We Study Billionaires - The Investor’s Podcast Network - TIP 063 : Quant Investing with Patrick O'Shaughnessy (Business Podcast)

Starting point is 00:00:00 We study billionaires, and this is episode 63 of The Investors Podcast. Broadcasting from Bel Air, Maryland. This is the Investors Podcast. They'll read the books and summarize the lessons. They'll test the waters and tell you when it's cold. They'll give you actionable investing strategies. Your host, Preston Pish, and Stig Broderson. Hey, how's everybody doing out there?

Starting point is 00:00:30 this is Preston Pish and I'm your host for The Investors Podcast. And as usual, I'm accompanied by my co-host, Stig Broderson out in Denmark. Today we've got a great guest for you. Actually, we've got two guests on the show. A lot of people know one of the guests who we have a lot of the time, and that is Toby Carlow, and he's the author of Deep Value and Quantitative Value. He's joining us today. And the reason we invited Toby on the show is because we're talking about this field of study that everyone loves, which is Quant Value Investing. One of the leading experts, in the field is obviously Toby, but also the other leading expert in this field is Patrick O'Shaughnessy. If you guys remember, I think it was maybe two, three episodes ago. We had James O'Shaughnessy on the show,

Starting point is 00:01:13 and James was talking very briefly about his son Patrick. And so that's who we have on the show with us. So we are thrilled to have Patrick here. And Patrick comes with just a wealth of information. He is truly one of the experts in this field. He's written the book, Millennial Money, How Young Investors can build a fortune. He's also the founder of this website called the Investorsfield Guide.com where he posts all this free content where he talks about quant investing and a multitude of other topics. And on top of that, Patrick is also a portfolio manager at O'Shaunicee asset management. So with all that said, Patrick, we really want to welcome you to the show. Thank you so much for taking time out of your day to talk with us and to help enlighten our

Starting point is 00:01:54 audience with some of the ideas that you're going to share. Well, thanks very much for having me, guys. I've now listened to a bunch of the episodes. of your previous guests, a lot of whom I've known. So this is going to be a lot of fun to continue the conversation. Well, we're thrilled to have you here and we can't wait to jump into some of these questions. So Patrick, before we do that, I want you to really kind of provide our audience a little bit of a background and story about yourself and how you eventually found yourself following in your dad's footsteps. And for many people out there, they might see that you work at Oshonnessy asset management company and think that that's always been really a passion for you as

Starting point is 00:02:28 finance, but you have this really unique background and path and how you kind of arrived at that. And I really want you to share that story and kind of that background with our audience. Sure. So the unique path is an atypical field of study for someone that's in finance and then just pure dumb luck. So I'll explain how both of those played a role. But I studied philosophy in school. So I never took a single finance, actually not even a single business class. And when I graduated, I don't think I'd ever even used Excel. Certainly hadn't studied markets at all. And so my interest was really in philosophy and sort of an unofficial minor in psychology. And what I'm interested in is what makes people tick, how people think, how they act, how they behave.

Starting point is 00:03:09 And what I learned very quickly coming out of school was that the stock market specifically, it's probably the place that all the most interesting topics intersect the most. So it's like this one grand human psychology experiment. And so studying that was very interesting to me with my background. and an interesting, fresh thing to look at, given what I had been studying in school, which was sometimes esoteric German philosophers and things like that. So it was a nice change up to move from something totally unrelated, but a good field because it teaches you to think.

Starting point is 00:03:42 It teaches you to argue and reason and build a case for a style of investing or a particular stock you might want to buy. So there's a lot of crossover, even though you're not talking about markets at all. And then I just happened to graduate in the summer of 2007 right into the teeth of the worst financial crisis that we've ever seen. And I started as an intern. I didn't know what I wanted to do. Like a lot of philosophy majors, they graduate having no clue what's next. A lot of them go to law school or go to academia and those things were not for me. So I just started as an unpaid intern, literally like looking for office space and putting together chairs and unglorious things like that.

Starting point is 00:04:18 and very quickly just fell in love with markets and then had a kind of trial by fire in 0809 and have been doing research and portfolio management stuff ever since. I just got a piggyback question real fast, Patrick. So you're this quant guy. So when you think of a person who's a quant investor, you think hardcore math. And when I think of a philosophy major or a person who studies at for their undergrad, I think that's a person who's probably very English or literature, great at writing, background. And so you typically don't see people that would mesh and kind of jump from such a drastic change.

