Animal Spirits Podcast - Talk Your Books: Value & Momentum with Jack & Wes

Episode Date: November 25, 2019

On this edition of Talk Your Book, we spoke with Alpha Architect's Wes Gray and Jack Vogel about value and momentum strategies and how they developed their investing process. 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 Batnik 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 position, and the securities discussed in this podcast.

Okay, we are sitting here with Wesley Gray, CEO of Alpha Architect and Jack Vogel with a V, CIO. We're going to be talking about all things value and momentum, and we're going to start with quantitative value. So this index seeks to buy the cheapest, highest quality value stocks. First question, can you still purchase stocks at a discount to their intrinsic value? That's a loaded question. Who wants it?

I'll take it. Hold on. Hold on. I'm going to interrupt myself. Sure. I just have to say, before we get started, that you two are two of my favorite people in the financial services industry, have been hugely influential on a lot of people listening, myself included. So I'm very excited to get going. So with that, can you still purchase stocks at a discount to their intrinsic value was? So here's what I'd say. We think we can buy stocks at a discount to what people will expect

the future intrinsic value to be. Because who actually knows what the real intrinsic value is? But a lot of times these valuation proxies are just, it's an estimate of what people think it's worth now, but we know on average they're probably worth a little bit more than that or will be perceived to be worth more than that. And that's how you earn your spread. So who the heck knows what the actual DCF discounted cash flow of any stock is? I don't think anyone actually knows that. But in this game, it's really about understanding what are you paying today and what do you think

people will pay in the future? and I think a lot of times cheap valuation metrics are a way to kind of capture the spread, basically. Just very broadly, what is the difference between discounted cash flow analysis, classic value investing versus what you all do, Jack? Yeah, so classic just discounting cash flows is when to project out the future cash flows of the firm that eventually hopefully the shareholders get to receive. And then obviously there's a lot of assumptions that go into that. So it's what are your starting rates?

What's your growth rate over the next couple of years? then maybe what's your steady state growth rate, then you have to figure out what is the discounting rate with which you're going to use to discount those cash flows. So a lot of assumptions into trying to figure out, hey, today stock A is worth $100. I did my DCF analysis, and according to this, it should be worth $120, assuming my discount rate's 10%. So that's discounting cash flows. Now, what we do? Just real quick, what cash flows are we talking about? Are these dividends? Is it free cash flow? Is it earnings? What So you can use a couple models. You could do dividend discount model. You could do free cash flow to firm

free cash flow equity. There's a lot of different models you could use to try to discount and come up with what you perceive to be the price that the stock should be worth today. And it's a fun exercise for people to do to try to do this and say, hey, what's the stock work today? Did you ever go down that road either of you where you were actually doing this sort of stuff? Yeah. I mean, I used to be hardcore, I say, Bible thump and Ben Graham guy where I do the whole DCF. in Excel, call up the CEO, channel checks. I did all that crap for probably 10 years before I just said, hey, this FOMA guy's taught me a better way. And these computers are way more efficient, and I'm a bonehead. So that's why I think we use systematic ways to do valuation,

because I've been down the bang your head against the wall approach, and it just didn't work out for us. So you guys are probably sick of the whole, I'm sure all quants are sick of the is value dead question. But which arguments against value? the value premium sort of coming in actually could make sense in your mind that people are putting, because obviously there's probably a lot of arguments out there that are just, you can push by the wayside pretty easily, but which arguments do you think are actually could be valid and worth thinking about? So, I mean, the general framework of how we think about, well, why does anything work in the first place is you got to get your returns from one of two buckets. You're either

taking more risk, so you're going to earn higher expected returns, or there's some mispricing that's really difficult or costly to arbitrage. And in the case of value, it might be the Baby got thrown out with the bathwater problem where, yes, we all know there's idiots that don't want to own things that are in Amazon's path. And yes, these companies will not become Amazon, but in the future, they might be perceived to be a little bit better than how they're currently priced. So this would be a mispricing, but it's arguably not easy to just say, hey, let's go buy things in the middle of Amazon's warpath. So difficult to arbitrage mispricing. So anytime anyone makes an argument about any premium, not just value, but momentum, quality, whatever the hell it is, The first argument is, okay, we know one component of this return is probably associated with fundamental risk.

