Robert Leonard (02:41):
I have quite a few big topics that I want to talk to you about today, but I want to start at a high level and discuss your mission, which is to spread financial wellness. What is financial wellness and why is that your mission?

Brian Feroldi (02:53):
So in general, I am a huge fan of mission statements and mission statements get a really, really bad rap and that’s 95% of the time that you read about a mission statement, it’s BS. It is just corporate fluff. It’s almost something that is required to be put on your website and companies do not live out their mission. So because of that, I myself, for more than a decade thought that mission statements were terrible. I have since come to fully believe that good mission statements, when acted upon and created honestly, are kind of like a North Star in both your personal life or in your professional life.

Brian Feroldi (03:39):
I am a huge fan and advocate of FIRE, financial independence retire early. That’s where my passion lies. However, when I was creating my career mission statement, I thought hard and I was like, there is a lot of people out there. In fact, the majority of people out there are not interested in financial independence, like that is not something that’s on their radar and I decided to make my mission to spread financial wellness and financial wellness to me is not just about any one thing related to finance.

Brian Feroldi (04:10):
It’s about thinking of your finances holistically. Just like if I said to you what’s health wellness. Is it lifting weights? No, that’s a component of wellness. There’s physical wellness, there’s mental wellness. There’s wellness with relationships. There’s just wellness in general with your life. I try to apply that same kind of thinking to your financial life. So if somebody comes to me and they say, “What stock should I buy?” I say, “Well, let’s back up. Do you have an emergency fund? Do you have multiple sources of income? Do you have a will? Do you have life insurance?” It’s thinking about your entire financial life as opposed to one small segment.

Robert Leonard (04:48):
Just out of curiosity, was The Motley Fool a turning point for you with mission statements? Is that what made you believe that mission statements weren’t all BS?

Brian Feroldi (04:57):
Yes. They were a major influence on me and The Motley Fool is a big believer in mission statements, but what I’ve found is that companies that have wonderful mission statements and really live them, it helps them on so many dimensions. The biggest is it attracts and retains like-minded employees. The best known example out there is Tesla. Tesla’s mission is to accelerate the advent of sustainable energy, and if you are a believer in climate change, and if you want the world to change for the better, that’s an incredibly attractive mission statement and they repeat it over and over and over again and that is the lens that Elon must look through when he’s making decisions.

Brian Feroldi (05:43):
My favorite example of that is a few years ago when he’d said, “We’re going to open source our patents. We’re going to give our patents away to our competitors for free.” Why would you do that? The answer is because their mission isn’t to completely crush the auto sector. Their mission is to accelerate the adoption of sustainable energy and does opening up their patents to their competitors accelerate the adoption of sustainable energy? The answer is yes. That’s why they did that.

Brian Feroldi (06:10):
So when you have a great mission statement, it aligns all of the stakeholders of a business around a singular mission and stakeholders are employees, management, customers, suppliers, everybody that is involved with Tesla is focused on that mission and it just makes decision-making very simple and it just builds loyalty amongst all of the company stakeholders.

Robert Leonard (06:34):
I really like this idea of financial wellness that you brought up. It put a concept or a term to something that I try to do here with the show, and it’s one that I hadn’t really thought of before, because when I started this show, I really originally thought it was just going to be about stock investing. Then as I started to talk to people, I realized, well, to be a good stock investor, there’s certain things you need to do.

Robert Leonard (06:54):
One of them is to be invested for the long-term. Well, you can’t be invested for the long term if you have issues with your personal finances. If you have an emergency and you don’t have an emergency fund, then you’re going to have to withdraw from your investments, which fails that principle of being invested for the long-term. So I said, okay, well I need to add a personal finance component to the show because that’s very important to actually becoming a successful investor. I hadn’t really thought of it as a full package of financial wellness. So I really liked that you put this concept that I’ve been also trying to approach to a set of two words or three words or strategy.

Brian Feroldi (07:26):
You bring up an excellent point. Stock picking is fun. Everybody wants to know what is the next stock that I buy that’s going to give me a 10X return. That’s exciting to talk about. However, even if you had the next great stock in hand, that information is useless to you unless you have money to invest and the ability to hold it for a long period of time, and you won’t have the ability to hold it for a long period of time unless your personal finances are taken care of.

Brian Feroldi (07:59):
If you have one income, lots of debts and very little cash and you buy the next great stock and then something happens in your life, your income disappears, you are in financial trouble and the odds are very good that you will have to sell that stock that you think is going to go up hugely to cover a short-term emergency. So to me, you can’t invest well or you can’t invest the right way unless your personal finances are taken care of.

Brian Feroldi (08:28):
I actually believe that personal finances are at least 10 times more important than investing. So that to me is, again, why I say financial wellness. So you have to take care of your personal finances to become a good investor. They’re linked

Robert Leonard (08:41):
I completely agree, and that’s exactly why my strategy or my focus with the show has changed a bit from just stocks to also including that personal finance component. I have a wide range of guests on the show. Some believe that you can beat the market by picking individual stocks. Others are very adamant that you can not beat the market and you shouldn’t even try. You shouldn’t waste your time.

Robert Leonard (09:01):
I like to have both opinions on the show because it allows the listeners to learn both sides of the argument and make a decision that I think is best for them, and what’s true for them and what they think is true since there is no strategy that fits all, not everybody listening to the show is going to be a stock picker, not everybody has the time to invest in stocks. That said, to set the stage for the rest of our conversation, where do you fall on this hotly debated topic? Can individual investors beat the market?

