Secrets of a Stockpicking Star

Jonathan Berk: I’m Jonathan Berk, the A.P. Giannini Professor of Finance at the Graduate School of Business at Stanford University.

Jules van Binsbergen: And I’m Jules van Binsbergen, the Nippon Life Professor in Finance at the Wharton School at the University of Pennsylvania. Join us on a journey as we explore the science and strategy of better decision making.

Jonathan Berk: Today we will consider an important business decision: the decision about whether to buy a good business. Whether you’re a sole proprietor thinking of buying an established small business or a conglomerate considering the decision to buy up a new brand or starting a new division, the same question needs to be answered: What is a good business to buy?

Jules van Binsbergen: To make this decision concrete, let’s consider a business purchasing decision most of us make: buying stock in a public company. How do you put together a good stock portfolio? Which stocks are good buys, and which ones are not?

Jonathan Berk: So, as usual, last week I was talking with one of my golf buddies, and he was telling me what a great stock picker he is. He’s never, ever told me about any bad investments he’s made, but he always tells me about the great investments he makes. And the thing about this guy is his investment strategy is incredibly simple. He tries out products. If he likes the products, he buys the stock. So, the question is, does that make sense? Is his investment strategy a strategy that’s going to make you a lot of money?

Jules van Binsbergen: Well, Jonathan, your buddy’s argument sounds pretty convincing if we hold all else equal. All else equal, a firm that makes good products is certainly a better investment than a firm that makes bad products. But can we hold all else equal? And as we’ve now seen several times, the answer to that question is usually no. We have to think this through carefully.

Jonathan Berk: And the thing that is holding all else equal is he’s not worrying about the price. So, holding all else equal, if I have two investments and they cost the same, I would much rather invest with a good company than a bad company. But as we’ve discussed last time, you can never hold all else equal. If the company is a particularly good company, it’s going to have a high price. So, really, what you’re interested in is not whether the company is good or bad, but whether or not the price of the company is a good price or a bad price.

Jules van Binsbergen: Yes, because overpaying for a good company is a bad investment strategy, whereas underpaying for a bad company will make you a lot of money going forward. So, it’s not just about what you’re getting, but also what you’re paying for it.

Jonathan Berk: And so, the real question is not whether the company is good or bad, but what price you’re paying for the company. And I’d like to make the argument that for a nonprofessional, it’s going to be very rare or next to impossible to find investments whose prices are attractive. Or another way of saying this is it’s going to be really hard for such a person to find good deals in the stock market.

Jules van Binsbergen: What it’s all about is about competition and whether or not you have a competitive advantage that you can exploit when you’re picking stocks. Because if there’s a good deal but everybody already knows about it, then everybody will want to invest in it, and everybody will put in buy orders. There are going to be too many buyers and not enough sellers. And so, the price will go up, and the investment opportunity will disappear.

And so, the only way in which you can make money investing in “good companies” between quotation marks is if you arrive at the party early, meaning you find out that the products that the company makes are better than what people thought up until that point. And so, if you’re the first one to figure that out and you get into that stock early, there may still be a possibility for you to make some extra returns. But if you’re arriving at the party at exactly the same time as everybody else, then obviously you’re not going to be making extra money.

Jonathan Berk: And it’s not easy to arrive at that party early. And the reason is, there are a lot of people who devote their entire lives to looking for good parties. And it’s unlikely that individual investors will have the time or the resources to do a better job than the people whose career is built on trying to arrive at the party early. It’s like a sports fan stepping onto a football field and thinking they can outplay Tom Brady. It’s just not a very likely event.

Jules van Binsbergen: Indeed. And so, I mean, it’s not that there are no good and bad investment decisions in the market. I think that the main thing is, can average investors tell them apart? Because to be able to tell them apart, you need to have something that other people don’t have. That’s exactly that competitive advantage point. And of course, by definition the average investor doesn’t have a competitive advantage compared to everybody else.

Jonathan Berk: You know, Jules, when I teach this concept in class, I always tell an old joke, which finance professors have told for decades. And the joke goes like this: A finance professor and his student are walking down the street, and they see a hundred-dollar bill lying on the ground. And the student reaches down to pick the hundred-dollar bill up. And the professor says to the student, “Oh, don’t bother. If that really was a hundred-dollar bill, it would be taken already.”