Even if things were just purely risk-based, like DFA says, well, there can be preferences or taste preferences. How do you value risk? Like maybe sometimes people think that to own something that wiggles around a lot, they should get 5% premium. But what if taste change? They might say, well, now we just prefer three because whatever the risk aversion changes, whatever. Is this all semantics? Like, who gives the shit? Yeah, I mean.

What do you think? Here's the thing. I think risk preferences are probably pretty stable. Stuff that's chaotic and wild requires extra return to hold it. And I also think that there's a lot of idiots in the market, despite what Fama said other day on with Barry. And I do think they affect asset prices because it's not exactly easy to like hold a lot of these strategies that have quote unquote mispricing. So I think you're going to be able to earn that premium if you're in a position from a capital perspective to not be so worried about the day-to-day relative performance and career risk and have it.

Well, did Fama kill value investing? Because we know what happened after his paper came out in 91, whatever year it was. So you see the excess performance and then plateaued? Yeah, well, an argument, well, did momentum investing get killed by jiggottish tip in 93? No. But it didn't catch on. It went on its best run ever then. Yeah, the thing is, if value investing was dead after it became more well-known,

wouldn't you expect it to have a huge period of performance as the money rushed in? and that really hasn't happened because the money is still flowing into value funds. Yeah. As of recently like that. And if you really actually look at the value premium, remember, if it's risk or mispricing, the issue is if it's risk, which obviously probably is part risk, well, look at the fundamentals. When you bought the risk 10 years ago, like the fundamentals actually, they were risky. And guess what?

The realization was true. Big tech, cloud, Amazon actually kicked people's asses. And so that risk premium, you were getting paid to own shitty business. it was actually realized. But that doesn't mean on an ex-ante go-forward basis that the current valuations aren't pricing in the fact that Best Buy would get crushed by Amazon. So we always got a bet on a go-forward basis, not in a rear-room year. And I don't see why buying crappier businesses that are weaker and riskier fundamentally, if you just believe in a risk-based argument, wouldn't pay higher expected premiums because why the heck would anyone own them?

Do you ever look at relative valuations between value and growth and things like this and say, oh, now it looks preferable, like now is a good time? Or do you completely not pay attention to that? Yeah, I mean, in general, we look at them, but it's not like we're making allocations decisions off of that. And it also varies wildly depending on which valuation metric you use. Because right now you see people saying this is the biggest discount ever from value to growth numbers are saying, no, it was way worse than the tech bubble.

Well, the tech bubble was just ridiculous. That spread was obviously huge. And so at that point in time, it might have made sense to just overweight value on a relative basis. We don't generally make tactical asset allocation decisions based on that. One could try to do that, but in general, what you see is that it doesn't work that well. So before we get into the specifics and we're going to, you guys do so much research, ridiculous amounts of research. How do you incorporate new evidence into your process? In other words, let's say just like compliance-wise, if you had to update it or if you found something statistically significant, how does that process work

where you're like, no, what we're doing now is good with the fact that you're always looking for more. I mean, I'll take that. So the first thing is once you've done this stuff for 20 years, like you've already tested every database, you've read every single paper, what you start to identify is a lot of quote unquote new ideas or just basically old ideas that have been repackaged. And this is not just in practitioner world where there's obviously an incentive to do this, to make it new and exciting.

But even in academic research, a lot of times people will be like, hey, we found this new factor and it will get published because the referee didn't do a good job. And then someone will say, well, actually, that was just value momentum, but you needed to do a better proxy or control for this. So the reality is there is nothing new under the sun. Buy cheap shit, buy relative strength, do trend falling. As far as I know. And hold on. Yeah. Just deal with it. These are the premiums that seem to be most robust, have the best evidence form, etc. So anyways, that's the bottom line. It's very hard to find new ideas that would tip the scale tour like, hey, we need to incorporate this just to do it.

And then Jack can talk about it because we're in the middle of actually dealing with this right now. Let's say you do find really cool ideas or even things actually make it even simpler than before, which is actually what we try to do. Then there is an issue with you got to communicate to your investors, communicate to the public, educate and form, etc. But there's certainly not a reason why you can't do that. Jack can tell you if we're in the middle of this.