Starting point is 00:04:54 I mean, when I think quant investing, I think hardcore statistics. I think people that are just running all these algorithms, programming and things like that. And it's just amazing to me that you were able to jump into that realm without much of having a background in that. Did you study a lot of that on your own? Did you go and take more courses? How did you really kind of bridge that, I guess, that gap? There's a lot of things that fall under the quant umbrella or descriptor. And some of those things involve, you know, algorithmic pyrotechnics and crazy math and,

Starting point is 00:05:23 you know, a lot of trading. That's not really what we do. The better way to describe what we do is a sound investing strategy that's been systematized that we have identified through a lot of research, certain rules or DNA or common attributes shared by stocks that have tended to do well, and then build a systematic approach around those factors. And so a lot of those things we'll talk about them today sound a lot more like a fundamental investor might say about a different company than a quant. So there's a lot, there's a wide range of what might be called a quant. And I think that's

Starting point is 00:05:55 important to note that our holding periods are long. We'll hold some stocks for five plus years. It's very different from the high frequency trading type stuff that scares people and makes quant almost a four-letter word sometimes. That being said, there's definitely some catch-up I had to do after school. I went through the CFA programs. I'm a CFA charter holder, called myself, a lot of programming and statistics stuff. I did go through kind of the motion, not as easy as it's just jumping in with a philosophy degree, but the CFA did help a lot. I absolutely love how you just threw out. Yeah, I'm CFA, you know, certified. Like, that's no big deal. For the people in our audience that are listening, I'm just going to throw something out there

Starting point is 00:06:33 to get your CFA. It is so darn hard. I don't think people have any idea what he just threw out there. But that's studying for years. That's like going as deep as you can possibly go. That's one of the hardest charters you can possibly get. Those guys are like the Jedi Knights of Finance. So don't let them fool you by just casually throwing that one out there. I think what the CFA says about you more than anything is it's a testament to your ability to just punish yourself with studying. It's really just about the hours.

Starting point is 00:07:02 It's not particularly hard. You cannot pass without putting in the time. That's probably what it certifies more than the knowledge of finance. because I've forgotten probably 90% of it. Wow, that's amazing. I wish I had my CFA. I'm going to probably work on one of those here in the future. Yeah, I love the metaphor to be the Jedi of something.

Starting point is 00:07:20 I mean, we should always strive for that, guys, be the Jedi of something within finance. No, so Patrick, when starting your research, I find it really interesting that the companies that buy back the own shares most aggressively are performed the market by 3.3%. You also address that many high-conviction companies use, excessive amount of debt to do so. So as a stock investor, how worried should I be about debt being the funding for share buybacks?

Starting point is 00:07:50 I think buybacks in general is one of the more interesting topics out there today. And it's also become one of the main focuses of the kind of financial media. And I would say the majority of the stories are that buybacks in aggregate are bad. There are some very famous people out there saying that they're very short-term oriented, that it's about boosting stock price, that they're being done at the expense of research or investment, which would be better investments for the longer term. And what happens is that all these writers tend to paint all companies that are buying back their shares with one broad brush.

Starting point is 00:08:24 And the research that I've done suggests that there are a lot of different kinds of buyback programs and that the conviction level with which companies are repurchasing their shares, the simplest way to think about that is what percent of their shares outstanding are they're buying back in the last one year or two years. If you're buying back a few percent, that's arguably not a very high conviction bet on your own stock price, whereas if you're buying back 10 percent or 20 percent or 30 percent, that's a pretty big bet that your share prices undervalue, hopefully. That would be the best motivation for a big buyback program.

Starting point is 00:08:56 And what you find is that these low conviction versus high conviction firms perform very differently across history. So companies that have a combination of really good cheap prices, you know, low people, e ratios, low price sales ratios, things like that, that are buying back huge chunks of their shares have outperformed by a pretty considerable margin and done so very consistently through time. Whereas the lower conviction guys, they have outperformed a little bit. So they've outperformed, say, growth stocks that are issuing shares, like to think about a Facebook or something like that today, they've outperformed by a percent or so, but not nearly