Brian Feroldi (09:27):
I am a firm believer that individual investors can beat the market. Having said that, I am an enormous fan of Jack Bogle. He is on my Mount Rushmore of investors, and when people come up to me in everyday life and they say, “What should I invest in?” My answer is always the same, index funds. I think index funds are the correct investing vehicle for 98% of the population. You don’t have to understand anything about finances. You just need to know the very basic mechanics to keep your costs slow and ride the long-term trend of the stock market, and you will do extremely well over time.

Brian Feroldi (10:06):
Most people that I come in contact with that believe in index funds, or at least believe that stock picking is impossible tend to reference studies of mutual fund managers. These numbers clearly show the vast majority of mutual funds underperform the indexes over time, therefore stock-picking is impossible. That argument makes complete logical sense to me.

Brian Feroldi (10:28):
People that are pure or think that stock picking is impossible, what they miss is that managing somebody else’s money is unbelievably difficult. Investing and beating the market is very hard with your own money, when you don’t have to justify your actions to somebody else. Mutual funds and financial managers are not in the business of beating the market. They’re in the business of gathering assets. That is how they make more money.

Brian Feroldi (10:59):
A mutual fund with $1 million that spanks the market will make 100 times less money than a mutual fund with a hundred million dollars that loses to the market. So the incentive isn’t to beat the market. Beating the market helps them gather assets, but they’re paid to gather assets. Moreover, they are judged based on short-term results. That is the yardstick that mutual fund managers are judged by.

Brian Feroldi (11:26):
You beat the market over a short period of time, your assets grow. You lose the market over a short period of time, investors withdraw their funds. If you put me in charge of a mutual fund, I would do terribly. I would just do terribly because the system is so incredibly hard to manage somebody else’s money and meet their expectations because you can’t think for the longterm, or it’s incredibly difficult to think and act with the long-term in mind.

Brian Feroldi (11:54):
Individual investors have none of those limitations. You are not beholden to justify your results. You’re only beholding to yourself. That is an enormous advantage, enormous and if you can take advantage of that by buying and holding great companies for long periods of time, I’m convinced that you can beat the market but that is something that, again, I only think 2% of the population should do.

Robert Leonard (12:24):
I absolutely love that you just said all of that, because that is exactly the conclusion that I came to, not that long ago. There’s a lot of people that I look up to and highly respect that believe you should only invest in index funds. Jack Bogle, being one of them and there’s some others that I’ve had on the show. The other day I was sitting down and I was thinking to myself, “How can these highly intelligent, highly educated people believe that … What is causing them to think that this is the case?” Then I came to the same conclusion that you just mentioned is that every single reason or resource or document that they’ve ever used as a reason as to why people can’t beat the market was based on a mutual fund or a money manager or a hedge fund.

Robert Leonard (13:04):
Then I realized, well, as individual investors, we’re not beholden to those same issues that they have. We don’t have to worry about people withdrawing their money. Our incentives are misaligned. Charlie Munger talks a lot about incentives. I would argue that fund managers’ incentives are misaligned as an individual investor. We don’t have that. So it’s these types of things that make me believe that as individual investors, we can beat the market. Now as a hedge fund or a money manager, that’s a whole different story.

Brian Feroldi (13:31):
I agree completely, but again, if somebody comes to me and says, “I only do index funds, it’s the only thing I recommend,” I 100% support their decision. The only thing I’ll push back and say, “I disagree with the statement, it’s impossible to beat the market. So don’t even try.” I would say, “Nope, I think it’s extremely hard, and if you have the time, patience and willingness for self-reflection, for learning, [inaudible 00:13:55] that it is possible to beat the market.

Brian Feroldi (13:57):
I know that because I personally have done it and I know dozens, if not hundreds of people that have done it. I’ve seen it’s done, but stock picking is not for everybody. It’s only for a small subset of people.

Robert Leonard (14:09):
I agree completely. Like I said before, that’s why I bring on these different types of guests because not every strategy is right for every person. Some people just don’t have the interest in stocks. If they had to read a 10K, they would rather call their eyes out or do anything other than read a 10K and they just don’t have the time or interest or knowledge to learn about this. In that case, you’re better off just buying an index fund.

Brian Feroldi (14:29):
100% agree.

Robert Leonard (14:31):
As an investor, how do you classify yourself? Do you think you’re more of a value guy, a growth investor, mix of both, your own strategy?

Brian Feroldi (14:39):
I don’t have any one given strategy. If you look at my portfolio, there is a smattering of companies in there. If you had to put me into a category, I guess I would be GARP, which is growth at a reasonable price. My investing strategy is to fill my portfolio with as many high quality companies as I can find. I’ve developed a checklist that I use to judge whether or not a company is high quality or not. So every time I come across a potential investment, I take the company and I run it through my checklist, and it’s a very simple checklist.

Brian Feroldi (15:19):
It asks questions about revenue, margins, moat, management, long-term growth potential, the corporate culture. Does it have recurring revenue? Has it beaten the market, et cetera. I take any stock through this checklist, and at the end I have a quality score and I simply try and buy the highest quality companies that I can find at any given time that are also trading for the most reasonable valuation. That would be my strategy. I’m not going to necessarily buy the fastest growing stocks. I’m looking for the fastest growth, with the highest quality at the best valuation. That would be how I categorize myself.

Robert Leonard (16:04):
You said you’d buy as many as you can find. So when you think about that, how do you think about portfolio allocation? Do you say you want to target three companies, five companies, 10 companies and when do you say, is this company going to bring up the average of my portfolio? So I’m going to invest in it, or maybe it’s a good investment, but it’s not high enough quality. It actually might bring down the average of my portfolios. I’m not going to add to it, but I want a little bit more diversification. How do you think about in terms of how many holdings to have?