And then I add to this joke an addendum. And the addendum I add is, I look at my students and I say to them, “How many of you have actually found a one-hundred-dollar bill on the ground?” And nobody raised their hand. Nobody raises their hand. And the ensuing silence is exactly the point, which is, A, if there is a hundred-dollar bill lying on the ground, it’s going to be picked up very quickly. So, the likelihood of you finding it is very low. And B, if you have a hundred-dollar bill in your pocket, you’re going to look after it very carefully, and so you’re very unlikely to drop it.

Jules van Binsbergen: Well, one thing that you can add to that, though, and that really introduces that idea of competition into this joke, is that it depends a bit on how busy the street is. If the street is completely full of people, then of course the probability that that hundred-dollar bill will stay lying there is incredibly low. If the street is abandoned and nobody’s there, then of course the hundred-dollar bill might lie there for a bit longer. Although, of course, once it would become known that hundred-dollar bills are lying around on this street all the time, my prediction is it will get really busy really soon.

Jonathan Berk: And also, your competitive advantage: If you happen to live on a street that’s a very quiet street, and somebody dropped a hundred-dollar bill, your likelihood of picking it up is much higher than an average person.

Jules van Binsbergen: Yes, absolutely. Another addendum to this example, which I really like to make in classes, this idea that suppose that there’s this building out there and you’re convinced that it’s full of one-hundred-dollar bills. And actually, you talk to a lot of people, and a lot of people say there are one-hundred-dollar bills lying in this building all over the place. And you think to yourself, I should be going to this building because why on earth is nobody going there to pick up all these one-hundred-dollar bills? You get so overconfident. You go into the building, start picking up the hundred-dollar bills. The building collapses and you’re dead.

And so, in the end, there was a reason why people were actually not going into that building to pick up those bills. It was just that you were not realizing what the rest of the market knew that you didn’t know. And you should’ve thought it through better and think, why is it? Can I understand why the rest of the market is not going into that building to pick up those one-hundred-dollar bills?

Jonathan Berk: It’s another all else equal mistake. Right? If I know there’s a really good deal out there, then all else equal, I should take advantage of the deal. But everything is not all else equal. The fact that nobody else is taking advantage of the deal tells me that there must be something else going on. It’s too easy.

Jules van Binsbergen: Indeed. So, Jonathan, how does information get into prices? Right? So, suppose that the price of a stock is lower than it should be, and therefore it is a good buying opportunity. So, let’s just say there is a given quality for the firm, but the price of the stock is not reflecting that quality and the price is too low. So, how is that price going to equilibrate?

Jonathan Berk: Well, I mean, first of all, everybody is going to want that deal. Everybody wants a good deal. So, people are going to start buying that stock. At the same time, somebody has to sell that stock. If it is a good deal to buy, it is a bad deal to sell. So, it means not only am I getting a good deal, somebody else is getting a bad deal. And I would argue that that’s not going to last very long. Very quickly, the people selling are going to say, “Wait a minute. I don’t want to sell at such a low price.” And the people buying are going to queue up to buy at that low price. And very quickly, the price will start rising, and will keep rising until the point where it’s no longer a good deal.

Jules van Binsbergen: Indeed. And the same thing, of course, holds when we take the other scenario where the price is too high, and then the price will be bid down through the same process to arrive at the right level of the price.

Jonathan Berk: And really, the only way you can get a good deal in [markets] is you have to be the first person who arrives, and you buy a limited amount, and then you can make money. And there are people that do that, but they need a lot of resources and a lot of skill to find those special deals that nobody else sees.

Jules van Binsbergen: So, the key thing then is to determine whether or not the price is higher or lower than where it should be. And so, the question then is, how do you measure the should be? And so, therefore often what we talk about is what’s called price multiples, which are relative measures of valuation. And so, for different firms, you can take the ratio of the price per share to the earnings per share of the company, or you can take the ratio of the price per share of the company to what’s called the book value of equity, which is a measure per share of the replacement value of the plant, property, equipment, and all the capital that the firm uses to produce its products.

Jonathan Berk: And since savvy investors understand the all else equal argument, and understand that it’s the relative price that matters, they almost always just talk in terms of multiples rather than in price.

Jules van Binsbergen: So, let’s go and talk to Cliff Asness, because Cliff Asness is an expert in finding good deals in markets, and he has a particular approach to go about this. He’s been very successful at it, so let’s see what he has to say about this.

Jonathan Berk: OK. Well, welcome, Cliff Asness, to the show. We’re very honored to have you. For people who don’t know, Cliff Asness is a manager and co-founder of AQR Capital Management, one of the largest asset managers in the world. And I would say not only that, universally regarded as one of the most successful asset managers in modern history. And it’s really an honor to have you here.

