PERSPECTIVE3-5 min to read

The Value Perspective Podcast episode – with Dan Rasmussen

Hi everyone and welcome to The Value Perspective podcast, where this week we are joined – for a return visit – by Dan Rasmussen. Dan is the founder of Verdad Research and we last had him on the pod in June 2021, when he discussed his passion for history and how it helped him as a value investor. You could also say history has repeated itself because, the last time Dan was on the pod, he had just welcomed his second baby into the world and, this time, he has just welcomed his third – many congratulations from us! In this episode, Juan Torres Rodriguez and Andy Evans chat with Dan about how reviled value is today, relative to when we last spoke; how memory and probability work together; his contrarian view on Michael Porter’s ‘Five Forces’ framework and quality investing; ergodicity and how volatility is not the best measure of risk – though it does matter in certain circumstances; and, finally, the opportunity for investors in Europe. Enjoy!



Juan Torres Rodriguez
Fund Manager, Equity Value
Andrew Evans
Fund Manager, Equity Value

JTR: Dan Rasmussen, welcome back to The Value Perspective podcast. It is a pleasure to have you with us again. How are you?

DR: Great. Thanks for having me back here.

JTR: I am joined today by my colleague, Andy Evans, so I will let him introduce himself ...

AE: Hi Dan. I am taking the place of Ben Arnold this time around. Ben co-hosted you in the previous episode and is very sad to be missing out this time. Hopefully, I will do a good job of filling in!

DR: Great. Excited to get to know you and it should be a fun conversation.

JTR: Dan, for those wo may have missed our first conversation – which we recorded almost two years ago anyway – please could you give us a brief introduction about yourself?

DR: Absolutely. I am the founder and CIO of Verdad Advisors. We are a hedge fund and manage about $850m across a few different strategies. We do deep-value equities, we do high yield credit and then we have a business doing crisis investing and countercyclical investing. So, when things get really ugly, we can call capital and deploy it into economic crises.

AE: Dan, last time you were on the pod, you had just had a new baby – and I believe that is also true this time around. That is quite a way to celebrate being on our podcast!

DR: Yes! In fact, our third child was born on the same date as our second child, two years apart, which is a coincidence. We had a girl this time so we are up to two boys and a girl and we are six or seven weeks in.

JTR: Congratulations, Dan. Now, Verdad is very generous with the research you put out and allows other investors and the investment community to see what you are looking at and share ideas. Please could you give our listeners a little bit of background behind that effort and tell us how it is going?

DR: We write a research piece every week – I’ve done that since 2015 – so that’s a lot of accumulated research. And what we are trying to do is make our firm transparent – we’re trying to show the research. Quantitative investment firms – and investment firms generally – are really research firms, right? You’re studying the market, you’re studying companies – and very early on I said, Well, why don’t we just make that infrastructure transparent and show people our research? I am a great believer in showing, not telling – you know, if you want people to get to know you, the best way to do that is to show them what it is you do. And the best way an investment firm can show people what they do, I think, is to show off their research.

JTR: That’s really interesting. Correct me if I’m wrong, but Verdad started up during Covid – you guys saw a great opportunity, with mispricing everywhere, and you launched a fundraising for one specific vehicle that did extremely well. Can you walk us through the story behind that, please?

DR: Yes. We wrestled – as I think many value investors did – with the period from 2018 to 2020, when value really didn’t work. And not only did it not work – the exact opposite worked, right? You can think of value investing or factor investing as like a ranking algorithm, where you rank from the best to the worst – and from 2018 to 2020, if you just flipped the ranking, you would have done really well. So if you had bought the least profitable, most expensive, highest growth, worst companies you could possibly imagine as a value investor, they did awesome. And if you picked the cheapest, highest dividend-yielding, highest free cashflow-yielding, most profitable businesses, you did terribly.

Everything I thought I knew was cast on its head, which was very humbling – as I think it was for many, many value investors! So I said, Well, what I want to know is, are there times when value is more reliable or tends to work better? And I start started on a research project, really in 2018 and 2019, and what we found is economic crises and recessions have historically been the best times for value. And, if you think about why that is, it’s in part because value investing is about expectation errors, right? You are trying to buy something where the market has an expectation that is way too pessimistic and the reality turns out to be OK and the stock reverses.

And what happens during crises and recessions is the entire market has a big expectation error, in that it becomes convinced the economy will never recover and basically trend-extrapolates all the bad things that have happened over the previous year and says they are going to keep happening. And, in reality, economies tend to recover from crises and, especially, developed economies tend to recover very strongly from crises. And often, the worst-hit cyclicals end up recovering the most – things like, say, industrial manufacturers or consumer cyclical businesses or energy stocks. They get whacked when the economy goes into crisis and then, if you buy them, you are buying them at a huge discount at a time when their forward growth rates are actually the highest they are going to be across a full cycle.