Starting point is 00:09:32 to the same degree as companies with these high conviction programs. Now, are they all good? Definitely not. There's definitely concerns about debt and the use of debt to just sort of do a swap, a debt equity swap. But you have to remember that debt is not always a bad thing. And what I found in general is that while there are certainly offenders who have levered up to the hills in order to buy back stock, on average, companies that are buying back shares don't really look all that more levered than the rest of the overall market. So it's an easy narrative because it's, but there are definitely companies that do it for the right reasons. And those companies have tended to outperform. Yeah, and it's really interesting what you said, that the companies actually, like the most high-conviction companies, actually less leverage. That was something that surprised me whenever I saw that,

Starting point is 00:10:18 because it seems counterintuitive. But one of the things or one of the strategies that some companies might apply right now with the interest level being so low, is that they would issue bonds and then they will buy them back whenever the interest rate increases. Is that a strategy you think will be applied

Starting point is 00:10:35 by these companies, because that would really signal like a shrewd management. Or do you think it's a temporary thing we are looking at the markets at the moment? I think that if the last five years and maybe my whole career have taught me anything, it's to not make any investing decisions based on interest rate forecasts, because most everyone has been wrong and wrong for a long time. Now, if that strategy were executed properly, then yeah, brilliant strategy. Sounds good. One of the interesting things that we find historically is that if you take a simple factor

Starting point is 00:11:04 like debt to equity as a measure of firm leverage and compare debt to equity between companies and other similar companies. So a utility to a utility, a consumer stock to a consumer stock and so forth. The companies that actually do the best are ones in the middle of the distribution. So companies that use some debt but aren't the most leverage. So the worst performing stocks are the ones that have the highest debt to equity and actually the ones that use no leverage have tended to underperform as well. So some smart mix of leverage into the capital structure has been what's been rewarded. Now that, I want to be clear that that's not a factor that's nearly as predictive as something like value, which I think we'll talk about today as well.

Starting point is 00:11:44 But if there's anything to note from leverage historically, it's that the tail ends of the distribution have tended to underperform a little bit. So I just want to throw something out there, just to kind of piggyback on this. First, the reference that Stig had for that 3.3% that Patrick had referenced in one of his blog posts, we're going to have linked to that in our show notes so people can read that and kind of see a little bit more detail behind what we're talking about. But to throw some contrast to that argument, I just wanted to throw out that billionaire Mark Cuban absolutely hates share buybacks. I mean, hates them. We wrote this raging blog post about why he thinks share buybacks are horrible. So I want to have a link to that as well. And I want them to be kind of

Starting point is 00:12:25 right next to each other. So whenever you guys go into our show notes, you can kind of read both sides of this argument. Now, my personal opinion, and I really like the way Patrick described this, is that it's really all about the conviction. If the company's doing share buybacks at a really modest level, typically what they're doing with those share buybacks is they're putting them into their equity treasury account. And what they're then doing is then they're issuing them out to their employees as incentives when they're doing it at a very small and not much conviction behind it. When you have them doing it at a high conviction rate, they're actually saying, And you know what? We think our company's undervalued relative to the yields we're going to get by

Starting point is 00:13:02 maybe purchasing other equities or other operational investments within our company. And so what we're going to do is we're going to buy back our own stock because we know what we're buying. We know what kind of food we're cooking for ourselves here if we repurchase these stocks. And when they do that at a high conviction level, it's actually good for the shareholders. That's what Patrick's getting at. And I completely agree with that opinion. But I really want to throw that out there. I want people to see that contrast so they can read and make the determination for themselves. And I see Toby has a comment. He wants to piggyback on this as well. I would just say this. Sometimes it's important to think about the mechanics of what's actually

Starting point is 00:13:34 occurring versus sort of trying to detect it as an investor. So what Pat's talking about is detecting a company that's going to outperform subsequently. And that's something that's shown by conviction investing. But it's also helpful to think about the nature of the buyback. So a buyback that's undertaken at a premium to intrinsic value. I'd agree with Mark Cuban on that. that will destroy value and that's a bad thing. But a buyback undertaken at a big discount to intrinsic value does create value for the remaining shareholders. It may be that that doesn't necessarily show up immediately in the investment results. I think Pat, you would agree that when they're deeply undervalued and undertaking buybacks, that's a pretty powerful signal together.