Cliff Asness: Thank you, Jonathan. I think that’s a gross exaggeration, but I enjoy gross exaggerations.

Jules van Binsbergen: Welcome. We’re very happy to have you.

Jonathan Berk: So, let me ask you, Cliff. The objective in this particular episode is to talk about what has commonly become known as efficient markets, the idea that a good stock is not a good buy. It’s a cheap stock that’s a good buy. So, with that in mind, I have two questions for you. One question is a very general question: How hard is it to find good deals in the market? But I’m going to make that very specific.

Because this morning when I was brushing my teeth, I was thinking about this interview. I was thinking about that very specifically. Lots and lots of academics go and try to do what you do. And the thing is, we know academics are very smart. But the thing is, not all of them succeed. What is it that allows some people to succeed and other people not to succeed?

Cliff Asness: Well, first of all, it’s nice to know in the era of Zoom you’re still brushing your teeth. I’m not sure all of us are doing that. I’m going to give you kind of a weird answer. Obviously, some people can translate the theoretical to the practical better, and the real world trading cost, and size you can run, and judgments about whether something is real or whether it’s a data-mined artifact. Those all do vary. But I’m going to give you an answer that maybe will be a little surprising.

The capacity to withstand pain and the capacity to explain when things are not working, why they’re not working. You have to be good at what you do long term. If you could stick with it and convince others to stick with it, I think you’d at least have a reasonably good investment product. Those two things that are often an afterthought: you being able to tolerate it — and don’t think you’re not your worst client on occasion — and being able to explain it to others.

Real-world investing strategies, even if you’re very good, work a little more than they don’t. They don’t work all the time. People talk about stocks for the long run. In geekspeak — and I’m sure your students are familiar with these things — the stock market is like a 0.4 Sharpe ratio. Go simulate that in Excel. It’s excruciatingly hard to stick with at times.

And if anything, my answer to that question is probably pretty different than it would’ve been 20 years ago. I think I appreciate that side of it, both for ourselves and for clients, how tough it is to stick with a strategy. Truly everyone talks about the long term. Actually, being long term is a superpower in investing if you can do it. It is very hard to do.

Jules van Binsbergen: That’s a very surprising answer, Cliff. Because we spend a lot of time also in our classroom and in our research thinking about how to best design the strategy. But what you’re saying is that what is really an important skill is to convince both yourself as well as your clients to stick with the ideas that you had. And so, the ability to withstand adversity apparently is the most important skill. Now we know that that’s generally true in life, but apparently that is true here in the investment world as well.

Jonathan Berk: So, Cliff, when you’re on the golf course, you’ve always got your buddy telling you how much money he’s made in the stock market. Right? Let’s assume they’re telling the truth. How do they do this without the resources of AQR and all the intelligence of all the employees you have and all of that?

Cliff Asness: I think when it comes to people who are talking to their friends on the golf course — I don’t golf, so I’m trying to come up with someplace else. I do go to cocktail parties occasionally back when there used to be cocktail parties. You get a lot of people talking about the stock or even the market. I don’t think the market is very easy to time, and you hear a lot of opinions about that.

Jonathan, you said something important. You said let’s assume what they’re telling you is true. A, I don’t always assume that, but for the sake of your argument I will. But what I won’t assume is that the people who lose terribly are as anxious to tell their golf course stories.

Jules van Binsbergen: Yeah, you’re so right about that. People rarely tell me how poorly they’ve done on their stock picks. I mean, this is also one of the reasons for why we study, when we study investment managers, that when returns are self-reported, of course, the funds that did well are much more likely to report the results than the funds that didn’t do so well.

Cliff Asness: By the way, this is not different than fear of missing out, FOMO, on Facebook. They tell us there’s an epidemic of depressed people because everyone thinks that other people’s lives are better than theirs because they’re looking at their Facebook or their Instagram and all the fun they’re having. You don’t hear about people’s problems on Facebook. There are exceptions to that, of course, but as a rule they’re positive posts.

You don’t see people at cocktail parties going, “Oh, man, I suck at stock picking. Let me tell you about the — I made all this money, but I lost it all on these —” Again, there are exceptions. I would listen to that person at the cocktail party. They’d be kind of fun, the honest person who was telling you that, but that’s not the rule.

So, you do have to be very careful of the financial version of FOMO where people are cherry-picking their winners, even if they’re not lying about them. And who speaks up is being cherry-picked. So, I will call myself a cynic that the individual doing this casually can add a whole lot of value, certainly at the concentrated picking of individual security level. But I made a big concession to my efficient market roots that I think there are some people who clearly can.

