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Exclusive Interview | COVID-19 behind us, inflation will have big influence on how markets behave: Aswath Damodaran

The 'Dean of Valuation', Professor Aswath Damodaran said he's an optimist on India in the long term and views it as a growth story. But added that it requires a lot more work to realise its immense potential. In terms of sectors, Professor Damodaran believes healthcare and retail are ripe for disruption.

June 28, 2021 / 02:51 PM IST

Professor Aswath Damodaran, one of the finest minds globally on valuation and markets, believes inflation is the biggest factor that will influence markets going forward, as stocks continue to rally in the United States, on the back of an economic recovery and healthy corporate earnings.

Damodaran, who teaches corporate finance and valuation at NYU's Stern School of Business, also weighed in on cryptocurrencies, India's growth story, the upcoming Internet IPOs in India, and how investors should approach them. He spoke to Moneycontrol on the 10th episode of Moneycontrol Masterclass.​

Here are the edited excerpts:

Q. You've often said that the markets are a consensus of the optimists and the pessimists, you can disagree with the markets, but you have to respect that. Who do you think is winning right now?

A. Well, I think it's always an ebb and a flow. No side ever wins forever in markets. And I think I've also described markets as kind of a consensus of humanity. So what you see in markets are all the pluses and minuses of humanity.


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So I think when people complain about markets, they're actually complaining about themselves. What we do what we call irrational or behavioral finance is just a reflection of what human beings do. They gather in crowds, they're afraid to go against, they move in herds. So I think markets move, I always look at what markets are telling me even if I don't agree with that.

Q. You've said in the past that the Fed is like the Wizard of Oz, its power comes from the perception that it has power. The markets seem to have shrugged off Fed's hawkish commentary, even the Indian markets seem to have recovered since.

A. Right now, there are two forces pulling at markets and they're pulling in opposite directions. One is that economic growth is coming back, especially in the United States. It's coming back stronger than expected. If you look at earnings estimates for the S&P 500, they've been up almost every single month for the last 12 months. People are getting more optimistic about growth and the economy coming back. That's the good news.

The bad news is it might be coming back too fast. And we add on top of that the stimulus package there is a concern that inflation is coming back with that growth. Inflation has always been deadly for stocks. So what do you see are the ebbs and flows between the two groups what they call the optimists and pessimists? The optimists look at inflation and say it's a passing phase, it's transitory, and it’s not going to lasts.

The pessimists look at that same phenomenon and say, this is going to be troublesome, difficult for markets to deal with. And I think the Fed has to play a very careful game, it's got to make it look like it's in control, when in fact it's not. So it's interesting that the Fed came out and talked about how it might have to raise rates, why it has to raise rates, because rates are going to go up anyway, whether the Fed wants to or not, so it's got to act like it's in control. So it would be interesting to see how it plays this game. It's going to be a tricky game.

Q. But do you think markets are approaching bubble territory? How long can the central bank can go on printing money? Dr. Michael Burry, for instance, has warned retail investors about a 'mother of all crashes'. And he said when crypto falls from trillions or meme stocks fall from tens of billions, Main Street losses will approach the size of countries. What do you make of that assessment?

A. Michael should have retired after the 2008 crash. Right after The Big Short came out. The market gurus take themselves too seriously. You're in the right place at the right time, you look like a market expert.

And I think there are people who think deeply about markets, Michael Burry is not one of them. So I think that to even respond to a comment by him is giving him more value more respect than he truly does deserve.

Could markets be in a bubble? Absolutely. It could be true at any point in time. And looking in the past and saying this looks just like 2008, or just like 2000 is exactly how we get into trouble. Market crises never resemble each other. In fact, what I am reminded of when people keep pointing to the past is all these army generals who prepare to win the last war. And guess what the next war looks nothing like the last one.

So I'm afraid that on this one I've got to look at Michael Burry and say just stop talking. I mean, it's a no, and tweeting just makes it worse.

