On this episode of The Long View, Daniel Rasmussen, founder and portfolio manager of Verdad Advisers, breaks down the shortcomings on forecasting, what investors needs to know about investing factors, and which investments he thinks are the best bet.
Here are a few highlights from Rasmussen‘s conversation with Morningstar’s Dan Lefkovitz.
Why You’re Betting Against Hubris When It Comes to Value Investing
Dan Lefkovitz: I wanted to go back to that concept of meta-analysis that you mentioned. So analyzing the forecasts that are embedded in markets, you talk about betting against hubris. Can you explain what you mean and how you go about doing this kind of meta-analysis?
Daniel Rasmussen: So the idea is that if the future is unpredictable and if it’s always unpredictable, and yet we know there’s a human need to plan and to make forecasts, how can we find a way to profit by betting against people’s hubris, betting that other people are going to try to make predictions in areas which are inherently unpredictable? And they’re going to be too confident that their forecasts are right. And I think that’s sort of my first meta-analytic approach for thinking about strategies that should work. And I think the most obvious strategy here when you think about that type of meta-analysis is value investing. Value investing, which means to buy stocks that have low prices and to short stocks or avoid stocks that are very high prices relative to their current fundamentals, because the valuation of each stock is pricing in a forecast. So the very expensive stocks are pricing in a very optimistic forecast that future cash flows are going to be much higher tomorrow than they are today, versus the stock people are most pessimistic about the trade at the lowest-valuation multiples tend to be stocks that people have very pessimistic observations. Future cash flows are going to be the same or negative growth relative to today.
And what that means is that there’s a wonderful paper by the folks over at O’Shaughnessy Asset Management called “Factors from Scratch” that show that when you put these things into motion, what you see is that you take a set of things that are very expensive and set of things that are very cheap. Over the next year, the very expensive things will actually grow faster and do better on a fundamental basis than the things that are very cheap. Nvidia NVDA will probably have higher growth next year than some tissue manufacturer or soda can manufacturer, some boring business like that that trades at very low multiples. But although they have better fundamentals, the expensive companies have better fundamentals one year out, those fundamentals often underperform the expectations that are embedded in the valuation multiple. And when you reset that a year from now after that one year of growth or one year of decline, the forecast for the following year or the following set of years, which is what then becomes the valuation multiple is often quite random.
Yes, we might have a view on 2025 growth, but do we have a view on 2026 growth? Or more importantly, do we have a view of what—at the end of 2025, our view of 2026 will be relative to what happened in 2025. You’re getting into these degrees of complexity that are so hard to anticipate, and so they end up unfolding randomly. And therefore, the expensive stocks, their valuation multiples come down, and the cheap stocks’ valuation multiples go up. And it turns out that that multiple change is bigger than the fundamental difference. And so value stocks end up doing better over the long term than growth stocks. It’s an arbitrage of betting against the hubris of other people’s predictions. There are other areas in which you can think about making those types of meta-analytic investment decisions, but value investing, I think, is the most obvious example of a place where you’re so clearly betting against the hubris embedded in other people’s growth forecasts.
Why US Investors Won’t See the Value in Value Investing
Lefkovitz: I wonder, has the most recent period where value has underperformed growth, at least in the US, so badly, has that tested your faith at all in the factor?
Rasmussen: Yes. That’s why it’s called the humble investor instead of the arrogant investor. It’s because I’ve been a value investor through a horrid period for being a value investor. And so I think it’s taught me a few lessons about being too confident in your forecasts. So I think a few observations about the value factor. I think first, yes, value hasn’t worked in the US, but it’s worked fine internationally. And so if you’ve been a value investor in Japan or a value investor in Europe, you’ve actually done quite well relative to the market, even though in the US, actually, it’s been a horrible investing strategy. And so we have to explore the historical contingencies. Why is it that value investing hasn’t done well in the United States?
