October 24, 2023 • 1hr 21min

Aswath Damodaran - Making Sense of the Market Pt. 2 - [Invest Like the Best, EP.349]

Invest Like the Best with Patrick O'Shaughnessy

In this episode of Invest Like the Best, host Patrick O'Shaughnessy welcomes back Aswath Damodaran, Professor of Finance at NYU's Stern School of Business, for a wide-ranging discussion on the current state of markets, valuation, and investing. As a follow-up to their conversation 18 months prior, they explore how higher interest rates, geopolitical risks, AI, and other factors are impacting the investment landscape.

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Key Takeaways

Two prevailing market narratives: 1) The last 18 months of higher rates are an aberration and we'll revert back to the low-rate environment, or 2) The last decade of ultra-low rates was the aberration and higher rates are the new normal
4% interest rates and 3% inflation may be a reasonable expectation for where we end up after current economic uncertainty settles
Companies and investors need to adapt to a higher rate environment by revisiting hurdle rates, capital allocation, and cash management practices
China is the biggest macro risk due to its economic troubles and interconnectedness with the global economy
The U.S. stock market's outperformance has been driven largely by big tech companies benefiting from the shift to a 21st century digital economy
AI offers potential to change how we live and work, but also has downsides and may not be as transformative as some predict
Entertainment business models are in flux due to streaming disruption, with no clear winners yet emerging
Bank failures like SVB revealed the need to rethink deposit stickiness in the age of social media
ESG investing was oversold and is facing backlash, but impact investing will likely replace it in some form
Active management is in secular decline but some niche, disciplined active managers may survive
The focus on the Federal Reserve is unhealthy and takes focus away from company fundamentals

Introduction

In this episode of Invest Like the Best, host Patrick O'Shaughnessy welcomes back Aswath Damodaran, Professor of Finance at NYU's Stern School of Business, for a wide-ranging discussion on the current state of markets, valuation, and investing. As a follow-up to their conversation 18 months prior, they explore how higher interest rates, geopolitical risks, AI, and other factors are impacting the investment landscape.

Topics Discussed

Current Market Narratives and Interest Rate Environment (2:57)

Damodaran outlines two competing narratives in the market:

The last 18 months of higher rates are an aberration and we'll revert to the low-rate environment of the past decade
The past decade of ultra-low rates was the aberration and higher rates are the new normal

He leans towards the latter view, stating: "I wouldn't be surprised if we ended up where we were in 2007 - 4% rates and 3% inflation, and a market that reflects that."

This shift has major implications:

Companies need to revisit hurdle rates and capital allocation practices
Investors need to be more attentive to cash management
The era of easy access to risk capital is likely over

Macro Risks and Global Economic Outlook (13:17)

Damodaran identifies China as the biggest macro risk, stating:

"The biggest macro issue to me is China, because China is in trouble. And the problem is, unlike Russia, if China goes down, it takes the rest of us down with it."

He explains that China's authoritarian system, which previously provided predictability, is now creating "discontinuous risk" as the government fights for political survival. This poses challenges for multinational companies heavily invested in China.

U.S. Stock Market Outperformance (18:22)

Discussing the long-term outperformance of U.S. stocks vs international markets, Damodaran attributes this largely to big tech companies benefiting from the shift to a 21st century digital economy. He notes:

"If you look at the ten largest market cap companies in the world, you've got five of the six FAANG stocks...The US, in spite of all of its faults, has created at least an environment where the companies that are most suited for the 21st century economy are most likely to grow."

He expects this trend may continue, with the next wave of innovative companies also likely emerging from the U.S.

Nvidia and the AI Boom (21:35)

On Nvidia's massive growth, Damodaran notes it's unprecedented in absolute terms, adding $700 billion in market cap in one year. He attributes this to Nvidia being well-positioned for the AI boom, with an 80% market share in AI chips.

However, he believes the market has overreacted, stating: "I doubled the value of Nvidia as a company with AI in there, but I was still 40% below the market price. I think the market has gone a little over the top in terms of reacting to the AI aspect."

Artificial Intelligence: Potential and Pitfalls (23:27)

Damodaran provides a balanced view on AI:

AI is the culmination of big data and increased computing power over 20+ years
It has potential to change how we live and work, similar to past tech shifts like PCs and smartphones
However, he's skeptical of the most optimistic AI predictions, noting past tech advances also had downsides

He states: "For every winner there will be losers. For every disruptor there will be disrupted...Are we going to be better off because of AI? I'm not so sure."

Valuing AI Companies (29:01)

On valuing AI startups, Damodaran emphasizes the need for a clear business model:

"Unless you tell me how you plan to make money, you're not a business, you're just a movement...a lot of so-called AI businesses are not businesses yet. They're AI movements, AI ideas."

Entertainment Industry Disruption (46:48)

Damodaran discusses how streaming has upended traditional entertainment business models:

Netflix's "produce 100 shows, throw it against the wall" approach vs. traditional pilot system
Uncertainty around movie theater viability
No clear winning business model has emerged yet in streaming

He notes: "I cannot think of a single company where I can point to that company, say those guys have a model that they've actually figured out. So I think everybody is in motion right now, and none of them is a solid business model right now."

Bank Failures and Deposit Stickiness (1:03:28)

Reflecting on the SVB failure, Damodaran highlights how social media and interconnectedness can impact deposit stickiness:

"We discovered that deposits are not that sticky. Especially if your depositors all are homogeneous, they come from the same group and they talk to each other all the time...In the space of two days the bank went from being healthy to effectively done."

He suggests regulators may need to consider factors like depositor demographics and social media usage when setting capital requirements.

ESG and Impact Investing (1:06:17)

Damodaran is critical of how ESG investing was marketed:

"When you use virtue as your primary selling point, you get no debate because who wants to push back against goodness? So for the decade ESG advocates got no pushback...They overreached, what they claimed, basically sold it as all cake, no calories."

He believes ESG is being replaced by impact investing, but cautions that many impact investing strategies may have unintended negative consequences.

Active Management's Future (1:11:13)

On the future of active management, Damodaran advises:

"I would want to have a firm that I can sustain, which often means settling for smaller scale, looking for a portion of the market where I have something to bring to the table and then not getting tempted...The active investing that I see surviving will be active investors who found a niche, something special that they do, and stay disciplined enough to stay in that niche."

Overemphasis on the Federal Reserve (1:13:27)

Damodaran expresses frustration with the market's obsession with the Federal Reserve:

"I am so sick and tired of discussions that revolve around central banks because I think it has become a reason for copping out. The reason for not dealing with fundamentals is the Fed will do it or the Fed did it...It's very unhealthy because it means we're not talking about the things we should."

He argues for less focus on the Fed and more on market fundamentals.

Conclusion

This wide-ranging conversation between Patrick O'Shaughnessy and Aswath Damodaran provides valuable insights into the current state of markets, valuation challenges, and the future of investing. Damodaran's balanced perspective on topics like AI, China risks, and active management offers a thoughtful counterpoint to prevailing narratives. His emphasis on adapting to a higher rate environment, focusing on fundamentals over Fed actions, and maintaining discipline in active management strategies provides actionable advice for investors navigating an uncertain landscape.