# Insights on Investing Amid Uncertainty: A Conversation with Aswath Damodaran

Economic Backlash and Political Influence on Company Valuation

If you’re reactive, we’ve already lost control of the game. I step back and ask, why are these disruptions happening? What forces are driving this change? I’m convinced we are witnessing a global backlash that began after 2008 when trust in the institutions supporting globalization started to wane. Another influential force is the disruption seen in private businesses, which has made its way into the realm of government. This trend began in Latin America with leaders like Nayib Bukele in El Salvador and Javier Milei, who suggested that we can apply business disruption to governmental processes. This shift can be unsettling, indeed.

Returning to the fundamentals, a company’s value has always hinged on cash flows, growth, and risk. This core principle remains unchanged. Regardless of external circumstances, value ultimately manifests in one or more of these areas. I consider current challenges, like potential trade wars and tax changes, and ask where they will impact individual companies. Understanding this helps me feel more secure about my position. Writing allows me to clarify my thoughts, almost like consulting with a psychiatrist about my investment processes. I might not have the answers yet, but I am navigating through a pathway to find them. For those feeling unsettled right now, remember you are not alone. My advice is to gain perspective and return to fundamentals.

Matt Argersinger: That sounds like sound advice. Currently, many analysts face challenges as they incorporate the political landscape into company evaluations. This new approach may be uncomfortable for those of us at the Motley Fool, as political connections increasingly matter. Tesla’s CEO Elon Musk and his relationship with the current administration exemplify this situation. Has this dynamic influenced your view of Tesla’s valuation?

Aswath Damodaran: It has, indeed. Customers are heading into Tesla showrooms but opting not to buy due to political alignment. Historically in the U.S., we could consider government a background player in company dynamics, primarily responsible for tax collection and regulation. However, in other markets, particularly outside the U.S., political connections significantly contribute to a family’s competitive advantage in business. My experience valuing companies globally has made me acutely aware of this shift, and now I apply these lessons to U.S. valuations.

When valuing Tesla, it is crucial to assess how being central to this political discussion impacts revenue growth, profit margins, and reinvestment strategies. There are both advantages and disadvantages in this context. For instance, Tesla is better positioned to manage tariff implications than companies like Stellantis, GM, or Ford, which source many parts from Mexico and Canada. Understanding these nuances must integrate into our valuation process, considering cash flows, growth, and risk rather than leaving them unexamined amidst external stories. The dynamics we observe in other parts of the world may feel unfamiliar in the U.S., but we must adapt to this evolving landscape.

Examining companies like Disney, it seems impossible to ignore the influence of politics in its valuation. Politics is ingrained in the company’s performance and must be included in analyses. We have to engage with the reality of our market circumstances, not an idealized version of it.

Matt Argersinger: Focusing back on Tesla and considering the Magnificent 7 stocks, each of them has faced about a 20% drop from their high, with Tesla down nearly 40%. Is there a particular stock among the Magnificent 7 that you find compelling due to its business attributes for long-term growth or value at this moment?

Aswath Damodaran: I own six of the seven, which might bias my perspective. I acquired shares in Microsoft back in 2014, and in Apple around 2018-2019. Despite the market drops, I continue holding six of the seven stocks because they seem well-positioned to capitalize on current uncertainties. In the event of a trade war, companies with a physical presence, like manufacturers, face the brunt of the impact. Conversely, firms that operate primarily in cyberspace, such as online advertising companies, are less affected because their operational base is not tied to one location.

These companies have adeptly navigated crises over the last decade, cultivating resilience that should continue to yield earnings growth. While I initially owned all seven, I sold my Tesla shares shortly after the election—not due to politics, but based on valuation metrics. I assessed the price, market cap, and revenue expectations for Tesla, guiding my decision.

