Invest Like the Best with Patrick O'Shaughnessy - Dan Rasmussen – Investing Through a Crisis - [Invest Like the Best, EP.163]

Episode Date: March 16, 2020

My guest this morning is Dan Rasmussen of Verdad Capital. Like me, Dan and his firm focus on quantitative research. Just a month before the COVID crisis hit markets, they completely and published a study on investing during periods of market crisis, which is the topic of this conversation. We discuss what works and what doesn’t during and after acute periods of panic in markets. I think you’ll find it extremely informative. Because Dan’s firm and my own share many beliefs about investing and conduct similar flavors of research, I try to offer devil’s advocate questions throughout. Please enjoy. This episode is brought to by Koyfin. For more episodes go to InvestorFieldGuide.com/podcast. Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub. Follow Patrick on Twitter at @patrick_oshag  Show Notes 1:54 – (First question) – What he sees in the markets today given the atmosphere right now 4:26 – An overview of their study: Crisis Investing: How to Maximize Return During Market Panics 8:38 – How things get more predictable during crisis 11:15 – The length of these crises and assets they focused on 12:40 – What happens to bonds and credit during these times 15:50 – Geography of crises 18:14 – How does this impact the philosophy of just index investing 20:40 – Positioning of value in this market 27:50 – Lessons from other crises 32:21 – Importance of a blended factor approach 35:44 – Role of momentum 38:10 – What else he is paying attention to during this crisis Learn More For more episodes go to InvestorFieldGuide.com/podcast.  Sign up for the book club, where you’ll get a full investor curriculum and then 3-4 suggestions every month at InvestorFieldGuide.com/bookclub Follow Patrick on Twitter at @patrick_oshag

This episode is brought to you by Coifin. I've become very interested in the best software tools in investing. And when I asked Twitter for the best Bloomberg alternative, the overwhelming winner was an excellent new product called Coifin. It's a web-based platform that lets you analyze stocks, ETFs, mutual funds, and other asset classes in one place. I've been using it every day to track what's going on in the market, and I think if you try it, you will too.

Coifin has a ton of high-quality data, powerful functionality, and a clean interface. The best part is that it's free. You can sign up at www.coiffin.com. A-O-Y-F-I-N.com. Hello and welcome, everyone. I'm Patrick O'Shaughnessy, and this is Invest Like the Best. This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money.

You can learn more and stay up to date at investorfieldguide.com. Patrick O'Shaughnessy is the CEO of O'Shaunicee Asset Management. All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaunsi asset management. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of O'Shaughnessy asset management may maintain positions and the securities discussed in this podcast. My guest this morning is Dan Rasmussen of Verdad Capital. Like me, Dan and his firm focus on quantitative research. Just a month ago, before the COVID crisis hit markets, they completed and published a study on investing during

periods of market crisis, which is the topic of this conversation. We discussed what works and what doesn't during and after acute periods of panic in markets. I think you'll find it extremely informative. Because Dan's firm and my own share many beliefs about investing and conduct similar flavors of research, I try to offer devil's advocate questions throughout. Please enjoy. Dan, great talking to you. Great to do this on short notice. I really appreciate it. I think a great place to start, given your area of focus and specialty, would just be on a lay of the land, what you've seen thus far in parts of the market that you focus on in your portfolios. And, then I want to go pretty deep into a study you put out not that long ago about investing through

periods of crisis and really take it piece by piece to share with the audience the lessons that you learned, I think, in a two-year research project. So this was not some reactive thing in response to COVID, but a long, careful study that you and your team have put together. So maybe you could begin with the lay of the land and then we'll dive into the research. This has been a very fast-moving sell-off, one of the fastest moving sell-offs ever, and it's been very dramatic. Obviously, we're nearing a 30% almost drawdown in the S&P 500. Small cap typically gets hit worse, is down nearly 40%. International small value, holding up a little bit better, but still mid-30s draws. So this is a pretty painful drawdown, probably the worst we've seen since 2008 in the data. We look carefully at the high

yield market as well. That market is sold off sharply. Triple Cs, which are the worst part of the market for high yield or down 15 since the end of January. Single B is down 10, double B is down seven, and then getting into investment grade, double A is down 1%, single A down 1%, triple B down 5%. That's even with the rates dropping. So it's been a punishing time to be in small cap value, punishing time to be in high yield, although relatively much less than being in the stock market. And even people in and P-500, I think, are feeling a lot of pain. And when you are talking to people, I think, you meet a range of different reactions from people from, can you please show me the comps to 1929 to should I start buying now or should I wait a few days? So you're seeing, I think,

the very wide spectrum of reaction from both from near total panic after a sharp drop in the market to folks salivating to get back in. But I would say this is a once-in-a-decade-type sell-off. And historically, if you look at the previous times when this type of sell office has happened, you've tended to see losses that range, let's say, 20% plus draw down the S&P 500 from here. If you look at 1987, maybe this is the bottom. If you look at 2008, it could go down another 30 or 40%. So a lot of uncertainty. It's gone down a lot.

