Ep393: Kevin Carter – The Math of Shorting a Stock Is Against You

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Quick take

BIO: Kevin Carter is the Founder and CIO of the Emerging Markets Internet & Ecommerce ETF (NYSE: EMQQ) and Chairman of the EMQQ Index Committee.

STORY: During the Dot-com boom, Kevin came across Amazon, but he dismissed it as just a bookstore not worth its valuation. He decided to short Amazon and lost a third of his net worth at the time. Had he bought the stock instead of short selling it, he would be $50,000 richer today.

LEARNING: Short selling is a bad investment idea. Nobody can do a perfect valuation; always know that you are working with estimates.

 

“Good judgment comes from experience, and experience comes from bad judgment.”

Kevin Carter

 

Guest profile

Kevin Carter is the Founder and CIO of the Emerging Markets Internet & Ecommerce ETF (NYSE: EMQQ) and Chairman of the EMQQ Index Committee. Prior to EMQQ, Kevin was the Founder & CEO of AlphaShares, an investment firm offering five Emerging Markets ETFs in partnership with Guggenheim Investments. Previously Kevin was the Founder & CEO of Active Index Advisors, acquired by Natixis in 2005, and the Founder & CEO of eInvesting, acquired by ETRADE in 2000. Kevin received a degree in Economics from the University of Arizona and began his career in 1992 with Robertson Stephens & Company.

Worst investment ever

In the late 90s, Kevin was a very confident young value investor. He wanted to be like the likes of Warren Buffett. He had worked as an analyst professionally and got paid very well by hedge funds and mutual funds for his research.

The Dot.com boom hits

The Internet showed up, and then the Dot-com bubble burst. Kevin was relatively successful at that point and confident but also a bit naive.

Kevin got wind of a new e-commerce company, Amazon, but he thought of it as just a bookstore. He believed that it shouldn’t be valued any differently. He spent a lot of time comparing Amazon to Barnes and Noble and was convinced that it would not amount to much.

Kevin concluded that with a $1.4 billion market cap, Amazon’s stock would sell for just a fraction of that. He even predicted that the company would be lucky to sell for $200 million in cash.

Short selling Amazon

Kevin decided to short Amazon in March of 1998. He lost about a third of his net worth in a day and a half.

Amazon’s current market cap is $1.6 trillion. Had Kevin not short sold Amazon and instead bought the stock, his position today would be worth $50,000.

Lessons learned

Don’t make valuation shorts

Short selling to make money is a bad idea because it has complicated mathematics behind it. Most of the time, it is just not worth it. The other problem is when you short something, and you’re wrong, your exposure gets bigger.

Andrew’s takeaways

Let go of hindsight bias

When people make mistakes, they will often engage in hindsight bias. They look back and wish if only they had done this or that. The truth is, when you are making decisions, you’re making them with the best information you have and the application of your judgment at the time.

Nobody can do a perfect valuation

It is tough to make a 100% correct evaluation. The solution is always to question everything when developing a valuation estimate and accept that it is an estimate.

Actionable advice

Understand and work with the price-to-earnings-to-growth (PEG) ratio when picking a stock.

No. 1 goal for the next 12 months

Kevin’s number one goal for the next 12 months is to have fun and try to re-enter the real world.

Parting words

 

“Have fun and enjoy the rest of the year.”

Kevin Carter

 

Read full transcript

Andrew Stotz 00:03
Hello fellow risk takers and welcome to my worst investment ever stories of loss to keep you winning. In our community we know that to win in investing, you must take risk but to win big, you've got to reduce it. To join our community go to my worst investment ever.com and receive these five free benefits first, you get the risk reduction checklist I've created from the lessons I've learned from all my guests. Second, you get my weekly email to help you increase your investment return. Third, you get a 25% discount on all a Stotz Academy courses. Fourth, you get access to our Facebook community to get to know guests and fellow listeners. And finally, you get my curated list of the Top 10 podcast episodes. Fellow risk takers This is your worst podcast host Andrew Stotz from a Stotz Academy, and I'm here with featured guests, Kevin Carter, Kevin, are you ready to rock? I'm ready. Well, let me introduce you to the audience. Kevin Carter is the founder and CIO of the emerging markets internet and e commerce ETF, which is under the ticker code em qq on the New York Stock Exchange, and he's chairman of the EM qq in index committee. Prior to em qq Kevin was the founder and CEO of alpha shares, an investment firm offering five emerging markets ETFs in partnership with Guggenheim investments. Previously, Kevin was the founder and CEO of active index advisors, acquired by the tissus in 2005. And the founder and CEO of E investing, acquired by E trade in 2000. Kevin received a degree in economics from the University of Arizona and began his career in 1992, when he walked into the offices of Robertson Stephens and, and company, Kevin, take a minute and filming for their tidbits about your life.