I think, as West said, there are a ton of papers. that we've read and the books we wrote and the research we've done, we tried to synthesize all that ahead of time. And so we're, let's say, 10 years out now, it's like, okay, well, what's new? And so like one thing, you could be like, oh, hey, what's this investment cap M idea? This seems different, right? It's somewhat different. And basically says investment is a factor and expected profitability are two factors. In academic finding, it's a different idea. But kind of investment is a proxy for value, not perfect proxy, but you end up getting back to that. And then on expected profitability, it's kind of quality and momentum. So the same kind of

same factors just pop out from a different whole model build up from like first principles like economics. It is kind of crazy looking back on it that not too many additional factors have been at least that we found have popped in there that we're like, yeah, we need to add that in. There's usually different theories where there's not like a tight, coherent reason why value momentum work because the issue is it gets in the arguments of like the phama schiller arguments and then people get in their little religious camps so what jack's talking about like lou zang and his colleagues the investment cap them is a way to say hey let's believe in neoclassical economic models we can derive a model the in state is not value momentum the in state is like growth in r oe and growth

and investment and it actually maps into like a fundamental kind of old school economic world but the in-state is basically that is value momentum. So whether you want to call it neoclassical or you want to call it behavioral and risk, whatever, we're all in the same in-state, but we just, academics like to argue about the why and the cause effect a lot more than the outcome. Value is a flat circle, as I say. Yeah. You guys made the transition from academia to, okay, let's actually apply this stuff, which is pretty rare. So what is the difference between these ideas that you write about in the papers and then the execution in the real world? So, I mean, a lot of the facts, And we see there's all these new papers about, and the cross section of stock returns, replicating anomalies.

You see all these factors that fail. And it's like, well, hey, why'd they fail? And it's because when you go in and like dig into the nuanced details on some of these really cool factors that look awesome on paper, a lot of them are just proxies for illiquidity, market making type stuff or just overridden by small cap bias that even though you have an SMB factor in an regression, it doesn't pick up all the noise. So I still remember being as like a PhD student sitting in on investment seminars where people are presenting papers. I'd be listening and reading to the paper and I'd be like, oh, yeah, that's just massive small cap bias. That's cool. You have a statistically significant T stat of seven on five factor alpha, but you just have a massive small cap bias. Right. So how many sort of constraints did you guys have to put into your actual portfolios to make them work better in the real world are actually more realistic in terms of market? cap or liquidity or how much they trade, that sort of stuff?

So I'll give you just a little bit more background because I think we got lucky in the sense that none of us had real jobs in investment business. And that sounds like a bad thing. But you also don't get framed incorrectly. We come at academic research where they're, hey, let's go to French's website. What are they going to do? Take a thousand stocks, do decal sorts. Wow, cheap stuff works really well.

And so intuitive, you're like, well, if that works really well, and that's how they do it, if we're going to try to make money, shouldn't we want to do something kind of like that? Because we weren't thinking about tracking error, because we never came out of that world. And we'd always been dealing with ultra-high network brainiacs that totally understand this. And they got 20-year horizons. So we just were never influenced by the real world. And so we always just said, hey, this is what the academic research says. These are the general processes.

We should build portfolios that mirror that. And then the next question is not including like the career risk stuff. because, again, we still don't really obviously care about that. But as far as like implementation on like trading costs, frictional, we don't have to do that much that's any different than what you do in academic papers. You're just not going to be trading the $10 million those companies. But frankly, you don't need to a lot of times. You're pretty much benchmark agnostic more or less than.

Yeah, we just do what we think is going to earn these risks from his pricing premiums over a long haul. Which, as West mentioned, definitely had an influence. We didn't come worried about benchmark hugging or staying. close to the benchmark. So there's pros and cons of that, but I guess the one pro is we build our portfolio is somewhat different, I would say, than other. So let's talk about this. So the first step in the process is you identify the investable universe, which for value is what? The Russell 1,000. Around there. Yeah, around there, but kick out financials. So kick out financials. Okay. Why? What's your problem with financials? They did poorly the past decade. So we had a perfect

crystal ball. No, that's not the reason. So one of the main reasons is, we have step two is kind of these negative screens where we're trying to in value investing as you're trying to buy cheaper stocks and cheaper stocks generally have issues with them. Businesses going down, et cetera, et cetera. So in some of these models to avoid the value trap or the so-called falling knife in value investing, some of the models we use have leverage as one of the main variables to highlight or try to identify bad value stocks to kick out. And just inevitably, financials have much different capital structures is from a debt equity structure compared to like operating companies. And so that was one of the main reasons we booted them out to be honest with you at the outset. And that's just how a lot

