#44 – The Think Tank Manager

HOW STEVE KNOWS THE GUEST

Steve read Dan’s book in a morning, sitting by the pool in Dubai at Christmas. He emailed Dan who quickly replied and they scheduled a call in January when Dan agreed to come on the podcast. They hope to meet in person when Dan visits London later this year.

Chapters

Transcript

STEPHEN CLAPHAM: Hi, welcome to the Behind the Balance Sheet podcast where we meet leading investors and commentators and educate ourselves about the world of investing and the world. Our mission is to remove some of the mystique around investing and improve our understanding of what makes a successful investment or indeed an unsuccessful one. Our goal is to inform, educate and entertain. We hope you enjoy this and every episode.

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STEPHEN CLAPHAM: Dan Rasmussen is the founder of quant shop Verdad Advisors and author of an excellent weekly vlog and a new book the Humble Investor. I’ve enjoyed his blog for a long time not just because we’re both skeptical of private equity and its ability to continue to deliver anything near historical returns we’re also both wary of private credit but it stands arguments which i find interesting because they’re almost invariably thought-provoking our discussion in the podcast touches on private equity but we mainly cover topics where we are less in agreement for example the importance of profit forecast where Dan’s research suggests they’re a bit of a waste of time but i know that a good analyst can generate significant returns by getting long-term forecasts more accurate than the market. We also disagree on forecast horizons. Dan thinks you’ve got the best chance of getting the next order right because it’s close as thin. But my experience is that quarterly forecasting can be much more variable, and you can have much greater confidence looking 18 months out in many cases.

STEPHEN CLAPHAM: Dan thinks growth isn’t that persistent. I argue there are lots of great companies like Coca-Cola where growth has been highly persistent over decades. It isn’t so much that we disagree on these subjects, it’s more that we view these factors through different lenses. We discussed Dan’s favourite metric, gross profit total assets, why it’s important and why it’s persistent. I really enjoyed talking to Dan and I’m sure you too will enjoy our conversation. So Dan, welcome to the podcast. I’ve been reading your blogs and Substack for quite a long time and really enjoying it. So I’m delighted you’ve come on. And you started in private equity after graduating from Harvard and doing an MBA at Stanford. I’m guessing you didn’t always want to be an investor.

DAN RASMUSSEN: You know, I didn’t, Stephen. I studied history and literature as an undergrad, and I actually wrote a book. A book that was my senior thesis about a slave revolt in New Orleans. So I think if you’d asked me in college, I would have said, you know, maybe I want to be a historian or a writer.

DAN RASMUSSEN: But when I was graduating from college, I talked to a bunch of people and all my favorite professors said, absolutely don’t become a professor. It’s the worst career ever. Don’t do it. And then I talked to my dad, who’s a lawyer, and he said, you know, Dan, you know, I was the top of my class at law school.

DAN RASMUSSEN: All the people at the bottom of my class went into business. They weren’t as smart as me, but they made three to five times as much money, retired 10 years ago and didn’t work as hard. So don’t become a lawyer, go into business. It seems like it could be relatively easy.

DAN RASMUSSEN: And so I was sort of inclined to try business and I went and applied to a bunch of random jobs and I ended up getting a job at Bridgewater. And I was very lucky that I did because Bridgewater’s approach at that point was very much focused on studying history to derive the lessons that you could take from history and then apply it to trading different securities in the present.

DAN RASMUSSEN: And so I sort of thought, well, gee, maybe investing is a place where I can take my interest in studying history and indeed philosophy and a variety of other things and apply it to trying to make money, which obviously would be preferable to not making money. And so I think that’s really what got me interested in the field. And that’s really been true. It’s really the way I’ve built my investing style.

DAN RASMUSSEN: And what I’ve focused my research time on is saying, you know, gee, the future is really wildly unpredictable. It’s really hard to know what’s going to happen in the future. But can we study the past to derive lessons about the way we should behave? And I think that’s been, you know, one of the kind of guiding questions that has motivated my research and writing in the years since.

STEPHEN CLAPHAM: So the book, I mean, I was quite surprised because when I looked up your current book, which we’re going to talk about, The Humble Investor, which I’m sure, I mean, it’s a great book, I’m sure it’ll be a huge success.

STEPHEN CLAPHAM: But you were already a New York Times bestselling author with your first book, American Uprising, the untold story of America’s largest slave revolt. So, I mean, what made you write that? You were still at university when you wrote that, you became a New York Times bestselling author.

DAN RASMUSSEN: Yeah, so it was my senior thesis. I was just, when I went into college, my older brother actually gave me advice. He said, you know, in college, no one respects a generalist, so pick some very narrow niche and focus on it.

DAN RASMUSSEN: And so I was very interested in history. I got very interested in sort of the 19th century American South, the history of slavery and American expansion.

DAN RASMUSSEN: And probably my sophomore or junior year, I came upon this Slaver Vault, which was, you know, I was taking mostly independent studies at that point, and I got very interested in it. And so I spent, you know, two years. Three years, you know, researching and writing this book.

DAN RASMUSSEN: And so perhaps the only analog from that to investing is that I’ve remained very interested in this idea, obviously, of studying niches, you know, staying in narrow areas where I can feel like I can get a lot of expertise, rather than sort of entering the, you know, it’d be very tough to write a bestselling book about the Civil War as a 21 year old, but to write one about an obscure slave revolt, you know, much easier.

DAN RASMUSSEN: It’s it’s It was an unusual topic.

STEPHEN CLAPHAM: It’s much easier. But to get on The New York Times bestselling, I mean, that’s a pretty amazing achievement. You know, if you’re doing that now, I mean, to do it when you were a university student, is that what made Bridgewater hire you?

DAN RASMUSSEN: No, no. And in fact, this didn’t come out until I was already working at Bain Capital. And I didn’t tell anyone about Bain Capital about it until it came out because I didn’t want to. Them to think that I was slacking off and not doing my job. So I would just do it on sort of nights and weekends, finishing up the book and editing it and stuff. And then, yeah, so it was a surprise to everyone.

STEPHEN CLAPHAM: What made you want to write a book, another book?

DAN RASMUSSEN: From the beginning, when I started my firm, Verdad, I started writing a weekly research blog and I’d mail it out to everybody, first to my investors, and then the group became broader. And it was all my thoughts about investing, all the research I was doing. We do a ton of research here. I sort of think of my firm as a think tank that manages money. We’re constantly studying different things.

DAN RASMUSSEN: And then we translate that research into actionable investment strategies or decisions in real time. And after last year was our 10-year anniversary as a firm, and I got to thinking, you know, maybe this would be a good time to step back and say, well, what does all this mean? You know, I’ve been writing these weekly pieces that…

DAN RASMUSSEN: It sort of might comment on something that’s going on in the market that week, or it might comment on a piece of research that we’ve done on some esoteric topic. But what is the underlying thesis, or what is it that ties them all together? And can I put the best of our research together in a really punchy book that would convey sort of our core ideas to a new set of readers, hopefully?

STEPHEN CLAPHAM: Well, it’s a really excellent book. I mean, I’ve enjoyed your writing, as I said. I’ve enjoyed the weekly, but… The book’s divided into three parts. So the first section is on how bad we are at forecasting.