# Financial Expert Discusses Portfolio Adjustments and Market Dynamics

$750 billion—that’s a hefty number, and I expressed doubt over whether they could reach it long before political controversies emerged around the company. I decided to sell my shares about a month ago. While it wasn’t at the peak price, it was high enough for me not to feel regret. Currently, I own about one-quarter of what I used to have in NVIDIA. As those who have followed my posts know, I’ve staggered my sales over time because I genuinely admire the company and its CEO, Jensen Huang. However, the price I was holding it at felt excessive. I aim to keep just a quarter of it while maintaining my positions in the other five stocks.

Regarding Apple, I believe it has now reached a “steady state.” The narrative I’m investing in aligns closely with the market’s perception, making it a solid candidate to maintain in my portfolio. I expect it to continue delivering cash flows. Each iPhone update keeps me on edge since it’s still a smartphone-focused company. In the realm of online advertising, I foresee that Google (or Alphabet) and Facebook (or Meta) will maintain their dominance. Their platforms boast a vast user base which provides significant optionality if they can successfully innovate beyond their core businesses. That would be a welcome bonus.

I’ve owned Amazon intermittently over the past 25 years, buying five times and selling four. Today, it feels less shocking than before; I suspect that the shifts in their narrative have stabilized. However, concerns around regulatory scrutiny in both the U.S. and abroad loom large. Amazon doesn’t enjoy a great reputation among its peers, which sometimes leaves it isolated. Despite these risks, I will keep my investments in Amazon because I find today’s price acceptable. A year ago, when reassessing the so-called MAG 7 stocks, I deemed them to be overvalued—but not to a level that would prompt me to sell.

You might find my perspective puzzling, but taxation plays a significant role in my decision-making process. When I sell an asset, I don’t keep all the proceeds since I need to factor in a capital gains tax of around 23.6%. Living in California, I incur an additional 10% state tax. This means I need to see a stock overvalued by over 30% before considering a sale due to these tax implications. Although taxes shouldn’t dictate my investment philosophy, they can delay the sale of even an overvalued asset to avoid tax consequences. Despite this friction, I regard the MAG 7 companies as fundamentally strong. If you’ve never owned shares in them, you could hinder your chances of outperforming the market over the past 15 years, given they collectively account for 15% of the rise in market capitalization among all U.S. stocks.

Historically, these companies have propelled the market. To add context, examining the last 40 years of GDP shifts reveals significant outcomes. On one hand, China accelerated from 1.7% to 17% of global GDP; on the other, Japan and Europe have suffered declines. Japan fell from 17% to about 4%, while Europe reduced its share from 26% to 16%. The U.S. surprisingly maintained its stance, moving from 24% to 26% of global GDP. In terms of overall market capitalization, the U.S. began this year representing 50% of the global total.

Aswath Damodaran: The U.S. has managed to avoid the economic challenges faced by Europe and Japan despite shared issues like aging demographics. Advances in technology have fueled growth, enhancing the U.S.’s GDP share and equity market cap. Currently, technology companies represent about 30% of the market. This segment is vital to the economy and must feature in any balanced portfolio. If you prefer not to invest in the MAG 7, consider a tech ETF to ensure you include technology in your long-term strategy. It’s essential to have exposure to this sector.

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Matt Argersinger: In our current era of index investing, where many are leaning toward ETFs for broad security exposure, is price discovery still relevant? Notable investors like David Einhorn and Bruce Flatt have expressed concerns regarding the current state of price discovery, particularly for stocks that don’t fit neatly into mainstream indexes—be it small-cap or mid-cap companies lacking the necessary size or sector alignment to capture investor interest. With the MAG 7 possibly continuing their growth and prominence due to their heavy representation in indexes, where does this leave potentially undervalued small- and mid-cap firms? Can they find the necessary catalysts to realize their intrinsic value if they remain outside the big indexes?