And we don't necessarily know when things will hit the bottom, not that we ever do. Uncertainty is obviously a key word here. and I think drives a lot of market psychology, market action. The benefit that I think you and I always focus on of having data is the ability to build base rates, to try to separate ourselves as best we can from the particular circumstances that define this crisis, which are obviously almost always unique, with similar market reactions in the past to other events. And I think that is the true benefit of the study that you put out.

So I'd love you to just describe what motivated the study, what it is, kind of the basic methodology, and then we can get into some of the potentially useful results. Yeah, I think that base rate's view is key to our approach. So one of the things that we observe by studying, we spent about two years studying every economic crisis since 1970, which we define as any time high yield spreads went above 650s. So we define that one standard deviation above average. We like the high yield spread. It's a contemporaneous, very good economic indicator.

Ben Bernanke's thinks it's the best economic content. temporaneous economic indicator there is. And one of the things that we did, in addition to doing a lot of quantitative work, was go through and read the newspapers during each one of these crises to see what people were saying. Because I think that the psychology of crises is just about as interesting as the data. One of the things that I would note, there's a Stanford professor Mordecai Kurtz, who has a theory of rational beliefs, which is at any given time, there are a range of forecasts for what can happen. And those forecasts cannot be rationally disproven. So if you look at, for example, there's a betting website online called Metaculous. And if you look at the 25th to 75th percentile

expectations for how many people die of coronavirus, it's from 200,000 to over 20 million. So a range of beliefs, and nobody, by the way, can prove that 20 million is a better forecast than 200,000. We really don't know. And what you see going back, and who knows, I don't know, certainly what's going to happen with coronavirus. But we can look at these prior crises. And one of the patterns we see is the expansion of the breadth of rational beliefs at a time like this. If you look back with a prior crises, I'll read you a few quotes from them. This is from 19, these are all, by the way, from right around the bottom. So this is right around before stocks went up massively. In 1969, an investment advisor is quoted in the Wall Street Journal saying, the main excesses of the past few

years have scarcely begun to be liquidated. In 1986, an editor of a newspaper said, we're talking about a possible economic wipeout. A middle of 2000, they're selling the good with the bad, because they can. They're throwing everything out the window. I mean, the basic model of a crisis and what's happening now, right, is you have a massive expansion of the range of rational beliefs, massive uncertainty. And the reality is nobody, no matter how smart or how thoughtful, can disprove the worst-case scenarios. So today, we can't disprove the idea that this pandemic could kill 20 million people and shut down the U.S. economy for a year.

There's no way we can disprove that logically. We also can't disprove logically that there could be 20,000 deaths globally, and this could be over when warm weather hits, and the economy could be back to normal in June. We have no idea we can try to play out scenarios. But in every prior crisis, what you saw is people trying to game out scenarios, And I think the loudest voices and people that were most vocal in the media especially were the ones predicting the most dire outcomes.

And so one of the things that we observed as a consequence of that, I love this quote from Tolstoy and Anna Crenadies, is happy families are all alike. Every unhappy family is unhappy in its own way. And actually, bull and bear markets are like that too. Bear markets are all alike, but every bull market is different in its own way. And so what you see is because human behavior and human psychology in these moments actually becomes more predictable, returns and the data during crises become more similar and more predictable than they are in times of all markets, which is one of the things that we're fascinated by when we started studying these crises in death.

Can you say a bit more about this concept that things get more similar and are more predictable during these periods of time? What exactly do you mean by that? So during good times, money is easy. and as a result, a lot of stupid ideas get funded. And some of those stupid ideas, a few pivots later, turn out to be good ideas. A lot of companies that are kept on life support for a few extra quarters end up turning things around. So a lot of things that to a quant would look like extremely bad valuations or extremely low-quality stocks get bailed out by easy money by acquisitory companies when times are good.