academic papers kind of do. Because you can't really compare the leverage ratio of a bank or financial company to an operating company because it's like comparing apples and oranges. So that's one of the main reasons we did that. Okay. So investable universe, negative screen. What are you looking to get rid of and how do you do that? Yeah. So on those negative screens, again, to Jack's point, the intent here is just how do we cleanse this universe of total dirt balls before we even get into it because you might be buying value for a reason. And so it kind of breaks down to three main buckets. And Jack can explain some of our new research where we can actually simplify a lot of this, but essentially it's issues with like accruals. So if you have a lot of net income but

not a lot of free cash flow, yeah, there may be a good reason for that. But on average and in general where there's smoke, there's fire. And we're not in the business of trying to figure that out. We're doing quant. So if you're bottom 5% on different accrual type mechanisms, just bomb. You're out of here. We don't want to accidentally buy someone who's faking it, basically. So many companies that are booking sales before they get the cash. Yeah, stuff like this.

There's obviously a lot of manipulation potential in net income, which is accrual base versus just coal hard cash that's coming into my bank. There's a bunch of academic papers that basically highlight that, yes, this is true. Would we want to short these securities? Probably not, because if you look at them, they're already priced in the short rebate, but we don't want to accidentally buy them, basically. It's kind of like what we're talking about with Will's new fund. So that's one idea. There was like manipulation. So he's this thing called the Beniche model. Oh, the Beniche model. You know that, right? Yeah, yeah. The guy's name is

Benich. It's like old F-A-J. But all it is conceptually is there just, it's kind of like old school machine learning before they call it machine learning. They'll use like probate model where they say, hey, these people manipulated. We know they manipulated. We hypothesized that things are like your SG&A expense, your growth, how you mess with your depreciation, we hypothesize that these things matter. We're going to just data mine out that relationship and then out of sample see if that data mine relationship is actually predictive. And if it is, that suggests that this might be an interesting model to predict manipulators. And there's a similar analogous idea in financial distress. They're just statistical models where you're trying to predict better than

throwing a dart at the wall that this person's probably cooking the books or they can go bankrupt in the next 12 months. And obviously, if we're value investing, we don't want to buy a cheap stock that has a high chance of bankruptcy because we're trying to buy value that hopefully mean reverts and expectations and people like it again. We don't want to buy it because it could go bankrupt, obviously. And one of the neat things you found in quantitative value was if you just ran these three models, so accruals, manipulation, distress, and just said, hey, we're going to boot the bottom 5% on all these. No, actually, and just said, how does that universe due to like the universe including them it actually did better i think was like 50 basis points

or something like that so just kicking out the junk just added some value you talked about you've figured out there to be hard to short those why did you guys decide when you're looking at the quant stuff because obviously all the academic research shows these long short factors and i think maybe a lot of the lay people who just get into this stuff don't even realize that why did you decide to just go long only instead of doing some long short stuff is there something about back testing and looking at these stocks that it makes it harder to short them when you're taking the backtest into the real world? Long-winded answer potential, but I'll make it real short. So I launched a hedge fund in September 2008. And I had a Russell 2000 hedge on. Guess what? It got called in.

And guess what? If you own any stock that wasn't $100 billion, you were probably getting your short recalled in. And so the issue is unless I'm in a position of like AQR, some monster that can kind of shoehorn like Goldman Sachs to get me borrow, they're just going to say there is no borrow. And so the logistical nightmares and costs and infrastructure and brain damage associated with dealing with the short side, I think a lot of times the juice ain't worth to squeeze. And most people, it's really hard for people to conceptualize what we do, which is long only high tracking error. You can only imagine a market neutral thing that's totally wacky. And all you got to do is look at AQR right now. People buy alts going in thinking they understand it, and then when it doesn't beat the S&P, which is obviously not the appropriate benchmark, it doesn't matter.

They're like, we're selling this crap. So it's one of those things where operationally, I don't know if you actually win after costs and brain damage. And it's just from a behavioral standpoint, I think it's going way too out on the risk curve for normal people to really mess with. You've said that you don't care about career risk. And I don't think there's any firm out there that's more transparent and on the forefront of like educating their clients than you guys. guys. So I read the book quantitative value and you do a horse race with all these different metrics and what wins and what wins is enterprise value to EBITDA. Is that right? Yes. So is that the building block from which QVAL and I value derived? Is it enterprise value to EBTA? Yeah, that's our main value metric that we