Starting point is 00:14:16 It is a powerful signal and maybe just a few more points on bybacks in general because it's such a nuanced issue, right? There are definitely valuable and accurate criticisms of buybacks in aggregate. In aggregate, they've been missed time. The dollar value of buybacks peaked in early 2008, which of course was a terrible time to be buying huge chunks of your own equity. And the dollar values are peaking again today. I think it's crazy that people always focus on raw dollar values and not yields or percentages because the raw dollar value, the market's much bigger today. So it's a smaller percentage than it was in 2008. But still, it's still pretty high and elevated in terms of gross dollars being spent on buyback. So in

Starting point is 00:14:56 aggregate companies don't do a great job at timing their share repurchases, but those high conviction guys tend to do a slightly better job. And then we certainly wouldn't advocate just buying because of a buyback program as all sorts of other things you should look at, quality of earnings, debt levels, lots of other things that we could, valuations that we could talk about. But it does seem like those companies with the highest conviction do buy back at cheaper relative prices than the low conviction guys out there. So yeah, I think that it's really important to contextualize with what else is going on with the business. And the other thing that drives me nuts is, you know, you'll hear IBM has become the popular

Starting point is 00:15:30 sort of target for crappy company that's, you know, falling in sales quarter after quarter and it's a dinosaur and buying back their shares is burning money and so on and so forth. You have to remember that there's not some store that these companies can go to with high return on capital projects, that they can just plug in and start earning really impressive rates of capital. And sometimes buyback programs show a little bit of discipline on the part of managers behind these big companies because one of the worst things you could do for shareholders is start burning money on low return projects or investments. And it's not like these things grow on trees.

Starting point is 00:16:07 So, you know, IBM, just because it's not plowing all its money into R&D, doesn't mean that these buybacks are a bad thing. I love that you're saying that, Patrick. So if you go back two episodes, you can listen to Trink Griffin, the author of Charlie Munger, Complete Investor, and Preston, I talking about how bad IBM of this and how or above it has been wrong and why you should never do that as a value investor. So it's nice to see there's some nuance to the discussion. Yeah, so the fun thing about being a quant or a systematic investor is you own a lot of stocks, right? So I talk about, I'm interested in individual stocks as just sort of a side hobby.

Starting point is 00:16:45 And it's, I think, helpful to talk about them just to convey the principles that we're trying to invest based upon. But if you own IBM as a quant, it's going to be, you know, a tiny percent of your overall portfolio. And the goal is that a basket of stocks that kind of have that IBM-like profile, easy to hate, easy to build a negative narrative on, easy to talk about as value traps, for example, that a basket of those kinds of stocks tends to do very well. So it's key that you spread your bets, even though we're talking about individual name example. So who the heck knows what's going to happen with IBM? But they're a good one to talk about.

Starting point is 00:17:17 Toby, go ahead and hit up the third question. I do a huge amount of back testing. and one of the great things that I have access to is Pat, because I get these ideas that, you know, it's something odd that is just a little bit unexpected. And Pat has access to the best back testing system, probably in the world. And he's right in the weeds of it. He knows all of it in detail.

Starting point is 00:17:40 And crucially, he's very generously often available to me to answer my odd questions. So I was just wondering, what are some of the weirdest backtest results you've seen? And did you sort of subsequently sort of think through the result and work out why it was working and realize that it was a genuine kind of thing, not just the quirk of the data? It's a really interesting question. And maybe I'll use it as an opportunity to talk philosophically about back tests a little bit because they're becoming more and more popular. You're seeing more and more of these kind of logarithmic growth of a dollar charts that

Starting point is 00:18:14 show some strategy absolutely creaming the overall market and seeming to do it with ease over many decades. And the joke always goes in our line of asset management that no one's ever seen a bad backtest. Well, I've definitely seen a lot of bad back tests. And typically what they have in common is that there's something wrong with the test itself. You know, there's now a lot of services that allow people to enter in some formula and backtest it online. And there's consulting services that do this as well. And what I've found is that there are generally a couple big issues that people screw up when conducting back tests that lead to conclusions that make a strategy look a lot better than it is. So just to give you an example, the first would be the data itself.