STEPHEN CLAPHAM: Part two, you critique conventional investment theory. And part three, you look at market timing, bubbles and crises. So part one is about forecasting. And you show how bad we are at it. Do you want to start with telling the story? Because I think it’s a good scene setter of how the rats beat the Yale students.

DAN RASMUSSEN: Yeah, this is a wonderful old experiment. And they basically, they have two feeders, food feeders, and I’m going to get it approximately right because I’m not reading from the book. But the feed comes out of the one side about 60% of the time and the out of the other 40% of the time, but it’s random which side it comes out other than that it’s weighted to one rather than the other.

DAN RASMUSSEN: And it turns out that pretty quickly the rats figure out that more comes out of one than the other. And so they just sit there at the one that 60% of the time the food comes out of, and they just don’t move. So it’s an effective strategy. They figure out how to win. The Yale students, however, try to discern patterns in the randomness.

DAN RASMUSSEN: So they think, well, this must be some sort of math puzzle. And so if it comes out here, and then here, and then here, maybe it comes out twice here, and then twice there. And so they end up being much worse than the… Rats, their expertise or their faith in their own expertise. Their intelligence is what damns them relative to the simple strategy of pursuing base rates.

STEPHEN CLAPHAM: Yeah, it’s a very funny illustration. The book’s full of good illustrations. But, you know, I was really interested because you think that forecasting is fundamentally a waste of time. And so my question to you is, without I do disbelieve you and I’ll argue with you in a minute, but why is it that you think you’re right when every equity analyst in the world is busy looking at earnings forecasts and occasionally the cash flow?

DAN RASMUSSEN: Yeah, this is a great question. So I’ll start by saying let’s take out an extreme position, which I’ll call future nihilism, which is the idea that nobody can predict anything about the future. And I’m not quite there and I don’t think that’s the right answer. But let’s start from there.

DAN RASMUSSEN: And because I think that’s the bar we have to jump over. We have to prove that we’re better than complete nihilism. And future nihilism would essentially assume, you know, random chance that, for example, you know, a company’s earnings growth is completely unpredictable. So perhaps the best predictor of future earnings is today’s earnings, maybe plus or minus GDP growth.

DAN RASMUSSEN: And it turns out that for earnings forecasts, that’s actually a really hard bar to hit. That when you look at actually statistically how all these analysts do in predicting earnings, they really don’t beat a simple bar like take the mean and grow it at GDP.

DAN RASMUSSEN: That tends to be probably 20 or 30 percent more accurate than analyst forecasts. And the reason it’s more accurate than analyst forecasts is related to the methodology that most analysts use. Most analysts, when they try to predict the future growth of a company, look at the past earnings. Growth, right?

DAN RASMUSSEN: So they say, okay, well, this company grew revenue 5% last year and 7% this year and 9% the year before. And therefore, I’m going to put it as somewhere between a 5% to 9% grower. And so that’s what I’m going to extrapolate into the future. So they’re starting by extrapolating the historical financials.

DAN RASMUSSEN: And what we did is we looked at an old paper, a beautiful paper called The Persistence and Predictability of Growth and updated it with the latest 20 years of data. And what we showed is that Past growth, either of revenue or earnings or cash flows, does not predict future revenues, earnings or cash flow growth.

DAN RASMUSSEN: So the top quartile, for example, has no more likely, no more probability of being in the top quartile of future growth than the bottom quartile. And you can look at it even another way, which isn’t in the book, but was one of our recent research pieces, where Japanese companies are required to issue one year forward guidance on revenues and net income.

DAN RASMUSSEN: And they’ve been required to do this for 20 years. So you have a complete data set of how every public company in Japan thought they were going to grow earnings at every given point and then what ended up happening. And what we did is if you divide that into three groups, you know, your lowest growth, your middle tier of growth and your highest tier of growth.

DAN RASMUSSEN: You find that Japanese companies are about 50% accurate at sorting themselves into those three categories, which is kind of great, right? So random chance would be 30%, they’re at 50%. So they’re more accurate than random chance, almost twice as good at random chance.

DAN RASMUSSEN: But 50% of the time, they’re still way out, way wrong, right? They thought they were gonna be a fast grower, and they were medium grower, they thought they were gonna be slow grower, and they were fast grower, right? So the future, the unpredictability of the future is sort of an impossible, and remember, this is just one year forward.

DAN RASMUSSEN: So this is like in April predicting… Revenues through next March. So even on this very short horizon, they’re wrong directionally 50% time. 50% on their right was better than random chance. But what then becomes even more problematic is what happens when they’re wrong.

DAN RASMUSSEN: So it turns out that if you are high growth and you predict high growth and you achieve high growth, your stock does fine, a little better than the market. But if you predict high growth and you don’t achieve it, the market punishes you quite badly. And so in aggregate, betting on the high growth firms ends up being slightly worse than the average.

DAN RASMUSSEN: On the other hand, if you look at the low growth predictions, if you predict low growth and you achieve low growth, the stock market, you’re fine. You do a little worse than the average, but you’re basically fine. But on the other hand, if you predict low growth and then you achieve high growth, your stock goes way up.

DAN RASMUSSEN: And so on average, the stuff that predicts low growth actually does slightly better. And I think it’s in this essence, this. Sort of arbitrage in the way of looking at the world is to say, well, gee, if the biggest arbitrage is that other people think they can break the future, but 50% of the time, plus they’re wrong, what opportunities does that open up to me as an investor?

DAN RASMUSSEN: What should I do in response to that data? Well, first, I need to be humble about my own abilities. So first thing, let me stop doing that. Because if I know that I’m going to be just like those Japanese companies, I might be the experts on them.

DAN RASMUSSEN: It might be a short-term forecast, but 50% of the time, they’re wrong. Probably 50% of the time, I’m going to be wrong. And if the punishment for being wrong is this great, well, gee, it makes doing it not even worthwhile.

DAN RASMUSSEN: And what I want to do, therefore, is to say, well, if this worldview is right, if in fact predicting the future is so much more difficult than people think it is, and people are making these sort of systematic errors in terms of doing this and betting on it, you know, how can I arbitrage that? What should I do? And that’s really the sort of provocation that the book poses in the first few chapters.

STEPHEN CLAPHAM: It’s. Quite a radical idea. I mean, I don’t disbelieve your research, but I’m just curious as to why nobody else has done this.

DAN RASMUSSEN: In some sense, it’s because I do a lot of deep quantitative research, but I began as a fundamental investor and I ask relatively basic questions, you know, whereas I think a lot of academics, they’ve never actually worked in fund management. So they don’t realize the percentage of time that’s spent by your average analyst building these LBO models or DCF.

DAN RASMUSSEN: Models, right? So it just doesn’t occur to them to think, oh, really, that’s all they’re, you know, they think they have this sort of abstractions, like, oh, they’re making markets efficient by reacting to historical data or reacting to news, but they don’t understand that the reaction function is channeled through a model.

DAN RASMUSSEN: And once you realize that the model is driving these decisions, that people are spending all this time updating these models, this is a core activity of people on Wall Street, then you have to start asking, well, how accurate are the models? And, you know, you find that the Wall Street firms themselves don’t spend a lot of time on that.

DAN RASMUSSEN: If they would, they would have stopped years ago.

STEPHEN CLAPHAM: I mean, it’s not surprising that the sell side don’t spend time on, well, they might spend time checking how well they do for internal consumption. But I mean, I can perfectly understand why they wouldn’t want that to be externally consumed because it wouldn’t show them in a very good light.