use. So is there a composite around that? Do you look at other stuff? Because I feel like, yes, that might be the best over the long haul, but we don't really live in 20 year increments. So are any other factors that are incorporated or is that it? So right now, that's our main. value screen that we use to get down to our bucket of cheap stocks. You can make an argument and it's kind of understandable argument, hey, let's use a combination of a couple of metrics. EBIT, we're going to use free cash flow, eap, e-a ratio. Everyone kind of understands that. And we looked at that. We looked at that. We looked at how the combo did relative to EBIT or relative to the other ones. And you can go one of two ways. One way is you say, hey, let's look at

the combo on a long only compared to just long only use of one factor. there's like no statistical difference. So you could argue back and forth and no one's going to be right or wrong. I think it's what can you stick with. We prefer that measure just because when we've been looking at stuff, we think that's like a better proxy maybe for like takeovers than other measures. But you could argue and I wouldn't vehemently disagree that using a composite is not a bad idea. I couldn't sit here and say, you know, you shouldn't use a composite.

There's some other things to highlight. Sorry, just real quick. What if this particular factor, then the value factor goes out of favor. First thing is just stepping back. So one of the things we need to understand is that composites versus single metrics is not a fair thing because a lot of times a composite will implicitly embed quality in there. So really the fair horse race is if you're building a value system that is cheap and then quality,

we need to say, hey, is this cheapness metric by adding more complexity and adding more bills and whistles to it given we're actually going to do quality already, does it add value? there. And so if you compare, like, say, a composite metric that includes other things that we just don't frankly believe in, like something like book to market, no amount of back testing will convince me that that makes sense as a broad-based metric that's going to be able to, it's going to capture a lot of risk. I'm not so sure if it's going to be able to capture risk and mispricing. So why would I want to use that? Just because it back-tests better in a composite, not really. And that's especially the case. If I use EBIT, an enterprise multiple, which is business buyer

metric and then do quality. And if I compare that against whatever 50 items that are valuey and then do quality, do you see a difference there? And the answer is no. So even though when you do the one level horse race, it's unfair because a lot of value metrics embed other known variables like quality. And so it's like comparing book to market against this composite. Well, that composite is basically cheapness and quality. If you did book to market and add gross profits, which is what DFA did, you'll notice that you don't see these deviations anymore. So be specific about the quality. Where does that come into place? So you sort by enterprise value to EBITDA. You take the cheapest, what, 2%? Decile. Okay, the cheapest decile. And then

what do you do with the quality? That's how we get down to, at the end, like 40 to 50 stocks. And we just pick the highest quality stocks on there. So what does that mean exactly? Well, international and U.S. are slightly different as of right now. What we use on both sides, is we call it our financial strength score, which is similar to the Piotrowski F score, Piotrowski and Soto Paper. So what it does is it's kind of like a 10-point checklist to identify certain items that you would hope a company has, that's positive. Is that balance sheet stuff?

Yeah, it is. So one of them would be, is the company on net buying back shares. Share buybacks, everyone knows in general, are good for shareholders. Like if you're diluting shareholders, that's on net bad, at least in the past. So that's one of the measures that we use in there. So on the U.S. side, we have 10 of these measures, like free cash flow. So we have 10 of these measures. And then on the U.S. side, we add in some longer term quality measures.

But in general, the whole idea is to within your value portfolio, go to the higher quality value stocks relative to just buying the whole bucket. And to think back to first principles about why does that make sense is if you buy it all cheap stocks, they're going to do pretty good because there's usually a mix of risk and mispricing and buried in there. We believe, and not just us, but a lot of other academic research suggests that once you're in the cheap kind of dirtball bin here, who do you think is most likely to be the baby thrown out with the bathwater stock? Well, it's probably not the cheap stock that is issuing debt, issuing shares has worse operational momentum. That's probably cheap for a reason. But those stocks that have equal cheapness, but those that are, they've got year-over

operational improvements and whatever, gross turnover, asset turnover, they're buying back stock, they're paying down debt, their current ratios are improving. These are the type of firms that may have been thrown out in a sentiment bomb. All you guys competing against Amazon are losers. Well, actually, that's maybe true, but at the margin, the one that might be able to rebound and be in a position to win over the long haul and earn kind of this change in expectation benefit are those that are cheap but high quality versus cheap but actually like a piece of junk. That's the kind of economic reason of why it's structure like that.

Then just going back to like what some of the research say on this. So I mentioned that Petroski and So paper. And I think it's kind of important though because we talk about value investing, which is where value stocks historically did better than gross stock, just looking at that. So in this paper, what Pietrowski and So do is they say, hey, maybe it has to do with people's expectations being incorrect. And how they test that specifically is they look at value, high quality. So they split value in half, high and low quality.

