Animal Spirits Podcast - Talk Your Book: Crossing Wall Street with Eddy Elfenbein

Episode Date: October 28, 2019

On this edition of Talk Your Book we chatted with Eddy Elfenbein about his ETF, the buy list, passively investing in active stock picking, why it's so difficult to do nothing most of the time with your investments, fulcrum fees and much more. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Rithold's wealth management may maintain positions and the securities discussed in this podcast. On today's Animal Spirits Talk Your Book, we're talking with Eddie Elfinbine portfolio

for the advisor shares focused equity ETF, ticker CWS. So being in the blogging world for as long as you have, you've obviously seen the active versus passive debate beat into the ground like we have. But I think you're a perfect example of why these labels don't really make sense anymore. So you're technically an active stock picker, but you trade so infrequently that you're more of a passive investor than most. So what is the reason that you decided to become more of a long-term buy-and-hold type investor? I see myself as an innovator. I'm pioneering the one-day-a-year work week. So that's what the fund is about. But what I did was when I started the blog, this

is back in 2005, I wanted to show investors that investing is made far more difficult that it needs to be. And I wanted to show investors that you can do well in the market. You can even beat the market by a pretty simple method. So I started posting my buy list in 2006. At that time, it was 20 stocks. And what I did said at the beginning of the year, these are the 20 stocks. I'm not going to make any changes during the year that's locked and sealed and I can't touch it for the next 12 months. People were unbelievable that I would do that. And they would say, Don't you make any changes? No.

What exactly would you say you do here? So the other 364 days, I do nothing. So then I was trying to show people that you could do it. And I posted the results on my blog since 2006. And then people wanted to know, was there a way I can invest in the entire buy list? And so in 2016, we launched the ETF, which is we can't say it is the buy list, but we have to say it's based on the buy list as operationally possible that we mimic what the buy list is. So before we get into that, I'd be curious. You obviously didn't wake up one day

with thinking like, oh, I'll buy 20 stocks. I'll equally wait them. What sort of iterations did you go through with your career? Were you ever a market timer? Like, how did you arrive at the place where you did? Let me see. It's an interesting, long career that many different areas. My background before I did the blog was in investment newsletters. So I was involved in that with a company called Phillips Publishing, which is no longer around. And before that, I worked for a retail brokerage just as a sales assistant. But I was always interested in sort of the buy and hold long term focus on companies know them very well, having a smaller portfolio. So like the Livermore stuff, the market, that just never resonated with you?

Never resonated me. Much closer to like the Peter Lynch School. Again, I don't have anything against it, but it's just sort of more for my taste. Well, you're lazy. Exactly. That's it. That helps it. It's a benefit. So, okay, the first major question, because today it's, it's, everything is quantitatively done, right? It's, it's just machines everywhere and the algaids and the manipulation, all that sort of stuff. What sort of advantages can an actual human being have over the machines? I think too often the machines are very, very mechanistic and they miss, uh, the broader significance of what's going on. A good example. we look at the behavior of value stocks. In my opinion, I think that, and there's a lot of research behind this saying that value has changed. Because of the financial crisis, we get these book values for these major financial companies that are bloated, really higher than they

ought to be. So therefore, they're swept in with low price to book. But even aside from just financial stocks, there's been accounting changes. Yeah, absolutely. Absolutely. And so a lot of these things. When you follow the model, I mean, what you put in is when, you know, garbage in, garbage out. So a lot of times they really do miss what's going on. Or you can see a, say, dividend aristocrats. Say, there are companies, they're just raising their dividends so they can say they raise the dividend. You like the dividend peasants. That's right. So, okay, so you hit on value and maybe people think that you're a value investor, but I don't think you quite exactly are that. How would you describe your investment philosophy? I basically,

focus on companies with a competitive advantage, a lot of times referred to as moats, which is often misunderstood. People want to see it as overly sinister. Sometimes it can be very, very fleeting, but I look for companies that are well-run and have a well-defined market niche. These are tend to be high-quality companies, so as far as I don't aim for a factor, but as far as factors, it has a bias towards quality quality and defensive okay what about like garp or not really uh i don't i don't know how much it does correlate with so i would i would suspect that one of the narrow on a big down day i know i'll perform one of the sectors with the the thinnest moat because it's always so changing is technology so think about black by for example in o kian the list goes on and on is this typically an area

that is underweight your portfolio typically yeah so you You talked about the difference between the quant and the qualitative. You obviously have a sort of theory about how the world works. I remember one of my favorite blog posts of yours. I guess it was from a few years ago. You had the Elphin Bind Theory to explain the entire stock market, if you remember that. And you talked about the difference between we have these cyclical and defensive names, then we have these more value and growth names, and you kind of split it up into four quadrants.