STEPHEN CLAPHAM: But there is the idea of the equity analysis become much more. Professional in recent years. And it would surprise me that if some of the big firms don’t look at this very carefully.

DAN RASMUSSEN: Yeah.

STEPHEN CLAPHAM: Because I would argue that I’m very good at forecasting company profitability. Now, that’s not to say that I’m very good over a large universe, but I’m very good at finding things that I can forecast better than the stock market.

STEPHEN CLAPHAM: And it would be very surprising to me if firms like BlackRock and Fidelity and so forth, these multi-trillion dollar firms that are… Employing hundreds of analysts and producing thousands of models every year. It’d be very surprising if they weren’t testing how accurate they were.

DAN RASMUSSEN: I think that anyone that’s tested it has found basically what I’ve found, which is this huge degree of unpredictability. And if they test it correctly, they’ll generally find that the forecasts are worse than using just a mean forecast. It’s really hard to beat a mean that grows at GDP.

DAN RASMUSSEN: The variance and forecast is too big and the error rate is too high. And I think that, you know, Stephen, one of the things I’ve reflected on is, and there’s this fundamental tension you’ll hear these days, people talking about the pod shops. And they’ll say, you know, gee, the pod shops are so forecast, so focused on next quarter’s earnings.

DAN RASMUSSEN: You know, why are they so focused on next quarter’s earnings? And my take is that predictability sort of has to be better in the short term than the long term, right? Like it’s got to be easier to predict tomorrow. Than it is next week. And it’s easier to break next week, the next month, it’s easier breaks next month, the next year, right?

DAN RASMUSSEN: It’s just got kind of sort of has to be that that way. And so I think that maybe the reason all the pod shops are so focused on next quarter’s earnings, it’s the only place that can really get an edge. Because the longer term forecast becomes so much more difficult to do. You just have more future uncertainty compounding, and more potential room for error. And I also I.

STEPHEN CLAPHAM: Completely disagree with that because and you know i’ve done this and i’ve spent a lot of time thinking about it a lot of time doing it because when i was in the sell side i used to get phoned up every quarter by what are now the pod shops so the predecessors forerunners of the pod shops and i’ll spare them the embarrassment by naming them but their their principle is a you know one of the richest men in Wall Street.

STEPHEN CLAPHAM: And these guys would phone me up and they’d say, oh, Steve, we’d like to know your forecast for the next quarter for an airline.

STEPHEN CLAPHAM: And I’d say, you know, we had this conversation three months ago. I don’t really know why you’re calling me because I told you that my probability of forecasting this airline’s quarterly profit next quarter is very, very limited because there’s so many, you know, there’s so many variables.

STEPHEN CLAPHAM: Where… I have an idea that I’ve had some external confirming evidence that something’s happened that isn’t in the analyst model. So I think that they’re going to either beat or miss significantly.

STEPHEN CLAPHAM: Then I’ll give you a call so you can save your phone bill and your time. And of course, we did this, we had the same joke every quarter. But I think that there’s a huge, particularly with a stock like a company like an airline where there’s a huge number of random elements.

STEPHEN CLAPHAM: But what I think is is perfectly possible is that if you look at 18 months you can find a number of companies where the stock market and analysts have failed to recognize some change in the external environment which dictates that the probabilities are very heavily skewed either to a beat or a miss.

STEPHEN CLAPHAM: 18 months out. So this is just to say that there’s more randomness, I think, in the short term, and more ability to apply skill, looking at, you know, a 12 month picture, an 18 month picture, a 24 month picture. Do you disagree with me?

DAN RASMUSSEN: I mean, yeah, I mean, I think that, you know, we can I think I always have to be careful in what I’m saying to differentiate between, I don’t think it’s impossible that skill exists. So I’m not one of those extremists that says there aren’t people that are really skilled. I think there are people that are really skilled, but what I’m concerned with is the average or the sort of market cap weighted reality.

DAN RASMUSSEN: And I think that I can’t tell you about you and I can’t tell you about Citadel, or I can’t tell you about people that are… Super high achievers, but I can tell you about on average. And I can tell you that on average, when you start studying this, the ability to predict the future declines over time, the further out that you go, the more unpredictable the future becomes.

DAN RASMUSSEN: And I think that perhaps the reason that people don’t like to acknowledge this is they say, well, when I try to do short-term forecasts, I’m wrong so much of the time. I must be better at the long-term forecasts. And I think that’s just selective memory a lot of the time that people…

DAN RASMUSSEN: When you think about short-term forecasts, you think about all the mistakes that you make, because of course you make mistakes. And then with the long-term ones, you know, two years later, you’ve sort of forgotten that you made that forecast or you’ve adjusted it some way. And so I think that the reason that a lot of firms, you know, don’t go through and systematically build.

DAN RASMUSSEN: You know a database of past predictions and so why would i do that you know why would i take predictions from five years ago you know what use is that to my business today it’s an introspective journey but it’s but it’s tremendously revealing of how difficult the problem is i don’t know Citadel particularly.

STEPHEN CLAPHAM: Well and it wasn’t who i was referring to but you know let’s take a generic pod shot I mean, I would be amazed if they weren’t measuring exactly what their analysts were forecasting and working out what they were good at and what they were bad at in order that they could improve their accuracy.

DAN RASMUSSEN: And I think they are. And I think we’ll see them entirely focused on next quarter.

STEPHEN CLAPHAM: Yeah, that’s fair enough. I mean, you also you think the capital asset pricing model is a waste of time, which I completely agree with you. I’ve never I mean, I understand it’s a useful construct. To understand a theory, but it’s of no practical use whatsoever.

DAN RASMUSSEN: It’s of no practical use, and it’s such a waste of time that it’s forced upon finance students worldwide to construct these silly things.

DAN RASMUSSEN: I think a big part of the problem, right, we’ve talked about the unpredictability of future growth. Risk is equally unpredictable. I don’t think if you can’t break future… You can’t predict the numerator and you can’t predict the denominator. You can’t predict the X and you can’t predict the Y.

DAN RASMUSSEN: You know, how are you supposed to know how volatile a stock is going to be multiple years in the future, how risky it is? I mean, I think there’s this sort of intuition, right, that, you know, risk and return should be related. And where I think the mathematicians have gone wrong is not allowing for the possibility of errors and not allowing for the possibility of imprecise predictions, right?

DAN RASMUSSEN: There sort of has to be a model where risk and return are linearly related. But what if we just don’t know either variable and the future is kind of chaotic and random and we’re trying to separate some signal from the noise? And it’s not going to explain.

DAN RASMUSSEN: The CAPM just doesn’t explain this, particularly for equities. Higher volatility equities do not have higher returns than lower volatility equities on average. Where CAPM can be more useful is sort of as a. A broad intuition around asset classes, right? Okay, stocks are more volatile than bonds and they have higher returns than bonds, but it’s not always true.

DAN RASMUSSEN: Oil is a heck of a lot more volatile than stocks, but oil doesn’t offer higher returns, right? Just the fact that something is volatile tells you something about its volatility, but it doesn’t necessarily tell you something about its returns. And I think that’s where CAPM fails.

STEPHEN CLAPHAM: No, I thought the Warren Buffett comment that the stock that’s halved has seen its volatility go up.