Brian Feroldi (16:32):
I think of my portfolio like a cruise ship. Like, it’s very hard for me to turn it, especially at this point. I’ve been investing for more than 15 years. When it comes to portfolio concentration, I understand both sides of the argument. Some people say you only have to hold 10 stocks or less. How could you possibly know and understand and study more than that? Other people say diversification is perfectly fine. I’m comfortable with both, and essentially I’m an investor that says you do you.

Brian Feroldi (16:59):
My personal strategy is to own dozens of stocks and when I come across a stock that I am interested in, if it was a brand new stock to me, I would buy it immediately. For me, whenever I buy, I essentially move in 0.05% increments. So half a percent increments. If I come across a stock that I really like, I’ll devote 0.5% of my portfolio to it and then I will watch it because I don’t understand everything on day one.

Brian Feroldi (17:28):
When you own a company, your knowledge about that company compounds over time, just like the stock itself. If I see that the company is executing along the lines that I initially hoped for, I will add to that company at better and better value points over time. That can be a little confusing. So let me just break that down. Let’s say I buy a stock and it’s trading at 10 times sales and 50 times earnings. I’ll note down, okay, I bought the stock at X price and it was trading at X valuation.

Brian Feroldi (17:58):
In the future, if the company is executing, my goal for every future buy is to re-buy that same stock, assuming the thesis is still on track, at a lower valuation than my previous purchase. Now, that could be because the stock price went down or the stock price went up slower than revenue or profits went up.

Brian Feroldi (18:20):
So if my first buy was 10 times sales, my next buy, I’m hoping to get at nine times sales, irrespective of where the price of the company has been. I try and space those out say every three months, every six months and I slowly move in to a company. My personal rule is I cap it at 3% of my capital and it would take me probably like two years to move into a company that I really like. Like I really liked it, it would take me like two years to build a 3% position to the company.

Brian Feroldi (18:50):
Once it has 3% of my capital, I don’t add any more. It is up to the company to earn its spot in my portfolio and if you look at my portfolio today, it’s fairly concentrated. My top position is just about 10% of my portfolio. My number two position is about 9%. My number three is about 6%, et cetera, et cetera. So my top 20 are somewhere along the lines of 70% of my assets, but I didn’t pick them. The market did. They earned their position as my top holdings because the stocks went up so fast. So my winners slowly become a bigger and bigger part of my portfolio and my losers fade away into obscurity. So I let my portfolio concentrate itself.

Robert Leonard (19:36):
Now, when you think of adding more capital to your portfolio to invest, now that 3% is a bigger amount. As a dollar amount, it’s larger. You take a position at your portfolio just being, say a round number of 100,000, 3% is one number and then say five years from now, your portfolio is 200,000. Now you’re still going to allocate 3% to another position. Now 3% is much bigger because it’s 200,000. How do you consider that dynamic?

Brian Feroldi (20:01):
Exactly the way you said it. That’s why I think in percentages and not in dollar amounts, but the way I think about this strategy is rewind the clock 20 years ago. If 1% of your portfolio was Amazon, you’re rich. Amazon has done so well that 1% has grown to be … Even like $1,000 invested in Amazon 20 years ago is worth, I don’t know, $200,000 today? Something along those lines, assuming you’d never added to it.

Brian Feroldi (20:29):
1% of your portfolio was Enron, it’s irrelevant. 1% of your portfolio faded away to zero and you get a tax write-off for it. If you find the next Amazon, the next Netflix, the next Tesla, you only need a little bit to do extremely well, as long as you don’t sell. So knowing that, my strategy is to just constantly look for and try and add the next Amazon, the next Tesla, the next whatever, to my portfolio, with the knowledge that I’m going to be wrong a lot, but I only have to be right a few times and then not sell to beat the market.

Robert Leonard (21:04):
I absolutely love this concept, and this is something that I learned, I’m not sure if it was from you or for somebody else at The Motley Fool, but this is exactly the concept that I was taught and learned from you guys. Again, I’m not sure who said it, but somebody said, I think it might’ve been Tom Gardner or maybe somebody else, but they said, “If the company grows significantly, 1% is all I need, and if it doesn’t go, 1% is all I want.”

Robert Leonard (21:25):
When I heard that, my mind was blown and I was like, that just makes so much sense. I ran a little bit of numbers just to put some real understanding behind it and really grasp the concept and I was just like, “Wow, that is so true,” and it’s really made a big impact on how I invest.

Brian Feroldi (21:41):
That quote comes from Tom Engle and on The Motley Fool. He is kind of a legendary investor. He has been financial independence for a few decades now, and he has just thumped the market by just using sound, very basic investing principles and yes, the official quote is, “If this stock is the next great growth stock, a little is all I need. If it’s not, a little is all I want.”

Robert Leonard (22:05):
That’s exactly right. I love that quote. It’s ingrained in my brain and I have it pretty much everywhere that I can make investment decisions so that I remember that when I’m thinking about portfolio allocation and sizing. Another interesting thing that seems to be pretty common throughout The Motley Fool universe is adding to winners. It doesn’t sound like you do that, given that you like to keep something at a specific size in your portfolio. You don’t typically add to your winners?

