from book to book. However, the developments are subtle. In the early books, he is freaked out by the Great Depression, and this theme persists throughout his books and his professional career as much as we know from his children. Schiller was averse to risk, and special situations are perfect for the risk-averse investor who still wants to pursue excellent returns, the value-based investor. He started out with the idea – and this is absolutely in 1955 – saying, “I want to protect individuals from charlatans and losses. I never want anyone to go through the Great Depression-type thing again.” Then over the five books, he started to loosen up a little.

After World War II, the economy boomed. The U.S. had all the factories. Germany and Japan had been all bombed out. Europe was devastated. For a 10- to 15-year period the U.S. operated essentially as a monopoly. The U.S. grew in everything until the Japanese introduced cars in the late 1960s. The second factor concerns a technology transfer from the war to the private sector. Hewlett-Packard and Texas Instruments started along with the military contractors.

In the second and third book in 1959 and particularly 1961, in Fortunes in Special Situations in the Stock Market, Schiller introduced this theme: “I’m a purist for special situations. I want to measure risk.” He was so academic and obsessive about it, he practiced it in the real world. He started saying, “I cannot deny the wealth created in post-World War II, new era companies.” He started adding these observations in the books even though there’s nothing in special situations about a fast-growing tech company. The analogy is of Munger influencing Buffett to be more growthy. However, Munger had a pay-up for quality mentality. Schiller, with the tech companies, was willing to take a bit more risk. It’s completely strange and different, but it’s a development. Schiller lost 5% of his fear of the Depression, and he embraced the booming market of the 1950s and early 1960s.

John: It sounds like around the time these books originally came out, Buffett was running his partnership, and he had a bucket called “workouts.” Would you say those workouts were in line with what Schiller would call special situations?

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