Jonathan Berk: When you think about it, we all have a golf buddy or somebody like a golf buddy telling us what a genius they are. One of the things that you notice when people tell you about their investment strategy in a social environment is, more often than not, the investment strategy is so simple. It is so clear to do. And I always think to myself when these people tell me the strategy, what makes them think that nobody else has thought of such a simple strategy?

Jules van Binsbergen: And also the question of who is on the other side of that trade. Right? I mean, this famous saying, if you don’t know who the sucker is, it is probably you.

Jonathan Berk: Yeah.

Cliff Asness: Jonathan, I think you’re thinking the same way. But I would sum it up as they leave price out of their strategy. Often their strategy is about what they think is going to be a big thing. Back in ’99, 2000 during the first wave of tech stock mania, people would say things like, “Well, the internet is going to change the world.” And I think that was fairly obviously true at the time.

All right. Should you be paying an infinite multiple for drkoop.com? He was the surgeon general who then launched a dot-com at the time. There were many other examples. The Nasdaq as a whole, the Nasdaq-100, was selling for about a hundred price-to-earnings multiples.

Aside from trading. Trading is a whole different world. If you’re trying to predict what happens tomorrow or even the next few months, or even the next year, that’s a lot — Like Warren Buffett always talks about a voting versus a weighing machine. That is a voting machine. If other people decide to jump on the bandwagon, a good trader doesn’t necessarily need to have a big grasp of price.

I’m a little cynical that there are great natural traders who could just feel the market also, but I don’t dismiss the possibility. But if you’re going to hold something as an investor for a decent length of time, there are really basically two things that go into it: the quality, and it could be multidimensional quality, of how well they execute, how fast they can grow, what markets they’re in, and what price you’re paying to begin with.

Let me tell you a story. This is from the tech bubble, ’99, 2000. I remember speaking to an audience, and the audience was very cynical. I’m doing my “value has never looked more ridiculously stretched.” And there are people there. Somebody raised their favorite stock. I forget which one it was, but I’ve said it was Cisco, the networking stock for at least 10 years, so I’m going to stick with that though it may be a lie.

And I asked them basically this question: If you’re going to have to hold Cisco not for a month but for 10, 20 years — you love it, I get it; you love it, and we disagree — at what price would you get out? And I was trying to induce them to answer the question that we’re groping around. And the answer — I still love the answer. Thank God I don’t remember who it was because it would be very mean of me if I did. But the answer the person gave me at the event was, “If it was selling for X, well, if it dropped to half X, I’d be out.” They went the opposite way.

Jules van Binsbergen: That’s perfect.

Cliff Asness: Again, they might have misunderstood. I really did try to preface it with this is a long-term hold. So, basically saying if I could buy this for the next 20 years at half the price. They were giving me a momentum answer to a value question.

Jonathan Berk: What I like about that analogy is it not only illustrates that professionals can make all else equal mistakes, but it’s another example of where it is difficult to stick by your guns. That the earlier point you made, that a part of the skill of a professional is somebody who’s willing to stick with their strategy.

Jules van Binsbergen: So, earlier you made a remark which I’d found very interesting, which was in the golf course, the person who was willing to discuss their mistakes would actually be somebody that you would be willing to listen to. And you also seem very willing and open to discuss the things that have gone poorly. Why do you think this is so difficult for most people to do?

Cliff Asness: Well, for one thing, I just think most people haven’t thought through the strategy. I think the world respects — I’ll be honest, it’s self-serving of me — I think being open and honest about these things, the world respects it. Not that I’m always respected. Doesn’t always work. It doesn’t work each time and it doesn’t work with each person. But I think, on average, people do sense who’s BS-ing them and who’s giving them the truth.

I do think I’ve gotten better at it over my career. It’s like all the people who do sports analytics talk about how coaches who’ve been successful over the long term are actually better coaches not because they’ve learned what play works, but because they’re more steadfast in doing the play they believe will work, even if it’s going to get them yelled at if it doesn’t. So, you do improve upon this.

But I think most people, they don’t quite get that if they lead with all the things they’ve done wrong, they can still impress people. They can still have people think they know what they’re doing. And this doesn’t work for everyone. If you’re genuinely bad at what you’re doing and you’re a bit of a boob, leading with seven errors and then never following it up with substance is really not a good strategy.

So, it does come down — and maybe I’m overendowed with this — with a certain level of self-confidence. Admitting your mistakes requires self-confidence because you have to have faith that people will make a judgment on the totality, not on the few things you told them that you were stupid about.