Q. If you look at recent fund managers surveys, whether it's the Bank of America, global fund manager survey, or even a survey that Moneycontrol did with domestic mutual funds in India, they say COVID-19 is no longer the biggest tail risk to markets, its inflation in developed markets like the U.S. What's your view on that?

A. I think inflation is the biggest unknown, COVID-19 is behind us in the rear view mirror, we're coming back from it growth is coming back, it's going to come back at different levels in different parts of the world, depending on how badly they're still affected by COVID-19. India is going to be slower back to normalcy than the United States is.

So I agree with them that inflation is the biggest unknown here, it's a wildcard. So from that perspective, how inflation plays out over the rest of the year, it’s going to have a big influence on how markets behave.

Q. And how do you really view internet memes, because they seem to have grown roots in the markets? We have examples ranging from Dogecoin to the Redditors betting on GameStop and AMC. How should traditional investors really approach this?

A. You know what markets are not immune from what's happening in the rest of the world, we live in a world where celebrities drive, what we wear, what we do, what we drive. And social media is the primary mechanism for driving perceptions, and views. And I think markets are caught up in the same phenomenon.

So what would you call internet memes is really a kind of explosion of two things. One is the power of social media to push an idea. And the second is the fact that celebrities have a very big role and how things happen. I mean, look at how much cryptos become dependent on Elon Musk.

Q. Do you believe that there's a future for active fund management even in emerging markets like India, for example, with the rise of passive fund management algo trading, smart-beta funds, and the like?

A. Active money managers have never done a good job, let's be quite honest about this. They've never been as good -- they've never been able to beat the market. The promise we now all know it. The emperor has no clothes. So blaming passive investing for your loss of market share when in fact, it's your performance that's causing it is I think, it strikes me as sour grapes.

The reality is active money managers around the world bring very little to the table. Why the heck should they take something away? Most of them have made money from Mean Reversion. Basically, that's basically what's allowed them to make money. So there's the emptiness of active investing has been exposed in the last decade and especially in 2020. I don't see how active investing makes a comeback to the way it used to be.

Q. And in this leg of the stocks rally, would you look at growth investing or value investing?

A. I think first we need to stop that this thing. If by value investing, you mean the style of Warren Buffett and buying companies whose best days are behind them, I think that entire style of investing needs to be retired. I think my definition of value investing is actually much more dynamic. And I'll give you my definition of value investing. I am willing to buy any stock, where the price is less than the value, whether its growth mature, I really don't care. So I think I don't know if there's anything, I think we need to turn to common sense investing.

Q. Since you brought up Buffett, I also have to ask you, both Buffett and Charlie Munger are pretty negative about SPAC. I think Buffett said it's a killer and Charlie Munger said it's not just stupid, but also shameful. You recently wrote a blog on SPACs- where you said the banker-centric IPO process has had a good run, but it's time for alternative approaches. However, neither direct listings nor SPACs have gone through that trial by fire yet, but if history is a guide, it will come sooner rather than later.

A. I think SPACs, the way it is structured now is too expensive and too inefficient. In a sense, think of what we're doing with SPACs, we're outsourcing our thinking, we as investors. We're letting a Chamath or Bill Ackman makes our choices for us, and especially with the conventional SPAC, we’re giving up 20 percent of the company in return for this expertise.

Nothing in markets is worth that much. So I think SPACs are going to evolve. And I like the way that Pershing Square is approaching the new SPAC of reducing that slice that they take upfront. Because I think that while direct listings work for some private companies, so many private companies, you need an intermediary. I don't trust bankers. I don't think they know what they're doing. But I don't trust SPAC sponsors enough to pay 20 percent. So I think we're going to evolve towards a middle ground where SPACs become more efficient and less expensive.

Q. Why are you very negative on cryptocurrencies, or is it just Bitcoin?

A. If Bitcoin is a good currency, my question is, why aren't more people using it in transactions. So when I run into Bitcoin enthusiasts, they seem to push this notion that Bitcoin is a great currency because they've made a lot of money on it. That's not my measure of a good currency.