Brian Feroldi (22:29):
Oh no, I almost exclusively add to my winners. To me, a winner means the business is executing and the stock is appreciating. I focus mostly on business is executing and less on the stock is appreciating because that’s what I care about. In the longterm, stock price has followed business fundamentals. So I want to buy companies that are rapidly improving their fundamentals. When I look back again I’m like, what have been my biggest winners of all time?

Brian Feroldi (22:56):
They’re stocks I mentioned before. MercadoLibre, Tesla, Amazon, Netflix. If you look at these companies over any time period, their financials were heading in one direction, up, and I consistently added little bits to those companies over time, just little bits here and there, but I try and add at better and better value points. It’s not always possible because sometimes valuation just go nutty, and if the company is executing at such a high level, it deserves to trade at a higher valuation.

Brian Feroldi (23:27):
So adding to that company, even though it’s more expensive than your [inaudible 00:23:30] purchase, make sense. I mean this year, or even in the last couple of years, Trade Desk, Shopify and Zoom. Those companies have executed so ridiculously well that it was nearly impossible to add to them at a better value point over time because their stocks just went straight up.

Brian Feroldi (23:48):
So portfolio allocation are guidelines. They’re not hard and fast rules. There’s so much nuance to investing, but in general, I’m a big fan of coming up with rules, guidelines, knowing when to follow them and then knowing when to break them.

Robert Leonard (24:03):
Let’s talk a bit more about valuation. We’ve kind of gone around that topic a bit and I think it’s one of the most daunting tasks for a new investor who’s looking to invest in individual stocks. You and I both agree that the valuation metrics we use are not just one size fits all. It depends on the company, the industry, things like that. Talk to us about the five stages of a company, which are R&D, launch, hyper growth, maturity, and decline, and then which metrics or ratios we should be using to value each stage.

Brian Feroldi (24:31):
When I first heard of the concept of PE ratio, it just made sense to me. Yes, a business is worth a multiple of its earnings. That just makes sense. The problem that I had is that once you learn of the PE ratio, you think it applies to everything all the time. When I first heard about the PE ratio was like 2005 and at the time, the company that I was working for just signed a deal with salesforce.com and I remember thinking, “Wow, this software is awesome. If this software went down, our company shuts down.”

Brian Feroldi (25:05):
That’s how awesome and that’s how important it was. Then I looked at, maybe salesforce.com is a good stock to buy and their PE ratio was 100, and I was like, “Nope, can’t buy it. Too expensive.” You can probably guess what happened to the stock since then. It’s up some insanely huge number, at least 20 fold from there. If you talk to a lot of investors, they all have very similar stories.

Brian Feroldi (25:30):
“Oh, this business is awesome, but this valuation metric, usually PE, is too high.” What I discovered over time is companies go through life cycles, just like products go through life cycles. Depending on where the company is, some valuation metrics make more sense than others. When Google was in the R&D phase, it had no revenue let alone earnings. So were you smart to invest in Google in the R&D phase? Yes, of course. You’ve made thousands upon thousands of times of your money.

Brian Feroldi (26:02):
But if your sole metric for judging a company was PE ratio, you would’ve said, “Nope, terrible. No earnings, no revenue.” So you can’t use price to earnings ratio when the price to earnings ratio doesn’t apply. The time to use the price to earnings ratio, which again is the most simple, is when a company is fully optimized for profits.

Brian Feroldi (26:26):
Like the company is no longer focused on growth. It is focused on generating profits. Let’s quickly go through the stages of a company. So there’s formation and R&D. Stage one, the company is brand new. They’re coming out with some new product, new service. They’re obviously have no revenue. They are purely trying to develop that product or service.

Brian Feroldi (26:46):
Eventually they launch that product or surface, if all goes well. And because they just launched, their sales have just started to materialize, just started to grow. How do you value companies at that stage? It’s incredibly difficult. The only way that I know how to, or the only metric that you can look at is price to sales ratio. Just how big is this company in relation to its sales? Because sales is the only number that you have to go off of.

Brian Feroldi (27:14):
Let’s say the company is with a billion dollars. Sales are going to be like a million or 5 million or some insanely small number. So the price to sales ratio is going to look enormous, and if the company goes on to be successful, it is a metric that you can look at and judge. As the company sales really ramp up, and again, we’re assuming that the company is successful. The sales are going to start ramping significantly and the price to sales ratio is going to fall over time, or at least ideally at will.

Brian Feroldi (27:41):
So at least that’s something to look at. The next phase is the most confusing phase, which is hyper-growth. If that company establishes product market fit and revenue really starts to grow, like really starts to S-curve grow, oftentimes, the companies purposely sacrifice profitability in order to reinvest, reinvest, reinvest, reinvest. When they’re doing that, they could become profitable if they chose to, but instead of choosing to optimize for profits, they’re choosing to optimize for growth.

Brian Feroldi (28:14):
So this is when you see companies that maybe they’ve reached break-even, or maybe they’re starting to generate profit, but their PE ratio looks enormous. Like from 2005 to 2015, ask any investor, “Hey, what do you think of Amazon?” They’d say, “Oh, way too expensive. Trading a thousand times earnings. That’s way too expensive.” What they were assuming was that Amazon was optimized for profits and it wasn’t. It was optimized for growth. All profits were plowed back in the business to build distribution centers, to grow Amazon web services, to widen the company’s moat.

Brian Feroldi (28:52):
So you can’t use the price to earnings ratio if the company is optimized for growth. Once the company reaches the necessary scale to start optimizing for profits, then the price earnings ratio becomes useful. So some companies that are there right now would be Microsoft, Apple, et cetera. Those companies are optimized for profits.