So, if I could give a life lesson. I’ve talked to my kids about this. That is one. I don’t have a lot of great life lessons, but that is certainly one. That if you’re down the middle about yourself — and no one is perfectly down the middle; we’re all a little biased to our own story — but if you’re as down the middle as you can be, have some faith in other people. I think it would work out for many more people better than they think, not just me. I might have lucked into the strategy over time.

Jules van Binsbergen: I love that.

Jonathan Berk: I think, actually, there’s an extension to this, which is not only do you admit your mistakes, but you learn from your mistakes. I genuinely mean learn from your mistakes. I don’t mean, oh, I made a mistake and I repeat the same mistake again. I really think to myself, what caused me to make that mistake, and how could I not do that again? I think it’s a very difficult thing to do, and I think human beings really struggle with that. I think there’s certainly a future podcast for a business decision maker. This is something we should focus on: Why is it so hard to admit that you’ve made a mistake and act on it?

Cliff Asness: Of course. You’re exactly right. That is the second half. Admitting you’ve made a mistake is lovely, and it makes for a very cathartic conversation. But if you learn zero from that mistake, admitting it doesn’t actually help. The second part is pretty important, too.

So, you’re right. I think they often go hand in glove. I think that person — not just me by any means, but the person who can admit to a mistake — almost by definition is at least halfway down the road to asking why they made a mistake and why they might not going forward. I mean, it’s odd to imagine someone admitting to a litany of mistakes, and then saying, “Well, what are you going to do to prevent that going forward?” and have them … if you have this conversation with someone — they’d made a couple of errors even though life’s been good — and you go, “Well, what have you learned from those errors?” and they go, “Nothing,” that would be odd.

I’m talking about ex-ante errors, not ex-post errors. And that’s another one of the huge problems. Right? I think ex-ante we launched too aggressively in 1998 at AQR. Ex-post, we got one of the most savage value drawdowns. Again, the next three years was wonderful, so I’ll always throw that in. The market has to go on. But that was ex-post. But I do think we made an ex-ante mistake.

There’s also, if I can be a little crass about it — and someone at AQR is going to yell at me for this — our legal world has people terrified to say the words “I made a mistake.” And they’re doing their jobs and they’re wonderful people, at least the ones at our firm. I actually like our legal and compliance people. I scare them when I say things like, “Yeah, I think we got that one wrong.” And they’re like, “You can’t say that.” I’m like, “Does anyone think we get everything right? Is there anyone on earth who thinks that?” My mother didn’t think that, and she was biased toward me.

So, I think that part of our culture — and it doesn’t mean it’s a net negative. There are a lot of legal protections we have, and it does protect the world from some things. But that part of the culture also pushes any corporate executive away from the words, “Yeah, we were wrong about that one. Our bad.”

Jules van Binsbergen: So yeah, one of the reasons why we decided to do the podcast to begin with is because people make mistakes all the time, and it is very difficult to learn from them. And so, you really need to talk them through and see the commonalities in the mistakes that people are making.

Thank you so much, Cliff, for spending the time with us. It’s been really great, and it’s been a lot of fun, too.

Cliff Asness: No, it has been fun. Thank you, guys.

Jules van Binsbergen: Thanks, everybody, for listening. We hope you enjoyed the podcast and the interview with Cliff Asness. We learned a lot from him. Certainly what he explained was that not putting price into the equation is going to make you make a mistake. I think that came through very clearly. But I was surprised with the fact that the most important investment management skill was to stick with it and to stick through it. I hadn’t expected that to be the answer to the question, what is the skill in shortest supply?

So, now next time, we’re going to apply the same all else equal logic to money management. So, should you put your money with the best manager, and best manager, [say], a five-star rated manager by Morningstar? If you put your money with that manager, are you going to get higher returns going forward, yes or no? That’s what we’re exploring next time. And the guest we have for that is Pete Briger, who is CEO of the Fortress Investment Group, one of the largest global investment managers.

Jonathan Berk: Thanks for listening to the All Else Equal podcast. Please leave us a review at Apple Podcasts. We love to hear from our listeners. And be sure to catch our next episode by subscribing or following our show wherever you listen to your podcasts. For more information and episodes, visit allelseequalpodcast.com, or follow us on LinkedIn.

The All Else Equal podcast is a joint venture of Stanford University’s Graduate School of Business and the Wharton School at the University of Pennsylvania, and is produced by Podium Podcast Co.