And in contrast, highly cash generative profitable companies, if they don't grow or they don't meet the intersection of what investors really like or enthusiastic about that time, can see multiples just sort of contract for years on end. So in good times, if you think about it, what worked in 2010s was buying SaaS software. What worked in the 2000s, commodities and emerging markets. In the 1990s, anything with Internet in it. Every bull market, it's different. Fair markets are much more predictable, and we can look at that in a few ways. One of the ways we can look at it is looking at the classic pharma-french factors. And there's a recent study that found those factors are about eight X as predictive

during these times of economic crisis. And the way we look at it is to say, okay, let's divide the market into times when high-yield spread, months when the high-yield spread is over 650 versus months when the high-yield spread is below 650. In what percentage of months do the pharma-French factors outperform the market, depending on that? So if you look at high minus low, which is value, value wins in 66% of the markets. We're at normal levels and 91% where we're at crisis levels. If you look at CMA, conservative minus aggressive, it wins in 46% of non-crisis months and 74% of crisis months.

Small minus big wins in 51% of non-crisis months and 71% of crisis months. So what you see is that the predictability of these sort of quantitative tools and even very simple ones like buying companies with positive net income and positive operating cash flow doesn't actually matter all that much during times of easy money. But during a economic crisis, the returns to simply buying companies that have positive net income and positive operating cash flow is essentially double. So you just benefit much more from the quantitative rules. And I think part of that is because, and again, investor psychology and what happens in a crisis tends to follow a very predictable pattern. I just want to emphasize the importance of this idea of base

rates and maybe even factors during periods like this, especially because thus far in this period, value, which has tended to work in crises, has done horribly badly in the first. It's literally just a couple weeks, so crises can last a while. I'd be curious to know the central tendency of how long these crises tend to last in your research and kind of what the key asset class, we've talked mostly about equities. What key asset classes did you study as a part of the crisis base rates? So the duration of the crisis ranges quite broadly. So I'd say from the time that high yield spreads hit 650,

the shortest they've been there is one to three months. And the longest, which in recent memory is 08, they were there for over 12 months. So, and I think these things can go on even longer. The drawdown in the S&P 500 and 2000 recession was, I think, something like 18 months or so. These things can last quite a while. We looked at a whole variety of asset classes.

So we first looked at stocks and divided stocks by all the major quantitative factors. Then we looked at corporate bonds and divided those by most of the major factors that you can look at. And then we looked broadly at the other major asset classes. We looked at investment-grade bonds, corporate bonds. We looked at treasuries, the alternative asset classes, private equity, and distressed debt as well. Within the bond universe, I'm curious what your most interesting findings were when separating the dataset kind of binary above or below 650 basis points of credit spread. What works in bonds during a crisis? What are the areas of acute danger?

So within credit, we have this concept of fools yield. And fools yield is the idea that in normal times, there's a tangency point between the yield on a bond and its total return. And that tangency point tends to be at around the double B territory, which is just a notch below investment grade. So in today's market, let's say the market a few months ago, double Bs were yielding about four and a half percent in 2019. And we basically made the argument that above that four and a half percent yield, any incremental yield you were promised wasn't going to deliver because what it tends to happen is those companies go bankrupt at such a high rate that your yield is eaten up even more so by losses. So buying an 8% yielding bond, you end up returning four, buying a 10% yielding bond,

you end up returning four. So in a good market, you never want to reach for yield credit. It's always a bad decision. If someone, 2019, offered to borrow from you at 23%. The chances you're going to get that 23% are minuscule. So you want to find that tangency point and just sort of hang out there. And that tangency point always tends to seem like an unattractive yield. In this type of market, however, yield is actually a little bit more. beneficial, you actually tend to do a little bit better reaching for yield. So in credit, you actually want to start buying a little bit of the yield of your assets. So if you are someone who sits out an investment grade most of the time, now is the time to cut down into high yield. If you're a

high yield investor and you're a smart high yield investor who mostly hangs out in the high double B area, you know, now has a time to maybe look at some single Bs. Be very selective and judicious, but there are real opportunities created in the higher yielding portions of the credit universe. That said, all the standard factors that you might expect are really important. So if you're going to do that, make sure you're buying companies with very high free cash flow and high free cash flow relative to debt with a high ROE. And the opposite actually of stocks, bonds you want to buy size. So, and not size of the debt, but size of the company is measured by market cap or revenue or profits. The bigger companies are safer. So if you can get the same yield, but one.

