How Smart Investors Get Sucked Into Irrational Exuberance & Lose Money | Guy Spier

we've spent a lot of time in the last few days talking about this very uh strange and slightly tumultuous period of Boom bubble and bust that we've gone through over the last few years and you've been talking about how a lot of very smart successful fund managers including close friends of yours and mine got sucked into a lot of these companies that seemed crazily overpriced but were very high quality uh in some cases at least very high quality or at least at least very promising and and so we're here at this conference of yours value X where a lot of people come in from around the world and it's kind of a nice barometer for the mood and in recent years you would have people coming in and talking to you about why you should buy a company like like snowflake at 100 times revenues and it was difficult it's been a tough time and you had people telling you you know here's what's so wonderful about cloudflare or twilio or carvana or Roku or or Spotify or Netflix and I'm I I'd like to talk for a while actually about this strange period and how how tempting it was how intoxicating it was how destabilizing it was and also how how you ended up resisting a lot of the temptation to pile into this stuff that was really very seductive because it had worked for several years it it was the way to make money yeah and where that starts for me is at the very very beginning of lockdown and I remember being in Zurich and the share prices of some of these um businesses that would benefit from Lockdown but we're all in the cloud and we're all this kind of SAS type business model uh we're absolutely soaring and one of the ones I remember was zoom and of course we were all starting to use zoom and I'd recently signed on to zoom maybe in the year before and um and the people who happen to have been in those businesses looked like utter Geniuses and I had always shied away from technology in general but especially software companies that had well uh that was spending an enormous amount of money to grab market share was the argument and uh I was I remember that I was invited to a launch with Eric Schmidt with monish and actually a former a student a very a student at Stanford Business School very felt very privileged to be invited to the launch and Eric Schmidt just took it as a non-questioning rule of business that there was of of the these new businesses is that there was market share to be claimed or land to be staked a bit like the American frontier West where they just let people ride as far as they could and all the land that they could see would be theirs and any amount of money that you spent to do this land grab was okay and Schmidt just so people know he he had run Google right he was he was the chairman of Google at the time so he had he was no longer the CEO I believe uh and so I I was kind of struck actually by we hold these truths to be self-evident there was no other way to work in business I mean this was and then um there were people in from my world the value investing World who'd invested in such businesses and with metrics and valuations that didn't make sense to me but they were being proven right especially through that covered period where the share prices of many of these businesses absolutely sold and it went to companies that maybe didn't have this sort of cloud when it takes all when it takes most component like Peloton for example so I remember that I changed my password because I was still in in a mentality of other valuation models for which these kinds of businesses would be cast out immediately and so I really spent quite a bit of time telling myself guy you're you've missed the boat you're missing the boat vote fear fomo is is something that spreads like wildfire through a population I remember that I changed my password so I you often use passwords that I have to remember I use them to kind of self-hypnotize or to remind me of something so maybe it's to have a positive attitude or to be happy or to take care of somebody It's a Wonderful way to kind of influence yourself because you keep having to bring it up and it kind of works its way into your subconscious so I I changed my passwords to remind me that I had to learn about these new rules of business if you like so that's the degree to which it got to me so what would you change it to during this heated period because I remember years ago you had Warren as a password for one uh for one website and and so I guess that was a way of you kind of tilting tilting the odds that you would behave in a in a high quality long-term myself and for a certain period of time uh because I felt like I had blotted my copy book through my experience at DH Blair the passwords were or they had an element of trusted in them so I wanted to be trusted so I just wanted to work that word into my mind I want to be trusted so be trusted everywhere and uh so you know I I'm sure that this is not very good from a password security standpoint there may be one password that will have to change right after this conversation it's an element there are only a few hundred thousand people listening you're you're okay guy but I'll have time during production but but the the phrase was new economy and and so rather than um and this was part of a longer phrase but but rather than ignore it and say this is not a place that I need to ever look for investment ideas just to to remind myself that this was something that I had to engage with seriously and there was uh I I'm gonna Hamilton I think is his name the seven Laws of Power how to get power and business I'm I'm mangling the name of the book but um I I read that book two or three times because it was it was relevant to the kinds of shifts that had taken place for example when um when we had Netflix and over-the-top services and this was again something that I had completely failed to um to focus on but then whenever I dove into so I had that going on and in a certain sense you can say I think that if I look at my mind so that um whatever it was that was spreading like wildfire and um a way of looking at the world and then accelerated by lockdowns and some of these businesses really did get a Tailwind to their businesses and soared and then of course I you've got my password changed so now I'm I'm saying no take these business seriously look at them carefully try and understand if there's a if if if if they are actually if you understand them correctly they are actually cheap and it was extremely frustrating for me because I had pounded into myself enough over the previous 20 something years uh valuation criteria that I just couldn't get there on any of them and it's not like I wasn't trying and for example in the case of Netflix um I saw these prodigious cash flows and we also I saw the subscriber growth but at the same time I saw them spending