So we finished that research around the winter of 2019 into 2020 and we had this idea of, Hey, let’s go raise a fund where people will commit to us now and then, when a crisis comes, we can call the money. We started marketing that in, I think, February 2020 and Covid hit in March. And all of a sudden we said, We were going to raise in advance of a crisis but, with the research done, we are in a crisis – so let’s just call the capital now. And we went and bought the most beaten-up, dirt-cheap, smallcap value stocks we could find in the summer of 2020 and held that for 14 months, liquidated it and returned the capital to our investors. Then we raised another fund to do that and we also think there is an opportunity to do that in Europe, which we will do whenever there is a big economic crisis – which I thought there was going to be in Europe but it seems like we have dodged it. We can talk more about that but we are also going to do that in Europe as well.

For US largecap today, read Japan in 1990

AE: We will come back to Europe a bit later but, just staying on the topic of things maybe shifting on from the past couple of years, back on this podcast in 2021, you said all the high-growth stuff has done fantastically well and deep value is very out-of-favour at this point in time. Where do you think we are in terms of how out-of-favour deep value is today? How reviled is it, do you think?

DR: I think it really depends on geography. If you, broadly, contextualise the last few years in the market – 2022 and 2023 have been a bit different but maybe almost the previous decade through to 2021 – that was a really simple story: it was US largecap technology versus everything else. Anything else you were doing that was not US largecap tech was doing much worse by comparison to any benchmark – because any benchmark that includes US largecap tech was doing so great and, the more you piled into that, the better you did.

And I think there were two general reactions to that among investors. One reaction was, Gee, let’s just go all passive – let’s just own the S&P 500. I think passive investing and low-fee investing is a wonderful thing for investors – the challenge with it, though, is that when investors think passive, they are really think the S&P 500 They don’t think, Let’s do a European midcap or a Japanese index fund or whatever, right? They really think US large cap tech. So you saw people piling into the US through passive investment vehicles and away from anything else ... anything smallcap, anything midcap, anything international.

And then the second group of people thought, Well, if I’m going to take my active bets, I want to take them in private markets. So you saw the inflation of a massive private market bubble. Both of those things, I think, are the defining attributes of the last few years. By contrast, the minute you step out of that world – the minute you step out of US largecap tech and smallcap tech; and the minute you step out of the private market and private market-adjacent, such as the recent IPO world – you get into areas that have largely been neglected for maybe 10 years. And, as a result, they are almost all attractive – international markets are attractive, smallcap markets are attractive, value investments are attractive.

You then have to think, What are the different dynamics by region? I sort of divide the world into four – I think of Japan, I think of Europe, I think of the US and I think of emerging markets. Each of those has different dynamics at the moment that are going on and that shape how interesting the value investment opportunities are. But, broadly, I think we are in a place that, if you looked at historical analogues and asked, What does this period quantitatively look like? You know, the one analogy would be, It looks like you’re sitting in Japan in 1990 – where the US is Japan and everything else is the rest of the world.

Basically, any money you moved out of Japan back then – to anywhere else – did better. That is how I feel about US largecap at the moment. And, by the way, even if you went into Japanese smallcap value, you would have kind of done fine, right? It was really just largecap Japan that was horrible from 1990 onwards. Now, the US dominance has gone on for so long and the growth dominance has gone for so long and we have just seen the reversal of those things. So the last year or so has been the first time in a long time where we saw a big value outperformance and the first time in a long time where we saw a big international outperformance.

It is the first time in a long time where we have seen a lot of these dynamics and my view is, often in markets, momentum and trends build on themselves – you know, you have one year of value doing well, one year of international doing well and people start saying, Oh great, let’s increase our allocation a bit. After three or four years, you have everybody justifying it with some narrative about why it’s happening – it tends to be exogenous – and then that is when it really gets into full swing. I think the chance for that is relatively big at the moment – your upside-downside ‘skew’ looks pretty good almost everywhere, except US largecap.

Where probability intersects with memory

JTR: That ties in quite nicely with our next question – and indeed a piece you published recently about how probability intersects with memory. Everyone remembers the narrative of disruption, value versus debt and growth and quality being the natural winners but how does this memory cycle work? It feels like it took people four or five years to move on after the dotcom era but what is your take on that?

