In this episode of A Long View, Daniel Rasmussen, who founded Verdad Advisers, discusses the challenges of making forecasts, what investors should consider when evaluating investment factors, and shares his thoughts on the best investment options.
Here are some standout moments from the dialogue between Rasmussen and Morningstar’s Dan Lefkowitz.
Why Are You Betting on Hubris in Value Investing?
Dan Lefkovitz: I wanted to revisit the idea of meta-analysis that you brought up. Let’s delve into the forecasts the market makes and discuss bets on hubris. Could you explain your approach to this meta-analysis?
Daniel Rasmussen: Well, if the future is inherently unpredictable—and it usually is—then there’s this need for humans to plan and predict. How can we take a chance on people’s hubris, betting that they’ll be overly confident in their forecasts? My initial meta-analytic thoughts lead me to value investing. Value investing involves picking up stocks that are undervalued or avoiding those that are overpriced based on fundamentals. Expensive stocks typically project overly optimistic future cash flows, while many actually experience flat or declining growth.
There’s a significant paper called “Factors from Scratch” by researchers at Oshas Asset Management that delves into this. What they found was that if you analyze stocks classified as either very expensive or very cheap, the following year, those deemed overpriced often perform better than undervalued ones. For example, while Nvidia might show growth, it still has stronger fundamentals than some basic producers. However, those high valuations can lead to high expectations that may not materialize. After a year, the forecasts seem to become random.
It’s quite possible to consider growth projections for 2025, but what about 2026? As one year wraps up, how do the projections hold up? Generally, overpriced stocks find their valuations decreasing, while those that are undervalued tend to increase. The migrations in valuations often surpass the differences in fundamentals. Consequently, over time, value stocks tend to outperform growth stocks. This is really about betting against the overly confident predictions of others. Sure, there are other avenues for meta-analytic investment decisions, but value investing stands out as the clearest example of challenging the hubris evident in growth forecasts.
Why U.S. Investors Don’t Recognize the Value in Value Investing
Lefkovitz: In the recent period of diminishing growth, especially in the U.S., has that tested your beliefs?
Rasmussen: Absolutely. The term “humble investors” really resonates; being a value investor has been quite challenging lately. This experience has certainly offered me lessons on confidence in forecasting. It’s worth noting that while value investing struggles in the U.S., it seems to be flourishing internationally. For instance, Japanese and European investors following value strategies have succeeded where those in the U.S. have struggled.
I think this boils down to a historically unique situation. The U.S. is currently riding a wave of innovation, a phenomenon we typically see roughly every 50 years. What normally happens is that optimism drives people’s expectations, yet tech firms have been consistently outperforming earlier projections, igniting the U.S. stock market’s success. Concurrently, people have elevated their expectations—driving stocks’ valuations higher as they surpass those expectations.
Moreover, many are focused on finding the next big company, whether that’s Google, Meta, or Microsoft. Often, these smaller growth firms, which typically aren’t the best investments, have thrived as investors chase winners. This dynamic defines the U.S. market, with a notable focus on large growth companies. Historically, during such innovation waves, it’s the innovators who benefit first, and then subsequently the consumers. This begs the question: when do technology leaders begin to price their results accurately, and when do genuine winners arise from consumer choice rather than tech innovation?
Why Small-Cap Investments Allow for More Extreme Bets
Lefkovitz: That’s fascinating. So as a proponent of small-cap value, are you suggesting there’s a unique advantage there?
Rasmussen: Yes, I’m somewhat agnostic about size as a factor. I don’t believe that simply being small inherently makes a company better. Yes, there’s a higher risk of failure among small to medium-sized businesses, but the interesting aspect is the sheer number of small caps compared to large ones—in the U.S., the Russell 2000 represents many more small firms than the S&P 500 does large ones.
This is particularly true internationally, where you’ll find a wealth of small and micro-cap companies compared to fewer large companies for various reasons. If you’re after extremes—wanting the cheapest 10% or shorting the most expensive—the small-cap sector is where you’ll find those candidates. Recently, many top growth companies were indeed in the small-cap segment, even though Nvidia stands out as an exception. For every Nvidia, there are probably numerous small caps that have experienced similar growth patterns lately. It’s this potential I find so appealing in the small and micro-cap fields.
Additionally, my background at Vanguard influences my viewpoint. Graduating when passive investing was surging made me think about the role of active management. If you’re to excel in active management, you need to carve out a niche that’s hard for others to compete in. While Vanguard engages with small caps, micro-caps are too limited in scale for them or other large index providers. My strategy aims to navigate markets where passive investing has trouble; it’s about having the analytical edge in areas that larger players overlook or find too challenging.