Kevin Carter 01:58
Well, I didn't get very far. I live 15 miles east of San Francisco, and I can see the hospital I was born in from my desk and from my bed. So I haven't gotten very far. And I've worked in the investment business for 28 years. And I, first and foremost, as an investor, I pray towards Omaha. And I try to think about all things through a warren buffett and Charlie Munger lens. But for the last 20 years, I've had one foot in the active world and one foot in the indexing world, with my long time partner Byrd malkiel.

Andrew Stotz 02:37
Hmm. It's interesting. I came to Thailand in 1992, and entered the world of finance in 1993. So just about the same amount of time, except I did all of that, here in little old Thailand, as the Thai economy was busting booming, busting, booming and busting. But you did a lot of your investment in emerging markets, let's say, from all the way over in the US. I'm just curious, maybe you can just tell us a bit about the body evolution, particularly. I'm interested in em qq a little bit to hear about what it's doing. And for those invest, those people who are investing who would like to know about it, who are listening, maybe you can just give us a little briefing about that?

Kevin Carter 03:21
Sure. Well, you know, when I got involved with emerging markets, 16 years ago, I basically learned two things on the first day, which you know, I give a lot of presentations. And I, I tell people, there's only two things you need to know. And I learned both of them on the first day. And the first thing, the positive thing is that, you know, the thing that's emerging in emerging markets are the people, right? You've got billions of people 85% of the world's people, and they are, their economies are growing faster, on average, their incomes are going up, and they want stuff, they want more and better food, more and better clothing, appliances, entertainment, vacations, cars, and they want their kids to go to Harvard. And so that's lesson number one, and the most important thing. And then lesson number two, is a problem. And I learned this in the first five minutes. When I got involved first with China. We, you know, we had, as I talked to you, as we were getting ready, we had some Google engineers that were clients of mine, right after their IPO and they said, Hey, we want to invest in China. And I said, Fine, I'll try to figure that out. And I figured we'd use an ETF. And I went over to our portfolio managers, and I said, Look, you know, give me a list of all the companies in the China ETF because these Google people want to invest in China. And before they gave me the list, my partner Byrd pulled me aside he goes, look, when you get the list of all the companies in the China ETF, you're gonna see that most of them are Chinese government owned banks and oil companies. And I, you know, I was sort of skeptical and say, yeah, I've heard about that, and he went on to explain how a Chinese bank might make a loan to a company that was basically bankrupt, so they wouldn't lay off their employees and have protesters. And that really bothered me and, and in the case of the China ETF, back then it was 80% state owned enterprises and only, you know, seven or 8% of the consumer. And so those are the you know, those are the two most important things is if you if you want to make money in emerging markets, you probably shouldn't buy the index that at least the big traditional index, because it's full of these inefficient and corrupt government owned banks and oil companies and, and the corruption is terrible. You got presidents of countries going to jail, as has happened in Brazil twice and Korea, once so, so you really got to focus on the consumer and, and for a long time, I told people that just by the emerging market, consumer ETF, when they'd say what's the best way to invest in emerging markets, I'd say easy. McKenzie says the growth of the consumer is the biggest growth opportunity in the history of capitalism. And there's a ticker symbol for that EC o n. And I had nothing to do with that ETF, but I knew it existed in it on the 30 largest consumer stocks. And about eight years ago, I looked at my own portfolio, which was very concentrated I had five stocks, all of which were placed on the emerging market consumer. And three of those companies were in the emerging market, consumer ETF and the database called them consumer companies. They were Chinese food, snack, food and clothing companies. But then I had two other companies that were definitely consumer plays, but they weren't in the emerging market consumer ETF because the database put them in a box called technology. And those two were the Craigslist of China, Wu Ba, which traded on the New York Stock Exchange has gone private now. And the fifth company was Mercado de Brae, on the NASDAQ, me Li which is the amazon.com of Brazil. And after I looked at my portfolio, I thought all of these are great plays on the consumer. The ones that are called consumer are growing at 15, or 20%. And I think they have a moat in form of brand equity. But the two other companies that are called technology companies, they were growing at 100%, and had incredible margins, whoo, buy at a 94% gross margin, which is where I look for moats. And, and while the P E's were higher, the P divided by the growth rate, the peg ratio, which is all I care about was lower and very reasonable. And so I had that thought. And then a few hours later, my phone rang. And it was a friend of mine with a three year old daughter. And she said, what's the best emerging markets ETF for my daughter's college fund? And I started to tell her to buy the emerging market, consumer ETF and then I thought, Wait a minute. That's not the best, the best one doesn't exist yet. emerging market internet companies and I literally went back to my office, after I got the call and started to build the mq queue.