one with a bigger company, you want to use the bigger company to get the yield. So that's the basic story in bonds in these types of markets. And for those investors who are thinking, wow, I want to buy the dip, I want to get back into this market. This could be a historic buying opportunity. High yield, especially the double B types of space, which is yielding today. High yields yielding a little over 800 to 8%. Double B is a little over 6%. For pension funds that have a 7% of return hurdle, this is a good time to be buying high yield. It's going to be safer than equities, it's less of a drawdown. So if things get worse, you're going to regret less diving into the market early. And the prospective returns, if things normalized in high yield, could be in the high teens or

low 20s. And actually in the last few crises, high yield returns have actually outpaced large cap stock returns in the first 12 and 24 months out of recession. Another key interesting area is the international nature of this current crises that's sort of a series of dominoes in terms of when it's starting to build in a specific country. Some of the crises in your sample set, for example, in 2010, really centered on Europe that everyone remembers well. Any thoughts on how to think about geography as part of crises in general and even as part of this specific crisis in particular? We focus this study primarily on the U.S. I'm not as prepared to speak about international markets, but I think that one big observation from looking at a variety of these crises is that you often do

paradigm shifts following them, that what worked going into the crisis tends not to work going out of the crisis. I'd say if you think about sort of the skill and cribdus of an equity investing in particular, those are overvaluation and bankruptcy risk. So don't pay too much for something and don't buy something that's going to go by bankrupt. And if you can sort of dodge those two quantitative investors or just people who have taken those two lessons to heart and then written them into laws, but I think most quantitative investing could probably be derived from those two fundamental laws that don't buy things that are too expensive and don't buy things that are bankrupt. But in times like this, I think it's prudent to say,

okay, we always don't want to go buy things they're bankrupt and good times are bad, so that should always be a filter. But what about overvaluation? And I would say that if you're looking for what is the most richly valued place in today's market broadly, I would say that there are, well, there are two places that are really, really overvalued. big and obvious ones in a lot of investors' portfolio is U.S. large growth. So big percentage of most total market indices, big percentage of the S&P 500, and very, very, very expensive relative to history. So if you're looking for where are you going to see, where could you potentially

see years of multiple compression, it's in U.S. large cap growth. The other area which is definitely as expensive is U.S. private equity, which is also, I think, if we talk about the skill of being overvaluation, the cribbeds being bankruptcy risk, is also. so the most levered part of the U.S. market. So I would say those are the places I'd say are most risky. And I'd say in contrast, international markets have been and continue to be relatively fairly valued, if not attractive. And after a decade of international underperformance, perhaps it's time for this crisis to bring that paradigm shift that crisis often do bring. It's interesting to hear you say all that when I was talking to some close investing friends this weekend. We were

discussing what is sort of the ultimate contrarian trade on a relative basis now. And it's basically like long, acquies short NASDAQ, and maybe with some small cap sprinkled in there, which gets you the value exposure for sure today. And maybe something around rising interest rates. Those are sort of the two things that have just ground in the same direction for this entire post-Global financial crisis period that I think require some careful attention for allocators, even though they've been wildly unpopular categories. Any comments on that on just the general idea of a reversion of this very longstanding trend of NASDAQ over everything? Yeah. Well, I think the one, I think important thing, and I think the thing that stands out is sort of the most obvious thing to do in this type of environment for equity investors is to go down in market cap. So if you think that there's one of the things that, again, you know, the tenor of things when I had to do this analysis for someone this week was to, you know, what happened in 1929? But what's interesting is you had a big crash, obviously that lasted from 1929 to 1932. And then the question is, well, how many years it take you to get back to the 1929? And the answer in large cap was 12 years.

But the answer in small cap was only four years. So in the four years from 1932 to 1936, small caps were up over 800%, which is sort of a fascinating fact. But that is broadly true of every economic crisis we've looked at. And every time that the S&P 500 has fallen this much, small caps have led the rally. I'm by a lot coming out, whether that's small value or small growth. Actually, both have beaten large cap. And usually small growth is a horrendous place to be.

But coming out of recessions, the size factor plays such a big role. So I would say that shifting down in size is a definite smart thing to do in my mind. And I think in terms of tech, I think we're still waiting to see. I think a lot of investors and me in particular, you sort of say, well, what's going to cause tech to lose? Because it just seems like it's kept winning for so long, winning on the fundamentals, winning on the valuations. And who knows what will be the catalyst for the paradigm shift with tech. But I think one of the lessons from COVID-19 is that we never see the catalyst coming for most major economic events are always a surprise. And the best way to prepare for surprises is to use

valuations, right, to avoid overvalued things that price in perfection, buy things that are left for dead that price in nothing. And if there's something that's priced for perfection now, it's the nests. It's no doubt that it's been a one-way trade. And obviously, you and I is a bit of a biased sample here in this conversation because we do a lot of the same type of research, I think, have reached similar conclusions about what kinds of companies should be in portfolios. But I'd love to hear a bit more, maybe even, I know it's been accentuated by this crisis in the last couple of weeks, but more of your thoughts around the positioning of value in general relative to the market measured by things like the spread and valuation, which we've thought a lot about