DR: I think that’s right. The piece covers some really interesting behavioural economics work about how memory shapes how people make probability judgments. It is relatively obvious and common-sensical that, in our everyday lives, our recent memories shape how frequently we anticipate something happening, right? Think of just after 9/11, your perception of how frequently terrorist events happened, or how safe airline travel was, was dramatically skewed because you had this very salient and recent event that anchored your probability assessments.

Then think about that playing out across different types of people in different age groups – and Covid is a great example here. With Covid, what you saw – which is really interesting and explains some of these behavioural economics trends – can be broken into three groups. First is older people: if you knew anything about Covid, one of the things you should have figured out from a statistical perspective is its impact was very age-skewed – you know, the median age of death was 85 or something.

So your chance of dying was just massively higher if you were old – but, with old people generally, their risk assessment of Covid was actually way too low. When the researchers studying this phenomenon looked into why, their explanation turned out to be that older people had experienced so many bad events over the course of their lives – so many things they were supposed to be scared of and yet they had survived them all – that, by that point, they just thought, Hey, this is another one of those. Like, I don’t need to pay that much attention to Covid – it is just like the scare over X, Y or Z three years ago and I survived that so who cares?

In contrast, young people tended to dramatically overreact because they had had fewer of those intervening events – they hadn’t experienced anything like this before. It was new, it was on the news and they massively overestimated the risks to them when, in reality, Covid posed almost no risk to healthy people under 40. And then, oddly enough, the people who most overestimated the risk of Covid were those who had trouble estimating the percentage of people in the world with red hair. So if you thought that, say, 10% of people in the world have red hair, you thought Covid was going to kill you the moment you stepped outside your house, right? People who had really bad understandings of probability had really bad reactions to Covid.

What the researchers extrapolate that out to say is the way our memories work – how many experiences we’ve had; how salient an event is; how good we are at relating math and probability and numbers to lived experience – these things shape the way we actually then act. And I think, naturally, it shapes the way we invest. So if you think about what that does to investors, they tend to be anchored towards the last three years – what worked over the last three years and what didn’t work over the last three years – and that is going to be shaping, in a large part, what people are willing to bet on.

One example I see in the market right now is the huge fervour over artificial intelligence. Now, if you had a memory of just the last few years, the one memory you might say should be really salient to you is: any time you hear about a hot new technology, buy it immediately and hold it for a year or two because these fads have just gone nuts in markets. Whether it is 3D printing or electric vehicles or crypto – just try to get in early and then you make a lot of money. Now, investing in fads has not generally been a good thing and, from a probability perspective, it is not a good thing – but, in recent memory, it has been a good thing. And, in recent memory, US largecap tech has been a good thing.

Yet these fads or these recent memories can be disrupted by big, salient events. So, if you have an event or a set of circumstances that change and the trailing three years of someone’s memory is something different, then you are going to see a very different pattern of behaviour that starts to anchor how investors make decisions. So the world in which we are living is a world in which investors have a very strong memory of fads doing well, of US largecap being the safest, best place to invest and of everything that’s diversifying being a waste of time and money.

JTR: So what needs to happen to help people move forward?

DR: A mix of things. Narratives are often easily disrupted because the world moves in a probabilistic way, not a narrative way. And the more specificity your narrative has, the more likely it’s going to be disrupted by random future events. One example – which I might have even used on this podcast last time, I’m not sure – is what happens when Amazon’s growth starts slowing down? Or Amazon prints a decline in revenue for a year or something, right? How do people want to re-evaluate Amazon or largecap tech in general, right? In a similar way, what happens with Google?

And actually, in 2022, we saw that, right? We saw slowing growth and Facebook and these massive revaluations downward as the narratives got disrupted. So while, to some extent, it remains to be seen what sort of salient events will disrupt these big narratives, one that is just naturally disrupting them already has been even one year – 2022 – in which value and international outperformed and in which people started to say, Gee, maybe I do need diversification, right?

You had the whole era of ‘Tina’ – of ‘There is no alternative’, right? – and, all of a sudden, now people are saying, Well, there are alternatives. And actually there are alternatives in the bond market. Gee, I can earn 5% in bonds – like, that’s fine. I’d be happy with 5%. Those facts on the ground are already changing perceptions and I wonder what other future events might happen. I still think the private market bubble has been burst – that bubble has burst in a dramatic way – but private equity has not yet.

Private real estate has – with that Blackstone REIT redemption crisis, right? That really changed the way people thought about private REITs and private real estate but the same thing hasn’t happened with private equity and private credit too. So that shoe has yet to drop – and I think a new narrative hasn’t yet formed. People are just reacting to the numbers and so, in 2023, actually you have seen a big rebound and a lot of the crazy fad stocks and largecap tech rallying in an AI fad – to the detriment, I think, of a lot of international and value-oriented strategies. It is like an echo rally – you know, people are just trading on what used to work but I am very sceptical that that’s really going to be the true end-state of the world.