A good currency, in my view, is one that used to buy coffee, buy your house, buy a car, and on that count, Bitcoin has failed, and not just failed, it's failed miserably. And there's a reason for it. I mean, think about it. Would you use Bitcoin to pay for something most people will not because they're afraid?

An asset needs cash flows. A currency cannot be an asset class. I mean, let's get that out of the way. It can be an investment grouping, which you put in like you buy fine art, you buy collectibles, you buy gold, and so it could be a collectible and the essence of a good collectible is that does well when the rest of your portfolio's doing badly and it does badly when the rest of your portfolios doing well.

I mean, think of gold. Gold's biggest claim to fame is when stocks collapse gold holds its value. If I use the same test on Bitcoin and I look at 2020, Bitcoin didn't behave like a collectible it behaved like a very risky stock. Put simply, if I add Bitcoin to a portfolio of stocks, I'm just adding something that makes my portfolio even more volatile. That's not the essence of a collectible. So if you're selling Bitcoin to me as an investment class that is uncorrelated with the rest of my assets, unfortunately, the facts don't back you up.

Q. Coming to India, the flow of money in the Indian market is huge. People believe that India's current per capita income can support higher discretionary spending, debt in the corporate system is also low, we are also sitting on one of the highest CapEx cycles. Do you think stars are sort of aligning for the India growth story to take off?

A. For the tenth time in the last 30 years, the stars are aligning, stars keep aligning. India has always had immense potential. But remember to get that potential, it's three steps forward, two steps back, you need systematic progress. And I think that requires a lot more work than we realized.

So I am an optimist in India, I think in the long term, I see India as a growth story. But I'm not somebody who's going to jump on the bandwagon say everything is lined up, things are going to happen magic.

When people say it's the beginning of a bull market. It's almost like people forget that we've had 10 years of plenty, that if you look at where the market is today, relative to where it was a decade ago, we've had one of the great bull markets of all time.

So if you're talking about an additional bull market, you need additional ammunition, because the same story is what's been driving stocks up for the last decade.

Stocks can go up in the midst of bad economic news, and they can go down, even when growth comes in. And that's what's scary right now is if you told me the people who are pessimistic about Indian growth, I'd be more upbeat about stocks. The fact that people are so upbeat about economic growth in India makes me scared because it means that you're going to get a lot of negative surprises along the way.

Q. When you look at companies, you would ask them what was your story for your company before the COVID-19 crisis? And what is the story for your company after the crisis? When you look at the Indian landscape, any particular sector that stands out for you? The story of IT companies, for example, changed post-crisis and they are confident of growing in double digits now.

A. I'll give you areas where I think COVID-19 will make a difference in India, one is healthcare. I mean COVID-19 has woken us up to the fact that Indian healthcare is woefully inadequate, so healthcare is one of those areas where I see immense growth potential in India and maybe COVID-19 has woken us up to that.

The other is retail. For as long as I can remember, people have talked about how retail in India is ripe for disruption. And guess what, the bulk of retail still in India is small shopkeepers that you go to and buy, buy items you need for the day.

I think COVID-19 more than anything else has forced Indians out of their comfort zone, the way we shop has been changed, irreversibly, And I think this might open the door, at least to that long-standing or long expected disruption in retail that people have told us is coming. Maybe this will be the start of a new retail landscape and I'd be looking at companies that are positioned to take advantage of that.

Q. The other trend that really stood out for India this year is the amount of money that's been flowing into the internet economy. I mean, we've had 15-16 unicorns in six months of the year versus all of 2020. What do you make of this trend?

A. I think we're all stuck at home. We lived online. There are parts of the year last year, where if I hadn't had Amazon Prime, and Netflix, I'd have gone crazy. So I think that COVID-19 has made us all much more adept online. And maybe this is pushed a lot of older Indians who might have might not have been comfortable with technology to become more comfortable.