And you talked about rising rates, falling rates, and then wider sort of yield curve and narrow yield curve. So how much of that do you take into account when you're thinking about like the macro world at large? Or are you completely ignoring that and just thinking about company fundamentals? Obviously those fundamentals can be driven by the macro. But how much of that is involved in your process? It isn't at all. It is, you know, the latter. I focus on company specific.

And I think it's too easily to be misled by an overly macro focus. A good example is I don't have any energy stocks in the buy list of people and which has really served me well. the last few years, I just look at it. Nothing has grabbed me. Nothing has said, and people think, is this some, they'll ask me, is this some prediction as far as energy prices? Not at all. I'll go anywhere where I think there's a good value. But what I like to do is really old-fashioned stock picking, just a look under the hood of a company, a find what I think is a good company going for an overlooked price. So you started this buy list in 2006. Let's just say that you were just starting from scratch today. How do you come up with these companies? So the top holdings,

you know, this is 20 stocks equally weighted. Is that right? Now it's 25, but I had to change that just for the ETF. I need a little more diversification. So let's just say that you were starting literally from zero. Where do you even begin? How do you find these companies? So I was asking you before we got on like, Serner, what's that? Danaher, what do they do? So how do you find these companies? Is there some sort of quantitative screen to begin with? Like, tell me everything. What What I do is I have a broader watch list of companies, which is probably about 80 to 100 names. And what are you watching? I just like to look at them.

I find them interesting for whatever reason. Maybe I like their earnings history. I like their performance. I like the stability. Maybe it's a dividend or risk threat. There's something about the company that has grabbed me. It's a strong moat, something. And I think there's just a finite limit of what I can cover.

So I'm constantly adding and deleting to this. is much more active list than the actual buy list. In many ways, that's sort of the minor leagues for the buy list. So all these, I mean, I just can't go into chapter and verse about the companies, but I know some basics about what they're doing. And I look at these and anything that drops down to a good price is a candidate for the buy list. I don't know if we said this, but at the buy list, at the end of the year, we swap in five,

swap out five. So, yeah, we'll get to that in a minute, but just sticking with these companies in particular, are you reading SEC filings? Are you looking at ratios? Are you looking at earnings growth? What exactly are you looking for? SEC filings is really the beginning. So are you looking at the numbers or are you reading? Absolutely. And I want to look at what the business is, what they're trying to do. So do you care about what the CEO is saying for the future of the company?

Sure, but I mean, I understand a lot of that is canned. So, you know, I understand that's how CEOs talk. Also, by a lot of times, by following the companies, you can get a better sense of, you know, who is on the ball and who is not. I'll give you a good example. You should talk about stock buybacks. You know, some use them well, some use them not so well. Affleck is a company. I trust them.

I've been following them for a number of years. I think they're on top of things. And there is such a, it is worth paying that price to get that high quality company, a company that you can trust, that you know the, the numbers they give you, the guidance that gives you is something that they can stand behind. So in terms of the stocks coming in and out, I'm curious to hear about the stocks leaving the portfolio. How difficult a decision is that? And what are the primary drivers of that? The main rule is if it's a company that is no longer the one I bought. Meaning that for, well, one is you can just have an acquisition. This happened all the time. There's an acquisition.

What happens if that happens mid-year? I'd just absolutely go with it. If they're bought out, I'll get the new shares of what they ever acquiring company. What if it's cash? This once happened in cash where I just, I think it was Biomet, and I just divided the cash in the other 19 companies at that day. I've never had it since it's been the ETF. But a good example is Raytheon is going to be bought by UT. So it's going to be Raytheon Technologies, but that will happen next year.

Are you allowed to talk about what your buy list did in terms of performance before the ETF? Because I know that you beat the S&P 500. Yeah, as long as I say it's the buy list. And when I tweet, I can say the buy list. So the buy list was launched. Was it on January 1st, 2006? Yeah. Okay.

So from 2006 to 2015, how did the buy list do versus the market? I don't have the numbers right in front of me. But it's beaten, you know, something like 230 percent to 160. Something about that. Michael's looking for the Sortino ratio or the Sharp ratio, I think, actually. And I do have, the beta usually runs about 0.95. So how do, obviously during the year, this whole idea of doing nothing is kind of a misnomer because people confuse activity with actually helping their portfolios.

