How to Understand Business as an Asset | Morgan Stanley Investor, Andy Chase

So down here you got businesses. Why do you own a business? I said this before. What's the reason? To make money. Put earnings in— so you look at a business and you look at it— there's a term in the stock market called PE, which— anyone here heard of PE before? Price earnings. Yeah, price earnings. Yeah, the real way you want to think about it is earnings over price. Flip the fraction. Why do you own a business? To put earnings in your pocket. I don't care if it's a flower shop, a gas station, you're starting your business. You want to put earnings in your pocket. And investors might put up with a loss for a year or 2 or 3. At some point, you got to show them how you're going to make some money or that business has no value. Does anyone know what the average PE has been for the last 50 years? And here are normal PE. 15 to 16. 15 to 16, somebody said it. So the normal PE is $1 of earnings over $15 to $16. That's— what is that? 6.5%. That's normal. We're actually right at normal right now. We are right at normal. Does anyone know what the average Treasury yield has been for the last 50 years for a 10-year bond? 6.5%. 6.5%. The average yield for the last 50 years on a Treasury has been 6.5%. Hell, there were years you could walk into a bank and money markets CDs for 1 day, 6 months were paying 5, 6, 7%. 6.5. So 6.5 to 50 are average. Lo and behold, the average PE is 6.5. Why are those— why do those need to be somewhat close? Think about it. I have a choice of buying a Treasury, but it won't grow, but I got no risk, or I could buy this business and I also earn 6.5 bucks on $100. Earnings could go up, they could go down, but over time hopefully businesses grow. They have to be somewhat The same. Question here? Did you get it? And if they're out of whack, which has happened a few times in history, something's going to give. There's one with 2, one with 2, one with 1.5. Yeah. So like in 2000, which is before your time, the market had a big correction, this dot-com bubble burst. The market was trading at 27 times earnings. Let's give myself some real estate here. And I'm going to bring this back to raising money in a venture business in a second. I just wanted you to understand how this just makes— gets some things here. The market was— you were earning $1 for 27 or 27 times earnings, flip the fraction. So you're earning, what is that, like 3.8% if you bought a stock. Now the $3.80, think of it in dollars. $3.80. was going to grow at some rate. Companies were growing 5%, 10%, and this is the S&P we're talking about. This is big companies. This isn't a startup company. It's something that was going to grow. Maybe they're going to grow earnings at 5% a year, 10% a year, 15% a year, some number. Do you know what the 10-year Treasury was then? 6.5%. It was 6.5%. So you're sitting here, you got $100 in your pocket, and you could earn $3.80 by buying the S&P, Or you could earn $6.50 by buying a U.S. Treasury. Which one do you want to own? U.S. Treasury. Yeah. And the market, boom, it just dropped 30%, 40%. When these get out of whack, right now it's the opposite, it's the biggest in history, the delta. Right now you're earning $6.50 for stocks and you're only earning $2 for a bond. The 5-year Treasury is at 1.35. People typically will look when somebody said, do you want a present value or discounted cash flows? Typically they will discount the cash flows at a 5 or 10-year Treasury rate. 5-year Treasuries are 1.35, 10-years are at 2.05. They're shockingly low, that's not the point. The point is you're sitting there, wait a minute, I'm earning 6.5 bucks if I buy a business, the S&P. This isn't one of your businesses, by the way, this is Johnson Johnson, as I said, and Apple. Or I'm earning 2 bucks in a bond. That's way cheap. And right now I'm earning $6.50 on my $100. I don't know if earnings are going to grow. That's the big debate. This year they may be flat because the S&P also includes energy stocks, and energy earnings are coming down or imploding. But if you took energy out of the S&P, earnings are up another 5% this year. I think most CEOs would be upset if they did not grow their earnings at 5%. So you're saying that the S&P is overvalued? Or they would— let me put it this way. If they don't grow their earnings at 5%, I think most CEOs are scared about their jobs. Year in and year out. You can't have a flat year. So you got $6.50, and these ratios have to all be somewhat similar because people will bounce asset classes. Smart people will say, wait a minute, if I'm earning 2% in bonds, I'll sell the bonds. But I can earn 5.25% by buying a building. I can earn 6.5% by buying Johnson Johnson. whatever, then smart people will bounce around and move, that's the question about asset allocation, they'll move from asset to asset based on what's cheapest at that point in time, and they'll mentally do their risk adjustment. What's