Starting point is 00:18:58 So we're very reliant on a couple big historical data sets, and there's just no perfect data set. So these companies do the very best to have stripped out things like survivorship bias, making sure to include companies that have gone out of business, because after all, all you ever did was invest in stocks that kept surviving. You probably do pretty well. if you didn't ever invest in any of the losers. So things like survivorship bias, companies restatements that happen and are backfilled after the fact, some statistical issue. So just the actual conducting of the test itself and maybe finding that something works

Starting point is 00:19:32 when its T-Stat is actually completely insignificant. Making sure you do in and out of sample testing, there's just so much nuance to all of this testing that we do. And it worries me that it's become so popular because, you know, listen, if you test enough things at random, test 300 things at random, a small handful are going to look phenomenal just by pure chance. So you just have to be very careful with back test. That's kind of my broad opinion of them that, of course, they're useful and it's a great way to test the market hypothesis. But usually, Toby, when I see weird results, it's because I screwed something up

Starting point is 00:20:05 setting it up. Let's take a quick break and hear from today's sponsors. All right, I want you guys to imagine spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year, bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating on the front lines of history. This is where you hear firsthand stories from people using Bitcoin to survive currency collapse, using AI to expose human rights abuses, and building

Starting point is 00:20:50 technology under censorship and authoritarian pressures. These aren't abstract ideas. These are tools real people are using right now. You'll be in the room with about 2,000 extraordinary individuals, dissidents, founders, philanthropists, policymakers, the kind of people you don't just listen to but end up having dinner with. Over three days, you'll experience powerful mainstage talks, hands-on, workshops on freedom tech and financial sovereignty, immersive art installations, and conversations that continue long after the sessions end. And it's all happening in Oslo in June. If this sounds like your kind of room, well, you're in luck because you can attend in person. Standard and patron passes are available at Osloof Freedom Forum.com with patron passes offering deep access, private events, and small

Starting point is 00:21:38 group time with the speakers. The Oslo Freedom Forum isn't just a conference. It's a place where ideas, meet reality and where the future is being built by people living it. If you run a business, you've probably had the same thought lately. How do we make AI useful in the real world? Because the upside is huge, but guessing your way into it is a risky move. With NetSuite by Oracle, you can put AI to work today. NetSuite is the number one AI cloud ERP, trusted by over 43,000 businesses. It pulls your financials, inventory, commerce, HR, and CRM into work.

Starting point is 00:22:13 one unified system. And that connected data is what makes your AI smarter. It can automate routine work, surface actionable insights, and help you cut costs while making fast AI-powered decisions with confidence. And now with the NetSuite AI connector, you can use the AI of your choice to connect directly to your real business data. This isn't some add-on, it's AI built into the system that runs your business. And whether your company does millions or even hundreds of millions, NetSuite helps you stay ahead. If your revenues are at least in the seven figures, get their free business guide demystifying AI at net suite.com slash study.

Starting point is 00:22:52 The guide is free to you at net suite.com slash study. NetSuite.com slash study. When I started my own side business, it suddenly felt like I had to become 10 different people overnight wearing many different hats. Starting something from scratch can feel exciting, but also incredibly overwhelmed. and lonely. That's why having the right tools matters. For millions of businesses, that tool is Shopify. Shopify is the commerce platform behind millions of businesses around the world, and 10% of all e-commerce in the U.S., from brands just getting started to household names.

Starting point is 00:23:28 It gives you everything you need in one place, from inventory to payments to analytics. So you're not juggling a bunch of different platforms. You can build a beautiful online store with hundreds of ready-to-use templates, and Shopify is packed with helpful AI tools that write product descriptions and even enhance your product photography. Plus, if you ever get stuck, they've got award-winning 24-7 customer support. Start your business today with the industry's best business partner, Shopify, and start hearing... Sign up for your $1 per month trial today at Shopify.com slash WSB. Go to Shopify.com.com slash... WSB. That's Shopify.com slash WSB.

Starting point is 00:24:13 All right. Back to the show. All right, Patrick. So this is kind of piggybacking off of this conversation with backtesting. But when I think about all this back testing that people have been doing on the market over the past 50 years, I think it's important to highlight that interest rates have been at normal levels whenever you'd be looking at those results. And as we look at the current conditions and the expectation for future movements, interest

Starting point is 00:24:38 rates seem to be polarizing to 0%. Using Japan as an example for future performance in the debt markets, many think that those rates will continue to drop to zero or even negative moving into the future decade. Do you ever worry about the backtesting results that you've done in the past and that they might not necessarily correlate to the way securities will perform moving forward with that idea of this polarization towards 0%. Well, we're pretty lucky in that we've got data on just about every kind of market and macroeconomic regime, both in the U.S. and globally. So we can take kind of the core ideas that we're all about, which is, you know, really at the end of the day, it's ideas like valuation, momentum, return of capital, the shareholders, things like that.