Brian Feroldi (29:15):
Their hyper-growth phase is behind them and now they’re focused on generating profits. Finally, you could be in the maturity stage as I call it for decades. Even a century. You can just be there for a long time. Eventually, the company will become disrupted thanks to capitalism and its revenue and its profits will start to decline. In that phase, if the company is heading towards death, valuation metrics, no longer work and it’s very common for investors to get tripped up and say, “Oh, this company is only trading at five times earnings. It’s dirt cheap. Oh, its dividend yield is 6%.”

Brian Feroldi (29:52):
Well, if those earnings are heading towards zero valuation metrics don’t work. So it’s mostly about thinking through the phases of a business. What happens to revenue? What happens to margins? What happens to profit and knowing when to apply which ratio to the company at any given time.

Robert Leonard (30:14):
I can relate to two of those examples, specifically. One, Amazon. You mentioned Salesforce is the one you missed. For me, it was Amazon. I looked at Amazon and said, this is way too expensive and for that reason, I never really have owned a significant portion of Amazon. I think I owned a couple of shares at one point and eventually sold them because it was just so, in my opinion, overvalued, because I was looking at the valuation wrong, like you mentioned. This was back when I was just getting started in investing.

Robert Leonard (30:39):
Then I’ve also been on the decline side where I said, “These metrics are just incredible. This stock is so cheap.” I didn’t understand this strategy or this concept of what you’re talking about in decline of how these metrics don’t matter when you get to this point. I was purely quantitative. I was strictly looking at the financial saying, “This is mathematically cheap. I should buy it.” What I learned there is, stocks can go lower and quickly learned what you just talked about and how that is so relevant to focusing on your valuation. Is it always a straight line from stage one to stage two and then so on through stage five or can companies go back and forth and how does that impact a company’s valuation?

Brian Feroldi (31:19):
Nope. Companies can go back and forth, up and down and it’s actually extremely exciting when a company goes from say the maturity stage back to the hyper-growth stage, or even back into the launch stage. It’s very rare that a company can do that, and history is littered with examples of companies that failed to do that. In recent memory, the company that did this best was Netflix. If you ask my kids, “What is Netflix?” They’ll be like, “The app on the iPad that plays movies and TV shows.”

Brian Feroldi (31:51):
I say, “Well, what did Netflix do in the beginning?” They have no clue. I say, “Do you know that Netflix used to send people DVDs in the mail?” And they’d be like, “Nuh-uh. We’ve never gotten a DVD in the mail from Netflix.” So Netflix was a DVD by mail company and it reached the maturity phage there and all the type of growth was behind it. Then management had the vision to say, “This business is dying. Streaming is the future, and they went backwards.”

Brian Feroldi (32:22):
So if you look at Netflix profits over time, back in the heyday of the DVD by mail, they were getting close to being optimized for profits and they had a PE ratio. Then they took the gut-wrenching decision to go backwards and say, “Streaming is the future. We are plowing all of our profits and some into original content and streaming,” and they basically abandoned their old business model in sake of their new one.

Brian Feroldi (32:49):
You look at their financial statements during that time. It was rough. I mean, free cashflow went from hugely positive to monumentally negative numbers. They had to take on debt to afford the transition, but if you look at the stock over time, eventually investors came to appreciate their new business model. It’s a bet that paid off hugely for the company.

Brian Feroldi (33:11):
So it is possible to go back and forth between these stages. It’s just very rare and as a side note, if you look at a lot of the auto stocks today, GM, Ford, Volkswagen, they’re all in the decline phase. Their core business, what they’ve done for 80, 90 years, all that is heading toward zero. ICE cars, internal combustion engine cars in my opinion, are heading fast towards zero. So they’re being forced to go backwards and to reinvent themselves as electric car companies and autonomous companies. Boy, is that hard to do. To change the culture and the business around a brand new product sector. So I don’t think many of them are going to make it.

Robert Leonard (33:54):
It’s really interesting that you bring up Netflix because I did know that they were a mail order business, a DVD delivery business, but I didn’t really consider that stage and how their relationship with it had changed over time. The two that instantly popped in my head were Kodak and Blackberry. I think we’re arguably seeing those two companies try and go from the decline stage back to launch or R&D, trying to get to hyper-growth. To be determined whether that will actually be successful or not, but we’ll see.

Robert Leonard (34:23):
Then about the auto manufacturers, what I found really interesting is a lot of big, super value investors are piling into, not now, but have been over the last three to five years of Fiat Chrysler. How do you see that stock in realm of the auto industry?

Brian Feroldi (34:40):
Not a stock I know well. It comes to the auto sector I know, in general, it’s a rotten place to make money. The auto stocks have a long history of destroying capital, not creating wealth and I have a really hard time believing that any of those companies will make the transition. I really do. I’m not saying they’re all going to zero or none of them will survive. The future of the auto market will not be just Tesla. Like it can’t be 100% of the auto market.

Brian Feroldi (35:09):
However, I find it to be extremely risky to bet on GM, to bet on Ford, to bet on Toyota, to bet on anybody successfully making the transition to the future of the automobile industry. To me, all of their valuation metrics are irrelevant. You can’t look at dividend yield. You can’t look at PE ratio. You can’t look at [inaudible 00:35:28] and say, “This is cheap,” because they are facing their core business going to zero and you are betting on buying their stock today that they will successfully make the transition and boy, is that going to be hard to do. So in regards to Fiat Chrysler, not a situation that I would know well, but I would not bet on it happening successfully.