They split growth in half, high and low quality. And what they find is that the value premium is really driven by the spread between value high quality, going along that and going short, growth, low quality. That is the value premium. In fact, when you do the opposite, and they show this in the paper, when you do go along value low quality and short growth with high quality, there's no. no value premium. It's gone. When people say quality is not important, I would probably disagree with that, especially within value investing. You talked earlier about the U.S. versus international. Do you guys ever look at all at the differences? So U.S. stocks have just killed international stocks for the past 10 years or so. Are you finding that stocks over there are just way cheaper foreign

stocks right now? Do you guys do much of that relative value stuff? Or you're just more worried about the relative value within those markets? Because I know it looks like you guys have 55% in Japan right now an I-VAL. So I-VAL, so if you just look at a yield basis, operating income or EBIT or enterprise value, in international, I think I-VAL is probably like 16-17 percent, i.e. cheap. In U.S. QVAL is also pretty cheap. It's probably like 11 to 12. So I mean, just in general, there's way more deeper cheap stuff, obviously in the international marketplace than the U.S. And I'm sure that's probably pretty intuitive, just given what we know about S&P versus international market. So definitely way more deeper, cheap stuff in international markets.

So if we ever get a return and these stocks start to do well again, is it because the earnings rebound and the businesses turn around or is it the multiple stops contracting and starts expanding? I think it's all about, you know, Bob Schiller, I think he was on Barry's podcast. And he talks about narrative economics. In the end, I'm leaning more and more anti-fama and all this stuff is driven by sentiment and stories. So to the extent the story changes, and I'll give you a perfect example. Oh, big tech. Yeah, it's a great monopoly, has huge economic mode, has network economics. Wait a second. U.S. government's going to regulate the shit out of it. It's now basically a bank insurance industry. All of a sudden, that sentiment changes. And then people

like, wait a second, brick and mortars are selling for 5PE, and then you get whole waves of the narrative changes. And I don't know when these things happen, but that's, in my opinion, at least, where you really get these value whips is the narrative changes out there. And it's not Amazon on killing everyone, because guess what? They're being regulated. Oh, we should look at all this cheap stuff that we thought was going to go bankrupt. And then you get these huge waves. It's just sentiment-driven revaluation. So I'm sure that you get this question because you guys are obviously wicked smart and you've done all the work and everything like that. But if somebody is, let's say somebody logs on and wants them to know about you guys, doesn't know anything. It just

compares you to the Russell 1,000 value, which we all know the problems with that benchmark, that there's really value and growth in there and the definitions are terrible. However, that, that is your benchmark. So how do you explain to the fact that, yeah, that benchmark sucks, but it's kicking our butt because it's not really value? Like, how do you overcome that? And same thing with momentum, which we'll get into later. But how do you square that circle with somebody who doesn't really know the nuances of this? Yeah. So our firm mission is empower investors to education, not try to beat a benchmark. So all we can control is our process and our transparency and communications with people. And we say, hey, let's say, we've gotten destroyed

by the R1K value by 20% this year. Just so you know, this is the process on our R1K value. This is our process. We believe in buying this top decal cheap on enterprise multiples. Here's the reasons why we also believe on sorting on quality thereafter. Here's the reasons why. This is what we say we do. X post. This is what we do. You can see it. It's in the factor attribution. This is our process is what we deliver. It's underperformed at Russell 1,000 by whatever, 20%. Maybe we're idiots, and maybe we should change the process. But just so you know, if we move from this process to that process, we're changing the process here, and we should probably understand what is the evidence associated with that process. Is that going to add value over time? Was it a lucky run,

et cetera? So all we can control, again, is transparency in our process, and this is why we do what we do. And same thing. Let's say we win by 20%. We're going to do the same explanation. We don't say, hey, we're so awesome and cool. We say, hey, we won because this process is now delivering these premiums. And that's why you should continue to do it and think long term. Going back to just, we build our portfolios, kind of how we think one could best try to invest in like the value premium from a long only stance, as opposed to long short. But we just build it upfront knowing we're trying to do it the best way we think that we can. But one of the downsides is going to have tracking out. And so a second point is we

try to highlight this to everyone. I probably sent hundreds of people who have come across our site and reached out to Vanguard because they're like, hey, hey, I looked at your value fund and you guys are down like 1% and the market's up to like over the past two days. What's going on? And it's like, well, hey, when you end up talking to this person, really, if that person's going to compare you at all times to the market, really the answer is they need to be in the market. And so when it gets to like advisors. Advisors need to understand how do you want to use this? Because like if your client can't stick with it, we tell advisors like, dude, you'd be almost crazy to go all in on this if you know ex-ante, which is very true for a lot of people, that your client's going to compare you to the market.