And I wouldn't be surprised if this is again, a global phenomenon of being able to do things online more comfortably playing up as higher values for companies can make that can make our lives easier to be online.

Q. The other thing that people are really looking forward to is a whole bunch of internet IPOs, for example, Zomato and Paytm, Delhivery, Nykaa, Flipkart, and so on. Now people often draw comparisons with the kind of wealth that the internet companies created in the US. But if you look at some of these companies in India, they didn't go from idea to IPO in three to four years or with minimum funding. I mean, they've been raising funding in multiple rounds for five years, 10 years. So some investors feel that a lot of the growth or the value has already been squeezed out by hedge funds, or sovereign wealth funds, or the VCs. What's your own sense?

A. Well, these are cash-burning machines. I mean, they can burn through cash, like it's nobody's business. The question I always have with these startups is, are you building a business? Are you building an exit multiple? And the reason I mean by that is many of these many tech companies not just in India, but in the US as well. There's no interest in building a business. They're interested in building users subscribers, who can flip it to somebody else at a much higher price.

So I think there's going to be a shakeout, many of these IPOs are going to go public because the mood is right. But at the same time, they're not designed to be healthy, successful businesses, even in the long term. I mean, I call this the big market delusion using the notion that there's a big market out there, you push your company out, people buy your shares, but then they realize it's hard work building a business to take advantage of a big market.

So I think that the question I would have if I were an investor, not a trader, but an investor in these companies is which of these companies are being run by managers who really understand what it takes to build a business not just talk about how big their market is?

Q. In terms of how you value them, many of these unicorns command multi-billion valuations, while making losses. So the usual defaults like PE or price to book value ratios don't work here. So how should investors really approach these IPOs?

A. First and most IPOs are priced, this is around what they're not valued. And if you've read my material, I make a big deal about price versus value. Pricing is based on what other people are paying for similar things. So if you look at VCs and you look at why did they pay this price, they look at what are people paying for similar companies out there and since none of these companies have earnings or book value, or even revenues, the pricing is often based on metrics. Then you and I might look at, what are you doing?

So if you're an investor, be very careful, don't get drawn into the pricing game, because your game is different, you have to think about value, even if the managers are not and the VCs are not, which means you’ll walk away from some of these companies saying, hey, I see the pricing is high, but I cannot justify the value that you would need to get to justify this pricing.

Q. But leaving IPOs aside, how does one really value a disruptive company? How does one make sure the price is anchored in value?

A. That's why I said business models matter. To value a startup, I need to think about what's the business model here? How will they eventually make money, you cannot value a company without thinking about pathways to profitability.

I'll give you an example. You start a great site that millions of people visit your site, ask me to value your site, and I say, okay, tell me how you plan to make money. And you say, look, I have lots of people visiting my site, would say, that's not enough. Tell me do you want to sell ads? Are you going to have subscriptions? That's what I mean about managers who think about business models and think through them to tell me what the value is going to come from.

So here's the bottom line, you cannot value young companies without telling a story about the company. That story you might get by listening to what managers say, but look at what they do because that's really the ammunition used to tell a better story. You cannot value these companies without a story and converting that story into inputs into valuation growth and margins and reinvestment.

So it's not something that everybody likes to do, it makes people uncomfortable because there's a lot of uncertainty. But here's my redeeming, here’s the redeeming feature. It's not just you that's uncertain, everybody is, but you've got to try your best to get over that, and try to tell a story you can fill out and convert into numbers.

Q. One more thing that VCs say is that you can't use traditional accounting metrics in the way you value startups, because those metrics kind of look at the past, whereas VCs look at the future. So you will have to look at different metrics, the DCF (discounted cash flow) model will not work here.

A. That's such absolute nonsense. I mean, the only people who say that really don't understand what a DCF is. A DCF doesn't require past data, the DCF is always about the future. If you have issues with accountants take it up with accountants don't take it up with people who do valuation. If you do valuation, it's all about the future. If you're telling me the future doesn't matter, then we have an issue.