Andrew Stotz 08:03
And what year was that?

Kevin Carter 08:06
It launched in November 2014.

Andrew Stotz 08:09
So you've now been doing that for, let's say, eight, nearly eight years. Six and a half. will be seven in November. Okay. Got it. And how many stocks are in that? ETF?

Kevin Carter 08:26
Roughly Right. Right now there's 96 companies, but the list is growing. Right? Last there was 40 something and there is a muse. This is the fastest growing sector in the world. And there are literally hundreds of unicorns, you know, whether it's the Uber of Indonesia, or the you know, the go jack, go jack or I mean, there, there's a lot going on the Amazon of India, Flipkart, the Uber of China's coming public, so I think it'll be over 120 companies by the end of the year.

Andrew Stotz 09:01
And from a let's say, a region or a country waiting. Is it mainly China or mainly Asia? Or how do you how is the weighting distribution?

Kevin Carter 09:13
Well, with so we, you know, we own every single publicly traded emerging markets internet or frontier market, I'm sorry, emerging market internet or e commerce. And we include frontier markets in our definition of emerging and it's a about two thirds China a little less, you know, 60 something percent of China and in Asia is definitely you know, the largest part of it as it should be, I mean, not gazes. You know, if you look at emerging markets, on a GDP basis, or on a stock market cap basis, or on a population basis, it's about 60% Asian To start with, so that's a you know, it's the weighting of the internet space is a little bit bigger than in the broader indexes and then it's About in our fund probably 10% 15%, South America, and then the rest Eastern Europe and Africa.

Andrew Stotz 10:11
Yep. And just out of, I mean, I'm very interested in and I know that some of the listeners would be interested in this type of exposure. Maybe you could just explain how is the sun stock selection process, like, when most people who are listening, think of investing through some sort of ETF or fund, they think about an active fund manager picking the best bets, putting the money down and making those but sometimes with a with an index, or a passive ETF, generally, the fund manager will just say I own all of those stocks at market cap weighting. So you kind of got a very large, you know, difference here between a passive fund and a pure active fund. How do you fit into that scheme of things? As far as stock selection is concerned? Sure. Well,

Kevin Carter 11:04
I mean, ultimately, this is a rules based index. So we don't use the P word passive. Yep. I hear. I think that it's correct to consider most indexes passive, but yes, as you know, as I've said, I mean, I come from the active side. And that's one of the things that I think has given me an advantage in the indexing world is that I understand investing, and I understand what gives companies value. And, and, and I asked questions, and what I've found is that, for whatever reason, the people that populate the world of indexing don't always do that. And so I found a lot of problems in the passive version of indexing. So, for example, it when you get into emerging markets, sometimes you have a country that the database says, is in this country, or that country, but then you open the financial statements, and you find out all of the revenues coming from a totally different country. So you, you might have a, for example, as a South African Furniture Company, that was the largest holding in the emerging market, consumer ETF. And the database that it was South Africa, it made furniture, so that was a consumer durable. And it was true, the company traded in Johannesburg, and was headquartered in South Africa. But all of the stores that sold the furniture were in France, and Germany and Australia. So, the database doesn't always match the reality. So we have to do a decent amount of manual work in identifying the proper companies and making sure things don't get missed. And we've also recently added a rule to our index that gives the index committee the ability to basically override the rules. And if something is getting missed by the rules that should be included, or something's getting included, that we don't think should be included, we can exclude it. So I'd say we're, we're on the cutting edge, if you will, of the very gray area between act act traditional active and indexing.