Two fault-lines running under deep value

AE: Listening back to the last podcast on the train, in preparation for this one, I sat there thinking, Dan’s great – I don’t think I disagree with anything you said! But obviously that is because you were just ticking off all my beliefs – it was classic confirmation bias. So let’s turn that on its head: we are three people with a pretty similar belief system in the merits of deep value so what if, in two years’ time, we do another podcast but everything’s gone wrong? What do you think might have tripped up deep value in the current situation?

DR: There are two real fault-lines with deep value that people should be aware of. One is that deep value just is economically sensitive for companies, right? It just always is – you’re always overweight companies that are sensitive to economic developments and, when bad economic developments happen, deep-value stocks don’t magically outperform just because you bought them, right? They tend to get whacked even more because their revenues and their profits tend to be cyclical. That is what creates the crisis-investing opportunity – but that’s also what creates big drawdowns in deep value.

The second thing worth noting – and it is related – is the liquidity dynamics. Deep-value stocks tend to be smaller – just sort of naturally, right? They don’t have big market caps relative to their fundamentals and they don’t have big market caps generally. And they’re not that ‘sexy’ so they’re not something you’re trading in your Robinhood account – you’re not like, Hey, I’m going to log in and buy some boring German industrial stock! You want to buy some electric vehicle stock or something, right? These stocks are more thinly traded and so market liquidity dynamics do also affect deep value, which means you do see this enhanced volatility. So, if you’re looking at the classic reason why deep value underperforms, deep value underperforms anytime the end of your performance state is some sort of crisis or economic downturn – you’re always going to say, Well, my trailing window for deep value is terrible, right? It is a common reason.

And there is something I like about that – you know, there are the ‘known knowns’, the ‘known unknowns’ and the ‘unknown unknowns’, right? And, with deep value, you kind of know the risks you’re taking – it is usually relatively clear. Whereas, when you’re buying a sexy growth stock that’s near perfect, what is the risk? You don’t really know. What’s the risk to Apple? It’s like, I don’t know – I think iPhones are pretty awesome. I love my iPhone. They seem to be doing everything right. They are even building their semiconductors in-house. The company is perfect. What’s the risk? I don’t know, right? What’s the risk to Nvidia? I don’t know, right? They are kind of these perfect stories and so you don’t know how you’re going to get blindsided – and then, when you do, it’s really, really bad. Whereas, with deep value, you know what you are getting into and there is something very pleasant about that.

But it is easy to imagine a world in which deep value does terribly because we have experienced it so recently and that is in investors’ heads – yet that is also what makes it attractive. Think of energy stocks, for example. Energy stocks were actually kind of in favour – there was the shale boom in the US and so, around 2011, 2012, 2013, 2014 even, people were piling into shale and energy stocks. At the time, for example, Chesapeake Energy had one of the best 20-year records of any stock – and then 2015 happened and energy all crashed.

Some people ‘bought the dip’ in energy in 2016 and then lost more money over the ensuing years and then ESG came along and said, All of energy is evil – we all use it but somehow all the companies that produce it are evil! – and so we have to get out of energy. And then basically, at that point, all the value investors had been so burned on every energy stock they had bought for five years, all the institutional people were under all these pressures to drop it ... and then, all of a sudden, energy has its best year ever, right? It just blows out good – and then you look at the stocks and they are still cheap.

But what you have seen is these cycles where things get out-of-favour, then they get more out-of-favour and then they do well. And then they can do well for years. That’s sort of the way we are with deep value – we’ve had some bad experiences, we’ve had a period where it just hasn’t worked and that has created a huge withdrawal of money from the sector. Yet with deep value – because it is liquidity constrained and because it is very sensitive to expectation errors – small changes in expectations and small changes in flows can change valuations in a big way. That makes me very optimistic for the next few years and, in essence, it reduces the risks. The riskiest areas are the ones people are extremely positive about and think nothing can go wrong – and the least risky areas are often the ones where the risks are most obvious and most salient and most recent.

A contrarian take on Porter’s ‘Five Forces’

JTR: Now, few things in investment at present are as contrarian as being critical of Michael Porter! We did not touch on it last time but I know you do hold a contrarian view on Porter’s ‘Five Forces’ framework and quality investing in general so could you talk us through your reasons?

DR: My father is an antitrust lawyer so he covers competition and mergers and acquisitions – not in the sense of doing the deals himself but in dealing with the FTC [Federal Trade Commission] and regulatory approvals when their competitive status is threatened. So I always knew a lot in the back of my head about antitrust law and, at the same time, when I began learning about investing, I was exposed very early on to Porter’s Five Forces and competitive strategy frameworks.