Aswath Damodaran: Addressing your question, there are three components to consider. First, the shift towards passive investing has been dramatic, especially over the last 15 years. For the first time last year, investments in passive vehicles like ETFs surpassed those in active management, including mutual funds and hedge funds. Passive strategies now account for over 50% of market investment—a significant trend. This shift raises questions about why it’s occurring. One major reason is that the performance of active investing has been historically poor. Active managers have routinely underperformed the market—not just in recent years, but historically, including periods from the 1950s to the 1970s. In the past, mutual fund investors often had no insight into their fund’s performance as they received infrequent statements, lacking comparisons to gauge their returns.

Additionally, even if investors were dissatisfied with their mutual fund’s performance, alternatives often didn’t present better options, leading to a reliance on whatever fund was available, no matter how poorly it performed. This inefficiency illustrates why I view Jack Bogle as a pioneer in finance. He launched the Vanguard 500 Index Fund, fundamentally changing the landscape of investing. For a long time, the choice was either to invest actively or utilize that one index fund. Today’s diversification in index fund offerings allows for multiple strategies.

The Evolution of Active and Passive Investing: Key Insights

In the past 15 years, significant changes have occurred in the investment landscape. Today, investors can monitor their active fund performance almost continuously. While enjoying lunch, for instance, it’s possible to check how a mutual fund is doing compared to market benchmarks over the last three, five, or ten years. This frequent monitoring reveals the underperformance of active investments, making it more evident to everyone involved.

Accessibility has increased as well. During that same lunch break, investors can quickly and effortlessly transfer funds from an active investment to an ETF (Exchange-Traded Fund) in just five minutes. Choices have expanded beyond just the S&P 500; now, investors can select ETFs focused on tech companies or Asian markets. Many of these passive vehicles charge only 5 to 10 basis points, effectively replicating what active funds offer. These shifts suggest ongoing trends rather than transient phases. Rather than simply waiting for a market correction to bring investors back to active strategies, the popularity of passive investing seems firmly established, in part because much of it is replicable.

Passive investing is reshaping market dynamics. When money flows into passive investment vehicles, it typically goes into larger-cap stocks, particularly those found in market-cap-weighted indexes. This influx helps drive large-cap stock prices upward. Such momentum partially explains the remarkable performance of the “MAG 7” stocks. However, it would be misleading to suggest that passive investing is solely responsible for this trend. The underlying technology and disruption are strong factors, consolidating markets that previously had many players into winner-take-all scenarios.

For instance, the retail industry was once highly fragmented, with major players holding only a small percentage of market share. The rise of Amazon has transformed retail into a highly consolidated market. Similarly, advertising was once a splintered field before Google and Facebook emerged as dominant forces. The car service industry saw a similar consolidation after Uber’s entry, where now only a few companies account for a significant share of the market. As industries shift toward consolidated winners, it’s natural for the stock market to reflect those trends. This change suggests that even if passive investing were to vanish completely, the larger companies’ dominance would likely persist due to evolving economic circumstances.

Another critical issue in investing is understanding company value, particularly regarding whether a stock price is undervalued. In a class discussion, I posed a scenario to my students: if they were 100% certain about a company’s value being higher than its current price, would they invest all their money in it? This hypothetical highlights an essential point—regardless of conviction about a stock’s value, the actual price must adjust accordingly for investors to make a profit.

This uncertainty impacts investment strategies. When investors feel unsure about a company’s value or the price adjusting to it, diversification becomes key. A concentrated portfolio might be appropriate only if one is confident about both the value assessment and price movement. For instance, I often find myself investing in uncertain spaces, like Tesla, where I feel the need to hold 30 to 40 companies to mitigate risk. If an investor only has five stocks, it’s not inherently bad, but it depends on their choice of companies. Holding five stable, mature companies might be viable.

However, considering today’s uncertainties, U.S. investors may want to rethink their investment strategies. If your portfolio historically contained six or seven companies, now might be the time to expand to 20 stocks. You don’t need to merely rely on index funds; an actively managed approach can also be fruitful without sacrificing diversification. Personally, while I actively manage my investments, I opt for index funds for my children. They lack the time and inclination for the research and maintenance that active investing requires, so a simple index fund may serve them best.