STEPHEN CLAPHAM: But it’s a hell of a lot less risky. And, you know, just that very simple example should tell you that, you know, no university academic worth his salt would be dream of teaching the capital asset pricing model in his class. But I don’t think any of them have been discouraged in spite of the great man’s clear pronouncement. So listen, part two of your book, The Humble Investor. Why did you choose the title The Humble Investor?

DAN RASMUSSEN: Because I was very focused on this idea about being humble about our ability to predict the future.

DAN RASMUSSEN: That’s sort of the core message, right, to take away, which is to first, you know, take the mode out of your own eye, as it were, and to say, well, gee, you know, if I start from the premise, start from my future nihilism premise, you know, let’s start from the premise the future is entirely unpredictable, that anything that I do to predict the future isn’t going to work, then what should I do?

DAN RASMUSSEN: What follows from that. And that’s sort of the thought exercise that I’m trying to provoke.

STEPHEN CLAPHAM: It’s so interesting. Part two starts with how do you find an edge? And you highlight that historically cheap stocks do better than deer stocks and small caps beat large caps. Now, this hasn’t been true for the past, I don’t know, 10, 15 years. And so my question to you is, could it be different this time?

DAN RASMUSSEN: I think it’s a great question, Stephen. And I do want to first off acknowledge that I’m well aware that, first of all, the small caps have been terrible for 15 years, almost everywhere, with the exception of Japan.

DAN RASMUSSEN: And that value has been terrible, particularly in the US, although it’s done fine internationally, which people are somewhat less aware of, that the sort of underperformance of value is largely a US phenomenon. And I think that there are a few things to take away from that. I think one…

DAN RASMUSSEN: As a historian, who was it that said, you know, what happened? It was events, you know, what happened is events, right? Events happen, and they matter, people matter, right? The history and the future are not some…

DAN RASMUSSEN: Gray series of mean reverting numbers. Rather, they’re numbers that measure human achievement and human failure. And so we have to recognize that the numbers are telling a history, and it’s a history of people and their events.

DAN RASMUSSEN: And so there has been something unique that’s happened over the past 10 or 15 years that we have to understand in order to understand why value hasn’t worked. And what’s happened over the past 15 years is very simple, which is that there’s been a massive technological innovation, a technological leap on the scale of the railroads or the invention of the Internet that we have lived through.

DAN RASMUSSEN: And that evolution, it’s happened on the Internet. And those technology companies that have been the drivers of this innovation of the cloud and SaaS software and mobile, the benefits of that have been accrued. Massively to the largest players, which is so unusual, right?

DAN RASMUSSEN: Typically, you see small companies growing faster than large companies, because, you know, it’s easier to go from a billion in revenue to 2 billion in revenue, than it is historically to go from 100 billion to 200 billion in revenue.

DAN RASMUSSEN: But in the age of the internet, what it’s turned out is that these firms that develop these winning scale edges, they can go from owning the entire US market to owning the entire global market. And they keep scaling. And by the way, you know, a lot of it’s zero marginal cost, although that’s changing with AI.

DAN RASMUSSEN: And so what you’ve lived through is this tremendous innovation wave. And because of that, all the stock market profits or the vast majority of the profits in the last few years have accrued to a very small set of global technology leaders. And that’s what’s happened, right? And so you can say, well, you know, why is value not worked?

DAN RASMUSSEN: And you say, well, actually, it’s not. Value has probably been fine. What’s happened that’s been abnormal is how wonderfully large growth has done. That’s the historic anomaly. And it’s an anomaly that’s easily explainable. And the question now as we sit here is, will this continue?

DAN RASMUSSEN: Will this phenomenon of the largest U. S. Technology companies continuing to grow at massive, massive scale and massive profitability, and thus their stock prices to continue to drive the market years into the future, going to continue? And I think that, in my mind, I think there’s the future nihilist view, which says, who knows, but probably not.

DAN RASMUSSEN: Why would these seven stocks magically produce? Higher earnings growth forever or higher returns forever than other 493 US stocks. It just doesn’t seem totally plausible as a forecast. It seems like there’s a lot of hubris in extrapolating that past. Extrapolating the past generally doesn’t predict the future, so why would it for these stocks?

DAN RASMUSSEN: And I think then there’s a specific problem with these stocks, which is that they’ve in the past year gone from low CapEx, low marginal cost, highly scalable businesses to massively investing in a highly capital intensive, high marginal cost. Activity, which is AI, which I think people don’t fully understand. These AI models are extremely costly to run.

DAN RASMUSSEN: Each search on ChatGBT costs massively more than each Google search. And so I think their business model, at least they’re trying to change their business model to one that looks to me to be significantly worse than their previous business model.

STEPHEN CLAPHAM: I mean, it’s perfectly obvious, isn’t it? I mean, they can’t make the same returns from the AI investment they’re making their core business. I mean, it’s patently obvious. And yet the stock market is rewarding them for spending the money and creating deteriorating returns. Well, do you have any sort of theory about that?

DAN RASMUSSEN: I do. And I think that, again, this is my historian lens. And I’m a fan of Robert Schiller, a big fan of Robert Schiller. And he has this book, Narrative Economics. And that narratives shape human events as well, mimesis. And I think if you think about the lessons you’ve learned as an investor, the number one investor lesson you’ve probably learned over the past 10 years is don’t bet against Silicon Valley.

DAN RASMUSSEN: They come up with something crazy. So I’m going to produce electric cars. And you say, oh, they’ll never make electric cars. And then they make the electric car. And then you say, well, they’ll never make electric cars profitably. And then they make electric cars.

DAN RASMUSSEN: Cars profitable. And then they say, we’re going to make autonomously driving electric cars. You say, no, they’ll never do that. You know, that spend is crazy. And then they do it. You know, and that’s been sort of the lesson that people have learned. And in fact, kind of the stupider, crazier that the idea that’s come out of Silicon Valley has been, the better it’s done, right?

DAN RASMUSSEN: So if you said, well, there’s no chance people are going to accept some digital currency that’s created by, you know, hackers in Kazakhstan and trust that with their payments or their savings. That’s just insane. You would have missed out on all the gains of Bitcoin.

DAN RASMUSSEN: And I think because that lesson has been so ingrained in people’s heads, you come out and say, well, Google and Microsoft and Tesla, they all want to spend massively on AI. I don’t, gee, I don’t think that spending is a good idea. And people say, well, who do you think’s more likely to be right on this?

DAN RASMUSSEN: The CEOs of Google, Microsoft, Tesla, Et Cetera, who are all, have all been just on this complete winning streak. Or you, you know, the stupid cynic who has been skeptical of everything, and been wrong, and been wrong on, on every major technological advance, which have all worked. Cryptos worked, you know, autonomous driving’s worked, electric cars have worked, right? It’s just sort of a litany of lessons.

DAN RASMUSSEN: And I think that’s the challenge we face today, Stephen. You know, all the short sellers have gone out of business. All the skeptics have folded. And we’re living in this age where an unbounded faith in the future of innovation has been the winning strategy. And I question whether that can continue. I think nothing continues forever. I think everything cycles.

DAN RASMUSSEN: And so maybe I’m the… You know, the oldest 38-year-old on the planet, you know, writing that these timeless historical lessons will continue, you know, but I think that they will. And I think any student of history realizes that there are trends and there are temporary narratives that pervade in markets, but you can’t bet on them continuing forever. That’s going to end in disaster.