between the cheapest stocks and the broader market, whether in the U.S. or internationally. Any thoughts there? Yeah, yeah, a few thoughts. So I'd say first, one of the reasons we did this research into crisis investing is that we got a lot questions from investors saying, when's value going to start working again? You know, I've heard this story that value is a good thing to do, but I heard it in 2010, I heard it in 2011, I heard it well, I'm hearing it anew from you in 2018 and 19. I'm not sure I believe it again. So when is value going to start outperforming? I said, okay, well, let me go to a bunch of research. And one of the

things I said, well, again, we don't know really well what works in big bull market expansions. It's always something different that works. But actually in crisis, value consistently does seem to have worked. Now again, so far in this crisis, it hasn't. It's been a pain trade even more than it was. The stuff that was losing before this is lost even more. It brings to mind the Bible passage that to those who much is given, even more will be given and everything will be taken away. We're hoping not everything will be taken away from value investors. But I think that my answer to when value will start working again has been for a year or two, wait for the next crisis and then you're going to see valuation start working again and values start working again because the evidence suggests,

that if the base rates are a guide and value works 55% of the time in good markets, it works 70 to 80% of the time in bad markets, coming out of those bad markets. Coming in, it can be painful. And I think that you then say, well, one of the things we've spent a lot of time looking at is valuation spreads. Now, we're getting really into the depths of quantitative bwancuri at this point. But spreads, think about this as the ratio of the most expensive 10% of stocks to the cheapest 10%. And you can look at that. In the U.S., you can look at it internationally. And what you've seen is essentially a massive widening of those spreads. So the ratio between the most expensive and the cheapest stocks has gotten to levels we haven't seen since 1999. And the absolute valuation of the cheapest stocks is at levels that were last seen in 2008 or 1999, right prior to relatively value rallies.

And the gross stock valuations, again, are priced at extremely high levels. And so I think value investors, I think the argument from a quantitative perspective would be that usually value investing relies on multiple expansion in order to work that in your paper factors from scratch. As you rebalance these portfolios, the cheap stocks revalue up and the growth stocks don't grow as much as people thought, so they revalue down. And that multiple exchange is what drives the majority of the value premium historically. And what you've seen in contrast over the past few years is that spread widening has been

so punitive that value stocks have just kept getting cheaper as gross stocks kept getting more expensive. And that goes a large part to explaining why the value premium hasn't worked of late. And now what that does have, however, though, is like a coiled spring that you push down on and push down on and push down on and push down. Either the spring breaks or you see a massive bounce back. And I think when I look at the fundamental characteristics of a lot of value stocks today, they don't look like bankruptcies, risks, other than maybe some sectors like energy. But you're seeing a lot of very healthy cash flow, generative, net income, positive, high gross profitability, high return on equity businesses, trading at just crazily low multiples because they're out of favor. Just to try to

play devil's advocate, given how much I agree your assessment of sort of value stocks today, we stare at some of the portfolio characteristics and with sort of awe and wonder of the relative prices that can be had without sacrificing any or certainly a lot of quality in the portfolio. It's kind of striking today. But just to play devil's advocate, what do you think the best arguments are that the spring might indeed break, meaning that value as we see it in the data so reliably across the base rate data that to invoke that devil, it's different this time and value is not going to work? Have you heard good arguments to support that idea? And if so, what are they? Yeah, I think that the best argument to be made is that the quality of the growth businesses today is different. So growth businesses are

so high in quality that they're generating so much cash, so much in profit, and they're growing that profit at such crazy rates that you'd have to be a fool to not buy them. Look at Microsoft or Adobe or any of these other sort of total glamour stocks, that it's really hard as a fundamental analyst to come up with any reason why that company is bad. We're not going to keep winning. And I think that that's really what's driven the continued multiple expansion of those types of names, that if you look at the other factor that's sort of won over the past decade, that sort of worked, it's been really high ROE, ROIC companies like MasterC or Ferrari, where now went from being priced sort of with the market to being priced just a crazy premium to the market. But they're

really high quality companies. So you step back and sort of say, If indeed we are in this world where GDP growth is zero, where there's no economic growth, interest rates are zero, we should really prize those few high quality companies that can navigate this market. And in contrast, do you really want to own the manufacturing companies, the asset-heavy industrials, the energy stocks, the banks when rates are at zero that comprise a fair amount of the value benchmarks? And I think that there's a very logical argument to be head for that.