Andrew Stotz 13:16
And when you let's just say that you go through your rules process, it sounds like to me it sounds like your rules process is kind of maybe somewhat of an elimination process, or is it a ranking process? In other words, once you've got your universe to say, Okay, these 96 companies fit our rules, then, what is this structure? Or the idea about how you then wait, is it market cap weight, or is it some other

Kevin Carter 13:42
type of weight, it's, its market cap weighted, with one modification, which is the largest position is limited to 8%. So when we rebalance in June and December, we'll will rebalance back to a market cap weighting with 8% as the largest weight. And that's because Alibaba and Tencent, which are the two largest of these companies, they're significantly larger than the third and fourth largest company. So if we put them in at a pure market cap weight, they would be like 40% of the fund. And so to ensure that we meet the diversification rules, we limit them at eight. And that basically takes some of the market cap away from Alibaba and Tencent and pushes it down onto the smaller companies. So it serves as almost a small cap and mid cap, tilt boost, Yeah, a little boost. And that's it and then between the rebalances the stocks move and you know, we usually by the time we get to the next rebalance, Alibaba and Tencent aren't in the number one in two spots, one of the second tier companies, Mercado, Libra are pinned to a doula will have outperformed and become the largest but then we'll sell it back down and and then we do have a Fast Track IPO rules, so anything that comes public, it's over 10 billion in market cap is added with after three trading days, we don't wait for the traditional.

Andrew Stotz 15:11
And I know you know previously talked about your expertise in the area of tax harvesting and other ways of kind of augmenting kind of passive style investing. Do you do any things like that? Or is it just pure market cap weighting Once you've made your selection, and then just rebalancing? Um,

Kevin Carter 15:30
well, first of all, I mean, ETFs, by the nature of their structure are very tax efficient, particularly versus a traditional open end mutual fund.

Andrew Stotz 15:38
So can you explain that to the listener who don't understand that?

Kevin Carter 15:43
Well, I mean, I can put it in very simple terms. Every year I've had it explained to me in detail several times in the last 20 years, but I don't bother holding on to those details, because they're not my job. But basically, the the way that ETFs grow and shrink is through market makers contributing a basket of securities into the fund of individual stocks to create new units, and the way that and also take them out to redeem shares, that structure leads to basically no capital gains taxes for the shareholders, or very minimal capital gains. distribution. So this is a structural advantage of the ETF as a product category. And one of the main reasons why ETFs have caught on so much is they're very tax efficient. Traditional mutual funds have really serious tax problems, including, you know, I don't know what the numbers look like now. But at one point 40% of the value of the vanguard s&p 500 fund was capital gains. And if you invested in the fund today, and they sold the stock they bought 20 years ago, you would have to a part of the taxes even though you didn't get the gain over 20 years. So the traditional mutual funds are, you know, die, a slow death, largely because the ETF structure is advantageous for investors. So it's a pretty tax efficient vehicle. And I think we actually are sitting on and carrying forward about $30 million of capital losses. She said there are gains around the edge.

Andrew Stotz 17:28
And what about reinvestment of dividends? If you receive dividends of companies that are in there? Are you reinvesting those, or you're distributing them to the holders of the ETF? They're reinvested? Got it? Okay. Well, that's a lot of detail. And I'm particularly interested in AI. If, for the listeners out there, I really suggest that you go and search to try to find out more about em qq ETF, you can just go to em qq etf.com. And learn more. And I know, I will be learning more. And you know, what I call these, what you're doing is what I would call kind of exposure fund. It's not so much that you trying to say, I'm going to pick the one that's going to outperform, but it's like, I'm going to give you that exposure to this specific area. That's not going to be that, you know, you're not going to be sucked into having have exposure to you know, Chinese banks that is owned by the government and could do anything. Would you agree with that, that it's kind of an exposure fund? or How would you describe it?

Kevin Carter 18:29
Well, I mean, it is an exposure fund. You know, I think that in the in the ETF nomenclature, they call us a thematic fund,

Andrew Stotz 18:37
automatic, but got it, but I don't I,

Kevin Carter 18:42
you know, as I told you, as we're getting ready for this, I made this fun for a very specific reason. But I've been involved with emerging markets for 16 years and trying to find the best way to capture the real growth, which is in that consumption story. And, and I stumbled on what I think is, in fact, I'm quite confident. I'm not 100% sure, but I'm pretty sure that what I stumbled on is the fastest growing sector in the world ever. terms of these companies, and I offer $100,000 reward that for anyone that can prove me wrong. I I'm not 100% sure that I'm right. Well,

Andrew Stotz 19:20
what about railroads?

Kevin Carter 19:22
Well, railroads were largely bound to physical limitations. These e commerce businesses are quite scalable. Yeah. And so the 11 year, for the last 11 years, the average annual growth rate for revenue has been over 37%. Wow. So and I again, I've given a presentation over the last six and a half years to hundreds of professional investor groups, 100 CFA societies around the world. I've offered $100,000 reward to anybody that could show me a sector of publicly traded companies. Ever grew for 37%. for a decade, actually, the number was 38 and a half for the night, then years ended 2019. But now when I first gave my talk about this, I offered people a ham sandwich. If they could show me a sector,

Andrew Stotz 20:16
your confidence has obviously grown.

Kevin Carter 20:19
Well, that was so that was in 2014. When I first launched and I, you know, I don't have my chart here. But you can see those numbers were 40% a year plus. And then I kept giving this talk. And I decided I should make it a little more exciting. When I was in Hawaii, I offered NASA before I got to why I gave a CFA society somewhere and I made it a $10,000 reward. And then I was asked to give a talk to the CFA Society of Hawaii in 2018. And maybe it was just being in Hawaii, I was so happy, I changed my reward to $100,000. But then we put a few rules in and so there has to be at least 20 companies, cherry picking, you can't include the companies that are part of our index. So Penny, I could be wrong. But look, it's hard to for any company to grow at 30% a year for any reasonable, pretty tired sector to grow at close to 40% for 11 years is I think unprecedented. And what's causing it is it's really, it's a mash up of three themes that are captured in em qq three mega trends. The first one, we talked about billions of people in the developing world wanting stuff, right? They're the thing that's emerging, and they want all the things we take for granted. And, and then the second mega trend is something that we take for granted as well. And, you know, back then, when I had this idea, I was already seeing how my family's consumption was changing because of the smartphone. Right? I had a smartphone when I got, you know, eight when I created em qq but we only had it for a couple years. And back then my family went to Target four times a week or five times a week. But I started to notice the truck was coming to my house once a week. And then twice a week and the trips to target were going down. And so I was seeing how the smartphone was changing consumption. But I had a computer for 20 years before I had a smartphone. The reality is all these billions of people that are becoming consumers, they have never had a computer before. So the computer is the second mega trend in the story. But it's not on the desk. And it never will be. So all of those billions of people are getting a 6080 $60 $80 Android based smartphone, made in China running on Android, as I mentioned. And it's bringing with it the third mega trend, which I've had for 25 years, called the internet. I got the internet in 1995 in the marina district of San Francisco on a telephone, dial up modem. And now the internet shows up in my pocket. Well, most of the world never got wired. And so all of these people are getting there, they're going from nothing to a computer to the internet. And it's changing their worlds in a big way. And it's still pretty early. I mean, you know, smartphone penetration in India is only about 30, you know, two or 3%, which means you've got 900 million people in India alone, that don't have a computer or the internet. So it's those three mega trends are driving this unprecedented growth. And part of it is well is that because the consumption infrastructure in emerging markets, as you know, is underdeveloped or undeveloped. And when I say consumption infrastructure, I'm talking about bank accounts with the debit cards in everybody's pockets, and televisions on the wall that have 1000 channels coming into them. And Target stores because those things don't exist. The emerging market consumers leapfrogging to more digitized consumption and bypassing the mall, bypassing the bank account, bypassing the cable television. And that I think is also explaining the incredible growth rate and it's quite a paradox you would think, you know, the FinTech, part of the story, the mobile payments, part of the story is the fastest sub part of the E M qq story. And, and it all starts with payments. And you know, as you know, in China in particular, but all over emerging markets, you can use your phone to pay for everything. And

Andrew Stotz 24:53
I went to China to do my PhD and I started in 2013 In, literally, you know, everybody used cash. And by 2016 when I finished my PhD, everybody was only using their phone. Nobody carry cash.

Kevin Carter 25:12
That's exactly it. And now I mean, I remember two years ago and the Nanjing subway station, I tried to buy a bottle of water at the newsstand and I walked over the counter and I bought my water bottle on the counter. I tried to hand the man a Chinese bank note. And he told me no, you can't have that water. Yep, with money. But up on the street, I could buy, you know, pigeons and turtles with a QR code, right or obscure. Like the Alibaba is grocery story to the lobster has a QR code on his wrist. It's true. Yeah. So um, so it's sort of a paradox, right? You'd, you'd think a FinTech entrepreneur in San Francisco, like me would be on the cutting edge of this. But I African way, is on the cutting edge of mobile payments, barring more than half of the world's you know, phone based payments are done by people in Africa. It's a

Andrew Stotz 26:08
little bit like wine memo, you know, the big coveted prize for a telecom company in 1995, when, you know, at the time I was coming of age in Thailand was to win the landline contract where you would put down the landlines, and one company got this great landline contract where they put down the landlines for all these phones. And within a couple of years, everything moved cellular and the whole country pretty much skipped that landline and all of a sudden that became a huge loss maker. So I can see that the LeapFrog. I mean, I could talk to you for a long time. But I have to say that my audience really wants to know, your worst investment ever. So now it's time to share your worst investment ever since no one ever goes into their worst investment thinking it will be. Tell us a bit about the circumstances leading up to it, then tell us your story. Well,

Kevin Carter 26:58
so in the late 90s, I was a very confident young value investor, a Charlie Munger and Warren Buffett want to be, and I had worked as an analyst professionally and got paid very well, by hedge funds and mutual funds for my research. And, and this internet thing showed up. And, and the.com. Story was rolling. And I was in addition to being young and relatively successful at that point, and confident I was also a bit naive. And I had decided that this company amazon.com was really just a bookstore, and that it shouldn't be valued any way different than that. And I spent a lot of time analyzing it and Barnes and Noble, had been a pretty, you know, popular growth stock back then they had been sort of consolidating the traditional bookstore business, and I just remember looking at it say, well, Barnes and Nobles got their own website. And they've got, you know, a lot more experience in this. And so I shorted amazon.com in March of 1998. With my small net worth, I had made a decent amount of money. But then I take in a year and a half off with my wife with my new wife and gone and traveled and spent a lot of it. And so but I had a little bit of money left and I shorted amazon.com and I lost about a third of my net worth in a day and a half. And as I think I shared with you via email my write up I did back then I concluded that with a $1.4 billion market cap, that there's no way Amazon could be worth that. And that while you know that I do at that point that stocks didn't, stocks could trade off of their fundamentals for an extended period of time. But I was quite confident that within a couple years, that stock would sell for a fraction of what it was selling at the market cap was $1.4 billion. And I think I wrote that any rational businessman would be happy to sell that company for $200 million in cash. And I before I came down here to do this, I pulled up just to check the market cap of Amazon. And it's 1.6 trillion now, which I think means I think my position I think I should $50,000 of Amazon. And if I hid rather than shorted if I had bought it, if my calculator was right, and I'm not missing anything that would be worth $50 million today. Ah ha.

Andrew Stotz 30:16
What have you learned from this experience?

Kevin Carter 30:18
Oh, wow, I learned a lot. And you know, as they say, good judgment comes from experience and experience comes from bad judgment. And in many ways I should have already been I kind of knew the first lesson, which is don't make valuation shorts. I mean, I had worked as the wing man for a couple of years before this for a guy named Joe fastpack, who was one of the sort of, you know, Kings of short selling, and he used to tell me that we don't make valuation shorts, we find fraudulent companies. And but yet I did I sorted something based on its valuation, based on its

Andrew Stotz 31:03
price valuation short for the audience basically means that you determine what you think is the value of this company, you look at the price, and you say, this stock is way over the value that I calculate, and therefore I think the stock price is going to crash, and therefore I'm going to take a valuation short was that is that how you would describe it?

Kevin Carter 31:25
Oh, certainly, that's part of the way of describing it. I think it's people rightfully, are focused on earnings. And they're, they're looking at the price to earnings multiple, how much do I have to pay for $1 of earnings. And that's, it's good to look at that. Because ultimately, what makes a company valuable is earnings. And so you definitely need earnings to make something have value. But, but what Amazon basically pioneered was, let's not even try to make earnings for a long, long time. Right, let's, rather than focus on this year, next year, the following year, and reporting earnings, let's not necessarily lose a lot of money, but let's grow and grow and grow and build a platform on which when we choose to, we can start to make it profitable. And that's become, you know, a bit more commonplace, right, that companies aren't getting valued based on their short term, you know, near term earnings forecast, but rather on the longer term, longer term, opportunity.

Andrew Stotz 32:50
So lesson number one is don't make valuation shorts. Any other lessons you learned from this?

Kevin Carter 32:57
Um, well, short selling has very difficult mathematics behind it. And really, Frank is really just not worth it, I mean, look at the most you can make in a short is 100%. Right, that's the most you can make. And, and by the way, if you shorted stock at 100, and it goes to zero, you make 100%. And if you shorted at one and it goes to zero, you also make 100%. So a lot of times when you short, something, you don't have to pick the top, you just find out what it's all the ropes. So the mathematics are just so far against you. And the other problem is, when you're short, something, and you're wrong, your exposure gets bigger, right? If you're long $50,000 of of Amazon and it goes down to 20 25%, you know, you've lost $12,000, and your exposure is only 37. Now, so it's become a smaller part of your portfolio. But if you're short something, and it goes up 50% Well, now you're if it was 5% of your portfolio, now it's seven and a half percent of your portfolio. And so it's short selling is a way to make money is I think, not really a good idea. Especially when you can make 1020 times your money or in the case of Amazon 1000 times your money if you're long and take advantage of the miracle of compounding. Yep.

Andrew Stotz 34:30
So maybe I'll summarize a couple of things I take away I mean, the first thing is we have to always remember and part of this podcast, we go back and we look at mistakes that people make. And we are engaging in hindsight bias. In other words, we're looking back and saying If only I had done this, but you know, when we are making these decisions, we're making them with the best information we have at the time, and then our application of our judgment at the time. So first thing for the audience to remember that as we think back the second Thing is, I would say, what I think a lot about is kind of the overconfidence, bias. I know, as an analyst I've valued, you know, many, many companies over the years, and I've taught valuation now for 30 years. And what I can just say is that I always tell my students, you are always wrong, it's just a matter of degree, nobody can make a perfect valuation. And so the answer to that really is questioning, you know, questioning everything. And even you may not have the capacity to ask the right questions such as, if you think back having to when you know, you were going through this, you wouldn't have had the capacity to be able to think the earnings of this company could explode by, you know, they could, this could go from $1 and earnings to 1000. Now, nobody would have that capacity to go to that length. So in that sense, this is where hindsight bias is really dangerous, because we're looking at a really an anomaly, right? But the point I would just make is in valuation, we come up with a valuation estimate, we look at a range of value, and we have to accept the fact that it is an estimate. That's kind of my biggest takeaway, anything you would add to that?

Kevin Carter 36:12
No, I mean, I think that that. Well, I mean, look, it's the irony in the fact that I, you know, as you mentioned that the same week that I was shorting Amazon, I also saw this company change its name from, you know, from K, tell the K tell calm and I found my copy of random walk, and I picked up the phone and call the author who ended up becoming my business partner. And he drove drugged me into China, and now I have a china focus us all emerging markets, but you know, a china internet company, or a fund that invests in Chinese internet companies, the amazon.com, of China. So the irony in that, that I went from there to here is not lost on me. And, and it kind of gets to what you said is like, the, the world is changing. And it's always been changing. And it's always going to change, and it's hard to make forecasts about the future. And but one thing is for sure, and that is the miracle of compounding. And, you know, that the worst investment, the other many of my other worst investment decisions, were selling things that I purchased, that were absolutely the right things to buy. And I was happy to take 100% or 200% gain in them. When if I had held them, I would have had, you know, in some of these 20 3040 baggers, but just by letting the allander flip over, and the in the miracle of compounding work, you know, in my favor.

Andrew Stotz 38:08
So let me ask you, based upon what you learned from this story, and what you continue to learn, what action would you recommend our listeners take to avoid suffering the same fate? And part of what I want you to address in that is that time, going back in that time, when you had the confidence of, you know, I think I've got this right, I'm ready to bet some serious money on it.

Kevin Carter 38:29
Well, I mean, the all that really matters to me, and I think to any investor is the peg ratio, right? It's the P e, versus the growth rate. And this is a, you know, this is Peter Lynch stuff 101 and it's not far off of john Burr Williams you know, theory of investment value, but, but in the math of investing is pretty simple, right? If you've got your, your you're competing against the bench, you know, the index called the s&p 500. And you can see what its p E is and its growth rate, so you can see what its peg ratio is. And then you've got you any other index your you want to compare yourself with, if you're if you're emerging markets, for example, and then you've got the risk free rate. And, and so, you know, anytime you can find a peg ratio lower than the s&p, and hopefully with a better business than an average business, then that's what you want. You want great businesses at reasonable prices. And, and it really all comes down to the peg ratio. And it's I'm still surprised a lot of times that not every investor seems to understand that. That

Andrew Stotz 39:50
Can I ask a question. So for a new investor, they may look back or for any investor, they may look back and say, Well, Kevin, when you were looking at Emma's On, you've estimated the growth, you know, and the peg ratio. And let's just say that, let's just say it had earnings or something like that and you say, you know, peg ratios next next years. And let's say the growth next year is 20%. But the question I have for you is, when you talk about the peg ratio, we're talking about p e, relative to earnings, growth, earnings growth over what time because if you had, if you had been able to accurately predict Amazon, you would have said 1,000%, average annual return in earnings growth over the next 10 years, but not over the next two?

Kevin Carter 40:36
Okay, well, you've just caught me, I guess, in not being consistent in my in what I'm saying. So, first of all, when I look at the peg ratio, I use the revenue growth rate. I mean, obviously, earnings growth is what you're there for. But, you know, to me, the purest measure of a company's growth is revenue.

Andrew Stotz 41:01
Right? Particularly in the area that you're looking at words internet, e commerce, that type of stuff. Yep, that's right. And so. And over what period of time are you thinking when you're when you kind

Kevin Carter 41:16
of know is long term five years? And so so what I look at is the P divided by the revenue growth now I but as you're pointing out with, sometimes there is no E. And so

Andrew Stotz 41:28
the problem is eliminated if you use revenue.

Kevin Carter 41:30
Well, is that the D, you know, stays, but that there's no E and the P E. So you can say, well, let's say Amazon, sell your for 1000 times earnings, and it's growing at 50%. You can say, well, that's a peg ratio of 200. Yep. Right. And so, so I, I'm thinking of the group that I invest in collectively, yeah. When I look at that group, well, I know we have some companies that aren't in earnings mode, right there in land grab mode, we winterize those numbers in, in producing the peg ratio. So that sort of core peg ratio for the group I invest in right now is point eight. Yep. So you've got 36 730, this year 38%, revenue growth and a P e of 30. So it's got half the peg of, you know, the Fang stocks and a third the peg of the s&p 500. But you're right, I have to rethink how I say that. Because I we definitely invest in things that don't have any year or?

Andrew Stotz 42:44
Well, I think it's a good takeaway, the idea of using revenue growth, number one, also for the audience out there, he talked about the idea of Windsor rising and if you were to rank, every stock that you're looking at, let's say 100 stocks, and you put them into deciles, you would see that the top decile of the fastest growth and the bottom decile is the slowest growth, but one out of those 10 could be massive growth or massive negative growth, and it would distort the numbers. So winds arising is just taking the average of that top decile and applying that, to that most extreme point, to try to take it out of them. And so last question, what's your number one goal for the next 12 months?

Kevin Carter 43:26
Um, well, my goal is pretty simple. to have fun. I'm going to Mexico to have the next three weeks. So I'm going to say my main goal is to have fun and try to re enter the real world, which is we talked about, it's a little stressful. So you know that stress disorder of being traumatized by the lockdown is probably worse than the stress of re entering the world. But I'm gonna do my best to overcome that excited as I sit on the beach.

Andrew Stotz 44:01
Sounds great. And one last thing I would say is that this discussion reminded me of one of my favorite quotes from Yogi Berra. And I just looked it up to make sure I got it correct. It says it's tough to make predictions, especially about the future. So listeners, there you have it another story of loss to keep you winning. My number one goal for the next 12 months is to help you my listeners, reduce risk and increase return in your life. To achieve this, I've created our community and my worst investment ever.com and I look forward to seeing you there. As we conclude, Kevin, I want to thank you again for coming on the show. And on behalf of a Stotz Academy, I hereby award you alumni status, returning your worst investment ever into your best teaching moment. Do you have any parting words for the audience?

Kevin Carter 44:52
No, have fun, enjoy the rest of the year and let's go to what he's wanting. One.

Andrew Stotz 44:59
Amen And that's a wrap on another great story to help us create, grow and protect our well fellow risk takers. This is your worst podcast hose Andrew Stotz saying. I'll see you on the upside.

 

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Welcome to My Worst Investment Ever podcast hosted by Your Worst Podcast Host, Andrew Stotz, where you will hear stories of loss to keep you winning. In our community, we know that to win in investing you must take the risk, but to win big, you’ve got to reduce it.

Your Worst Podcast Host, Andrew Stotz, Ph.D., CFA, is also the CEO of A. Stotz Investment Research and A. Stotz Academy, which helps people create, grow, measure, and protect their wealth.

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