If you wanted to reduce competitive strategy to its simplest element, it is all about scale – or relative market share – mattering. The more market share you have, the more quote, unquote ‘market power’ you have – and the more ‘market power’ you have, the higher your margins are because you can squeeze your competitors or suppliers or customers, right? They don’t have a replacement for you so they have to pay you more. Your market share is so high, you are the only game in town so, for example, your suppliers have to sell to you.

The Michael Porter story actually contains a lot of complexity – it is seven chapters and five forces and whatever – but, at its heart, it boils down to a pretty simple idea: that companies with more market power should be able to use that to obtain better margins and better outcomes. That is the essence of the idea and what’s interesting about it is it is so beloved by value investors – and even more so by quality investors – yet it has been completely discredited by economists and by the law as far back as the 1970s and early 1980s.

So what the antitrust law found – and really it was the University of Chicago law and market project – was there is actually no correlation between market share and margins and there is no relationship between market power and margins. So all of this research done in the 1970s – which was trying to say monopolies are bad and quasi-monopolies are bad and companies with market power are bad – Michael Porter basically just took and said, Well, if it’s bad from a competition and market perspective, it must be good for investors because they are buying these companies that can do these evil things so they will benefit from it. That is sort of Porter’s background – but the law and economics movement said, No, there is absolutely no evidence of this.

To bring that forward to the present day, the classic example here is Amazon. Not Amazon Web Services but think of its online retail business. The current FTC chair, Lina Khan, got that job after she wrote this article called Amazon’s Antitrust Paradox, where she argued, Here’s the problem: Amazon seems to me to have a monopoly on online shopping – or a quasi-monopoly or at least a massive market share – and yet, under the standards of the law and economics, something isn’t anti competitive unless you can prove consumer harm.

So if consumers aren’t harmed, it’s not illegal and so, even if you have 90% market share, if you’re not screwing your customers over, then there’s no problem. And there is really no way to show that Amazon has harmed consumers, right? The company has driven prices down. Customers have more choice at lower cost and so it seems like customers have benefited, not suffered, by virtue of Amazon – yet Amazon is a monopoly so surely it must be problematic. In essence, that is the paradox Khan was wrestling with – and she comes out and says Amazon is clearly evil so we just need to find a way to show it is evil.

Now, I don’t really love that approach but that’s really the paradox at its heart, right? Sometimes companies gain a lot of market share by virtue of having low prices – like, Walmart or something – and it doesn’t necessarily mean they are going to make massive margins as a result of that. In contrast, some companies have a very small market share – like Hermes, although that obviously now has more scale – but they have very big margins because they are luxury goods businesses or whatever.

So there are a lot of elements of Porter’s thinking that just don’t make a lot of empirical sense – and aren’t founded empirically – and what I would argue as a value investor is that people use Porter-type frameworks to justify buying expensive past winners, right? Market share and high margins are often used as a scoreboard – like you’re betting on the winning team – and there is something that feels good and secure about that. Whereas value investors are always betting on the underdog. We are saying, Gee, I think the company that’s out-of-favour, that hasn’t done well and is not on the winning team is going to do better.

Ultimately, I think the game of investing is ‘meta-analytic’ – it is about how reality plays out relative to expectations. So if you think great things are going to happen and then only OK things happen, you can lose a lot of money. But if you forecast that horrible things are going to happen and then only bad things happen, not horrible things, you make money. It’s not about whether it was good or bad – it is how that played out relative to what was priced in. So I would argue investors are much better suited ignoring Porter’s thinking – because there’s no empirical grounding, no empirical evidence, not a single quantitative study that has ever shown it works or has any relevance to anything! It’s just about a narrative and it’s really a narrative that justifies favouring prior winners.

So I think it is irresponsible that it keeps getting taught to generations of investors and it keeps getting taught at business school. In fact, when I was at business school, I basically got kicked out of my strategy class. We had five classes in a row going through each of the five forces and, every class, I would raise my hand and say, Professor, are you going to present any empirical evidence that what you’re teaching today is true? Or are you going to ask us to accept it on faith like we did last week? And after, I think, the third time I asked that, I got kicked out of the class! But I think there is a real truth that I was trying to get across with what I think we can all agree was an obnoxious question!

Why time matters with portfolio returns

AE: That’s great. I wanted to bring up some other pieces you have written, which relate to long-run portfolio outcomes and reference the ‘St Petersburg paradox’ and the ‘Kelly criterion’. That instantly got us interested because one of our pet topics is ergodicity and the idea that time matters in the context of expected portfolio returns. We have done a couple of podcast episodes on this subject but I would be very interested to hear your thoughts as I know you have approached it from a slightly different angle.

DR: There are a few important points for investors to consider here – even if these are abstract topics and hard to talk about. There are so many research pieces, where you can do the empirical work and then you can explain it pretty easily and it’s obvious. When you get into ergodicity and the Kelly criterion and the St Petersburg paradox, however, it’s so hard to make it understandable and relevant and we spent maybe three weeks just wrestling with it to try to get to something that made sense. So these are really hard topics but I do think they are important and worth diving into.

Starting with Kelly criterion-type thinking, the basic way to understand this is if you have an investment with a 0% expected return – and yet that investment has a variance of 10%. And whether it goes up 10% and then down 10%, or down 10% and then up 10%, you end up with less than the money you started with – even though you had seemingly symmetric returns in the upside and downside, you have less money. And if you had only gone up 5%, down 5%, you would have more money than if you had gone up 10% or down 10%. There is this ‘volatility drag’ so that, even if you have two investments with the same expected return, but one has higher volatility, the investment with higher volatility is actually going to end up with a worse outcome than the other one. So you have to consider volatility and the path of your investment through time, rather than just thinking, What is the pure expected return?

Another classic way to think about ergodicity is catastrophe bonds. A catastrophe bond basically pays you out a yield until a catastrophe happens – and then you lose all your money. Think of, say, a Florida hurricane bond – it will pay you 10% a year but, if there is a hurricane, you lose all your money. So it seems really good, the expected return seems really positive – and then you lose all your money. That is a classic example of a path where you go through time in a suboptimal way because you were thinking about expected return and time zero and you weren’t thinking about the complete path or how that was going to play out over time.

Where this gets you, from a portfolio perspective, is it introduces a set of new ideas for thinking about volatility drag, of thinking about path dependency, of thinking about how, when we’re looking at these large data sets, we are going to transit one unique path through this dataset and not experience the full distribution of outcomes – because we just don’t experience the full dimension of time, right? Maybe that is because we’re 50 and we’re saving for 15 years from now; or even if we’re 30 and we will experience 35 years of investment history, the start and end point of those 35 years really matter. So you need to understand, How volatile is the thing I am looking at? How likely is it to be true across the horizon I care about? And so on. Those are really interesting ideas – thinking about how those really abstract ideas relate to investing.

There are a few different ways you can think about them. One of the ways in which I contextualise or think these ideas are relevant is in the context of, What portfolio should I own or, broadly, what types of assets should I own? Based on this type of thinking, the longer-lived the thing you’re invested in has been, the more you can understand the distribution of potential outcomes; and the lower the probability your ergotic path is going to end up being disastrous. Whereas things that are really new and have less history – and so often seem sexier – are much, much more risky because you can’t really understand the true distribution of outcomes in the way you’d like to.

Another one is diversification, right? The idea you maybe don’t want to put all your money in one stock – you know, you need to achieve a certain number of stocks, or a certain number of bonds, before you are actually safe and before you have diversified away the risk the path-dependant outcome is actually going to be really bad for you. Another way to think about this is that perspective of Japan in the late 1980s: Japan has had an unbelievable run and you are so rich from investing in Japanese stocks you could go and buy, say, 50 golf courses in California. But if you put all your money in Japanese stocks in 1989, holy smokes – you do terribly for the next 30 years. So any decision that got you out of that was really good.

So you need to think about how, for example, these days there are more indices than there are equities – in the US, at least. So you need to think about, Am I style-diversified? Maybe I own 500 stocks but, if they are all US largecap stocks, am I really diversified? Or am I stuck in one category and the path dependency of that category could hurt me? Diversification is a way to reduce that ergotic risk. Consider investing in things with long histories – so, rather than saying I’m going to put all my money into crypto, maybe you say, Gee, I don’t think I really know the true path those crypto investments are going to follow or the true risks they’re going to experience, such as my exchange actually turning out to be a fraud.

The other dynamic of it is being sensitive to volatility. Investors always say, you know, I don’t care about volatility, I care about drawdowns or I care about loss of capital – and my response to that would be that volatility ends up being quite correlated with the things you say you care about. So if you care about drawdowns, volatility is really correlated with drawdowns; if you care about loss of capital, volatility is really correlated to complete loss of capital or bankruptcy – higher volatile things are more likely to go bankrupt.

So volatility is a useful tool – albeit not a perfect one. Just investing in lower volatile things versus more volatile things does not necessarily lead you to better portfolio outcomes – even if there are some strategies that have done that to good effect. But it is a useful way of thinking about the trade-offs when you invest in something. And knowing the volatility of a thing and understanding how that fits into your portfolio and making sure you are comfortable with that risk – these are really important things to know. And as smallcap or value investors, it is incumbent upon us to say, Gee, smallcap is a lot more volatile than large cap; value has been a lot more volatile than growth – and you need to be aware of that when you invest in this stuff.

That is also a really helpful conversation to have with people and to set expectations – to say, no investment is perfect. You are not going to get low volatility with high returns unless you’re invested in private equity, in which case, great and that’s probably a massive bubble and you’re going to find out why before long. Indeed, that is probably an example of one of these ergotic paths that is really detrimental to people – where long experience has not yet revealed the hidden risks. But I think this type of thinking is just a really sophisticated meta-analytic way of reflecting on portfolio choices, which drives you to make better decisions.

JTR: That is a great segue into my next question, which I will split into two. First up, how do you incorporate this thinking into your portfolio construction process – if at all? And then, you mentioned you are also a high-yield investor so how do you think about volatility in the context of capital allocation between high yield and equities?

DR: One really interesting finding from academic finance, which I love, is that bankruptcy risk isn’t compensated – in other words, buying things that have a higher probability of distress does not lead you to earn higher returns. The classic academic mindset is that markets are efficient so more risk should be compensated with more reward but we all know there are so many exceptions to that – and one of the most obvious is bankruptcy risk. And that is because of this ergodicity concept, right?

If your path ends with a potential zero, or the chance of a potential zero is incrementally higher, you want to avoid that investment like a plague. And I think, within the world of smallcap value or levered smallcap value and high yield, you’re obviously dealing with the question of bankruptcy in a more prominent way. Now, I’d say, Gee, if you’re investing in IPOs, you’re unwittingly investing in potential bankruptcy risk. Interestingly enough – and we did this analysis – the pool of IPOs actually have a higher bankruptcy risk or go-to-zero risk than do levered companies in the public markets or even, say, triple-C issuers. So your risk is greatest when you go and buy the hottest, most hyped, most new-fangled, innovative companies. Still, when you go into the world of value and high yield and these low or slow-growth or declining businesses, you are dealing more with bankruptcy risk and, therefore, it is really important to have a clear understanding of what bankruptcy risk looks like and how to avoid it in your portfolio.

That is a very important skill-set that really matters in our part of the world. Growth investors or largecap investors don’t really have to think about it as much – the chance that a largecap company jumps to default is only really an issue in the case of fraud, like Enron or WorldCom. Other than that, largecaps never really jump to default – companies go from largecap to midcap to smallcap and then they default. And so what we aim to do is run a barrage of different quantitative tools to predict bankruptcy and then basically screen all the companies out that have too high a risk of bankruptcy. That we find to be an effective portfolio tool that prevents those bad outcomes.

The case for investing in Europe

AE: Really interesting. You very recently put out a piece referencing Europe and the attractions of investing there – particularly Sweden. We are definitely not to going to push back against the case for Europe but I would love to hear your thoughts on what you see as the European opportunity.

DR: It is really interesting – I mean, if you rewind to a year ago, everybody was bearish on Europe, right? And you had so many reasons to be – not least, the Russia-Ukraine war and the ostensibly looming energy crisis that caused. And then you had this perception – which is very strong among US investors in particular – that European companies are less well-run, less efficient, less dynamic and have less innovation than, say, US companies. So why would you invest somewhere where you are getting, as they see it, this hodgepodge of quasi-socialist countries with slow and boring companies and potentially threatened by Russia and about to be hit by an energy crisis, which will cause a massive decline in earnings for the entire continent?

And then you’ve got the UK, where the perception is, ever since Brexit, they could do nothing right and now they’ve got some horrible economic plan or whatever it might be, right? It was just a litany of horrors. And then, last year, recession probability has come down a lot and, all of a sudden, European stocks went on this tremendous run for six or nine months as that recession probability decreased – and value stocks in particular. And then you see these weird headlines where, say, LVMH and CEO Bernard Arnault are catapulted into the rich list or list of most valued companies – and you say, Wait, that’s a European company. I thought they were all badly run and Europe was moving into recession. And all of a sudden, those things seem not true.

So what we were writing about first of all is, from a valuation perspective, Europe is really cheap relative to the US for all the reasons we just talked about. And then, all of a sudden, the economic outlook – you know, how comfortable do you feel with the US economic outlook, right? Look at how the US is priced – the US is priced to perfection, with an economic outlook that now looks cloudy. And, even if Europe’s economic outlook is cloudy – and I would say it looked like there was going to be a big storm but now it’s only cloudy – it is priced as though there’s a big storm coming. So you are getting potentially equivalent outcomes – and maybe Europe even has better outcomes, I don’t know – with massively different entry valuations.

Then, if you go through the different regions, Europe encompasses a bunch of different economic zones and different dynamics within it – you know, the UK has its own dynamics; Scandinavia has its own dynamics; Eastern Europe has its own dynamics; the Mediterranean region has its own dynamics. So you have a whole variety of things to choose from and what we were writing about was probably the places that are most interesting – they are small markets but they are really interesting – are Poland and Sweden. Poland is interesting because it is just so cheap. Now, it’s a really tiny part of the market – there aren’t that many stocks there – but, if you want just really cheap stocks, the entire Polish stockmarket – all five investable stocks! – are really cheap. And Sweden – which is also a really small market, with not that many investable stocks either – isn’t necessarily as cheap but, on a pure valuation basis, it’s cheap relative to its own history and has meaningfully more robust earnings growth potential.

And companies like Ericsson at the largecap end, down into the smallcap end, are trading at a discount relative to what are really quite attractive fundamentals. So you have sort of ‘quality at a decent price’ in Sweden and you have whatever you have in Poland at a dirt-cheap price. Those are two examples of some of the opportunity sets you’re seeing as a European investor. And those dynamics are really interesting – and they are very different from what you see if you are just oriented around being an investor in the US.

AE: Coming back to your point about memory and investment decisions, do you think US investors in particular have shifted their mindset to acknowledge they cannot just rely wholly on the US market, which does not seem to have happened over the past decade?

DR: It’ll take time. I think we are in the very early innings of any such move and, you know, people have been burned over and over again. I sit on one investment committee and there is a guy on it who has been a believer in US largecap growth stocks for, like, 10 years. There are also a bunch of value investors on the committee and so, any time value starts doing well, any time international does well, the value investors are always like, Oh, let’s increase our international, let’s increase our value! And this guy is like, Don’t do it – just keep a bias towards US largecap. And he has been right so many times, and the value people have been wrong so many times, that his voice carries a lot of weight.

And I think, for that perspective not to carry weight, it has to be consistently wrong. Look even at the start of 2023, where the NASDAQ was up 20% or something, right? So people’s instinct or memory for thinking an overweight to US largecaps is a bad answer – there is no memory of that. That is a memory that has never been in people’s heads for the last decade at least – and that is a large part of people’s careers. So I think, until you give the answer and it’s wrong three or four years in a row, people aren’t going to get it out of their head, which means we have a long, long stretch of US underperformance before any narratives really start shifting.

Two book recommendations

JTR: Dan, we are coming to the end of our session and, as before, we cannot let you go without asking for a couple of book recommendations – I think last time you gave us three! I know you review books for The Wall Street Journal now but – be they from there or not – what would you recommend we read?

DR: That’s a great question and, actually, a book I am really enjoying reading now is a biography of Stalin by Stephen Kotkin. It has nothing to do with investing but, at this time, the importance of Russia and understanding the Russian perspective of the world and understanding the history of Russia seems a lot more important – and Stalin and his story are quite interesting. It’s funny because we’ve had some investments in Russia, which are now valued at zero because we can’t sell them. And we were talking internally about when the Russian market might reopen so we could sell these equities or value them again and a colleague, who is from Zimbabwe and therefore has a very different experience of these things, pointed out, Well, the Bolsheviks closed the stockmarket in 1917 and it didn’t open again until 1992. So I wouldn’t get your hopes up that we are ever going to see any money for those Russian investments!

And I think, oftentimes, investing common sense can be quite boring so saying something new and interesting about investing is really hard. And it is challenging to write a book about investing that is novel and interesting because so many of the lessons are quite boring – so I’m always on the lookout for people who can really present a new perspective. And I think some of the most interesting stuff right now is going on in behavioural economics and psychology and where that intersects with markets. That’s the stuff I really enjoy – in fact, that’s probably the type of book I like the most. The one I reviewed recently that I really liked is called The Anxious Investor: Mastering the Mental Game of Investing, by Scott Nations, which just talked about the role anxiety plays in people’s portfolios. And gee, anyone who has ever been an investment manager and had clients can tell you that anxiety is a really important force! And understanding how to grapple with investor anxiety and what that means for portfolios is, I think, a very relevant question.

JTR: That’s really interesting. Dan Rasmussen, thank you very much for coming back to The Value Perspective podcast.

DR: My pleasure. Thank you, Juan. Thank you, Andy, for having me.


Juan Torres Rodriguez
Fund Manager, Equity Value
Andrew Evans
Fund Manager, Equity Value


The Value Perspective
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