I just think that when you abstract away from, I think only a very good logical argument could have led to such an extreme valuation divergence. And I think that my view is that investing is not a game of analysis, because on an analysis perspective, would I rather own Microsoft than Exxon? Would I rather own MasterCard than Wells Fargo? Of course, just look at the financial statements. One is just a much better company than the other. On the other hand, the valuations, the meta-analysis is to say that analysis is priced in.

And not only today is it priced in, but if there was ever a time that that logical analysis was two or three-X over-priced in, it's today. And I think that we come back to this argument of them. People say, well, what's the catalyst for this to change, to which I say a recession or sometimes an economic crisis? And that's what we're in right now. So maybe my bluff will be called relatively shortly in a year from now, if value turns out not to have worked, then maybe it's breaking will have broken and we can do another podcast,

which I hang my head in shame. The Nate Silver of the 2016 election, and I'm the terrible base rate predictor of what's going to happen coming out of this crisis. I'll have to hang my head with you, so maybe we could do it together if it comes to pass. Any thoughts on the other side of crises? So we've talked mostly about periods during which the spreads are very wide, an indicator of acute fear, crisis, panic, whatever you want to call.

but certainly an environment we're in right now. Crisis end, in this particular case, like you said, the range of potential rational outcomes is extremely wide. But we do kind of know how this crisis ends, which is that the virus gets under control, hopefully sooner than later and as few people die as possible. But on the other side of crises, there's always another side. What lessons did you learn there?

Yeah. So I think it's key to understand the drivers of the crisis. And this is Ben Bernanke's work, which is really, really excellent academic scholarship. And he talks about something called the Financial Accelerator. It's a really important concept to understand. So the financial exciters Bernanke's response coming, something called the Small Shocks Big Crisis puzzle,

which is why does small shocks like to be big crises? Big graphic example. In GDP, US GDP growth was down 2.8% in 2009. Stock market is down 60%. That was actually a big shock that led to a really big crisis. but oftentimes we see tiny little shocks lead to very big swings in asset prices. And Ben Bernanke was trying to answer, why is that the case? Why, as Schiller has said, why are markets so excessively volatile?

And what he finds and what he argues is that you have a small shock. That small shock causes people to be uncertain. And certain people that are uncertain really matter. And that's the banks and those are equity investors and credit investors. So anyone that's investing or lending money who starts to say, you know what, I'm not sure now is the right time to go into the market, or I'm not sure I should issue that loan right now. Why don't I wait for a month to see how things are going and then I'll buy stocks or then I'll start lending again. And what that causes, that's the financial accelerator,

because then all of a sudden people get locked out of the credit markets and they got locked out a new equity funding. And that means that that factory you were planning to start building doesn't get built. And the construction company that was going to work on that, all of a sudden doesn't hire its construction workers. And then the construction workers who are going to go to that restaurant to buy food near the construction site all of a sudden aren't going. And then the financial conditions of the actual real world start to deteriorate merely because of the upstream financing decisions that got made as a result of the uncertainty about that shock. This is the accelerator. And that's exactly what we're seeing now. Small shock leads to big real-world economic decisions. High-yield

spreads out in the 700s. No new lending, no new M&A activity. People that were in the M&A process calling them off, people that were selling big assets, stopping them, people applying for loans, knowing that they're not going to get them. And so that liquidity withdrawal disproportionately affects illiquid and small companies that rely on financing. So in the public equity market, small caps, even worse, microcaps. In the credit markets, obviously high-yield issuers. Now, what happens is that when that liquidity starts to return to the market, the biggest whipsaw up is going to happen first in the companies whose decisions were fundamentally based on the availability of liquidity.

So the minute that industrial company gets the money for that loan, they hire the construction company. And so that stuff, that construction company's financials then have a massive upward swing. All of a sudden, the earnings forecast for that industrial company go way up. And so that's the type of thing where the market just dramatically recovers merely because liquidity has been returned to the market. So what you can think of now, as an investor, there's always a price for your capital. And the price for your capital is still relatively low if you're buying Microsoft or Google or Facebook. They're not up against a wall right now and might never be.

But there are a lot of small illiquid companies who are up against a wall who are saying, I've only got six months left of liquidity, and then I'm going to need to draw my revolver or something along those lines, and they are desperate for your equity dollars or for your lending dollars. And that's what you're seeing in the high yield spreads. That's what you're seeing in the microcap U.S. equity market. And so coming out of these crises, anyone who is willing to provide those companies with liquidity, whether through debt or through equity, that's what whipsawes out the fastest. And I think that's the best explanation for why small cap works so well, why value worked so well and why high-yield bonds work so well when you buy them in these types of crises.