STEPHEN CLAPHAM: Well, of course, the share price performance can’t continue forever because they would be, you know, such enormously valuable. Businesses. Although if you take the railroad analogy in the 1870s, the railroads got up to, I think, three quarters of the stock market.

STEPHEN CLAPHAM: So, you know, we think 30 something percent concentration is bizarre and over the top. But I mean, we could double if we went back to the 19th century, which, you know, I think is an important thing to think about.

DAN RASMUSSEN: Yeah, well, I have a personal story. On that one, Stephen, which is my great uncle, who’s sort of a mentor, has been a mentor of mine. He’s an amazing guy. And his grandfather and his brother went into business together in the 1880s or 90s, and they bought a bunch of railroads and built railroads. There were big railroad tycoons.

DAN RASMUSSEN: And then in 1908, there was the big railroad collapse, and he went bankrupt, and his brother went bankrupt. But at the time, My great uncle tells the story, and I haven’t gone and fact-checked this, I should, but my great uncle said that at the time, gentlemen didn’t go bankrupt. So rather than go bankrupt, they kept the loans.

DAN RASMUSSEN: And my great-grandfather and his brother spent the first 20 years of their career paying off their father’s loans, and then before finally sort of emerging out of it. And that’s sort of where my great-uncle story comes in. And so I think, yes, of course, these concentrated bets can be fantastic and they can work for many, many years.

DAN RASMUSSEN: But the railroads still all went bankrupt, right? And look at what happened in the 90s. And so I think that as painful as it may be and as boring as it may be to counsel things like diversification at a time when everyone calls it de-worsification, of course it’s de-worsification, of course diversifying. Is always diversifying into things that have historically been lower returning.

DAN RASMUSSEN: But the reason for doing that is so you don’t put all of your eggs in one basket. And I think today, you know, the S&P 500 is very concentrated, and it’s very concentrated in a set of companies that are all taking the exact same bet, which is that AI is going to be this massively profitable innovation. And we don’t know if it will.

STEPHEN CLAPHAM: Well, I think we probably do know.

STEPHEN CLAPHAM: Do you think the growth of passive… Has also contributed to this because it means that price discovery has gone out the window. And, you know, David Einhorn was very eloquent on this. He talked about, oh, well, you know, there’s no point in finding cheap stocks because they don’t go up. Because there’s no value investors left looking for them.

STEPHEN CLAPHAM: You know, his traditional model was to buy something whose earnings were going to be upgraded and then wait for a Fidelity or a Capital to go, oh, we think their earnings are going to be upgraded. And. And push the price up. And he says that there’s just no value investors left doing that work. So there’s no point in doing it. I mean, have you thought about this at all?

DAN RASMUSSEN: Yeah, I think that the price discovery questions are very, very hard to answer. So I’ll say on that that I’ve tried to think of ways to sort of test that. And I approach everything, Stephen, with a skeptical lens. Let me try to test this. Let me run it through. Some empirical analysis.

DAN RASMUSSEN: And that’s why the book is full of my own empirical tests of various ideas, which is where I come to testing whether people’s growth rates are accurate or not, or whether people can forecast things. I just have this intensive ability. You tell me something, and I go and test it. And most of the time, it’s not right.

DAN RASMUSSEN: And so I’m skeptical of the price discovery argument because it’s very hard to test, and I don’t think he’s tested it. But what I’ll tell you is, I think, a very clearly testable hypothesis that is correct, which is that as you’ve shifted money from active to passive, that passive money has disproportionately gone into strategies that are benchmarked to two indices.

DAN RASMUSSEN: And those two indices are the S&P 500 and the Total Market Index. The US Total Market Index. So when people shift to passive, they’ve tended not to shift to say the FTSE developed XUS index or the US mid cap index. Passive for them means the most common, most salient passive indices for the S&P 500 in the total market.

DAN RASMUSSEN: So there’s been a mix shift in investor allocations towards the S&P 500 at a time when… The S&P 500 has outperformed virtually everything else, right? It’s very hard to find an index that has outperformed the S&P 500 over the last 10 or 15 years. It’s nearly impossible.

DAN RASMUSSEN: And the fact that it’s the biggest index makes it all the more compelling to shift towards passive by shifting to the S&P. And I think that’s where I have a beef with passive because I think passive means own the market cap weighted benchmark and own it at zero fees. Well, gee, that’s great. But if it means massively overweight the largest US equities rather than considering anything else, I think it’s a mistake.

DAN RASMUSSEN: And I think the simplest way you see this is US versus international, where there’s a huge premium to being listed in the US, which has nothing to do with fundamentals. It’s entirely driven by just having a US listed ticker. And so investors are just massively shifting their allocations into the United States, 80% US, 90% US, 85% US.

DAN RASMUSSEN: And so why do I need international stocks? And I think that these errors are being driven in part by the shift to passive. And I think that that’s a more obvious thing that I think you can definitely prove. Whether it’s impacted price discovery, I don’t know necessarily how to prove that on an individual stock basis.

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STEPHEN CLAPHAM: There’s a great table in the book, and you look at the persistence of growth among firms starting in the top quartile, looking at revenue. Revenue is quite persistent. Profitability is not quite as persistent. And you say that profitability is actually less persistent than chance. And I thought it was a brilliant…

STEPHEN CLAPHAM: So can you explain your conclusions and then explain, you know, well, why is anybody a growth investor?

DAN RASMUSSEN: Yeah. So basically what we find, again, is that historical revenue growth or earnings growth. Does not predict future earnings growth or revenue growth. And this is really hard to believe because it seems so intuitive that it should.

DAN RASMUSSEN: And so we’ve broken it out in a whole number of different ways. One of the ways we look at it is we say, take companies that have grown in the top half. What’s their chance of growing in the top half again next year?

DAN RASMUSSEN: Or we say, what about top quartile growers? What’s their probability of being in the top half of growers next year? And then what if you compound that? Say, what if they’ve grown revenues fast, their top quartile over the last two years, the last three years? Does that predict their next two or three year compounded growth?

DAN RASMUSSEN: And what you find in every case is that the historic growth does not predict future growth. In fact, it’s worse than a coin flip. So the coin flip is the better analog. And remember, this is a very crude estimate. We’re not saying 9% predicts 9%. We’re saying, hey, top.

DAN RASMUSSEN: Quartile predicts being in the top half, and that’s a coin flip. And if you compound it, it’s a coin flip times a coin flip times a coin flip. And so I think this is sort of the striking finding of this work is that relying on historical growth rates or historical financials to predict future financials doesn’t work.

DAN RASMUSSEN: But if we had Chris Mayer in the room, the author of 100 Baggers, he would say, well, actually, that’s quite wrong because, you know, the company’s in my portfolio. Have grown consistently year after year after year.

DAN RASMUSSEN: And I don’t disbelieve that you’ve done the research and this is the findings, but I find it hard to square with my perception that there are some high quality companies out there that grow consistently over time. So why is it that Coca-Cola has been a consistently strongly growing company over decades, yet your results suggest that if I look at a Coca-Cola, it’s highly unlikely that that will happen.

DAN RASMUSSEN: I think there are a few things to note there. I think one is that, again, I can’t say anything about skill. So it’s possible that there’s 1% or 5% or 10% of people that can reliably pick. These companies that grow sustainably over time. And I don’t have a way to sort of prove that that’s true or not true.