the risk that Apple's earnings could go down? What's the risk that I can't raise the rents? What's the risk that interest rates may go up? But the key to this thing is that that top case, which I've erased, Interest rates going up and down affects everything. And file that one away. Because if you can earn 10% in a Treasury, why do I buy this building paying 5%? You don't. If I can earn 10% in Treasury, why am I going to invest in one of your businesses? You don't. Right? Smart people in institutions, I don't care if you're Stanford Endowment Fund, I don't care who you are. You don't, and it affects everything because everything is relative to everything else, and where you start is by looking what could you earn by taking no risk. I'll just buy Treasury, make 10%, see ya, not going to deal with you guys. So next part of the lesson, I just want to go through why that exists, and that's not the best eraser on the planet, but. Uh-oh. Might use green, maybe it's less stainy. Blue. So when you have a balance sheet and you're an investor, think of it this way. You've got the big asset classes are cash, bonds, Stock, real estate, and private equity venture capital out here. If you lived in Texas, you might have oil and gas. Theoretically, you could have art. But if you're— the main asset classes that wealthier people have, or Stanford Endowment, or Yale Endowment, those are the big asset classes they'll keep money in. And I always put them in that order because they go left to right in terms of risk. They go left to right in terms of liquidity. You're getting a little less liquid every time. They're going left to right in terms of complexity. I mean, how much easier is it to buy a bond or a stock than buy a building? If I buy Apple stock tomorrow, I can sell it on Friday. If I buy this building, can I get out of it the next day? No. No. Fees. Anyone have any idea what a typical building Equity managers make here? Half of 1%, 1%, something like that. You know what it costs for a property manager? Typically 5 to 10% of rents. If you have somebody managing this building, they'll charge you 5 to 10% of rents. Does anyone know what the commission is buying and selling a house? Homeowners should know this. 6%. 6. 6 coming and going. I mean, typically here you're paying 1/6 of 1%. This is 6% coming and going, and I joke with people when they buy their first home, The day you buy any property, you just lost 10%. Absolutely. You buy a house for $1 million tomorrow, you are absolutely down $100 grand. You're down more than that on your equity. Why? You paid $60 grand just in commission. There's your 6. There's always some closing costs, escrow. Let's call it another $5 grand. So there's $65 grand. You outbid somebody by 3%. You outbid somebody by $30 grand to get the house. They bid $970,000, you bid $1 million. So you lap these in and you're out $100 grand and oh shit, I only put 20% down, $200,000 down. So you've lost half your equity. Or every time on real estate. So, and you gotta give it some time to make that money back up. I mean, 'cause it's, you buy for a million, it's gotta go to $1.1 million before you even break even. Yeah. But I'm just saying, so fees and also return. And the reason I put stocks actually over time will always beat real estate, 'cause companies can grow their earnings more than a landlord can raise rents over time. I don't know if that makes sense, but the reality is over time, shame on you or Apple Computer or Johnson Johnson if they can't grow their earnings more than a landlord can raise rents. Landlords could raise rents 1, 2, 3% a year. They'll raise rents by demographics. Why does real estate give you a better return? It doesn't. On average. Not even close. No, real estate— people can lever it up. I mean, the 50-year average for stocks is like 8% a year, 7% a year, something like that. Isn't real estate 12%? No, no, no, no. Real estate's like 2%. Go and take a look. 2% to 3% is the appreciation in real estate. It goes up by demographics. The last bunch of years since '09, since the real estate crashed, it snapped back up. So has the market come back up a little bit too. No, real estate does not go up that much. Ask your parents, it's funny how real estate's changed. You ask your parents if they make money in real estate, parents used to think of housing as an expense and it's only the last 10, 15 years that people started thinking of housing as an investment. I guarantee you, you ask people from another country that have immigrated here, they always think of housing as an expense. They never, you grew up in India, you grew up in China, You never made any money in your real estate. It's because of the growth in the valuation, isn't it, at the time? It's just rents didn't go up, the things were static. I mean, rents don't go up. And I'm not gonna spend a lot of time here, but fees get higher. When you buy these things over here, you're generally doing it for peace of