Robert Leonard (35:45):
You recently tweeted a quote that I really liked. So I want to talk about this a bit more in depth. The quote was, “10% of your long-term returns are determined by how you behave in bull markets. 90% of your long-term returns are determined by how you behave in bear markets.” Break that quote down for us and explain what you meant by it.

Brian Feroldi (36:05):
When the markets are going up, it’s easy to feel like a genius. If you were buying stocks anytime after March, of 2020, you think investing is easy because all you know is buy stock, instantaneously get rewarded for doing well. When the markets are going up, your decisions matter, but they don’t nearly matter as much as what’s happening in bear markets. I’m going to steal something for Nassim Taleb, which is he’s the author of Antifragile and a number of wonderful books on thinking and investing.

Brian Feroldi (36:38):
I love this concept that he has. He says, “Your investment returns will be generated from when you start investing until your uncle point, and your uncle point is whenever the pain of watching your portfolio do whatever it is, becomes so great that you decide to give up.” If you tell yourself, “I’m going to invest in stocks, I have a tolerance for stocks,” it’s easy to maintain that attitude when things are going up. It’s incredibly hard to maintain that attitude when you watch years of investment gains and returns evaporate in a matter of days.

Brian Feroldi (37:16):
If you do not have the mental fortitude to hold all the way through the downturn, you will not realize the long-term return to the market. You will realize the long-term return to the market from when you start until when you panic sell. That will be the returns that you get. The other thing I meant by that is when the markets are down, when there’s a bear market, that is when generational buying opportunities open up, and if you have cash and the willingness to buy stocks that are trading at depressed prices, that’s when you will make all of your money. So that is just a reminder to me that how you behave when things are going well, is an order of magnitude less important than how you behave when things are not going well.

Robert Leonard (38:10):
We’ve talked a bit about companies falling from grace and entering that decline stage. How do we determine that before it’s actually happening if we can’t use financial valuation metrics? How do we analyze a company and realize that it’s falling from being great? Then on the other side of that, how do we identify companies that might be becoming great?

Brian Feroldi (38:30):
It’s really tricky. There’s no easy answer to that because a lot of the time it requires foresight about disruption technologies. In general, if you’re an investor, you need to study disruption. You need to study what happens with disruptive technologies and one of the hardest concepts to embrace is the concept of the S-curve. Whenever a disruptive technology comes in, a truly disruptive one, it’s always adopted on following an S-curve. So again, let’s go back to the biggest disruptions in the market right now is Tesla and the auto makers.

Brian Feroldi (39:05):
It’s very easy to say, Tesla only sold half a million vehicles. If you look at all the other auto makers combined, they sold like 90 million. So Tesla isn’t even 1% of the market. How can it have this insane valuation when compared to all of the rest? I think one of the reasons is because markets understand S-curves better than individual investors do.

Brian Feroldi (39:30):
If you say, well, test has been around for 20 years. It took them 20 years to get the 0.5% market share. It’s going to take them another 20 years to get to 2% market share, but that’s just not how things work. They take forever to get to 1% market share, and then they take just a few years to go from 1% to 10% and then they just take a few years to go from 10% to 80%. That’s how disruption works.

Brian Feroldi (39:57):
If you’re an investing in a mature company that is on the bad end of disruption, it’s really hard to identify that and be scared of that ahead of time. For example, I think that ExxonMobil, all the oil companies are on the verge of a disruption and if you just look at their production numbers and stuff like that, the electric vehicles have barely made a dent at all in oil demand.

Brian Feroldi (40:23):
However, if you think out and believe in S-curves and play that forward 10 years, it’s not hard for me to imagine that there will be a huge imbalance in the demand for oil based on the electrification of everything by say, 2030. Once there’s a small imbalance in supply and demand prices go crazy. It doesn’t take much of a demand shortfall for oil prices to just collapse. The economics of oil and all fossil fuels, in my opinion, are over. There’ll still be demand for oil and natural gas, all those kinds of things for years and years and years, but the economics have been disrupted, and it’s really hard to see that kind of thing coming ahead of time, but you need to be vigilant if you’re going to own big mature companies, especially I would say in the next 10 years. I think the next 10 years are going to be so unbelievably disruptive that it’s going to be a very challenging environment for investors to invest in.

Robert Leonard (41:22):
When you talked about the hyper-growth or exponential growth of market share, say of Tesla, that reminds me of a quote that Charlie Munger often quotes and that saying that, “The first 100,000 is the hardest,” and it’s true, it’s the same as the market share. Getting that first 1%, gaining that first 100,000, that’s the hardest part. Then from there, the rest kind of takes care of itself. It’s a compounding effect, that 100,000 compounds on itself and grows much more rapidly. That 1% market share compounds and grows much more rapidly until it hits 80%, like you said.

Brian Feroldi (41:55):
Yeah, I think that that’s correct. It’s a great observation and yes, the first 100,000 is so painful, but you got to do it.

Robert Leonard (42:01):
You wrote that 2020 reaffirmed your belief that the market is not perfectly efficient. Why does 2020 prove that markets aren’t efficient?

Brian Feroldi (42:10):
If you talk to academics or there’s a lot of academic work out there that says that they believe in efficient market hypothesis, which is essentially stock prices reflect all available information at any given time and they’re always perfectly efficient. That’s again, sounds logical in theory. I’ve just been investing long enough to know, to not believe that. I think that markets are largely efficient.

Brian Feroldi (42:38):
They are mostly efficient. However, there’s human beings that are making decisions behind them, buying and selling. Different investors have different timelines. A trader who’s thinking about what’s happening in the market today is operating and thinking completely differently than I am. I’m thinking what’s going to happen in five years. I’m focused on what our price is going to be in five years, they’re focused on what a price is going to be in five minutes. We’re just absorbing and looking at information differently.