Starting point is 00:25:21 And we can test those in the 70s in a crazy interest rate environment very different from the one we've lived through in the last 30 plus years. We can test it in Japan since 1989 to see, okay, value works everywhere. about in this weird deflationary kind of stagnant economy. And we can stress test these things. And for the most part, those key core ideas, and there's a lot of ways I know you can measure value momentum, et cetera, but those core ideas have pretty much stood up to every out of sample test, every macroeconomic environment, every different scenario we put them through. Of course, there's bad periods of underperformance, but they've always survived and tried. And I think the reason for that is the reason why the strategies work in the first place. So I know you had West Gray on the show,

Starting point is 00:26:03 And I think he and I would probably agree on this being more of a behavior story than a risk story. So that's the big debate in our world is, does value investing work because it's some risk that you're being compensated for? That would be sort of the gene pharma efficient markets view of why value stocks outperform. And then there's the behavioral explanation, which is that at extremes, the market overdoes it. So the market is a discounting mechanism. It's effectively making predictions about each individual stock's future. And so a value stock, it sounds great, but it's a nice way of saying really pessimistic expectations, really crappy company, bad outlook, and what we find, and then the opposite for growth,

Starting point is 00:26:43 you know, fantastic outlook, credible future growth rates, things like that. And what we find is that people over extrapolate and underappreciate the fact that markets are mean reverting. So IBM should trade a lot cheaper than Amazon. There's no doubt in anyone's mind. But IBM perhaps is trading too cheap. So the market has over-extrapulated its bad recent results in sales. And any sort of little positive surprise would catalyze an upward move in IBM and vice versa for a company like Amazon.

Starting point is 00:27:10 So I'm a subscriber to that behavioral explanation for why value works. And because of that, because people are not going to change, human nature is not going to change. Hey, guys, can we continue? I just want to continue the conversation on Amazon because I just want to hear your thoughts on this. So whenever I look at Amazon and everyone's trading it at ridiculous multiple, and they're really trading it off of the top line revenue. And what they're doing is they're looking at that revenue growth and they're saying, you know what,

Starting point is 00:27:36 if Amazon would choose to basically start making a 10% margin on that revenue, it would be priced at where it's at right now. That's how they're really doing it. They're basically saying that it would be a 10% and then they're basically using a market cap off of that. But the fact of the matters is they aren't choosing to have any margin at all. There's some quarters where it comes in positive. There's the following quarter it comes in slightly negative.

Starting point is 00:27:58 and it's Jeff Bezos's method to basically just keep growing his company like a weed and you're seeing his revenue, his top line revenue, just growing like a weed. Now, recently, I think you're starting to see the revenue start to taper a little bit and you're not seeing it grow at nearly the growth rate that it has in the past. And so my question to you guys is, what's his end state? You know, Monich Pabri has a great explanation. He says, whenever you have a human being that gets so big, it starts to become unhealthy for that person because they're so big and there's something that

Starting point is 00:28:29 biologically holds them back from basically functioning appropriately. He says, I feel like you see the same thing with businesses. Once they get so big, it's kind of like there's this barrier or like you're approaching the speed of light where you have to basically start slowing down. And so what's the end stay with Amazon and how is the market going to treat their market cap? I think they're going to get obliterated whenever we start to see their top line revenue start to taper off. I'm so heavy. you said that, Preston, because I don't know. Actually, I'm so desperate to figure out what Amazon is doing that I forced all of my grad students to make a valuation of Amazon. And they came up with like 30 different results because it's so hard to figure out. And to me, I think the whole point

Starting point is 00:29:10 is that do they have any pricing power? Like the whole business model and the way that they're scaled, they need to have some kind of pricing power before you can start to argument for the current valuation. And I'm not sure because they are competitive advantages is that they don't have any margins. That is at least what Jeff Bezos is saying that they have no margins. That is how we can keep competitors away. But I just can't see how they can start making any kind of money, like real money compared to the current valuation with the current model that they have right now, simply because the industry that they are operating in are just too competitive whenever they start to increase the margins. I thought it's probably not that interesting on Amazon. It's just one of those