Like it should be like a satellite portion of your portfolio, right? We're benchmark to CPI. We're lucky. Yeah. That's a great. Now in terms of the education stuff, do you guys find it's harder to educate on the momentum story? Because obviously it seems like value seems pretty easy. You're buying a dollar for 50 cents or whatever. Momentum doesn't have nearly as much assets in terms of funds. And obviously, if you break it down easy enough, momentum is pretty easy to understand, but it's kind of counterintuitive for a lot of investors. It flies in the face of first principles, right, by low, sell high. Is it harder to educate people on that?

I would say not if you believe that the story is part risk and mispricing. It's hard to arbitrage. It's clearly tough to argue on pure risk side. But most people, normal people actually know humans. They talk to them every day. So they're much more in tune, I think, with realities of it would be. behavior. And then you just highlight, hey, look at this strategy. It's worked forever, it's worked everywhere. Look how maniacal and volatile this is. It has edge, but look at this damn thing. And they're like, that's insane. Like, I can't stick to that. And you're like, yeah,

you're solving my own problem for me here explaining why, even though it's kind of behaviorally driven arguably, it's not exactly easy to exploit. Rent tech's not doing long, short momentum because they can't lever that. They'll die. Yeah. And one of the neater things that I've liked in the research over the past couple years is kind of tie in. There's a Novi-Marx paper. It's called Fundamentally, Momentum is Fundamental Momentum. And the whole idea is, as you said, hey, this seems to be crazy. Past prices are predicting future prices. And so one of the arguments, and I don't want to dig too much in, but essentially people in the past didn't talk, didn't agree that fundamentals were related to momentum. But what he finds in this paper is that fundamental momentum, like

earnings per share growth is related to price momentum. They're not the exact same metric, to be clear, but they're very highly tied together. And this kind of makes sense, right? If you have a company or a segment of the economy that's doing well and they're growing earnings per share, you might expect them in the short term, because remember momentum's over a shorter term period, to continue to do well. Now, over the next 10 years, who knows, but over the short run, we'd expect it to go. So can we just define real quickly, because this is sort of a muddy topic, like, what is the difference between momentum and trend and growth? Because there seems to be a lot of misnomer's and overlap. And so how do you guys

think about these three buckets? So I'll just give you the history of why there's so much damn confusion. So if you actually read Jaggedy St. Tipman, 93, the quote-unquote famous momentum paper, they don't mention momentum one time called relative strength. And that makes sense because what now is called momentum used to be called relative strength, and that's just saying, hey, at a given point in time, we're going to look at securities, sort them on their past performance, and we want to buy those that are relatively stronger. Okay, great. So how the heck did the academics confuse us? Well, Mark Carhart wrote this paper, I think it's in 94, and he created this thing called the momentum factor, which is using the giggedy sentitment 93 relative strength. Then

the academics started calling this thing momentum, but that confused the people in trend-falling world because they use trend and momentum interchangeably, where momentum or relative strength or cross-sectional momentum is this idea that at a given point time, we're going to compare each other relative to one another and pick you. That's momentum, cross-sectional momentum, or relative strength. But then trend-falling now, because now we've got to have a new term to highlight this, that's over time comparing point A to B for a given security, how is it doing? And so if it's trending, i.e. it's moving over time positively, that would be good versus if it's moving down over time, that's bad. In order to simplify it, hopefully we just

say we call that trend falling. But I also understand why a lot of people call that momentum, but then that confuses it if you're talking with people that are influenced by academics calling it momentum. It's very complicated. And then how's it tying to growth? Well, If you just go on Morningstar or Vanguard's website, you look at your buckets. They have that little like three by three grid and its size, which is pretty simple, like small, mid-cap, large-cap, and then value to growth. And so value to growth is just you split, let's just use PE ratio as an example. So the cheaper things on PE ratio or value, the more expensive are in growth.