So how hard is it for you sometimes to really do nothing? Even though you're still doing the work on these companies, you're not proactively trading them. Is that hard sometimes to just sit on your hands and know that I'm more of a long-term buy and whole purchase of these stocks. I mean, human nature works on everyone, including me. So sure, but also I think I would be a terrible trader. And if I had gone in, I probably would have done worse for myself. But I think there is an advantage in that when I decide each stock, and I think, so 25 stocks with a five-year holding period, and I change five each year,

that means the average holding period is five years. So when I make that decision, I have to say to myself, am I comfortable owning this stock for an average of five years and not making any changes? That completely changes your mindset about going about deciding what stocks go in and what stocks go out. In many ways, I think it's a big advantage for it. See, I think you're really 20% quantitative because you still have rules in your process. You just, so I think that's, and honestly, that's one of the hardest things for allowed investors to do is just follow a plan. And you have, you've obviously laid out a plan that is not quantitative in the factor sense, but it's a plan in that it's quantitative in sort of a trading sense, I guess.

Yeah, I mean, people want to overthink it. There's a lot of money to be made in making finance much more complicated that it needs to be. And so just sticking with these very solid rules. And I think of Barry Rittoltz always has taught me so much about behavioral economics. And that's why I think the low trading focus on the long term, that really does, work against your instincts and it's better that you do that. I think one of the things in portfolio management that is really often overlooked are position sizes. When you're giving money to a discretionary stock picker, how do they know what's their best idea? And how do they wait that

and how do they manage that? So is naive diversification, and I don't mean that pejoratively in the way that you do it, is that maybe the best approach? Like going into a year, do you have any sense of what your best idea is? No, I don't. And it's always a surprise. in the coming year, what is the number one stuff? So said differently, if you were given the flexibility to wiggle the portfolio weights, would you do better or worse? It sounds like potentially worse than... Probably.

Probably would, yeah. So I just also want to give Eddie a quick plug here. I think he is genuinely one of the funniest people on Twitter. I say to Josh, at least once a week, did you see what Eddie just tweeted? This is one of my personal favorites. Why don't they always talk about ETF performance since inception? If you're going to use any movie, it should be Dark Night. Apropos of nothing, just wanted to throw that out there.

So you've been writing for a while, as we said, how has, or has it, has writing helped you as an investor? It forces you to organize your thoughts. You know, you can't sound coherent on paper until your thoughts are straight. And that's the best way to think about investing as well. You know, go about it as a business. People spend more time, you know, thinking about buying a refrigerator than they will putting $20,000 in a stock. So writing is a great help. It organizes your thoughts.

Where are you seeing people use your portfolio in terms of their overall portfolio? Is this a core? Is this maybe something that they put alongside a core holding? Where does this fit? Is this, again, the advisors often think in terms of bucket. Is this mid-cap blend? Like, where does this belong, I guess, is the question? I would say it's probably, yeah, mid-cap blend. probably sounds the best. I don't know exactly what different RAs use it for or probably they maybe sometimes just outside a core holding, a secondary tertiary holding. RAs are a big part of being an ETF manager. That's sort of the major client group. But I don't know. I don't know if there's a single rule for what people use it for. So let's just get back to where we were in the

beginning. Obviously, you're very much an active manager, even though you're not trading frequently. where do you come down on the active, passive thing? Is this just, I mean, I know we're beating a dead horse here, but I just be curious your thoughts. I mean, we're at the point where I really don't, you know, the argument is so tired. I don't care anymore. I see it as I have nothing against passive.

If that's what you want to do, it's a perfectly fine way to go about it. I'm a person that it's like a gearhead for stocks. I really enjoy that. It's for old-fashioned stock biggie. And the people, you know, I'm not trying to CWS is not for everybody. It's for people who enjoy stock picking, the excitement you get out of... An earnings pop.

Yeah. I mean, there really is nothing quite like that. And that you have... Have you tried meth? Still, it doesn't. This is still better. Because you're trying to, you're against a market that's always moving, always judging you. One of the things about the...

Remember, the market always says to an active manager is, no, you're wrong. No, you're wrong. You're wrong. You're an idiot. You don't know what you're... That's what it says every morning to me. And you have to fight back it. That's what you're up against.