DAN RASMUSSEN: But I think if you separate the question of like, well, is it true? Can I sub-segment any type of company, right? So let’s take technology companies or, you know, let’s, right. Almost any one of those things ends up not meaningfully predicting future growth in any reliable way. And I think the problem is always, you’ve got to, you’ve got to take the thought.

DAN RASMUSSEN: Picture, right? You can’t just take Coca-Cola. You got to take all the companies like Coca-Cola. And it turns out that when you take them all as a group, rather than focusing on one specific example, you see the unpredictability of growth over one, three, five-year horizons. Now, I’ll get to another point, Stephen, which is I think sort of where you’re going.

DAN RASMUSSEN: What is persistent or predictable? And Coca-Cola is a great example of this. What is persistent or predictable? And this is where I have more sympathy towards what some on Twitter call the compounder bros than I do for the quote unquote growth or GARP investors, because I think that there is a persistence to return on assets.

DAN RASMUSSEN: So what you do see is that if you take every company and you rank them, my preferred metric is gross profit divided by assets, but it’s basically an ROI metric. What you’ll see is that today’s ROI as measured by GP to A. Predicts five years or even 10 years from now as gross profit assets.

DAN RASMUSSEN: So that companies do have sort of a persistent characteristic of return on assets. And if you look at those companies that have very high return on assets like Coca-Cola, they do persist in having high return on assets. And as a result, those companies end up being safer.

DAN RASMUSSEN: They tend to be more likely to have persistent long-term growth. It doesn’t mean that over any three-year or five-year period, they’re necessarily going to grow faster than the market. But simply that their sort of stability over the long term is much more likely, that they’re better businesses in almost every sense of the word than the lower return on asset businesses.

DAN RASMUSSEN: And so I think that where I sort of separate it out is, you know, from a quantitative investor perspective, right, there are sort of two polarities, right, which is you either want to buy value where people are basically they’re wrong in being excessively pessimistic about a set of companies.

DAN RASMUSSEN: And you’re saying, gee, you know The future is hard to predict. I know you think that every oil and gas company is going to go out of business because of climate change, but what if they didn’t?

DAN RASMUSSEN: It’s that sort of like, but what if? That’s sort of the value investor mantra. I know you think that, but what if it didn’t come true? What would happen? What if coal didn’t go to zero? Then what would happen? And so that’s sort of the value investor type stocks.

DAN RASMUSSEN: And then there’s the quality, what I tell it’s sort of the quality type of stocks, which are the really high return on asset businesses. And by the way, those do really well over time too. Call is an example of it’s a persistently high return on asset business and those things are not correlated.

STEPHEN CLAPHAM: It might not be good to buy it today because you might end up paying too much for it. No, I completely get that. But why do you choose gross profit to assets? Why do you choose that metric?

DAN RASMUSSEN: This is always a tension between quantitative and fundamental investors, which are fundamental investors will say, well, that’s a lousy metric. It doesn’t tell us anything about a company in particular. And I’ll say, yes, it might not tell you anything about anything in a company in particular. But if you compare companies across a broad range, right, you’re trying to sort 3000 companies.

DAN RASMUSSEN: It’s the best metric because it’s crude. And when you get into, say, return on investments, net income is way too volatile, which is one of the reasons it’s not persistent. But gross profit is pretty stable, actually. It’s closer to revenue in terms of its stability. It’s much less volatile than net income. The further down the income statement you go, the more volatile the series is.

DAN RASMUSSEN: So you’re trying to find a less volatile series. Gross profit is less volatile. And then divide it by a balance sheet metric, in this case, total assets. And what you find is it does a great job of comparing across firms. And if you just scan within any industry and you say, hey, show me the ranking, you’re not going to be surprised by what companies are on the top. It’s very intuitive.

DAN RASMUSSEN: And so I think it’s a beautiful metric because of that. It’s just great at ranking and sorting, even when it comes to analyzing an individual company and say, well, it doesn’t take into account this or it doesn’t take into account that, all of which is true. But that’s not its main function. Its main function is comparison.

STEPHEN CLAPHAM: And you have found it to be a more persistent measure than other measures, partly because of volatility lower down.

DAN RASMUSSEN: Exactly. The lower down the income statement, net income is way too volatile. So ROI is far less persistent than gross profit to assets, right? Because what we want is a reliable way of sorting 1,000 companies that if I looked at the same 1,000 companies five years from now, there’d be a very high correlation between this sort and that sort.

DAN RASMUSSEN: And that’s what gross profit to assets is good at. Whereas ROI is not good at that because you have companies that have One year they have some special loss or there’s an out of the cycle, right? It adjusts for all of those things.

DAN RASMUSSEN: It makes perfect sense. I mean, gross profitability is one of the things that, you know, when, you know, I’ve got these online courses and we spend quite a lot of time sort of trying to help people understand business quality. And we look at gross profitability in some detail.

STEPHEN CLAPHAM: Now, we’ve both been writing about private equity and I’ve been really enjoying your blogs on the subject. And I know that I’m needling a bunch of people in the private equity industry because when I write about it, I get, you know, the incoming mail in response is always, well, you don’t know what you’re talking about. I’m in private equity.

STEPHEN CLAPHAM: And I just don’t get what people find so difficult about this because it’s blindingly obvious, isn’t it, that the opportunity set today isn’t what it was 20 years ago. We’ve had declining interest rates and rising valuations. And that’s all stopped. May or may not be going into reverse. And the higher starting valuations have got to be a barrier to returns.

STEPHEN CLAPHAM: And the sheer weight of money invested in private equity funds today, relative to where it was 20 years ago, inevitably must lead to lower returns. That’s not, you know, leaving aside the fact that debt… Will cost you more. So your leverage will have to be lower. Why don’t allocators understand this? I mean, it’s so obvious. And I get so much pushback. Do you get pushback on your side?

DAN RASMUSSEN: Yeah, it’s remarkable, Stephen. I mean, I think you look at even basic arguments you can make about private equity, right? So you’d say, well, gee, private equity companies are a lot smaller than publicly listed companies. And smaller companies are more risky than bigger companies. And they borrow a lot more money.

DAN RASMUSSEN: And companies that borrow money are more risky than companies that don’t borrow money. And third, most private equity funds own concentrated portfolios of 10 to 20 securities. And owning a concentrated portfolio of 10 to 20 securities is far more risky than owning a diversified portfolio of 500 or 1,000 securities. So therefore, private equity should be multi… You know…

DAN RASMUSSEN: Much, much more risky than owning the public stock market. And you’ll get so much pushback on even that, right? People say, oh, no, that can’t be true. My private equity firms are not volatile at all. It’s not risky at all. I’ve never lost money on a private equity fund, right? Or something like that. And I think that people just don’t realize the risk, right?

DAN RASMUSSEN: So that’s sort of step one. And the reason they don’t realize the risks even, I think this is sort of an important thing to understand, right? Is that private equity, that’s sort of of target universe of private equity is tiny. It’s tiny. So they’ll always in the marketing materials, they’ll say, well, there are a million private companies and only 10,000 public companies.

DAN RASMUSSEN: And so the opportunity set for private equity is massively bigger. But how many dry cleaners does it take to add up to a Facebook? Right. I mean, who cares if there are 10,000 dry cleaners? Right. I mean, I don’t care. Right. Like add up all their profits. You’re not even going to get close to Facebook. Right.