Can you talk about the importance of a blended factor approach during periods of time like this? I know you studied individual factor spreads. Correct me if I'm wrong, but I think you, like us, believe in sort of taking multiple shots at an individual company or security to build models. And I'm reminded, as you talk, I'll never forget the statistic that in 2009 from the bottom for the first 12 months forward, the worst decile of momentum was up an average. of 236% from March 09 to March of 10. And the best SLA value, while not quite that extreme a number, was an unbelievable rebound in that period of time after obviously some serious pain. So just to throw another crazy stat on that for people to drive the point home, I'd love you to talk

about in that idea. Obviously, you don't want to be on the wrong side of that whipsaw, the idea of multifactor portfolio construction, model building, and investing. Again, I think it's the Scylla and Carbdis idea. The Silla is overvaluation. the crib, this is bankruptcy risk. And you as an equity investor are trying to stare, or as the credit investor are trying to steal your ship through those shoals. And I think the very basic idea of a multi-factor approach is to say, what are the factors that tell me whether something's overvalued or undervalued? And then what are the factors that tell me whether it's going to go bankrupt or not? And if I can use a blend of those things, that's going to lead me to them. So starting with value,

let's say that's half of your model, you're going to say, well, I want to look at companies that are cheap and I want to blend a variety of cheapness metrics because a company could be cheap on price to book, but they've got a lot of assets that don't generate cash flow or don't generate profits. So you want them that are cheap on PE multiple as well as price to book, but then sometimes earnings doesn't translate into cash flow or they're investing a massive amount. So you say, well, I also want it to be cheap on a free cash flow yield basis. So you blend all these types of value metrics to actually get the model to tell you what's actually cheap and what's not just a trick based on one of the accounting ways of describing it. So that's value you want to buy.

blend those together. In bonds, it's easy. You just take the yield and that's the price, so you're done. On the other hand, or you compare the yield to quality of bonds, but that's really a multi-factor idea. And then the other percentage of your model, right, is things that aren't going to go bankrupt. And so what you're really looking for in both stocks and bonds, positive operating cash flow, are they self-funding so they can get through whatever it is without getting whacked? Are they profitable? They're not taking massive impairment charges that are going to send messages to the bank. These people aren't creditworthy. And then when you complete, compare those cash flow and earnings metrics to balance sheet ratios.

Is the return on assets, whatever way you want to measure that, relatively good? Or is this company a melting ice cube where the return on equity or return on assets is lower than the cost of capital for the company? So it's just a self-liquidating venture. You don't want to do that. That's going to go bankrupt eventually. And then you can look at things like debt to assets, a short interest, things that are going to tell you very quickly whether the company is getting worse

and deteriorating. And blending a lot of those different things together, such that your model isn't missing things or isn't misinterpreting things or isn't getting too hung up on one thing, I think is really important in both stocks and bonds. And those multi-factor approaches help give you portfolios that are designed or really do what we're trying to do in the end, which is, again, to avoid overvaluation, avoid bankruptcy risk, and thus profit by buying and holding to a long term in both equities and credit. Any thoughts on the role of momentum plays? One of the questions that we've got consistently this week is, this is all great. You're modeling businesses for avoiding bankruptcy risk or impairment risk through your quality factors, but that could sometimes be based on data that is now in the light of a freeze in commerce, much less relevant for certain companies. And so how are you handling that? And basically our answer is momentum. As price changes, price captures a lot of information. And we can avoid the absolute worst momentum stocks that helps us sort of shore up that information.

if you will. Do you agree with that? What role do you think, if any, momentum plays before, during, or after acute crises? Yeah, and I think that momentum is a signal that's sort of telling you to be careful. And we think about it as the probability that all your other things are wrong. Momentum tells you, gee, this looks astonishingly cheap, but it's 90% cheaper than it was last year. And whoever's been selling it has probably been selling it for a reason. So maybe I shouldn't just naively buy it because I think it's cheap. And that's what momentum is telling you. I'd say, look, momentum is always important to consider. It's always a good risk mitigation tool.