And I think the reality is that it’s because of historically unique and rare circumstances, which is that the US has been through an innovation wave, the likes of which has been seen only roughly every 50 years in this country, where these large-cap tech companies have so dramatically performed in terms of their fundamentals, such as to be in the top 1% of the historical sample in terms of growth rates of earnings and profits and revenues, and to have done that on such a massive scale that was unprecedented. And so that usual mean reversion where you say, well, gee, the things that people are optimistic about should underperform those optimistic forecasts. In fact, tech companies have outperformed those optimistic forecasts, they’ve done better than anybody thought they could have done, because nobody had really seen growth at this scale before. And that’s really what drove the success of the US stock market. And simultaneously, you’ve seen a rerating upward of those stocks. People, as they outperformed expectations, increased those expectations, so valuation multiples rose.
And then second, people were searching for the next Google or the next Meta META or the next Microsoft MSFT. And so you had many of these small-cap growth companies, which normally is the worst place to be in the market, actually do quite well as people attempted to pick the winners. And so that’s been the dynamic that’s defined the US for a number of years, the dominance of these big growers. The question is, is that historically, those types of innovations, first, the rewards go to the innovators, and second, they go to the customers. And I think what my question is, is when will that transition occur, where the winners of this technology wave start to have essentially those results priced in, and the true winners become those who gain more from buying the technology than the builders did.
Why You Can Place More Extreme Bets When Investing in Small-Cap Value
Lefkovitz: Interesting. And the size premium, you’re a fan of small caps or small-cap value, I should say?
Rasmussen: Yeah, I don’t have as much of a strong view on the size factor in the sense that, I don’t know that intrinsically, a company should do better because it’s smaller. I don’t think there’s necessarily a great rationale for that. I think you could make a risk-based argument that smaller companies are more likely to go bankrupt and more risky, and so they should command a return premium, perhaps. But I think what’s more interesting to me about small caps is that there are so many more small caps than large caps. In the US, there’s the S&P 500, and there’s the Russell 2000—there are almost four times as many small caps as there are large caps. And that’s true, and especially go abroad. International markets are just full of small and micro caps for a whole variety of reasons, and there are many fewer large caps.
And so what makes it interesting is if you’re looking for extremes, if you’re saying, hey, I want to own the cheapest 10% of companies, or I want to short the most expensive 10% of companies, almost all of those companies are going to be very small. And so I think that I like small caps, and I like investing in small and micro caps because they give you a way to make more extreme bets on the factors that you’re interested in betting on. If you think that you want to bet on areas of the market that are not followed by analysts that are more inefficient, of course you’re going to end up in small caps. You want to buy the cheapest companies while they’re out there, they’re all going to be in the small-cap line. You want to buy the highest-growth companies until recently, they were all in small caps. Now, of course, Nvidia obviously isn’t, but for every one Nvidia that’s growing up, those rates are probably five or six or seven or 10 small caps that have grown at the same rate over the past few years. And so I think that that’s what attracts me to the small- and micro-cap market.
The other thing that attracts me to it, frankly, is that I grew up in the Vanguard world. I graduated from college and passive was already taking a large amount of share. And so as I thought about active management, what should active management be? I sort of thought, if I’m going to build a business in active management, it has to be in areas of the market that Vanguard can’t or won’t compete. And so yes, Vanguard does small caps, but it’s going to be impossible for them or any index provider to do micro caps at scale because micro caps are sort of inherently too illiquid to be put into a large-capacity product. The same is followed in my attempt to build, say, crisis-investing strategies where market timing is a place where passive can’t necessarily do, or thinking about market-neutral hedge funds. This is another area where passive is not a threat in some sense. And so I’ve thought also about the business logic of what I’m trying to build, of having that meta-analytic approach, knowing my competition, knowing how hard it is to win and saying, let’s find areas that might be more inefficient or just simply be difficult for very large competitors or passive to compete in.
Source: Why You’re Betting Against Hubris When It Comes to Value Investing