DAN RASMUSSEN: So what matters is the profit pool and the profit pool, the accessible profit pool of these private companies is probably two to four percent. The size of the S&P 500 or the public market, right? It’s tiny because they’re micro caps. They’re tiny little micro caps and micro caps have thin profit margins anyway.

DAN RASMUSSEN: And so you’re basically saying, and then you’re seeing institutional allocators put 40% now of their portfolios into a target universe that’s two to 4% the size of the public equity market universe, right? And they’ve gotten there over time by increasing their allocations. And what you see in an… Illiquid asset class, something that’s illiquid and small, is that fund flows matter a lot more.

DAN RASMUSSEN: And so as funds have flowed into the asset class, they’ve buoyed valuations, they’ve increased competition, they’ve made it easier to sell. If there are five private equity companies this year and 10 private equity firms next year, your ability to sell the companies in your portfolio has become easier by the fact that there are five new entrants who all need to deploy funds, and they’ll be happy to buy your company from you.

DAN RASMUSSEN: Portfolio. And so I think that sort of rising tide of new money flowing in has lifted all boats, but it’s lifted all boats by pushing valuations up, pushing valuations up. And now you’ve also seen the rise of private credit, which is promising equity market plus returns.

DAN RASMUSSEN: And those firms are doing that by lending to these private equity deals. And so I think that this whole thing has, yes, the returns have been good. And I’d say there’s been sort of two eras, maybe three eras. There was sort of the pre-2008 era, call it 1985 to 2006, where the returns were fantastic. Okay. Like you just look at those returns.

DAN RASMUSSEN: It was just unbelievably good. You’re talking about beating the public market by four to 600 basis points a year, four to 6% per year on top of the, you know, that’s after the fees, which were insane, right? And then I’d say there’s the period from sort of the financial crisis to the present, where private equity has kept up with the S&P 500, which is remarkable because small caps have done so much worse than the S&P 500.

DAN RASMUSSEN: But they’ve kept up with the S&P 500. And I’d argue that’s the period where the economics were deteriorating, but the fund inflows were magnifying. And so you had great, great economics with limited fund flows for the first 20 years.

DAN RASMUSSEN: Then you saw deteriorating economics with increasing fund flows for the last. And now we’re in this period right now where the fundamentals are deteriorating and the fund flows are deteriorating. And what you’ve seen as a result is that hold periods are getting longer and longer. The private equity firms can’t sell their businesses. And as a result, the trailing returns.

DAN RASMUSSEN: For the first time, if you go look at endowments and foundations, the last two or three years, the ones with lower private allocations have done better. Now, if that continues, you’re going to see even worse fund flows.

DAN RASMUSSEN: And because these things are recursive in a way, fund flows can drive outcomes just like outcomes drive fund flows. I think we’re in the beginning of the first two years of what I think will be a very, very challenging period for the asset class.

DAN RASMUSSEN: It’s almost impossible for it not to be. But what I’m puzzled about is why this isn’t clear to the vast majority of… People and I get enormous amount of pushback on it. Now you get all sorts of comments about, well, you know, these private equity people, they’re brilliant operations.

DAN RASMUSSEN: And you studied nearly a thousand PE deals over 25 years where there was public data available because there were debt securities. And you concluded that private equity doesn’t add value operationally, which is actually very consistent with the commentary from.

DAN RASMUSSEN: Being capital where he says that there is the tiny what can you just describe what you did in those conclusions so what i did is i looked at the subset of private equity deals where public debt was issued at the time of the buyout so now you can talk about this being some skewed sample in some way and let’s just assume for the sake of argument that it is a skewed sample in some way right it’s not perfect but If operational improvement is an explainer of private equity returns writ large, then we should see it even in a skewed data set, right?

DAN RASMUSSEN: Like we should see, okay, like here it is, the operational improvement, right? I mean, it should show up, right? Otherwise, it can’t drive returns in aggregate, right? If it’s not showing up in a sample of 1,000, especially these 1,000 larger deals, which are probably a disproportionate weight in the overall, right? It probably doesn’t show up at all, right?

DAN RASMUSSEN: We should see hints of it, right? We should see the leaves move as the wind blows through the forest. And so we looked at the three years prior to the deal and the three years after the deal, what happens to revenue growth, EBITDA growth. We both do it compared to their sector. So you say, this is a telecom company, how did its revenue growth compare to the telecom sector prior to acquisition and post-ex.

DAN RASMUSSEN: And we also do it not doing it that way, just on a raw basis. And what you see is that revenue growth maybe slows a little bit, which sort of would… Would coincide with your view that active managers are buying companies that have a higher revenue growth because they think that’s going to continue and then chance happens and then they grow normally.

DAN RASMUSSEN: So you sort of see that slowing down of revenue growth. You see that margins don’t change all that much, which is sort of surprising, right? The sort of cost cutting doesn’t actually end up happening all that much, right? At least it’s not evident in our data set.

DAN RASMUSSEN: CapEx goes down a bit, which sort of goes through probably they’re cutting bad spending. But what you do see… Systematically huge change, right? Huge. And you see it in almost every deal. It’s a massive increase in debt, which sort of makes sense, right? This is leveraged buyout industry and they’re issuing public debt as part of the buyout. So of course, right, debt is going up and so is interest payments.

DAN RASMUSSEN: And so what you see is that, and I think this sort of should jive with our intuition, right? Who works in private equity, Stephen? It’s a bunch of former investment bankers, right? When did investment bankers magically learn to run industrial companies or consumers companies, right? Like, where do they all become? They’ll develop this.

DAN RASMUSSEN: They’re all geniuses.

DAN RASMUSSEN: They’re all geniuses, right? Is that really plausible? Or is it more plausible that what they’re really doing and what they’re good at doing is balance sheet engineering, right? Of course, that’s what they’re doing. That’s what they do in every deal, right?

DAN RASMUSSEN: Do they make an operational improvement in every company they’ve bought ever? No. But do they have debt in every case? Yes. And so I think that’s the operational change that’s happening. And I think that that’s where… What I think people miss about private equity. It’s a balance sheet game. It’s not an income statement game.

DAN RASMUSSEN: I love the quote from Bob Maynard, who was the CIO of the Public Employee Retirement System Of Idaho. He said, it may be phony happiness, but we just want to think we’re happy. If private equity just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks.

DAN RASMUSSEN: What do you make of that statement?

DAN RASMUSSEN: I love it. I mean, I think you see exactly what’s happening, right? Like who wouldn’t want it, right? If the market goes down 20 and private equity goes down 10, and you can say you beat the market by some massive amount because you made the genius decision to put half your money in privates, that’s sort of what’s happening, right?

DAN RASMUSSEN: Everybody loves it. There’s no one who dislikes it. As Cliff Asness calls it, it’s volatility laundering. Who likes volatility?

DAN RASMUSSEN: No, we won’t talk too much about private credit because it’s pretty obvious that… They’re just lending the money to the private equity companies. So, I mean, I think what they’ve been very clever about the private equity firms is kicking the can down the road and not bankrupting the businesses with very rare exceptions and lending them PIK notes and other funny instruments.

DAN RASMUSSEN: The asset class is still growing like a weed. So nobody’s… Reading your stuff or my stuff and good luck to them. And you’ve got a great table in the book on declines from peak search interest in Google Trends.

