August 23, 2024 • 1hr 10min

TIP654: Investing Across the Life Cycle w/ Aswath Damodaran

We Study Billionaires - The Investor’s Podcast Network

In this episode, Clay Finck interviews Aswath Damodaran about his new book "The Corporate Lifecycle". Aswath Damodaran is a professor of finance at NYU Stern School of Business and is widely regarded as one of the foremost experts on corporate valuation. He has written numerous books on valuation and investing and makes his university courses freely available online. The discussion explores how companies evolve through different lifecycle stages, how this impacts valuation and investment approaches, and key considerations for investors looking at companies across the lifecycle. Damodaran provides insights on topics like Tesla's evolving narrative, the challenges of the decline phase, and how to think about expected market returns.

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Key Takeaways

The corporate lifecycle parallels human aging, with companies going through stages similar to a baby, teenager, adult, and elderly person. Companies fight aging just like humans do.
Different skills are needed to value companies at different lifecycle stages. For young companies, storytelling and narrative are critical. For mature companies, numerical analysis becomes more important.
Traditional value investing focused on mature/declining companies may miss out on big winners. Investors should be open to finding value across the entire corporate lifecycle.
The job of management is to maximize shareholder value, which means focusing on long-term value creation, not just short-term earnings.
Tesla is an example of how narrative and storytelling drive valuation for growth companies. Its story has shifted dramatically over the years.
Most companies fight decline aggressively, often destroying value in the process. Accepting and managing decline well can be the right move.
Diversifying across the corporate lifecycle, not just sectors, is important. Having exposure to young, growing, mature and declining companies provides balance.
Aswath Damodaran advocates against highly concentrated portfolios, preferring to spread bets across 25+ companies to increase odds of owning long-term winners.
At the right price, even declining companies can be good investments. Price is a critical factor in any investment decision.
Index funds provide exposure to the biggest winners in the market. Current S&P 500 expected returns are around 4.11% above T-bond rates.

Introduction

In this episode, Clay Finck interviews Aswath Damodaran about his new book "The Corporate Lifecycle". Aswath Damodaran is a professor of finance at NYU Stern School of Business and is widely regarded as one of the foremost experts on corporate valuation. He has written numerous books on valuation and investing and makes his university courses freely available online.

The discussion explores how companies evolve through different lifecycle stages, how this impacts valuation and investment approaches, and key considerations for investors looking at companies across the lifecycle. Damodaran provides insights on topics like Tesla's evolving narrative, the challenges of the decline phase, and how to think about expected market returns.

Topics Discussed

The Corporate Lifecycle Concept (1:47)

Damodaran explains that the corporate lifecycle parallels human aging, with companies going through stages similar to a baby, teenager, adult and elderly person. Key points:

Startups are like babies, needing constant care and capital
Young companies are like toddlers, falling and getting back up
Teenage companies put their potential at risk
Mature companies fight aging, similar to humans
An ecosystem of consultants and bankers try to make companies "younger again"

Damodaran notes: "Companies are run by human beings. And just as they fight aging in their personal lives, they fight aging as CEOs of companies, as the heads of companies."

Valuing Companies at Different Lifecycle Stages (3:43)

Different skills are needed to value companies at different stages:

Young companies: Storytelling and narrative are critical, as there is little historical data
Mature companies: Numerical analysis becomes more important, looking at cash flows, accounting returns, risk measures
Shifting skillsets are needed across the lifecycle

Damodaran argues that traditional value investing focused on mature/declining companies misses out on big winners: "For the last 20 years, if you've not invested in young companies, no matter how good they are, because the investment philosophy directed you to look for things like, hey, let's find low PE ratios, high earnings growth, big cash flows. All great things to look for, but you're not going to find them in younger companies."

Maximizing Shareholder Value (9:34)

On the purpose of companies maximizing shareholder value:

It's easier said than done because shareholder value is about long-term value, not just short-term earnings
Requires making tradeoffs between short-term and long-term
Shareholder value is the most long-term concept, contrary to critics who say it's short-term focused
Different shareholder groups may have conflicting interests (e.g. dividends vs buybacks)

Damodaran explains why shareholders are prioritized: "Shareholders have no contractual claim. They get what's left over after every other stakeholder group has been dealt with. If you don't take care of shareholders and they get a residual claim, there will be nothing left for them at the end."

Tesla Case Study (27:39)

Tesla provides an interesting case study in how narrative drives valuation for growth companies:

Tesla's story has shifted dramatically over the years - from luxury automaker to energy company to tech company
Elon Musk's storytelling ability drives Tesla's valuation
Price cuts in 2023 made sense given Tesla's goal of dominating the mass market EV segment globally
Tesla has advantages from being focused solely on EVs, unlike legacy automakers
Full self-driving and robotaxis provide optionality, though the business model is still uncertain

Damodaran notes: "Tesla could be a case study of why narrative is so critical to value. When I first valued Tesla, I valued it as a luxury automobile. And over the last decade, you've seen the twists and turns in the Tesla story. I'm not even sure at some points in time what kind of company Tesla is."

Management Through the Lifecycle (40:27)

The skills needed from management change through the lifecycle:

Young companies need visionaries and storytellers
As companies mature, operational skills become more important
Mature companies need defensive skills
Declining companies need skills in managing contraction

Damodaran argues investors should look for mismatches between management quality and market perception: "If you think a CEO is great and the market thinks that manager is amazing, you're overpaying for that stock. If you think management is just bad, but the market thinks that management is abysmal, that might be a good buy."

Managing the Decline Phase (48:33)

Most companies fight decline aggressively, often destroying value in the process:

CEOs are incentivized to try to return companies to growth
We glorify empire builders, not those who manage decline well
Examples like Blockbuster and BlackBerry destroyed value fighting inevitable decline
Accepting and managing decline can be the right move

Damodaran argues: "I have more respect for CEOs who come into a declining business, accept decline and then manage that decline well, because a corporation is a legal entity, if the reason for your existence goes away, there's no reason you should be sticking around."

Portfolio Construction and Diversification (55:34)

Damodaran advocates against highly concentrated portfolios:

Prefers spreading bets across 25+ companies rather than 5-6
Diversifying across the lifecycle is important, not just sectors
Having exposure to young, growing, mature and declining companies provides balance
At the right price, even declining companies can be good investments

He notes: "I'd much rather take my bets with 25 of the best companies rather than five, because with five, I run the risk of doing harm to my portfolio."

Market Valuations and Expected Returns (59:58)

On current market valuations and expected returns:

S&P 500 implied equity risk premium is currently 4.11% above T-bond rates
This is lower than recent years, suggesting stocks are less attractively priced
However, there aren't clearly better alternatives for capital allocation
Index funds provide exposure to the biggest winners that drive market returns

Damodaran explains: "Start of July of 2024, that number was 4.11%. The way to think about it is you could make about 4.4% in a T-bond. You are making 4.11% more on an expected basis buying the S&P 500."

Conclusion

Aswath Damodaran provides a wealth of insights on how to think about companies through different stages of their lifecycle. Key takeaways include the importance of being open to finding value across the entire lifecycle, not just in mature companies, and how narrative and storytelling drive valuation for growth companies like Tesla.

He advocates for diversification across the lifecycle, not just sectors, and warns against highly concentrated portfolios. Damodaran also highlights how most companies destroy value fighting decline, and that accepting and managing decline well can sometimes be the right move.

On current market valuations, he notes expected returns are lower than in recent years, but there aren't clearly better alternatives. Overall, Damodaran emphasizes the importance of investors doing their own reasoning and valuation work, rather than outsourcing decisions, to take ownership of their investment process.