Brian Feroldi (43:08):
If you look back at market history, you’ll find that markets always undershoot. They fall too far in bear markets because of emotions and they rise too high in bull markets because of human motions and greed. It’s just that if you look back at 2020, and again, I know we’re talking about Tesla a lot, but I’m looking at the 52-week range of Tesla. I see a 52-week low of 70 and a 52-week high of 884.

Brian Feroldi (43:36):
Name a company that is better covered in the market, more talked about than Tesla? Is there any company that has more analyst coverage, more exposure, more media coverage? In theory, if there’s one company that should be really well understood, it’s Tesla and you’re telling me in the same year, it makes sense that Tesla was valued at $70 per share and $884 per share?

Brian Feroldi (43:57):
Does that sound like an efficient market to you? It doesn’t to me and Tesla is an extreme example, but how about Apple? Big, slow moving, mature, Apple profitable? Apple’s 52-week low? 53. Apple’s 52 week high? 138. Is it really possible that markets are efficient, and one of the biggest companies on earth can gyrate between let’s say $800 billion in market cap, and $2.2 trillion in market cap? Does that sound perfectly efficient to you? So it just reaffirmed for me, given the extreme price swings that we saw, that markets are largely and mostly efficient, but not perfectly efficient.

Robert Leonard (44:42):
My next question is a big one and I think it could be taken a lot of different ways. So I want you to answer it however you see fit. It’s a question I get a lot from listeners on the show and I actually gave my opinion on it a few episodes ago. So I’d like to hear your thoughts. When should someone sell a stock?

Brian Feroldi (44:58):
Selling is a bazillion times harder than buying. Understand that at day one, because you have to be, “right about the timing,” and when I look back at my own selling history and my buying history, I’ve been wrong a lot. I sold all of my Apple stock in 2018 because I thought that the price reflected all of the positives and none of the negatives and the stock has more than doubled since then. So I should have, instead of selling all my Apple stock, I should have dumped all my other stocks and put it all into Apple.

Brian Feroldi (45:26):
When it comes to tough questions like this, I’m a huge fan of thinking slowly, writing things down and then referencing those things when you have a decision to make. So I have 11 reasons why I sell a stock and again, wrote them down because it makes you slowly think through them. Quickly tip them off.

Brian Feroldi (45:46):
Number one reason to sell is you were wrong. You bought a company for ABC reasons and ABC reasons are incorrect. Your thesis is busted and there’s a bazillion reasons why you could be wrong, but essentially the thesis didn’t play out. If you are wrong, sell and put your money in something that is, you think it could be right on. So that’s number one. Most popular reason that I sell is, I was wrong.

Brian Feroldi (46:09):
Number two would be accounting irregularities. If you hear the numbers can’t be trusted, how on earth could you make investment decisions? There are 99% of companies out there you can trust their numbers. I’m not going to waste time at all with the 1% where you can’t. So accounting irregularities equals sell. That company is dead to me forever. Luckin Coffee can do nothing to regain my interest. It’s dead to me forever.

Brian Feroldi (46:33):
Number three is a mega acquisition I don’t like. The relative size of the two companies matters a lot. My favorite types of acquisitions are when a hundred billion dollar company acquires a billion dollar company. Those are my favorite types of acquisitions. My least favorite is when a $10 billion company buys a $10 billion company. The two companies are huge because it’s an enormous distraction for management.

Brian Feroldi (46:59):
It takes a huge amount of effort to integrate them and if you look at the data, the data suggests that the vast majority of acquisitions fail and they fail to achieve management’s original targets. So if you’re investing in a company and that company goes and by some other company you don’t like, that’s kind of thesis changing in many ways. So if there’s a big acquisition that I don’t like I will sell.

Brian Feroldi (47:21):
Number five would be the culture deteriorates. This is really hard to detect in real time. Could be a big management exodus, could be Glassdoor ratings plunge. It could be a leadership transition. Something happens with the management and the culture of the business that takes a big turn for the worst. That can be a reason to sell. Number six, extreme valuation compared to the opportunity. This one’s really tricky because on the one hand, extreme valuations shouldn’t deter you from investing in great businesses, but I always think in terms of extreme valuation, compared to the opportunity.

Brian Feroldi (47:54):
If I think a company could be worth $200 billion, and that company is currently worth a hundred billion and it’s trading at some extreme valuation, I don’t see a lot of upside there. Like the valuation is super high, plus it’s already achieved a huge percentage of what I think it can achieve. I would be interested in trimming that company compared to its opportunity.

Brian Feroldi (48:16):
Conversely, if I thought a company was extremely overvalued and it could be a $200 billion company, but it’s currently a $5 billion company, I would not be in a rush to sell because I think the potential of that company to [inaudible 00:48:29] from even that extreme valuation is still there. So extreme valuation plus achieved a huge percentage of its opportunity, I would sell or trim. Number seven in a position that’s too large for me. My personal rules of thumb are 15% for a low risk business, 10% for a high risk business.

Brian Feroldi (48:48):
So 15% for Amazon, 10% for Tesla, for example. Number eight, I lost interest in the company, just not interested in owning it anymore. So I don’t mind selling. Number nine, the company gets acquired. So if it gets acquired and I want to own the company that’s acquiring it, I’ll sell. Number 10, I need the money for my personal life. So if I want to fund some purchase in real life, AKA, the reason we invest in the first place is to use money in our personal life. So if I have a need, we’ll sell to fund that, and then the final and last reason is because of taxes. If a company is down for me substantially, and I want to lower my tax bill, sometimes I will sell a loser that I’ve lost confidence in to lower my tax bill.

Robert Leonard (49:30):
We’ve talked quite a bit about Tesla and one of the selling points that you mentioned was inconsistent accounting or inconsistent financial results. Tesla has been in the spotlight for these types of reasons. There’s been some questions around their accounting practices. How do you consider that when thinking about Tesla?

Brian Feroldi (49:48):
To my knowledge, they’ve never had to restate financial accounting and they’ve never had to do anything along those lines. They’ve never got caught fudging their numbers or anything like that. To me, it’s more of like the Luckin Coffee, the Enrons, the WorldComs. We materially misstated our financial statements.

Robert Leonard (50:04):
So it has to be an actual act rather than just allegations or speculation that there might have been something going on?

Brian Feroldi (50:11):
Tesla is a bit of an outlier in a bazillion ways and it’s been the best mental training I’ve ever had for investing ever, is just owning Tesla because for six years, the stock did nothing and there was report after report, after report saying, this company is going to zero and Elon Musk is a fraud and blah, blah, blah, blah, blah, blah. So Tesla is kind of a unique case in many ways, but the general rule of thumb there is if I can’t trust the numbers, sell and move on.

Robert Leonard (50:39):
When I was first starting to invest, I was hyper-focused on financial statements and fundamentals. I mentioned that a little while ago. I didn’t consider qualitative factors at all. I quickly learned that that was a mistake and really a big flaw in my approach. So I’ve since changed that. For someone listening who doesn’t consider the qualitative factors of a business, or just doesn’t really add much value to them, I want to talk about an interesting idea, another one, you post a lot of great ideas on Twitter. You talked about how Tesla has a competitive advantage from receiving unlimited and free media exposure. First, explain what you mean by that and second, explain how investors should consider qualitative factors like this when analyzing a business, that’s not Tesla.

Brian Feroldi (51:21):
Good investing is just as much art as it is science. To me, the financial results are the science. They’re quantifiable, they’re numbers that you can put out there and they’re incredibly important for analyzing revenue growth, margins, returns on capital, earnings, growth, et cetera, et cetera. That’s the output of the business. The greatest investments that you can make are going to be companies that can grow their financial results from today many, many times over.

Brian Feroldi (51:50):
So the ideal company, you buy it today and its profits go up a hundred fold in the next 10, 20, 30 years, whatever. Well, how do you get that growth? Well, there has to be a compelling story, for lack of a better word for you to believe that the future financial results will be better than they are today. So when I think of qualitative factors, I think of things like moat. What is moat? Moat’s competitive advantage.

Brian Feroldi (52:19):
Show me the number that says this company has a competitive advantage versus another one. There’s no number. It’s all in your head. It’s all thinking about, well, does it have the network effect? Does it have high switching costs? Does it have brand value? Does it have counter positioning? Is the moat getting wider or narrower? Again, these are not numbers. These are concepts you have to think through when you are thinking about a business. Or think about a really hard one that is incredibly important is optionality.

Brian Feroldi (52:45):
Optionality is the ability of a business to launch new products and new services in either existing markets or adjacent ones that open up new revenue opportunities in time. Really simple one. Run the clock 25 years. What did Amazon do? Amazon sold books. What does Amazon do today? Well, it sells everything, but more importantly, the moneymaker for the business is Amazon Web Services. Didn’t exist 20 years ago.

Brian Feroldi (53:12):
Now it’s the company’s primary profit generator. There was no way to foresee that that was happening, but it didn’t take too much foresight to say, Jeff Bezos is an innovator that thinks long-term and the culture here is about innovating. That’s optionality. There’s no number that says this company has optionality, but if you think through when you see patterns and study other companies that have, it could make a qualitative factor to say, “Yes, this company has optionality. No, this one does not.”

Brian Feroldi (53:39):
Then there’s things like the revenue itself. I’m a big believer in investing in companies with recurring revenue. Again, sometimes that can be a number that says, yes, management says 70% of our revenue is recurring. Other times, it’s something you have to think through. Then there’s pricing power. If the company raised prices, will customers defect? What about the management itself? There is no number that says, this is a good management team. This is a bad management team. It’s all kind of thinking through. So good investing is a marriage between qualitative factors and quantitative factors.

Robert Leonard (54:10):
Brian, thanks so much for joining me today on the show. I typically don’t really grasp the quality of an interview until I’m doing my editing process on the backend, but I can already tell that this is going to be one of my favorites to date. So thank you so much for joining me. Where can everyone listening go to learn more about you and the different things you’re working on?

Brian Feroldi (54:28):
The best place to find me is on Twitter. I am @BrianFeroldi. I also have a Substack where I send out daily, very simple graphics of my best tweets, just in byte size. I can consume this in five second or less. So that is brianferoldi.substack.com.

Robert Leonard (54:45):
I’ll be sure to put a link to those two resources in the show notes and I’ll put a link to other related resources that we talked about throughout the show below so that you guys can click those links and check that out. Brian, thanks so much for joining me.

Brian Feroldi (54:57):
Appreciate it, Robert. Thanks for having me.

Robert Leonard (54:59):
All right, guys. That’s all I had for this week’s episode of Millennial Investing. I’ll see you again next week.

Outro (55:05):
Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday, we teach you about Bitcoin and every Saturday, we study billionaires and the financial markets. To access our show notes, transcripts or courses go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.