DAN RASMUSSEN: So the dot com theme peak search interest was February 2000 and the 12 month forward returns were minus 90 percent. And you’ve got a whole list of these going through. Well, where did you get that idea from? It was very clever.

DAN RASMUSSEN: Yeah, well, I was interested in sort of this narrative, you know, how much to narratives matter. And and so, you know, I wanted to go out and test it. And indeed, you see that when people get too interested in the narrative, when it becomes too popular, gee, you know, the returns end up looking terrible thereafter.

DAN RASMUSSEN: Right. It’s sort of an obviously intuitive, right, that stuff that gets people get too excited about overshoots. And I think that’s particularly been true in the sort of meme meme stock era.

DAN RASMUSSEN: How would you think about testing?

DAN RASMUSSEN: When the peak arrives, how would you know?

DAN RASMUSSEN: That’s a much harder question, Stephen. I don’t think you can. It’s really hard. And I have a whole thing in the book about predicting bubbles. And one of the things I observe is that smart people always identify bubbles too early.

DAN RASMUSSEN: It’s just the nature of things, right? Because overvaluation and bubbles, they always get worse and worse and worse. And the first hints of irrationality strike the smartest people first. And then the bubbles tend to continue for years longer. And it’s sort of a fool’s errand to try to call the peak of the bubble or even know when you’re in a bubble.

DAN RASMUSSEN: But I think that one can just try to take prudent action consistently over time. And it does pay off, right? These bubbles do burst and they burst so suddenly that years of excess returns can get lit on fire in a year or a six-month period. And all of a sudden, the trailing returns, the people that were sensible and stayed out of the bubble look better than the people that…

DAN RASMUSSEN: A year before were looking like complete geniuses and market beaters whose profits just get lit up and fire because so much of it is dependent on rising valuations, rising forecasts of the future, which drive those valuations, as opposed to actual cash flows and actual earnings.

STEPHEN CLAPHAM: Yeah. I mean, I think there are occasionally people ringing the bell. So the likes of Julian Robertson giving up because he just couldn’t make money buying proper companies and shorting. Tech fads.

STEPHEN CLAPHAM: I don’t know if it was to the day that he closed Tiger and the market top, but the two things weren’t far away. I think Jim Chanos closing his business, his short selling oriented fund, probably was close to the bottom in terms of creating real opportunity for short sellers.

STEPHEN CLAPHAM: Before we go, do you want to just say a little bit about Verdad Advisors and what you do and how you do it? And just explain to people how you came to this role.

DAN RASMUSSEN: Yeah, well, thank you, Stephen. I mean, I think that my big focus has been exactly what we’ve talked about, which is trying to study history, to derive the lessons from it, and then to turn that into investment strategies. And I think also I’ve grown up. I’ve grown up.

DAN RASMUSSEN: In a world where passive was huge, where I understood that you don’t want to necessarily compete with passive. And so rather than say, focusing on trying to develop another firm that manages large cap US equities or something, I’ve been very focused on niches, on small areas of the market where I think there are mispricings or where things are less efficient.

DAN RASMUSSEN: So I’ve done, we do a lot of work in micro caps, sub 400 million market cap stuff that index funds can’t even touch because they’re too illiquid. And our view is that that might be a place where there’s more inefficiency to be had.

DAN RASMUSSEN: And at very least, we’re providing exposure to something people can’t get elsewhere. And so that’s really what we built. We managed about $1.1 billion across a few different strategies. And all of the core research behind our strategies is really as described in this book around how we think about equities and value, how we think about credit, how we think about market timing.

DAN RASMUSSEN: And cross-asset investing. And all those different areas, I think, are places where we spend years studying long-term histories, long-term returns, and then trying to develop theses and testing them over historic data, and then trying to apply them in real time.

DAN RASMUSSEN: And so I’d say the great benefit of that is it’s very intellectually consistent. It makes sense. And the negative of it, I think, is that we… I probably have been too skeptical of the current bubble, what I would call the bubble.

DAN RASMUSSEN: We haven’t owned NVIDIA or anything like that, both because it hasn’t fit within the mandates of any of our niche strategies, but also because of my skepticism about things that have very high valuations. And I think that that’s sort of the fundamental issue that I think all investors are facing today, which is that the best performing thing is US large caps, and that’s also the most expensive thing.

DAN RASMUSSEN: And… Those things have been true for the last two or three years. And so, you know, how much do people want to risk on that and how much they want to diversify? And I think it’s a really hard problem that people are really wrestling with.

STEPHEN CLAPHAM: And you’ve grown the business really on the back of your writing. Is that?

DAN RASMUSSEN: Yes.

DAN RASMUSSEN: That’s my understanding.

DAN RASMUSSEN: Yes.

STEPHEN CLAPHAM: You couldn’t have done that 10 years ago or 15 years ago.

DAN RASMUSSEN: No, it’s the amazing thing about the internet. You can share your ideas, the huge audience very easily. And I think the internet is very merit based, right? If your writing is good and people like your ideas, people will pay attention. It’s the same with podcasts, right? I mean, I think it’s a wonderful…

DAN RASMUSSEN: Development you know for the davids as opposed to the goliaths right there’s no the intermediaries aren’t trusted anymore you know people people want to go out and find authentic voices of people that are doing interesting things or saying interesting things and doesn’t matter whether you have some big bank research arm behind you or not i.

STEPHEN CLAPHAM: Don’t know anybody else like you who’s done that that way and so i was very interested in that where i mean where do you see yourself going i mean Do you think this just carries on because as you write more, more people share it and more people find you and say, he sounds quite sensible. Let’s give him some money.

DAN RASMUSSEN: I mean, is that how it works? I hope so. Although, you know, my real hope, Stephen, is that I uncover some secret money making formula, hopefully in the next 12 months, and then I’ll go completely silent. So if you don’t hear from me, I’ve either gone out of business or I’ve discovered the magical elixir to making money, which I’m hiding from everyone else.

DAN RASMUSSEN: But hopefully it’ll continue in that pleasant. Middle ground where I keep sharing and hopefully the firm keeps growing.

STEPHEN CLAPHAM: Well, people can read your blog and buy your book, which is definitely worthwhile. Where can people find you, Dan?

DAN RASMUSSEN: I’m on Twitter at @Verdadcap or X, sorry, @verdad cap. And my website is www.verdadcap.com. And you can buy The Humble Investor anywhere books are sold.

STEPHEN CLAPHAM: Well, we’ll definitely link to that in the show notes. Dan, thanks so much.

DAN RASMUSSEN: Thank you, Stephen. I very much appreciate it.

STEPHEN CLAPHAM: I told you that Dan and I didn’t entirely agree, but this was largely a function of looking at factors from different lenses. Dan is interested in base rate and I’m interested in specific. And of course, both viewpoints are valuable, but for different applications, which is one reason I enjoy doing this podcast so much, because I get to learn about markets from different perspectives.

STEPHEN CLAPHAM: If you enjoyed the conversation, I highly recommend Dan’s book, The Humble Investor. And if you buy it via the show notes, there’s an affiliate fee which is donated to Duchenne UK, our supported charity. You can find it on my website, BehindTheBalanceSheet. Com. Thanks as ever for listening. Don’t forget, subscribe, and please tell your friends about the show.