I would, however, also say that if there is ever time to be a little bit lighter on the negative momentum, avoiding negative momentum, it's now because there are so many things that are getting thrown out purely because of their liquid. So I think that right now, you're looking for the stuff that has been sold off excessively, which is going to bounce back excessively. And so sometimes the pure momentum signal maybe is a little weaker at times like this than it otherwise would be. And I think certainly that's true on an asset class level. The stuff that has sold off worst coming into the crisis,

often stuff that performs the best coming out. And there's some truth to that even within the equity market. As you pointed out in 0809, that the stuff that got sold off worst, that worst desoph momentum rally the most, that's a dangerous game because you're trying to time because that's a risk tool. so you're taking off your risk tool a little bit. But if there was ever time to back off it a little bit, it's probably during these crises. Yeah, it's a classic example of trying to prepare and bake into models as much circumstance as you can. And while that stat is juicy, that 236 percent, the period leading into March 9th of 09 for those stocks was 90 percent down. It was absolutely vicious.

It is a delicate balance, but obviously process, I think, is key for any investor or quant or otherwise during this period. Any closing thoughts, Dan, on how you are postured against this market, maybe what you're watching most closely, anything that's important to you or you've been thinking about that we haven't discussed thus far? I think that it's really important. And I think probably the listeners to your podcast are not in this category. But I feel like I've been talking to so many people who are really, really scared and really even panicked by what's going on in the market. And one of the things they keep citing is they cite two things very often. One is you start around this time to get stories of, oh, my friend sold all of his stocks in

January because he knew something bad was going to happen. Why didn't I sell my stocks in January? The other thing is, I'm reading the newspapers, and it's just obvious to me that things are going to get worse. There's no way that economic conditions don't get worse. There's no way that coronavirus doesn't keep spreading, and the news about that gets worse. And those two sort of memes that spread through networks are sort of the common, very common things that we see in crises, at least from looking at newspaper reports, right? The most bearish people from three months ago all of a sudden get all the media attention

because they were right. And you know what? They're still bearish now. The guy that sold his stock in January hasn't flipped around and bought it again. He's telling you to keep selling your stock and he's buying puts because he thinks it's going to get worse because he was right the first time.

So the loudest voices in the room are the people that were right most recently and those people are the most bearish. And so the news reports, the media and your friend network is going to be massively full of the most bearish people's opinions. And I think the other thing to consider is that markets price things in before they happen well before they happen, right? So yes, business conditions are going to get worse.

Yes, the coronavirus is going to get worse for a time. But markets will go up for business conditions start going up. And markets will go up before the coronavirus starts getting better. As soon as we can rule out a set of rational beliefs, the tail end of the negative, worst end of the rational beliefs, as soon as that stuff gets ruled out, markets will start to recover. And so I think my counsel, and if there's one thing to take away from, studying every one of these prior crises, it's as much as possible, now is the time to rely on data. Now is the time to rely on base rates. And what base rates are saying very clearly is that now is a very good buying opportunity. And if not right now, because I think the data would also suggest that the true bottom often comes three to six months after the panic. starts. If not right now, then over the next few months is probably the best buying opportunity in stocks and bonds that we've been in for a decade. And all the voices of pessimism, all the experts

that are giving warnings, all of your friends that are telling you scary things and how right they were to be bearish three months ago, all those people, all those voices, you have to set them aside and act rationally. And I think the rational thing to do in this market is to start buying and maybe as much as your risk tolerance can take, maybe you start by buying high yield bonds, maybe you move into equities and I think with a focus on small cap and value. But I think that over the long term, 100% of panics in U.S. equities have resulted in reaching the prior peak. The markets are very, very resilient. And I think now is the time to more than ever rely on data and rely on plans that were come up in advance of these crises, rather than relying on narrative

of rumor panic or even expert forecasts as dire as those are right now. Well, this has been, as always, a great helpful discussion. Lucky to have had a lot of data that was sort of pre-baked, right, not knowing what the next crisis would be. Like you said, we never do. We're faced with one now. And I think no matter what, level heads are important, even if, as you say, this gets and seems a lot worse than it is even today,

which is Sunday, March 15th. So the perspective is hugely valuable, Dan. I really appreciate your time on a Sunday. and we'll catch up soon. Thank you, Patrick. Hey, everyone. Patrick here again. To find more episodes of Invest like the Best,

go to Investorfieldguide.com forward slash podcast. If you're a book lover, you can also sign up for my book club at investorfield guide.com forward slash book club. After you sign up, we'll receive a full investor curriculum right away and then three to four suggestions of new books every month.

You can also follow me on Twitter at Patrick underscore Oshag, OSH-A-G. If you enjoy the show, please leave a quick review for us on iTunes, which will help more people discover Invest Like the Best. Thanks so much for listening.