So if you wanted to add in momentum, you'd almost have to add like a third dimension and create like a cube, right, which would just be super confusing to a lot of people. And so what happens is just inevitably, momentum kind of sounds like growth. So people just say, hey, momentum is growth investing. What you actually find is that there is some overlap, but it's usually depending on which value metric you use, like 20 to 30 percent overlap on price momentum, i.e. the winners on a price or return basis compared to growth stocks. So the overlap is actually not that hot.

Right, because if value snaps back and starts having ridiculously good performance, you could have some overlap there. And those value stocks could turn into momentum names. That's correct. Why not? I feel like this is a common question. Why wouldn't you identify value stocks with momentum and go all in on that? You could totally do that. That's not a bad idea. I wouldn't never say like, hey, let's not do that. I wrote a post on our site and I said, hey, how do you combine value momentum? And at the end, I said, hey, you can, if you took value stocks and within

them as opposed to splitting them all in quality, said, hey, I'm going to split on momentum. What do you see? Good things, right? You want to pick the value stocks with high momentum. we decided to stick with quality, which is really a form of operational momentum, i.e., because like a lot of our measures are like, hey, do you increase free cash flow? It's like operational momentum. But so we picked the quality split on value because when you compare that portfolio to a long only momentum portfolio, you get less correlation. So when you pair the two together, you actually get more portfolio benefits.

But I can't sit here and say, hey, within value, use momentum. I would say, yeah, that makes sense. We just chose to use quality. So pairing your two funds, your value and momentum is more of a diversification benefit where hopefully they kind of... They act very differently. Yeah, in a portfolio sense, you get benefits. So when you guys first heard about this, I don't know where you were or when it was

in your life, but momentum, I think you explained the one time as like the opposite of value. At least that's what I remember. But this is anathema to everything. How long did it take you for you guys to be like, wait a minute, this works. Oh, my God, this really works. holy shit we should have a product that it works so well what was that like evolution like i'll tell mine because my evolution was probably way harder than jacks because i came out of the religion of if you even mentioned technical the altar the altar of phama yeah well in before that though

ben graham warren buffett you're not allowed to talk about this stuff because in the you know him and charlie munger have all these things where they talk shit about people that even mentioned technicals and so i was part of that religion once you're in your tribe it's very hard even in the face of evidence to change your mind. But it's just one of those things where if you open your mind and you start studying and you start realizing, well, why do markets work? It turns out that the same reason value arguably works is probably the same reason momentum arguably works. So let's just stop being religious about it and start being rational about it. And oh, by the way, you actually get a ton of benefits by if I'm a crudgy old man value investor, which I used to be,

if you actually pull it with momentum. So I'm actually the one that's in the best. position to benefit from it. So it took me a long time. I had been through a former brainwashing as a Ben Graham guy, which I still am. Jack, what about you? I still always liked value investing. That was just how you, I think almost anyone does it. If you just learn DCF, now I came out from a math background. I have a master's in math. So I switched right to finance, kind of didn't do like standard financing, but you at least learn like discounted cash flows at some point. And if you're a value, you just learn that. You want to buy a stock that's cheaper based on your model. Like, when you discount cash flowers like we were talking about earlier, you think that should be a good

idea. So how did I come around to it? I just kind of with Wes reading a ton of these papers and saw, as Wes highlighted, momentum actually helps value investors the most, which is crazy. Of all the strategies to help a value investor, you have to do almost the exact opposite. You know the Paul Rudd meme where it's like, who'd have thought we were here? talking about how momentum got into your life, you 10 years ago, never would have thought that I would have been the biggest shit talker on the planet, on trend, too, both, all these things. I'd have been like, you're insane. It's still such a tiny fraction of assets and value.

Is this ever going to catch on mainstream? And maybe it's good that it does it because potentially that would actually alter prices. Yeah, I would say at the margin, yes, because in order to get momentum work, it requires way more turnover, i.e., the capacity is way more constrained. So if whatever it is, the $800 billion that had been flown into value, if that all of a sudden turned on in momentum, you know, that would probably create a problem. But thank God when you talk to any institutional investor like momentum, you're one of those weirdos. They just only do value. It's just weird, but at least in my experience talking to them.

And I don't know why that is, but it just is. All right, Wes and Jack, thank you so much for coming on. We will link to all of the white papers, the whatever names you named, we'll link to it if people are interested. and we'll look at the site and everything like that. Thanks again for coming on. Really appreciate it. Yeah. Thanks for having us.

Appreciate you having us, guys.