an enormous amount of cotton content not only that there was at some point where they did not do a share issuance they did a convertible Bond issuance and all of this money was going into content and so the big question arose at what rate should this content be amortized and the company was being valued as if it didn't have to be amortized at all meaning that the library was an Evergreen Library that would continue to generate the revenues that it was generating and those seemed to be heroic assumptions to me and for what it's worth at one point I rejected Disney for the same reason because because in these content companies they're just sinking a huge amount of of their free cash into movie assets which are kind of these random assets some turn into a franchise that lasts forever like Star Wars or Aladdin and others turn into something that was watched once and is rarely watched again and if you know you just don't know where on that Spectrum it sits and in other businesses though that I I just they the some of them weren't even cash flow positive and so you had to go uh Michael mobusian has this wonderful piece where he talks about uh how to analyze uh uh businesses based on this idea of unit economics and unit economics in a certain way we talk about uh Charlie Munger talks about how ebitda is not a real measure of earnings and this takes you one step use the router term than that that's true beginning with the word bull oh yeah and um yes and uh but you're going one step further and you're saying actually free cash from operations doesn't matter the only unit of analysis that counts is um unit economics so what is the cost of customer acquisition and what is the lifetime value of that customer we're talking about lifetime value of the customer you're making assumptions about what's going to happen over the next 30 Years that is an extremely long time in in businesses which tradition technology has been something that that you can easily or or over time constantly gets competed Away by Innovation so can you really rely on those now on the other side it only dawned on me way after other people and it was frustrating for me because I had friends I'd I'd gone and given a Google Talk invited by Sarah Madan and I'd gotten to know people who worked in Google's Cloud business business and what we understood from Amazon was that these these Cloud businesses have amazing modes because once you locked into that particular Cloud then it's very very unlikely that you're going to want to shift so a lot of these businesses especially with the soaring share prices the people who said well unit economics is the way to do it we're being proved right but I was enough of a dinosaur let's say that I just wasn't I didn't feel safe updating my valuation models to that degree and there's something where you know I mean I think I brought it up to you over the last few days if I go back to those beautiful days after the financial crisis when monish calls me up and he says you know there's this amazing CEO and he's running a company called Fiat and fiat's got a four billion dollar market cap and 120 billion dollars in revenues and so you kind of say you know if this company can earn one or two or three percent on those revenues which is a perfectly reasonable thing to expect then this thing is potentially trading at only one times earnings or not far from one times earnings and that is a very very safe low to the ground valuation which is grounded if you like and then you have these things which are kind of so far away from the from the underlying cash flows uh and you're kind of relying on these analyzes like unit economics and despite being desperately wanting to be able to say to myself that this made sense I would find myself disappointed and in a way sort of my heart's sink I remember listening to a podcast with the CEO of Roku and I had discovered on that podcast that Roku had uh this man had a very close relationship with Reed Hastings that Reid Hastings had invested in Roku and um that this I and I understood what over the top was doing and I myself saw how little I was watching say cable TV and how much I was looking at these various apps that appeared on my TV and allowed me to stream all sorts of things and that rocku was at the absolute Center of this and so I would excitedly then bring up the accounts of Roku and I'd just be utterly disappointed to discover that I was looking at a 40 billion dollar market capitalization and revenues of less than a billion and and and with that I was just almost unwilling to look further it just it just the idea of walking down into that cave or walking down that path made no sense to me at all and so I was stuck there and I wasn't able to invest in them while the people who were invested in them looked smarter and smarter and smarter maybe just you know an interesting sort of question for any analyst or anybody who wants to succeed at doing fundamental analysis is to ask oneself when when when do you stop and start searching down a different path and there's a question you know should I have gone further down the unit economics analysis framework should I have spent more time looking and understanding at an understanding Roku or cloudflare is a similar kind of story on the other side and something that I admonish has taught me a little bit to do but I really could go much further is that we often stop searching at the wrong point and I think that it behooves me to go a little bit further despite the apparent High valuation just to see where the analysis comes to and to try and understand a little bit further I think I probably stopped too soon but it's kind of unbearable to me I trained myself not to do that on the other side I think that there are there there are if you take the Fiat example I would have stopped the analysis and said yeah but it's loss making and the automobile industry is going through wrenching changes and this company nearly went bankrupt so there are all sorts of reasons to stop the analysis from that side and what you need to do is keep going just to see where you get to and to see if there's subsidiaries for example that I mean in the case of of Fiat even if you assumed which wasn't the case that the whole of the automobile traditional automobile Indus business was not worth anything they had this Jewel called Ferrari which anybody who held the spun out shares of Ferrari has got multiples of our original purchase price just from the spun out shares so sometimes something looks really ugly and you have to go further down the road I think probably you're better off going into something that looks really ugly and seeing what's underneath and pushing your analysis through on that side then um then then trying to find reasons to sustain evaluation that doesn't make any sense but on either side one should not cut one's curiosity and try and push through further why why do you think these friends of us who are really smart really thoughtful investors got seduced and were were able to suspend disbelief and suspend skepticism I I'm wondering slightly if in some ways it was that they they learned the wrong lesson from the success of people like Bill Miller and Nick sleep in in buying things like Amazon that were very high quality and seeing value in in a different type of company if in in a way they took some lesson from that sort of behavior and and and then forgot that that bill and Nick had bought things like Amazon incredibly cheap and then managed to hold they they saw the quality and then rode them for for many many years what do you think why did why did people suspend that disbelief who who these are really talented investors they're not mugs yeah and I think that where I go to edits um absolute core is that uh the so so the one thing to be really clear about I believe is that any one of us is susceptible to this including Warren Buffett the the idea that a human is not susceptible to these moods or whatever it is that takes over I think is a very very bad conclusion to draw we're we're all susceptible to it and another way of looking at this very very unusual development in um human history is this concept of markets and stock markets and a price for some commodity or some asset whose value is disseminated across a population I mean we certainly didn't evolve with that we all know about the fact that our minds evolved to taste the berries and react positively if the berries didn't kill us and react negatively if they tasted bitter or did kill us there's this very very weird interaction that happens between stock market market prices and human psychology and the underlying businesses that drive changing economics are in themselves changing so the economics of the cloud which is a new kind of economics has never interacted with the human mind before and I think that we we need to understand that the stock market and so public markets are constantly changing interactions between prices psychology and the underlying economic environment and it will constantly test the human mind in aggregate Define something that works and so sooner or later you've got this constant machine that is going to find something in enough human Minds that when is spread across them results in price action and reinforcements of things that that kind of like are extremely unusual for a certain period of time and this interaction between prices and psychology leads to this huge diver Divergence between what is going on between the psychology and the price action and the underlying reality so I think that might kind of like I I hope it's a useful answer is that that will take over any human mind in the same way that we can say that you know the virus any kind of biological virus doesn't really make a distinction between say race doesn't make a distinction between the intelligence it doesn't make a distinction between wealth and you and I know that one of the great it's one of these strange equalizing factors and a great weakness for very very smart people is that if you've been through the university system if you've done well at exams if you've had all sorts of experiences that lead you to believe that you ought to be able to be successful say at investing you come to believe that there are certain things that you're not immune to and I think it's hard for especially for smart people to really make ourselves aware that we're in a sense more susceptible to these Market moods because we think we're so smart that we don't need to pay attention if you like so I think that's the kind of like trying to to attempt a very very um uh basic explanation which in fact doesn't explain much it's just saying there's a weird interaction between psychology prices and underlying economic reality but then I think that if you want to do dive into more of the weeds it's something along the lines of what you're talking about that you know a brilliant guy realizes that he can uh that that it started with Costco that Costco Inspire despite appearing to be expensive was really very very cheap uh he then has the realization and I'm talking about Nick sleep and Costco along with Zach and then he has the realization that actually Amazon is Costco and steroids and there's plenty that's been written about this and he gets it right and you're absolutely right that the Amazon was never in a sense not profitable and it was a point that was made to me recently by Nick that even even at the time when the share price had declined dramatically what they were doing was they were taking operating profits and pouring it into new businesses so they were they they had internally funded growth from a from a very very early point and some of the companies you mentioned were all externally funded growth they were being funded by the capital markets but if you study next sleep and it's in part my job to study what brings success to investors and to understand new approaches to Bringing success in investing then a natural thing to do in my shoes is to say well Nick found Amazon uh how many other analogous Investments are there and I myself have had great success by looking at business models that have been successful say in the United States and applying them in other countries looking for credit rating agencies in other countries looking for for-profit Education companies in other countries or branded Goods companies in other countries and so it would be have been very natural for those of my IL to say what other amazon.coms are there out there but um in the same way you know is it that perception is a weird thing so you're looking for those qualities you think you understand them and then you go into another business and you think you found them maybe you have maybe you haven't I think that a lot of the madness was that people really did believe that they'd found them but actually they hadn't because there was only one Amazon or very few uh in the same way that maybe maybe somebody sees one successful automobile company in the town of the century but most of them ended up when going bankrupt so it's a complex story but I hope that that helps to some degree to maybe give some kind of an explanation it also gives a sense of just how hard the game is that you're trying to you're trying to see patterns and extrapolate from them and learn learn from examples of success and you have to do it with a tremendous sense of nuance that it's uh our gift for pattern recognition can also get us in tremendous trouble yes and so this thing just turns on itself constantly and you know maybe you I know that you brought this up to me recently it's one damned relatedness after another they're also clearly sort of sweeps of Market history so um uh we we're coming we were coming out of a period it's amazing how for how long uh the Ben Graham discount to book value or discount to two or three very simple measures buying the lowest diesel uh in valuation worked really really well but it worked and and this is coming out of the depression when all sorts of companies nobody wanted to invest in the stock market all sorts of companies were trading at discounts to very simple measures of liquidation value and people like me and many other like me sort of just wished for the days when all you had to do was find one newspaper towns but that was working less and less well but what was extremely successful starting with Warren was looking for these better businesses and you had Ryan conniff and other fans looking for better businesses it's a very natural um transition progression to go from looking for better businesses High Returns on Capital High Returns on incremented invested Capital um not looking for say Book value but but valuing the brands inside the business based on their intangible value and not tangible value because if you try and liquidate the brand you're not going to get anything and then take it yet one step further into um unit economics lifetime value of the customer and I remember with a good friend of ours going through the valuation of um Salesforce and Salesforce invests an enormous amount in marketing they do these I don't remember what the name of the conferences are but they're incredible events where they invite speakers I've attended one in New York City thousands of people attending some some amazing brand name speakers their amazing opportunities to learn not just about at its core of those conferences how to implement Salesforce in your business but how to improve your life in Any Which Way but in order to reach a reasonable valuation for Salesforce at the end of your value of of your model you had to take away those marketing expenses you assume that they're no longer necessary and you have to make huge assumptions about how many customers leave you every year because that sort of determines the life cycle how much you've invested now for the revenue that that customer is going to generate and you had to make well we will discover whether there were heroic assumptions or not maybe they were not heroic assumptions but I ended up having a debate in my own mind whether the Assumption was heroic or not and that the the decision as to whether that company was cheap or not would have actually turned on whether the assumptions in the model were generous or conservative and that's a whole new world that seems to me to have been kind of a step too far at least when it comes to Value investing and getting more you know uh now that I'm listening to your podcast Fred Martin who's repeated this word in such a beautiful phrase in such a beautiful way uh uh prices what you pay value is what you get and you know the definition of value ultimately you can have it in your mind and and a false valuation model can be reinforced in the market because of the price action that makes you look right for a number of years makes you look smart but then eventually gravity pulls it down to earth and you discover what value really is you mentioned to me the other day that you've come out of this period with a couple of new checklist items and and you also talked about how you were protected by being in this ecosystem where you were reading things like Tom gainer's annual letter can you talk both about the checklist items that that a practical practical ways to protect yourself against these kind of Temptations and also how putting yourself in a certain intellectual space in a certain ecosystem also is a key way of protecting ourselves from um getting too carried away yeah so the the checklist item is an interesting Riff on something that Warren Buffett has said so we all know that Warren has said that he does not he would not mind if the stock market was closed for 10 years his valuation and his his um confidence in the value of the business is not reinforced by any particular price action or any particular quote he looks to the results of the business what are revenues how much cash is it generating what are owner earnings all of those good things but what I realized when looking at some of these companies that were investing in the future of their business not from operating earnings but from money raised in the market either through Equity offerings or through debt offerings and many of these companies had had originated inside of venture capital firms where the Venture Capital firms would have fueled their growth by putting their partnership money into those companies but then that kind of it seems like that continued in the public markets and there were plenty of investors who were willing to show up based on their unit economic analysis or Revenue growth and all sorts of other numbers to continue to fund the growth of those companies so they're taking money from the capital markets and they're investing it in operating losses because they're going for this uh they believe that Winner Takes all or when it takes most and they want to grab market share and everybody believes this and all of this is wonderful until the Music Stops and the capital markets aren't willing to fund your growth anymore which seems to have happened for many companies in in 2022 and then the company has to do some huge reorientation because they have to restructure their business model based on internally generated cash flows and what it seems to me is that in many cases at that point what appeared to be growth capex or growth expenditure was actually an operating cost to the business and the internal accounting up to that point implied that the business was profitable because they they could characterize these new flows of capital coming in from the capital markets as capex and suddenly maybe it's not capex and maybe actually all the business or aspects of the business are actually not profitable and so the simple checklist item that comes up is can the company fund all of its growth and all of its discretionary [Music] investment in potential new businesses from existing cash flows and in a certain sense what I'm saying is that venge capital is a world that uh I don't I'm respected deeply uh there are people who do it really really well and it's spilled over into Capital Market into public markets but I very much want my investments not to be of the VC kind where Capital markets are funding growth but where growth is if it's being funded is being funded internally so the simple question is can the company fund all of that from internally generated resources I.E it continued to grow can continue to grow even if the capital markets were closed they don't need to rely on their interactions with the capital markets

Channel: Guy Spier

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Length: 30min 29sec (1829 seconds)

Published: Mon Aug 14 2023