If you're telling me last year's financials don't make a big deal. I agree with that. But in a DCF, I'm not looking at last year's financials, I'm projecting the future. So when VC says, DCF doesn't work, because there's too much uncertainty. My response is, well, how does using a pricing multiple, make that uncertainty go away.

I mean, there are two things you can do with uncertainty. One is to act like it's not there, being denied and that's what VCs seem to do. The other is to accept the fact that the uncertainty looks in the face and make your best estimates. Because uncertainty doesn't stop you from estimating things, it just means there's a larger error term on what you estimate, make your best estimates, and move on.

Q. What do you make of the Ed-tech space which has seen huge interest among investors?

A. I'll tell you the reason it doesn't surprise me. There is no business that is more inefficiently run, and more ill-focused than the education business. And I speak of it as somebody who's in a university, I can see how screwed up this process is. It's also a huge business. So you take a huge inefficient business shouldn't be disrupted. Absolutely. My question is, why isn't it already happened?

So I think COVID-19 again, is one of those opportunities, we have to revisit something that we've always thought about for decades. Why isn't the education business changing? The real reason is inertia, education being designed a certain way, maybe COVID-19, shaking up the equation enough that people say maybe there's a different a better, more efficient, cheaper way of delivering education.

Now, some of these offerings that are in this space really, I think are going to fail, because they don't understand that the education business is not just about packaging and selling classes. It's much richer than that. But there are some that are recognizing that you bring both classes and the rest of the experience in, you could do it much more efficiently than most universities and colleges are doing right now.

Q. Just like education, do you think financial services banking are another area that's ripe for disruption? I mean there’s huge interest that you see among FinTechs, neo banking, etc.

A. It's a big business, it's inefficiently run and inefficiently regulated. One of my cynical views of FinTech is a lot of it is regulatory arbitrage, what you have is people taking advantage of the fact that they're under the radar they can do things that a bank or an insurance company cannot do.

Those FinTech companies are going to crash and burn eventually, because they will be successful as long as the regulators don't notice them. But once they get noticed, they're in trouble. But some of the FinTech space is clearly going after the soft underbelly what I call the soft underbelly of the traditional financial services business.

I'll give you an example. In the US, when you send the bank wire, which is basically electronic sending it from one branch to another branch, it costs me $25 to $40. That is absurd. It's pure profit. You know what, I'm hoping that Amazon starts a bank and goes after these guys, because, I mean, I'm praying for disruption in some of these businesses.

So the reality is, traditional financial service businesses have portions of the business that are really soft and ripe for disruption. And unfortunately, they can't afford to lose the profits from those businesses. But that's exactly what FinTech is going to do to that. It's going to take away the easiest and softest businesses.

Q. To wrap up, if you can give us three big trends that you are watching closely..

A. The first I think is what's happening in the automobile space, either moving away from traditional cars to electric cars and public transit. I think you're going to continue to see that with its consequences. What am I going to do with all these parking lots, not as big an issue in India as it is in the U.S., but we have billions of dollars invested in the traditional automobile, what happens to all of that?

The second is a related issue with commercial real estate. I mean, we have stores, we have malls, and it the trend might not be as strong in India. But in the US increasingly people are not going to malls, they’re not going to stores, whatever, and people are going to reduce their office space, maybe work from home. So I think the move towards hybrid work and less office space is going to be problematic for commercial real estate.

And the third is travel, what's going to happen when travel comes back and business travel is not as bigger part of the equation. Remember that business travelers subsidised the rest of us traveling for a long time, without people paying thousands of dollars for those business class seats, is there enough money to keep an airline afloat. So I think those are the three immediate issues I'm going to be looking at to see how they play out in markets.

Watch: Aswath Damodaran's take on markets, cryptos and IPOs on Moneycontrol's Masterclass Episode 10

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Chandra R Srikanth is Editor- Tech, Startups, and New Economy
first published: Jun 28, 2021 02:06 pm
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