And it is a thrill. And I've been able to get a group of followers that enjoy it as well. So I don't see it as us being in... Barron's did the article about me and the... It was a hit piece. And you know what? I'm glad that the financial community on Twitter came to your defense. They really did.

They were more upset than I was. Because I see, I understand how, you know, the media works sometimes. But, you know, he said, well, it's, you know, index funds can do this. Well, it's not an index fund. And I'm beating the market this year. So my, and that's net a fee. So no index fund can compete with that if you beat the market.

Well, let's talk about that because you were pretty early on in terms of being an innovator for fees. So can we talk about the fulcum free? What is it? The idea behind it? How does it actually work? Sure. So with the very first ETS, you have to have a fulcrum fee. So basically the fee that investors pay is dependent on how well we do against our benchmark, which is the S&P 500, including dividends.

So basically, if we trail the market on a trailing 12-month basis, the fee goes down. If we beat the market, then I get a little bonus. It goes, the fee goes up. So every month they're doing a 12-month look back. Exactly. So it's, as they say, skin in the game. Yeah. Are you surprised that this hasn't taken off more? I was kind of under the impression that this is going to be something that would make sense for active managers, especially since so many active managers have been having a hard time that they would maybe want to try simply like this to change up the game a little bit. It hasn't really taken off as much as I thought. Well, it does exist in the traditional mutual fund space and Fidelity has been using it for years. I think the economics are not wildly successful. So it involves threading a needle.

I can understand why other people haven't tried it. And I believe it is growing, that more people are doing it. And I think that in 15, 20 years from now, Wall Street will look more like this than it will, certainly in the hedge fund space. Let's get back to the five stocks that come out. How much of what comes out is based on performance versus businesses? And how do you separate the two? It must be really hard to say, hey, this stuff. stock was down 30% this year, the market was flat, but I really like the company because

if it's down 30%, it's probably because a company is deteriorating. And then at what point is this decision made? Like, do you know by November 1st, all right, these stocks are coming out? How does that process work? As I say is that if I'm doing my job in my weekly newsletter, which is a total ripoff, by the way. How does you charge for that? If I'm doing it correctly, people should have, it shouldn't be a big surprise by, you know, what companies I like, what companies I don't like. The difficulty is selling something just because I think it's too high in price. And my track record is pretty poor. And it's so difficult to, you can't watch the stock after you've sold it.

I sold Microsoft because I thought it was too high. It kept soaring. I sold Haiko, great, small company because I thought it was too high. And it just absolutely took off. So the stocks that are likely to come off, just generally speaking, are more likely to be winners than losers? No, not necessarily. It's probably about half that. Some, I think it's just just too richly priced.

And some, they've had some deterioration. For example, I had on the buy list for many years, bed, bath, and beyond. It was a great company 15 years ago. And just the bottom of, so like I said, it's no longer the company it was when I bought it. So would you consider yourself a business analyst or a stock picker or both? I guess both, yeah. So what sort of leading indicators are there inside of a business to determine when the business is deteriorating? Are margins the first thing you look at?

What do you look at? Operating margins is a great place to start. Also just looking at the details in what the company is saying about the 10Q. Here's a good example. Let me underscore that there are exceptions to this, but companies are often not done in by a poor balance sheet, but more often the poor balance sheet is a reflection of a company trying to mask over problems with the business.

Such as? It's less popular. their new product flops. So they'll go into too much debt to try to mask over the problems that they're having. So in your experience, does the market sniff that out ahead of time? In other words, does the price fall before the margins start to deteriorate? Or like, when does that happen? Does the price turn before the deteriorating fundamentals become apparent to you? In my opinion, the market is remarkably efficient at picking up things, even if it doesn't know why. That's interesting. Yeah. And it It does have a weird sense of picking things up.

So you talked about getting rid of some richly price securities. Obviously, stocks have been going up for a while. Now, the last 10-year returns are phenomenal in the stock market overall. Are there more stocks that are on your traditional watch list that are becoming more richly priced that you would love to get into, but they've just runs too far, too fast, I guess? Absolutely. And there's a lot of companies that have watched for years and they just get more and more richly priced. I think I'd love to see a pullback in a company like that.

Earlier, I said that Eddie's newsletter was a rip-off. That was, of course, a joke. It is free of charge. Where do people find that? Crossing wallstreet.com. Eddie, thank you so much for coming on. We really appreciate it. We'll link to all of this stuff in the show notes. And thank you for tuning in. Thanks for having me.