mind, you're doing it for liquidity, income or return is kind of tertiary. You buy stocks, real estate, private equity, you are, you're buying it for growth. And you're doing it a little bit for the rents in real estate, and you're doing a little bit for the dividends in stocks. Now let's focus out here, because I want you to understand that this is the key before I go back into— bring it back to venture stuff. Cash is paying basically nothing right now. Zero. You look at bonds, you typically look at a 5 and 10-year bond. What could you earn on a 5 or 10-year bond? That's kind of door number 2. And it used to be Treasuries. Treasuries are so low, it's hard. It's throwing me off. I think it's 3.5%. which I said is good for you guys right now, 'cause people are thinking, I'm earning nothing on my cash, I'll take a flyer on a venture deal. That's how it's going down. But if you looked at a 5 and 10-year reasonable company, like a, it doesn't have to be Apple, but I'm trying to think of a good business, Lockheed Martin or something like that. Disney. Disney, you can get 5 and 10-year rates You can get 5% bonds here, 4% to 5% easily for buying a Disney bond, literally a Disney out 5 or 10 years. And so before I take the leap and take more risk in stocks— so think of this as like a vector going up at 5% with no volatility or not much. Before I decide to pass go, collect $200 here, I'm taking more risk. Do I need a higher return? Yeah. Yeah. Risk is also subjective. If you're an 80-year-old person, you're going to demand a higher rate of return than if you're a 25-year-old person. So if I can get 5% here in this door number 1, if I'm 80, I may say I need plus 10%. I need 15% to take that risk. Otherwise, hell with that. Why would I do that if I'm 80 years old? If I'm 25, I may say just give me 3% more. Just give me 8%. And I'll take the risk. And then if you're in my business, you gotta figure out, can I get that? Can I get— if somebody said, if I need 10% more, I need 15% per year, I say, I'm not gonna guarantee somebody 15% every year. I think I can make 10%, but I can't do it. It's not worth the risk, 'cause risk is subjective. Somebody says, I only need 3% more 'cause I'm younger and I'm making money, I only need to make 8%, I'll say, done, 'cause I don't think these are great returns, and I think I can make 10%, so I'll go here. And I, because I can make, I'll say 10%, but if I think I can make 10% in stocks, what do I need to go to real estate? I get property managers, I got roofs leaking, I got washers and dryers breaking. If you own rental units, it's a pain in the ass. I just paid 6% fees coming and going as opposed to 1/10 of a percent. I can't get, Worst case, if I buy something today, I can sell it on a Friday. I'm out the next day, you know what I mean? It's gone. So I would say most people have another 5 delta minimum just to sacrifice liquidity. If I give up liquidity to somebody, I'm— if I'm getting 10% in stocks, I need 15 here. Question, can you get it? Or I'm not going to do it. I'm just not going to. No way am I going to do it unless it's personal real estate where you get a psychic return, if it's something I'm living in. But if I'm doing it from a pure investment standpoint, buying a hotel and buying an apartment building and buying a commercial strip mall, whatever, markets aren't stupid. And I mean, if you're leasing a building to Apple, you're going to get the same yield on buying that building that you would on their bonds because it's the same credit. Apple's promising to pay you the rents As opposed to promising to pay you the bond coupon. So if I buy a building and I'm leasing it to Apple down in Cupertino, I'm gonna get like a 4% yield. There's no risk that Apple's gonna default on that lease. If I'm buying a building and I'm leasing to startup companies, to you guys, what's my yield have to be? Much higher. Much higher, 10, 15, it's a much higher number. Markets aren't stupid. Now, so let's say I need 15 here. I need a 15% rate of return before I get somewhere between appreciation and rents. It's a pretty big number. Now I'm going to take a risk by going into one of you schmucks. Where's my $15 back? I need some— Now I'm taking business risk, I'm taking CEO risk, I'm taking liquidity risk, right? I don't know when I get my money back. I don't know if I'm going to get my money back. I'm not getting any current cash flow like rents or something or dividends. While I wait, I'm taking every risk known to mankind. I guarantee you I'm going to need at least 5% more, probably higher. So I need 20% to 25% out here minimum before I would look at any venture deal. Is that clear? This is— people have choices and it all starts because I can earn 5%, then I'll need 5% and I need 10% or 10% to 15%. Different people have different risk tolerances and preferences and liquidity, but I'm just telling you, you talk to somebody with money, they've got choices. They don't have to invest in you.