Looking ahead, uncertainty will likely play a significant role in investing. Unlike influential investors who command market attention, most of us do not control external catalysts that may shift stock prices. Therefore, a prudent strategy is to spread investments across various holdings and trust that prices will eventually converge to value.

Matt Argersinger: Consistent diversification emerges as a practical solution for most investors. Regardless of perceived certainty in valuations, it’s wise to hold 25 stocks or more.

Aswath Damodaran: That’s sound advice. Back in the 1980s, a portfolio of 10 may have sufficed, particularly for U.S. investors. Given the evolving landscape, investment philosophies should adapt as well.

Matt Argersinger: Let’s discuss a topic close to my interests: dividend investing. Recently, you’ve noted that companies that consistently pay dividends might be engaging in an interesting practice.

Advising Companies on Returning Excess Cash to Shareholders

Aswath Damodaran: The conversation often turns to the topic of dividend dysfunction, or what some might call dividend madness. Companies continue to pay dividends even when cash flows are inconsistent or stagnant. This may be due to inertia or a desire to align with industry peers who have established payout policies. For a company looking to return excess free cash flow to shareholders, my advice lies in weighing the options: dividends, buybacks, or a combination of both. The decision ultimately depends on several factors.

Understanding Buybacks and Dividends

We tend to overcomplicate the concept of buybacks. Both dividends and buybacks serve to return cash to shareholders but differ in execution. With dividends, every shareholder receives a cash payout. In contrast, with buybacks, only those who sell their shares receive cash. Dividend payments come with tax consequences for all shareholders, while tax implications for buybacks only affect those who choose to sell.

It’s important to recognize that neither buybacks nor dividends can create intrinsic value. While they provide cash returns, buybacks can lead to value transfers among shareholders. If a company’s stock price is excessively high—say, significantly over its intrinsic value—buying back shares may benefit those selling their stocks while transferring wealth from long-term shareholders who remain invested in the company.

To make the best decision regarding excess cash, I’d first examine the company’s stock price in relation to its intrinsic value. If it’s overpriced—perhaps valued at twice its actual worth—a special dividend would be my recommendation. This avoids the potential issue with regular dividends, which create expectations of future payments that may not be sustainable, especially in riskier industries.

Sector Considerations: Oil and Financial Services

Take oil companies as an example: I believe more of them should link their dividends to oil prices. When crude oil fetches $100 a barrel, they can afford generous dividends. However, maintaining a fixed dividend ignores the cyclical nature of their earnings and cash flows. As a result, dividend policies need to be more adaptable to reflect fluctuations in oil prices, to prevent companies from paying out dividends they cannot sustain.

Now, consider the financial services sector, historically a major player in dividend payments. Investors have typically placed their trust in banks, expecting stable returns because of their regulated nature. However, the 2008 financial crisis shattered this assumption. In 2009, we observed undercapitalized banks continuing to pay dividends, driven by inertia and peer pressure, which only worsened their financial positions. Thus, it’s crucial for banks to develop flexible dividend policies that correlate with their regulatory capital ratios. If their ratios are stable during profitable periods, they can pay dividends; if regulatory capital demands increase, dividend adjustments may be necessary to avoid contradictions between issuing dividends and raising equity in a pinch.

Overall, the rigid dividend policies seen in the last century were largely viable because U.S. companies benefited from predictable earnings. Today, such predictability is diminishing, indicating a need for greater flexibility in dividend policies. The growing trend of stock buybacks over dividend payouts underscores this transition.

Ricky Mulvey: Please remember that the views shared here may not reflect those of The Motley Fool. Individuals involved in the program might have interests in the companies discussed, and The Motley Fool may have recommendations related to them. This information is not approved by advertisers and follows the company’s editorial standards. Thank you for listening; we’ll return on Monday.

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