Aswath Damodaran, professor of finance at the Stern School of Business, New York University, in conversation with Morningstar's Jeff Ptak and Christine Benz. An extract from their conversation.
#1. Keep the faith.
There’s a crowd estimate of value out there in the market price. If you have a publicly traded company, you are making a bet that your estimate is better than the estimate that millions of people have put into the value of that stock. And that requires faith.
Valuation and Investing is an act of faith.
Faith, because you don’t know whether the number you’ve come up with is the right number—it’s different from the crowd estimate, and you need faith to act on it. Most people who claim to be valuation analysts don’t have the faith in their own valuation.
A good analyst will start with the premise that it’s OK to have your faith shaken, that you got to make an estimate that that estimate is wrong. I’ve never felt certain about a valuation, ever. If you’re feeling certain about a valuation, there’s something you’re missing in the process that’s leading you to this point of certainty where you feel that you’re right and the market is wrong.
I take issue with those who treat value investing as the heart of all investing. I call them value extremists. Their premise says that the market is always wrong and is full of shallow, stupid people. We are the enlightened ones, who think about the things that matter, and have an estimate of value that’s right and the market has to come around to our estimate.
I’ve never taken that attitude.
#2. Don't let arrogance get the better of you.
As an investor, you’re never the master of your craft. You keep working at it. The market will throw surprises at you. No matter how successful you’ve been in the past, there are more surprises to come.
The essence of investing is to learn that you’re going to continue to make mistakes.
I’m going to be wrong. I hope I’m a little less wrong than the market. You don’t have to be right to make money; you just have to be less wrong than everybody else. It brings down your anxiety level a great deal to know it’s OK to be wrong.
Another hallmark of the world we live in is we tend to hang out with people who think just like we do. We pat each other on the back, we agree with each other, and then we go back to our desks, and the whole thing blows up. I’ve learned some of the most valuable insights in valuing companies come from listening to people who disagree with me the most.
#3. Figure out what makes a business tick.
Single-dimensional analysts, people who claim to be experts on one sector and one approach to valuation, get tunnel vision. I find myself constantly telling people to step back, take perspective and elevate themselves.
I remember the first time I valued Uber. I knew nothing about ride sharing and I could say the same thing about most of the companies I valued. There are people out there who know 100 times more than I do. But I keep the feedback loop open. When you value a company, you start a process. It’s not the end of the process. Leave yourself open for when somebody says that it doesn’t make sense. Rather than get defensive, listen.
Hang out with people who think less like you. The first person I showed my Airbnb valuation to was not an analyst, it was to a friend of mine who is an Airbnb host. Because I wanted to see the holes in my story. What am I missing in the interaction between Airbnb and a host that I’ve not brought into valuation? You’re not going to hear that by talking to an expert in that area or to another analyst. You’re going to get more about that from talking to people who have rented an Airbnb recently or are hosts on Airbnb.
These are not valuation people that I talk to but people who know the business. Valuing a company is understanding the business. Understanding a business is not going through a financial statement and computing ratios. It’s figuring out what makes a business tick.
#4. Don't ignore Terminal Value.
Let’s say, you’re valuing Zoom, and you are optimistic. It’s a neat platform. We all use it. But even the most upbeat optimistic person on this platform will accept that this is not the platform we are going to be using 15 years from now. Technology shifts too much. We don’t even know what media we will be using. With AI who knows what the process will look like?
So, if you’re upbeat about Zoom and you’re projecting earnings and cash flows growing over the next five years, I’m all with you. But if you say that it’s going to go on forever, my question is, why? It’s a technology. It will die. When the technology dies, the company is going to go down with it.
Yahoo was not a bad company. It was a search engine, but that’s all it was. Once Google ate its lunch, it had nowhere to go. And with technology companies, that becomes part of the problem is as the technology fades, the company fades with it.
A few companies have managed to find a new life, and they’re often always offered as examples. Apple. Microsoft. But you cannot let exceptions be the driver of how you think about investing. You got to create rules that are looking at across the cross section what companies are able to do.
#5. Stay agile.
Markets start off inefficient, move toward efficiency. Market efficiency ebbs and flows.
People come in, they try to make money, they make markets efficient, markets become efficient, people stop trying to make money, markets become inefficient again. So, this is an ebb and flow process where there are times when you have more mispriced stocks and times when you have less mispriced stocks.
Depending on the time, you might find fewer or more companies to invest in. In a period of relative efficiency, you might put your money in an index fund. Then you sit back and wait. Six or 12 months later, a crisis hits. People behave irrationally and panick. You might be able to find stocks that are now mispriced again.
You got to recognize there are windows that open up and close up, and you’re trying to find those windows and take advantage of them.
Markets do find mistakes and correct them over time. That’s what drives me to be an investor. If I thought markets never corrected their mistakes, I would never make money. The question is, how long does that opportunity last? I think that lasts long enough for you to take advantage of it if you have faith. Because the moments at which you can invest in these companies could be moments that are most terrifying for you, like when Facebook reported their earnings report with that Metaverse investment and the stock dropped and everybody was fleeing and convinced that Mark Zuckerberg was driving the price to zero, was the time to buy Facebook. So, often it means being willing to take actions that make you uncomfortable, even though the rest of the world is telling you don’t do it.
Don't forget these gems:
- Valuation and Investing is an act of faith.
- The essence of investing is to learn that you’re going to continue to make mistakes.
- You don’t have to be right to make money; you just have to be less wrong than everybody else.
- Technology shifts. Technology dies.
- Some of your most valuable insights will come from listening to people who disagree with you the most.
Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter
