Can you state your name, your title, and company?
Jim Grant: Yes. Oh, I should do it. Yeah. I'm Jim Grant. I'm the editor of Grant's Interest Rate
Observer. And what I do for a living is write. I want to interview famous people, but who are
famous, perhaps, for reasons that the public is not fully aware of. I hope to elicit from them
new thoughts, frank admissions of things that they had not previously admitted to, and I
want to get them to laugh once or twice. Well, up next on Real Vision is a conversation
with Dan Rasmussen, who is quite an accomplished character. Dan went to Harvard as some people
do unusually for even a Harvard guy. He wrote a thesis, which turned into
a book called American Uprising. And it appeared when he was at the tender age of
23. And Dan then went on to found Verdad Advisers. And he's an investor. He is a thinker, and a most
accomplished essayist. And his essays deal with topics that pertain directly to the fine art of
buying low and selling high. So please join me in a conversation with Dan Rasmussen.
Well, I am seated directly across from Dan Rasmussen, a prodigy, a-- yeah, an actual
Forbes 30, under 30 entrant. He has turned 30, so that's kind of historical now.
Dan Rasmussen: It's old news. JG: And let's see, summa cum laude at Harvard, Phi
Theta Kappa, of course, Stanford MBA. And if time permits, we're going to get into the rest of this
program. I'm not finished with this resume yet. And the author of a published work of history
called American Uprising. And that was published in his 23rd year, which entailed-- which actually
provoked an active reportorial condescension mask. There's a review in the Washington Post, the
guy said, the critic said, paraphrasing Samuel Johnson, they said, it's kind of remarkable that a
man should produce a work that has some flaws. It was remarkable that he should produce work at all
at the age of 23. So I want you to know, Dan, that you're not going to be patronized on this program.
DR: Well, thank you. Jim. JG: So substantively Dan Rasmussen is here, not
because of his CV, as formidable as that is, but because he is a man of parts concerning
the fine art of buying low and selling high. And I have had the privilege of encountering
his prose because it was put in front of my eye by a mutual friend of ours. But I've read essays,
Dan, of yours on private equity, which you are not a fan of modern portfolio theory, of which you
are not a fan of modern financial theory and of the thoughts as they pertain to investing
of Michael Porter, of which you are not a fan. Are you a professional iconoclast?
DR: I guess I need to come up with something that I am a fan of after you've
given me that list of things I'm not a fan of. JG: Well, you're a happy married man, aren't you?
DR: Yes. I am. But she is a PhD in clinical psychology, so she works with crazy people
for a living. JG: So it's like a-- so it's a busman's holiday when she gets home.
DR: Exactly. So I don't know. Her vouching for me might be good or might--
JG: But you do seem to have I may be permitted to speculate, it seems a heartily thing to do
on really 10 minutes personal acquaintanceship. You do seem to be predisposed
to taking the contrary position, is that not correct?
DR: I think that's always been part of my DNA since I was a child.
JG: OK, so your investing life, which is now four years old. You had a career after Stanford at
Bain, you were a consultant. DR: I was in private equity at Bain
Capital. That was prior to business school. And then-- JG: Oh, prior.
DR: Yeah. And then started my fund after business school.
JG: And then Bridgewater. DR: Yeah, during college as an intern, yes.
JG: And then Verdad Advisers. That's with an E, A-D-V-I-S-E-R-S. DR: Yes, that's correct.
JG: O-R is kind of pretentious, right? DR: Yes.
JG: So tell us about-- I want you to tell us first about Verdad,
which is truth in Spanish. You informed me. And then we're going to double back and you're
going to tell us about some of the ideas that have informed you and perhaps have
propelled you. So tell us about Verdad, which you founded four years ago.
DR: Yeah, the premise of Verdad was really very simple, which is that if you looked, really, from
1980 to 2010, private equity as an asset class outperformed the public equity market by 6% net
of fees per year. And they were charging 2 and 20. JG: 6 percentage points-- DR: Per year.
JG: Yeah. DR: According to the industry data, so maybe it's
a little optimistic. But in any case, I think it's hard to argue with the early track records in the
'80s and '90s of Bain Capital, KKR, Blackstone. I mean, they were phenomenal. And if you look at
what they did, what did they do to generate those returns? Not what they call themselves that their
private equity or that its operational improvement or the marketing, but what did they actually do?
Well, they did transactions that met three key quantitative criteria. They were small, so the
average market cap of a private equity transaction is about $200 million, so these are micro-cap
transactions. Second is that they're leverage. So this is the leverage buyout
industry. And from the very beginning, every deal was levered 65% or more.
And 65 is the long term average. In the '80s it might have been as high as 80s.
JG: Oh, yes. DR: 80, 90, sometimes even more. And then third,
and this is really interesting, private equity for many, many years bought at a substantial discount
to the public markets. When private markets were inefficient in the early '80s I saw a letter
from Mitt Romney saying that-- this was in '93, and he said, I'm getting worried about valuations
because we're no longer able to buy in the four to six times EBIT range in which we used to over
the past decade. Four to six times EBIT. I mean, they were buying these things so cheap.
JG: That's earnings before interest and taxes. I noticed you didn't say EBITDA.
DR: Yep. JG: Which is-- did you intentionally--
DR: That was just because I was quoting from him. But I think broadly, in the '80s, '90s,
and early '00s, private equity was buying at less than seven times EBITDA on average.
JG: What does that translate to in price earnings terms?
DR: You know, it's hard for me to do the conversion because every deal is so
levered-- that's why you look EBITDA. But the public equity market over that period, the S&P
500 was maybe trading at 10 or 11 times EBITDA. JG: So the market was cheap by our lights,
interest rates were high by our lights, and these companies were marginalized.
DR: Right. And they were buying them cheap in private markets. They were using
the cash flows to pay down debt. And then they were selling them at higher multiples. And
so all those things were wonderful and smart, but what happened is that in the mid '00s private
equity became an asset class. And it's something that you would have an allocation to. And money
started pouring in and deal multiples went up and up and up until they were equal to, and
now almost higher than public equity markets. And what's problematic about that is not
just higher valuations mean you can't get multiple expansion when you sell, and buying
higher is obviously worse than buying lower, but the amount of leverage to get to a 65% levered
transaction went up and up and up. When they were buying at five or six times, they were putting
three turns of debt on, which is very reasonable, you can pay that off in five years. It's a great
transaction. But you put six, seven turns of debt on the business, it's really hard to pay that off.
The interest payments are extremely burdensome. Any change in your financial condition is going
to lead to bankruptcy. And so what I said is, well, I want to start-- I want to go back to
the '80s and '90s, a bit back to the future and buy companies that are small, cheap, and
levered, just like private equity deals in the '80s and '90s. But I found that you can't
do that in private markets today because everybody is so obsessed with private equity and
private markets, they flooded it with capital, everything goes to auction, it's impossible.
But if you look in the public equity markets, globally there are hundreds of companies
that look like that, they're small, cheap, and levered. And so I said, well,
I'm going to build an investment firm to focus on those companies, that have
the exact same quantitative criteria as private equity in the '80s and
'90s, but that happened to be public. JG: So this goes back to William E. Simon in
the Gibson Greetings Transaction of, what? 1970- something, right? I think they were the pioneers
in this. But it was an extraordinary opportunity because it was an obscure one, right? It was
outside the pale of good taste and sound practice. Leverage itself was thought to be somewhat
problematical. Leverage became domesticated ditto private equity business, and then it
became, as you said, became an asset class. My friend Paul Isaac says of the hedge fund world,
he says, its not an asset class, hedge funds are not an asset class, it's a compensation scheme.
DR: Yes. JG: And in a way, can you say the same about
private equity? Isn't that too kind of a compensation scheme for the general partners?
DR: I think it's a way of holding-- it's a brilliant way of
holding levered micro-caps. So then came upon this remarkable statistic
that, I think micro-caps of the past 30 years, 30% of years have been down years for micro-caps.
JG: And define a micro-cap for our viewers. DR: Sub 500 million of market cap.
JG: Yes, sounds like a lot of money when you say it fast.
DR: Right. But in the public equity markets, they're small. And even in the S&P 500, I think
it's one out of every four years is a down year. If you look in private equity over
30 years, it's one in 10 years. JG: But that speaks to the brilliance
of the private equity people, or does it speak to something else?
DR: It's a leading question, Jim. I mean, I think it speaks to-- the private equity is a--
holding levered micro-caps in a non mark to market vehicle that's private, and so you can make up
the marks every quarter rather than having to mark them to the public equity markets is a
brilliant strategy for holding the assets. And then you lock the capital up for a decade,
charge 2 and 20, make up the valuations. I mean, I couldn't imagine a better business model.
JG: Let's go back to making up the valuations. Can you elaborate on that one?
DR: Sure. So in public equities, your value of your companies, the share price
at the end of the day times the number of shares outstanding. And unfortunately, or fortunately,
depending on your perspective, those numbers are very volatile. Public markets could go up
2% or down 2% in a given day, in a month they could be up 6, down 10. I mean, it's just the
volatility of public equity markets is crazy. It's a characteristic of the market. And I think
since the '30s people have had big dreams of saying, well, why are-- prices of companies
shouldn't be so volatile. This is a bad-- JG: Business doesn't change every
day, why should the price , right. DR: Exactly. And private equity has in some sense
solved that question because they say, well, they buy a company, and then what's it worth
a quarter later? They say, well, the business hasn't changed that much over the last three
months, it's worth basically the same as it was worth before. So the old policy was to market
at one times your money until essentially you had sold it or had some sort of dramatic change
in the business and then you'd change the mark. But the accounting rules change, and now they have
to come up with some logic behind the valuation. But the logic is still appraisal, say, well, other
similar companies are like this and exclude that outlier, and I think it's roughly here. But the
end result of that is that if you look at the time series of private equity returns, it's less
volatile, not only less volatile in the S&P 500, it's less volatile than high yield bonds. In terms
of percentage of down years, it's actually less volatile than treasury bonds, because it turns
out that when experts do the appraisal accounting, they don't think the market valuation
has changed very much each quarter. JG: Experts in the pay of?
DR: In the pay of themselves, or the accountants who are being paid by the private equity firms.
JG: The more you talk about this, Dan, the more appealing it sounds as a line of work.
DR: Maybe we should start a fund together. JG: Any openings--okay.
DR: But it'll be a permanent long term cap. So maybe 20 year lock up.
JG: So you had the opportunity, before you wasted those two years
at Stanford, of staying in Bain. DR: Yes.
JG: Right? Of climbing the ladder. You threw it away.
DR: I mean, I think that my point of view then as now was that doing private equity
transactions at 11 or 12 times EBITDA and taking six or seven turns of net debt times to EBITDA out
to do those transactions was not a strategy that was going to provide investors attractive returns.
JG: We're not talking about investors, we're talking about Bain.
DR: Well, I think that the partners at most private equity firms
are doing very well. But I have always been somewhat of an idealist. And I think what
makes me interested and intellectually engaged is doing something I believe to be right or true.
JG: That brings us to Verdad. And it brings us to how you look for stocks and what you want to avoid
in stocks. But so you're managing $80 million after four years. So tell us a little bit, if
you would, please, about your portfolio. And then after you do that, we want to go back-- I want to
go back and talk to you about some of the things you've written about, and how those ideas might
be informing your everyday work and investing. DR: Yeah, so I think the premise
started that we wanted to buy small, cheap, highly leveraged companies to
do what private equity did in the '80s and '90s. And that was the genesis. That's the engine of
everything we do. But what I found-- and this is interesting and touches on some of the work.
I think I said, well, OK, well, how do I then choose-- if there are 500 small, cheap, levered
public companies, how do I choose? And I think, let's say there are a few different methods.
I think one would be to say, well, why don't you just do DCF model? Just kind of cash flow
models for each of them and choose the one with the best expected returns. But as I looked into
that I realized that the growth forecast that end the-- also, the discount rates that were plugged
into these DCF models were so erroneous as to be completely unreliable, such that if you looked at
any sort of empirical test, there was no way you could come to the conclusion
that that made any sense. And then the next one was to say, well, why don't
we buy companies that are really high quality businesses, that have great competitive position?
But as I looked at the evidence for that, I couldn't find any evidence that high quality
businesses or competitive advantage had any sort of benefit in terms of equity returns.
And so I started doing a lot of work on studying what the Chicago School of Investors, the
FAMA-French, the Dimensional Fund Advisors, AQR, that world, what were their insights
about how to predict stock returns? And I found that some of them are
very valid. Value, the cheaper you buy a company the higher the expected returns.
JG: Hold on a second. These people are telling you if you buy low and then sell high, it's OK?
DR: Well, it's remarkable that that's what the evidence suggests. And so I started basically
saying, well, let me look for what are the long term. And this is, also, I think part of the
influence of Bridgewater, because I think working at Bridgewater, even though I worked there for a
very short period of time, Ray Dalio had a very firm philosophy, which is that you want to take
something that's logical, like you should buy things cheap, you should test it empirically over
long periods of time and across multiple markets. And so everything I do today, I said,
well, what are the things that are logical? Like buy cheap. Can I test them over long periods
of time? And then can I turn those insights into principles, and those principles into profitable
investments rather than making case by case decisions to have a set of principles? And so we
found, for example, within the universe of small, cheap, levered companies, broadly, you want to
buy the ones that aren't going to go bankrupt. JG: Good call.
DR: It was a genius insight. Well, it turns out that there's been a lot of work
that's been done in what predicts bankruptcy. The credit ratings agencies do a lot of work. I mean,
and you can basically take all of this research and plug it into a model, and you'll find very
quickly that the stocks that are less likely to go bankrupt have higher equity returns if you're
buying levered companies. And so we've essentially just tried to build over the years more and
more research on what works in our universe, and apply that in investing in a systematic way.
JG: In the late 1980s, during the, what would prove to be the peak of at least one credit
cycle and certainly the culmination of a great love affair with leverage and with junk bonds,
there came to be something called stub stocks. You were two years old. I
don't mean to patronize you. In 1988 and '89, stub stocks became a thing on
Wall Street. A stub stock is an equity with a very, very leveraged balance sheet.
So the equity portion is kind of-- it's always residual, but it is truly residual.
And the idea was that the junk bonds would be refinanced at more advantageous
rates as the business improved and as the ratings agency caught on to that
improvement. And with a modicum of management expertise of growth, bingo, the stub would not
just be a good investment, but a fabulous one. DR: I mean, it's not a dissimilar...
JG: It didn't work. DR: Well, now that you've given it away.
JG: It didn't work, and the cycle ended in 1990 because the junk bond market blew up and
these things were-- it turned out were truly excessively leveraged. I forgot how many turns
of leverage to EBITDA, but they were, I think-- anyway, so my point I guess was, which I
should have phrased the former question, Dan, because I'm here to ask questions, not
to sermonize. But credit certainly and even ideas on Wall Street have their seasons and
their cycles. And, OK, now comes the question. We certainly, I would say, are in a season
of great acceptance of lots of leverage, because it costs a little money, interest rates
quotes are historically, if not uniquely low. And you are buying leveraged companies in this
particular season. Now, does it concern you that this is not strictly a contrarian technique now?
DR: Yeah, I mean, I think it's a great point. I think that where you see-- I think the greatest
excesses of leverage are in the private markets today. Private real estate, private equity.
They're taking on so much debt. And the volatility of those transactions is concealed by their
private nature. In the public equity markets, I think things are quite different.
I think that leverage is not looked upon favorably in public equity markets today. There is
very little appetite among public equity investors to own levered companies. In fact, there's very
little public equity appetite for small value stocks generally, or small stocks generally.
JG: Can you give us an example of one or two specific names that
you own and why you chose them? DR: Sure. And you'll find a commonality among
them. But I'll give just a few examples. So I own a Japanese die casting company that's
essentially part of the auto supply chain called oresti 58, 52. Oresti trades at 2.7 times
EBITDA, and is 54% levered. So you look at a transaction like that and say, well, either
this business is going to go bankrupt, which given that there is roughly one bankruptcy per year in
Japan out of 3,000 listed public equities seems like an infinitesimally small possibility.
Or at some point this company should either pay down debt or revalue, and it should be worth more
than 2.7 times EBITDA because that's a bizarre and insanely low valuation. Another example in the
UK would be a company called First Group. They own Greyhound bus, Greyhound buses. They
own school buses for students-- you'll probably see it in your neighborhood.
They also own an UK rail franchise, which is unprofitable. That company trades at
about four times EBITDA, it's about 45% levered. And so I look at that and say, companies like
that have one or two or three turns of net debt to EBITDA, these are not big credit risks.
They really aren't. What you're buying is a very cheap company that's very nicely levered
that is fully capable of paying down their debt. And so I think that broadly, is leverage a
good thing? No, leverage is a double edged sword. Too much of it is a very bad thing,
and a little of it can be very helpful in the right context, in the right circumstance.
JG: Ted Forstmann, one of the progenitors of Forstmann Little, said that leverage is like
chocolate cake, a little taste fabulous. He was one of the people who was in private equity
when it was still called leverage buyouts. The name was changed to reasons of optical hygiene.
DR: Well, it's funny. They keep changing it. So it was leveraged buyouts, and then it was private
equity, and then it was private equity and growth capital, and now they've renamed the trade
association, the American Investment Council, because they're investing in America.
JG: Who wouldn't want to own that? DR: I think it's worrisome though if you have to
keep creating new logos every two or three years to rebrand what you do.
JG: Yeah, it's like somebody who keeps shifting in his
residence that pays rent. So let's go back to what preceded the creation of
Verdad, which is the ideas that you have imbibed, and through your writings have helped
to disseminate. And I want to ask you two or three separate things that I thought
were so very impressive. Let's save private equity for a little while, because I think we've
given probably more than once over. Yeah, but it deserves it again, so we'll come back to it.
Let's talk about modern financial theory, investment theory. And you wrote a fabulous
piece, which I happen to have on my lap. And it's called The Bankruptcy of Modern
Finance Theory. And this came out, I guess, exactly a year ago.
DR: Yes. JG: And I thought it was his remarkable for
his writing as it was for its content. And so bravo. DR: Thank you, Jim.
JG: But one of the ideas was so, to me at least, so new and so iconoclastic, and therefore so-- not
therefore, but appealing, perhaps a little bit, because of its very iconoclasm was your attack
on the dividend discount model. This was, as you point out, this was a body of thought
that propounded by a John Burr Williams in 1938. And this guy was very clever with math.
I'm sure he did very well in his SATs. And he created kind of an algebraic accounting.
DR: Yes. JG: And if you read along with
John Burr Williams, you could see into the future, and knowing
the future, invest accordingly. It was a brilliant concept. Did that work very well? Did it?
DR: Well, I think Williams' central idea is that a company is worth the net present value
of its future cash flows discounted back to the present based on a discount rate. So in order
to assess the value of a company, all you need to know is its cash flows into perpetuity and how
risky it is, so you can assign the discount rate. JG: Just looked it up in the Moody's manual.
DR: And it's funny because I was speaking at my Alma Mater at Stanford Business
School, and I said, well, you've all been taught this methodology, does
someone want to stand up and just tell me what their salary is going to be in 2023, then their
net income after their expenditures, and then how much money is going to be in their bank account
on December 31st, and then just assign a discount rate in terms of how risky the probability is of
you earning that salary and having that net income are? And of course, people said they have no idea.
So if you have no idea for your own salary, well, you are the world's leading expert in you. How
in heaven's name could you have the hubris to think of what Coca-Cola's earnings are going to
be in 2022 or 2023? I mean, it's the height of foolishness to think that you
can see that far into the future. JG: And yet, and yet, this conceit that
the future is an open book rather than a closed book is ubiquitous in our line of
work. I mean, the Federal Reserve has-- I think if you sat down with a couple of these
people at the Fed, just poured them just a couple of beers to loosen them up, they might admit
that actually they can't see into the future and improve that before it comes to pass. They
will admit that. But they certainly come across in cold sobriety as seeming to believe it.
DR: Yup. Well, there's a wonderful book that I think has really changed my worldview. I think
it's one of the best books I've ever read. It's by Philip Tetlock, who is a student of Daniel
Kahneman, who wrote Thinking Fast and Slow, won the Nobel Prize. And Tetlock was one
of his star students. And Tetlock's area of interest is forecasting. How far and how
well do we see into the future? So for his-- JG: Is it a short book, is it?
DR: It's a very short book. You forecasted what I was about
to say very accurately. But Tetlock what he does is starting in the '80s, he
had about 400 experts, so people from think tanks and academia and the State Department. And he
asked them to make quantifiable forecasts one year in advance. So is the United States going to go to
this war with the Soviet Union in 1984, yes or no? And I think he collected something like
100,000 forecasts over a 20 year period. And they scored the accuracy of the
forecasts. And what he found is that experts were no better than non-experts at
predicting the future, and non-experts were no better than throwing darts at a board.
JG: Everybody knows that. DR: But what's interesting is that the experts had
a significantly higher confidence in the accuracy of their forecasts. So it was like doubly bad.
JG: I know. Yeah. 40 years ago I knew so much more than I know today, especially about the future.
So knowing now what we ought to have known then, then the future is in fact a closed book. We
can toss out the dividend discount model in its entirety, is that the whole book? Out?
DR: I think so. I mean, I think that if your entire model is based on perfect foresight
into the future, or even mildly good foresight into the future, and the future is completely
unpredictable, then that entire exercise is merely an attempt to increase your confidence
that increasing your accuracy, so it's doubly bad. And I think instead you have to say, given
that the future is inherently unpredictable, how do I make good bets? If you're
an investor, how do I make good bets? And the answer is not imagine I can predict
everything about how the world will unfold and then choose the best thing. It's to say a
priori not knowing things, what should I buy? JG: So we can't know the future, but we
can observe in the present how people are betting on the future.
DR: Exactly. JG: And that betting takes
the shape of valuations, no? DR: Yes. Exactly.
JG: So that leads us back to this die casting company in Japan trading at nothing.
DR: Yes. Exactly, because I think my view is that it's an odds game, right? Investing is
a game of meta analysis, not analysis, it's not what you think, it's what you
think relative to what everyone else is thinking. And the valuations are the best metric
of the consensus wisdom. And so if you buy things that are at the extreme of cheapness that everyone
hates because they think, I don't know, that the die casting business is a commodity business, it's
in the auto supply chain, autos are-- who knows why you would hate that company so much, the
margins are thin, there are dozens of reasons. But I think if you step back and say, however,
it's so darn cheap, is it going to perform better than these horrendously negative
expectations? I think the odds are in my favor. JG: You're describing the kind of the vintage
1934 security analysis Benjamin Graham. And Benjamin Graham evolved in life
as, I guess, we are meant to do. And after security analysis came the Intelligent
Investor, and after the Intelligent Investor came conversations in which he seemed to be pointing
in the direction that Warren Buffett later followed, namely the notion that the
price in value are not this positive. But what you want to say is a really great
company. And you want that at a good price. But you want growth for
what you don't exactly pay. But Buffett has tossed out the cigar butt, as
it's disparagingly called, the cigar butt Benjamin Graham to embrace something along the lines
of the Michael Porter view of what constitutes a really, really good investment candidate.
Can you help us understand that evolution, whether it is one we ought to ourselves travel?
DR: So there are elements of truth to it, that all things equal if you had a very cheap company.
But in many cases, the problem is that many cheap companies are on the path to bankruptcy, so
they have a time frame, they are truly junk. And so I think if you say, well, I want to buy the
cheap things that are not going to go bankrupt-- and that also fits with a sort of probabilistic
worldview. If you say, well, I want to have the cheap thing, something good, something
surprising has to happen for it to revalue. And I want the longest duration, the longest
number-- the most number of chances for something surprising to happen. You want the
company that's going to last the longest, which means the company that's least
likely to go bankrupt. And so insofar, as you define quality is that characteristic
of not going bankrupt. I'm in agreement that we should buy cheap high quality companies. Where
I disagree is this new definition of quality, which is, enters Buffett's lingo in the
'80s where he talks about wide moats and competitive position. And it's really entered
the vernacular of a lot of value investors, barriers to entry, market share.
JG: It seems to make so much intuitive sense, you don't want to-- for example, the podcast industry.
DR: Yep. JG: All you need is a microphone and a guest.
That's it. No barrier to entry. Anybody can do one. And you'd expect that for that reason
that the returns to podcasting would be just as small as they actually are. Where as to you
build a nuclear reactor, well, takes a little-- there's your moat for you. So what's wrong with
that particular insight, as trivial as it might seem? Certainly, there's some truth in it.
DR: Yeah, of course, there is some truth to it. But once you have businesses that are
generating tens or hundreds of millions of profit, the question is, how do you distinguish between
the good ones and the bad ones? It's not like, of course, if the podcast empire suddenly somehow
made it so it was generating hundreds of millions of profit and was a publicly listed company,
you'd say, well, there's got to be something there that's leading that guy to make money.
I mean, just look at this bottled water. I mean, why--
JG: We're paying that sponsor-- hold it one more-- DR: Very lucrative sponsorship by this French
water company. But why-- is there a moat to producing water? No, there is no barrier to
entry to producing water, and yet, people buy it. JG: Moats are water.
DR: Moats are water. So but I think more broadly this idea of moats or barrier to entry, we
have to look at where it comes from. And it comes ultimately from antitrust theories. And it comes
from this school of thinking that emerges from the general den of bad ideas, which is the
business schools. And they broadly think that an industry's structure should dictate the conduct of the firms in the industry,
which should dictate their performance. And even more broadly, a concentrated industry
should have firms that have higher profit margins, right? I mean, if a monopoly can use
its market power to make crazy profits, then something that has an 80%--
JG: They all want to be monopolies. DR: --market share, 70% market share.
And that was the idea of quality or moats that really has become popular. I think it
was popularized by Buffett and Michael Porter. And I think the only problem with it is that
it's completely empirically wrong. I mean, there's just no evidence for that. There's no
evidence that market share and profitability are related. There's no evidence that that creates
barriers to entry. It's just all a bunch of useless speculative theory.
JG: You have contended that profit
margins are mean reverting. Are they? DR: At least empirically they are. Now, they don't
perfectly revert. So if you have a 20% margin business and a 2% margin business--
JG: Well, Jeremy Grantham at the GMO, which is a lustrous money management firm in
Boston, it contends that something has happened. And observing the data, he points out that profit
margins have not for years seem to mean revert, that they remain elevated. And he questions
whether something isn't different under the sun. DR: And I think that Grantham is talking about
something that's slightly different than what I'm talking about. I'm saying within the cross section
of if there are 3,000 or 4,000 US public equities, and you take all of their margins this year,
next year, will there be mean reversion reserve? And the answer is yes. Now, on a market
wide basis, I don't-- I think Grantham probably had more insight than I do as to that.
JG: So many everyday observations that seem so commonsensical seem to find their polar opposite
contentions in the world of business academia. For example, the notion that uncertainty exists seems to be kind of an important academic
discovery, where as anybody who's late for a subway train in an appointment, knows intuitively
and in a very personal way about the factor of uncertainty. So tell us about how uncertainty
plays into, A, academic research and, b, into your everyday investing life.
DR: Yeah, well, I think academics love theory. And when practice doesn't align with theory, when
the reality doesn't conform to the theory, it just proofs that reality is problematic and needs to be
forced into alignment with theory. I mean, I think that I'm broadly anti-theory. I think very few
good ideas work. I think most theories are wrong. I think the world is far more complex and far more
uncertain to be diagnosed with simple theories. And I think as an answer to uncertainty,
the academics first answer is let's have a plan. And unfortunately, that's
almost the worst reaction to uncertainty. JG: Now, is academic, not
economics, but business theory, is inherently collectivist? DR: I think it is.
JG: Is there a politics to it? And if so, what might that politics be?
DR: Well, I think it's a celebration of planning. I mean, I think that broadly business academia
is focused on how to come up with a plan, how to come up with a plan for your investment.
Here's your five year forecast plan for your company. I mean, the only other place
you see five year plans is in Soviet Russia and Maoist China. I mean, you see that the
academics have a great affection for those types of economies because they want there to be plans.
JG: There was in the day a conglomerate called Teletime. And at the head of this conglomerate sat
a Henry Singleton, a considerable prodigy, who-- let's see, he went to the Naval
Academy. He went to MIT. He was a formidable thinker on quantitative topics
as well as other topics. He ran Teletime with the heretical idea that you ought to
issue stock when the price was high and buy in when it was low. And he was skewered for this.
For example, in the cover of Business Week for his financial engineering. I'm not sure if
that term existed, but certainly the contempt for what became financial engineering existed
in the early '80s. So Henry Singleton was taxed at one shareholders meeting by a guy who came
to sit down, Mr. Chairman, or Mr. Singleton, he said to them, what is the plan? We read your
annual reports. There's never any indication of what this company is going to do in five years.
And Singleton answers and he says, here's my plan. I come into the office every
day and I see what's out there. And if it's exciting, we do it. If it's not, we
wait until tomorrow. That's the plan. It was pure spontaneous opportunism
informed by price and value. Is that perhaps the long
term plan of Verdad advisors? DR: It is. I think that we want to be
basing our decisions based on principles, principles like buy low and sell high, principles
like do what is empirically proven to work. And I think if you make decisions based on
principles, whether that's Aesop's Fables or the 10 Commandments, you tend to make better
decisions than a sort of utilitarian calculus, if I do this, that will happen, these causal
chains. Because the causal chains, they never play out the way you would have anticipated. So at the
end of the day, wouldn't you have rather made the decision based on what you believe to be right?
JG: So you are in the very early phase of your career. And you are in that phase of
entrepreneurship that some of us remember so well, which is the knocking-on-door phase.
DR: Yes. JG: Right. So by the way, that too shall
pass pretty soon. It's just you're rich and famous. DR: I hope so, Jim.
JG: But tell me if you would about how your pitch is met in the world of investments.
So you go out and you say, private equity, which is an established asset class blessed by
the great foundations and academic endowments, blessed too by the wealth and sheen of the
general partners of the private equity firms, go out and say, actually, when you think about
private equity today given the valuations of the companies they buy, given the leverage employed
is going to produce zero returns in 5 or 10 years, that is almost mathematically certain, insofar
as anything is certain about the future. In contrast, we at Verdad with 80 million
under management and with a general staff whose ages perhaps are not as advanced as some
fewer gray hairs certainly. We at Verdad have seized upon the observation that if you buy
low and sell high with a leverage overlay, you will do well. Now, how does that pitch work?
DR: I think it depends on whether people generally like or dislike heretics.
JG: But here's the amazing thing. The heresy you described is the orthodoxy of about five minutes
ago. DR: There are no new good ideas in the sun. But
I think that on some level, is there an element to us walking in and saying, here are the
things we believe and you're entirely wrong? Yes, I think there's a hubris to that. But at
the end of the day, we're saying you're wrong because you think the world is predictable
and knowable, and we are embracing ignorance. JG: Right. You sold me. But how about the
Ford Foundation? So what do people say when you come to make your pitch? You obviously go
and see people. You're raising money, I presume. So what kind of reception do you get?
DR: It depends. I think most of our investors, the majority of our investors are
professional investors themselves. And so we've had very little success
with the people that allocate money to professional investors.
JG: Asset allocators. DR: Yes.
JG: How about the consultants? DR: I don't think the consultants very
much appreciate our message either, because it's threatening. And I had a conversation
with one large allocator, which stuck out to me, and I said, maybe I'm wrong and maybe
I'm right, but you could test whether I'm wrong or right. And I said, here's how
you could test it. You believe that your managers have extremely high conviction and
that their knowledge and expertise leads to that conviction and that conviction leads
to better outcomes that are more accurate. And so I said, well, why don't, today, ask every
one of your portfolio managers to provide the one year profit forecast from-- what do they think--
what was profit in 2017? What's profit going to be in 2018 for each of the companies they own? And
then see how accurate they are. And I will give you my prediction for every one of those companies
today on the spot, which is 3%. And I'm going to bet you that if you did this analysis, my 3%
forecast would be 20% more accurate than the forecast of all of your fancy managers.
And a year from now, if I'm right, we can come back together and we can talk
about investing. And if not, then you'll at least have rejected my hypothesis data, but
the fact that you're betting on these people because you believe they have industry expertise,
and that industry expertise translates into better forecasts, and those better forecasts translate
to results, but have never asked or evaluated the quality of their forecasts. I mean, to me it seems
crazy. But the world has been-- the planning. And I think some of this is academia, right? You
graduate from business school. And then you go and become an allocator. And the way you approach
investing is there are four buckets and five things on a grid, and you--
JG: Can we not get rid of the word bucket? DR: Well, I've just been looking for
more other blue collar working man's terms to integrate. JG: Lunch pail.
DR: Lunch pail and hammer and lever. I mean, it's a funny thing
about finance, the love of these terms. But I think more broadly, I think the proof of
what I'm saying I hope will be in the pudding. I think by your fruits you shall know them. I
mean, at some point-- and, look, private equity-- I say private equity, I don't think that these
vintages are going to do well. I've been saying this for years. Well, how's the last 3, 5, and 10
years for private equity done? Significantly worse in the public market at a 3 year and 5 year basis.
JG: Right. One of the features of private equity that is not so often talked about as
it perhaps might be is the lack of transparent marking of value. Tell me, if you
would, please, you must in your pitches say, our portfolio is in the paper every day, or on the glowing screen. Why are you taking their
word for the marks when they're self interested, and perhaps for that reason, not entirely
objective? So is that a convincing argument, or perhaps might it be an argument against you?
DR: It's an argument against us very much. I mean, people would far prefer to not deal with volatile
things than to deal volatile things, even if volatile things go up more. And I think that the
people love private equity for-- everyone in the value chain loves private equity for that reason.
There are never going to be any surprises. They're never going to go to their investment committee
and say, my investor in Blackstone 12 was down 13% over the past three months. They're never going
to have to do that. It's just a mathematical certainty nearly that will be exactly what it
was three months ago, versus the public equity managers, where you're constantly being surprised.
JG: Well, has anyone ever told you they prefer what you have written-- used this phrase
in print, phony happiness? Has anyone ever told you that's what they want?
DR: We did have one locator that won't be named who said they would love to
invest in what I did if I could provide it in a non-marked to market wrapper, but I explained
that the SEC did not look fondly upon non-marked to market wrappers of public equities.
JG: That person wasn't kidding, I gather. DR: No, they were not. But I think that
everyone values these smoothing effects, because I think that volatility can lead to
bad behavior. And so I think as an investor, if you're investing in volatile assets, your duty
is to be able to condition your investors behavior somehow to explain to them why that volatility
is a good thing or a natural thing and it's not a negative. It's just knowing the world as it is.
JG: Since Donald Trump's election we have had, with the exception, I guess a few months
this year, we've had a most serene stock market. Grant's Interest Rate Observer,
which I guess I bear some responsibility, characterized the President of the United
States as the avatar of tail risk. All right, from that day on the stock market was like a
lake at dawn, perfectly level and unrippled. And then came January, or February, but this has
been a time of very, very measured low-- measured as another -- low volatility. But
that's neither here nor there. Dan, I want to ask you about your
avocation, which is that of essayist. Yeah. So when-- as I mentioned at the start of
the show, you turned your Harvard thesis into a published work of history, which is a rare, rare
accomplishment indeed. And you have gone on to bring the world your thoughts on financial
theory and private equity and other topics, and specifically on the thoughts of the
eminent Harvard professor Michael Porter, in lengthy, like I'm guessing 8,000 or so word
essays. Tell me, A, how you find the time. And, B, what you're up to now.
DR: Well, first of all, I love it. I've always loved writing. I was a journalist--
JG: I thought you loved writing or loved having written. There's a difference.
DR: I think I love both. I find the process very rewarding, distilling my
thoughts. And I think part of it is, look, I am quite young and inexperienced, and so I think
that I shouldn't have the burden of explaining why my ideas are right, should perhaps the bar
should be greater for me because of my youth and inexperience. So I try as best as possible
to lay out the logic behind what I do in hopes the people will see that the logic makes sense and
bet on me even though I'm young and inexperienced. So I think that's part of it. But part of me,
I think there are so many pervasive myths. And I get bothered by them. I just, for example, in
business school we had to sit through this class on strategy, and I was just stewing listening
to the stuff. Barriers to entry. And so at the end of every class I would raise my hand and
say, well, professor, is there any evidence for what you've taught today? Or are we asked to
be taking this on faith, like we did last class? And after I asked that about three or
four times, he told me that I was banned from speaking from class. But I think that--
JG: Dan, what you might have done is have just excise that last part "or just like last time."
DR: I think that would have been more-- I've never been known for my diplomacy. But
I think there's something in the me that chafes at falsehood, or I think that I
want to expose these things because I think they're wrong and they lead to bad behavior. I
think relying on the dividend discount model, relying on choosing high quality businesses.
I mean, these things lead to problematic behaviors that lose people money.
JG: But except if-- it's like in a way Grant's Interest Rate Observer
cattling with what we see is the herd-like acceptance of the myths fomented by the Federal
Reserve. If people got up on their hind legs and criticized the Fed and threw stones at the
economists and their forecasts, where would we be? DR: It's true. But I mean, I think the remarkable
thing to me, right? You look at the Fed-- and we did a piece on this. If you look at the
Fed's predictions. And as you know well, they're completely erroneous. They have no bearing
on reality. And yet people time and time again, pay attention to them. The Fed, I think, has even
published reports saying that their own forecasts are wrong. I mean, and so but people keep relying
on them because they're so desperate for some-- I don't know why they're desperate
for some guidance or something. JG: I think people want to
believe that somebody knows. DR: Yes.
JG: There is this-- the first person plural, they, is a recurrent
word in American financial literature. It's oftentimes kind of a conspiratorial word
in the '20s. People would say, they're not going to let this market get away from them,
or they won't try anything before lunch today. DR: Right.
JG: So they used to be the forces of the Morgan Bank, or of this and that pool then were legal,
and increasingly time and regulations change, and now they are the government.
DR: And I think that we live in this era of a meritocracy where presumably the people at the
top are there by virtue of their own intelligence and hard work. I think that's very much the way we
think of things. But one problem with that I think is that-- there was a piece in Harvard Magazine
the other week called-- it was something like the Death of Experts or something and it was--
isn't it so problematic that the American people don't trust experts anymore. And I was talking
to a friend of mine and said, we should write a letter and say, where have the experts done
right? I mean, where have the experts been? The experts have been on the wrong side of almost
every major issue. And so one of the things that I'm working on now to address this issue, this
is my next essay that's sort of in process, but we're looking at this concept of expertise in the
context of company management. So we're saying that I think there's this idea, whether it's
through CEO compensation, or there are many other ways in which I think people believe that in this
meritocratic ideal that if we have this great CEO at the helm, a great helmsman, if you will.
JG: Leadership. DR: This leader will guide the company. And that,
in fact, the success of companies in the past is attributable to great leadership. And so what
we're doing is we've married the entire equity database with the CEO biography database. So we
can look at not only CEO characteristics, like do companies run by CEOs with Harvard MBAs
outperform the market? You'll have to wait to the essay to learn that they
don't. Or do MBAs broadly outperform the market? Well, it turns out they don't.
Or is past success, if you have a CEO who is CEO of one company, leaves and becomes
CEO of a second company, does their success or failure at the first predict their success or
failure at the second? It doesn't. Or even more, does the first three years of a CEO's tenure
predicts the next three years? And we're trying to ask all these questions, I think, because not only
are the results very interesting and contrarian, but I think they're revealing of
broader issues that I think are quite interesting and hopefully have broader relevance
than just narrowly the world of investing. JG: You're kind of a subversive character,
Dan, if I might say so. OK, so you have attained the age of 31. Yeah, it happens.
It's happened to you. I want to ask you, knowing now what you know, what would you have
done differently in your first 31 years? Then I'm going to ask you a follow-up question as
soon as I get an honest answer for that one. DR: Well--
JG: Would you have quit school and joined the circus? Do you hate yourself for having
gone to Harvard? Which is like all these experts. Stanford Business School. Like that. OK, go ahead.
DR: I think that-- but as St. Augustine has said, Lord, give me chastity, but not yet. And if you
replace that with virtue, I'd say it's easy to look back at all the bad things you've done for
31 years and say, I wish I hadn't done that, I wish I hadn't done that. But I think the
reality is that you learn from everything. And would I be able to critique business school if
I didn't have an MBA, probably not as effectively, or at least with a lot less credit--
JG: Well, the weather was probably great at Stanford, wasn't it?
DR: The weather was great at Standford.
JG: All right, so here you are 31. So what do you think for the
next-- given that the-- as we say, the future is perfectly transparent and we can see into the
distant. No, we can't. But given what we have just decided about the future, namely that you
can't see into it. I still want you to speculate on what the next 30 or 40 or even 50 years in
your case might bring. What do you see happening? DR: I think that my only goal is to live
according to my principles and my values. And I think that I have no sense of where that
will lead, but only that if I live according to those things that I believe to be true, I will act
in those situations as fitting. But I don't have a broad great grand scheme or plan.
JG: How about big money? DR: No. I mean, I think it's interesting. So
I have this investment strategy, but what's interesting about it is that based on all the
research we've done, we just can't manage much money. It's a wonderful strategy, but it can never
be a big strategy. It's a small little Corvette or Ferrari, but it will never be a giant profit
scheme. And I think there's something beautiful and wonderful about excellence regardless of
whether it's building a nice piece of furniture or running a great fund that's inherently satisfying.
JG: Well, Dan, I would say, on a very short personal acquaintanceship, I would say that
I am sitting across the way from a Ferrari. DR: Oh, thank you, Jim.
JG: Yeah, a human Ferrari. DR: Thank you.
JG: And it's been a pleasure to talk with you. And I wish you
all good things. In fact, I will go further, I will wish you things in the future just
as lustrous as they have been in your past. DR: Oh, thank you so much, Jim. I appreciate it.
JG: Thanks for being here today with us on Real Vision. Dan Rasmussen.
DR: Thank you. JG: Happy days. Well, that was Dan. Dan, I think
has aged very gracefully, don't you? I mean, he was an enfant terrible in his 20s, and
now he's a wise old hand in his 30s. It's a great pleasure to talk with somebody who
has accomplished so much in so little time. So thank you, Dan. And thank you ladies and
gentlemen for joining us on Real Vision. Which historic figure would
you most like to interview? JG: John Adams.
Why John Adams? JG: Because I wrote a book about him. And I
think he has a right to get back at me for it.