Starting point is 00:29:48 things. I don't think you necessarily need to have an opinion on every single stock. It's just, If it's not in my screen, if it's not in the portfolios, I tend not to look at it. I don't really know in relation to Amazon, I don't think that, to Stig's point, I don't think that they are trying to be, they're never going to be the franchise-style company. They're just going to be the low-cost operator, which seems to have been a very successful strategy. They may just be able to deliver packages to homes cheaper than anybody else, and that might be their competitive advantage that's just impossible to a road because they become so well-networked

Starting point is 00:30:19 and so close to everybody that no one can compete with that. I don't really have any great view on the valuation. It's just, it's too expensive for me, and I don't short individual names. But it's yet another good stock to illustrate a broader general principle behind kind of value versus growth investing. You know, Amazon is a lottery stock. It's like buying a lottery ticket. There will be certain of these incredible growth, incredible company stories, stocks that do extremely well in the next 10 years. This past decade it was Apple. And Apple earned out its outrageous. just pricing at different times, right? So, you know, if you do some back of the envelope stuff on

Starting point is 00:30:56 Amazon, they'd have to grow. Let's say they'd just grow with the market over the next 10 years or so. They have to grow their earnings, their bottom line at like 55% a year. That's happened before. It's about 0.3% of the time, which is a tiny, tiny percentage, but it has happened. And Apple's one of the companies that did it. So there are these kind of darling growth names that work out. They're the winning lottery tickets. But certainly, by the same logic, I wouldn't suggest to go buy a lottery ticket. We know that that's a bad idea. In general, through history, buying stocks like Amazon has been a really bad idea. But of course, we just don't know whether this will be the one stock that proves to be the exception that keeps people playing this game. Because now everyone

Starting point is 00:31:37 wants the next Apple and it seems as though Amazon might be that stock. It's an amazing company that we all use and all love. It's just priced outrageously. I love that metaphor that you use because there's so many people that say, if I would have just bought Microsoft back in 1990. And it's almost, you might as well just say, I wish I would have went out and bought that lottery ticket that won. Because that's really what you're saying is as far as probabilities go, like Patrick threw out the odds.

Starting point is 00:32:06 0.03%. Was that correct? Yeah. Yeah. So that's, to put that perspective, that's like nine times rarer than hitting a single number and let, you know, to put some numbers on it. So for the next question, we're going to talk about Wesley. gray actually. And I think people on the podcast know West, we had him on. And this is really starting

Starting point is 00:32:27 to become a family podcast. And I'm really saying that, well, I smile on my lips here because we had Patrick gone, we had his dad on. Now we're talking about Wes, which Toby wrote a book with, and Patrick before the show, just told us that he went out with two weekends ago in Vegas. So this has really turned into a family podcast. But Preston, I really come from a foundation of value investing. And we had Wesley Gray on the show the other day and he started to talk about momentum investing, which was something that was not really on our radar, which is basically the principle of buying stocks whenever they have soared and then hope that it will continue to increase in price. And it might seem like the opposite of value investing. It might seem like something

Starting point is 00:33:12 you shouldn't do if you're a value investor. But I've seen in your research, Patrick, that you have actually found that if you have a portfolio with 70% in value stocks and 30% momentum stocks, it's actually the most optimal portfolio mix you can have. Could you please elaborate on your findings? Sure. So first, I use the word optimal very delicately, optimal in the sense that in the sample of data with which we have to work, that sort of blend of 70% value, 30% momentum in a very simple test produced the best sharp ratio. I can all but guarantee that in the next five to 10 years, it will be some other mix other than 70-30 that proves to be best. Who knows what it's going to be? The broader point, though, is that there does seem to be some advantage of mixing these ideas

Starting point is 00:34:01 of value and momentum, which on the face of it seem like opposite things, right? So value stocks often have gone down, have bad momentum, and growth stocks often have good momentum, right? So it almost seems like you're talking out both sides of your mouth. But it's important to know that they're very different strategies. And the difference really is about time horizon. So when you buy value stocks, that's a strategy that works for a very long time. If you buy a basket of 100 value stocks today, on average historically, that group of 100 companies will keep outperforming for five years or longer. It's a very low turnover strategy values overall. Mementum, in contrast, is a much higher turnover strategy. So the idea is like value and you buy something because it's cheap, with momentum,

Starting point is 00:34:42 you buy something because it's gone up a lot in the last three to 12 months is typically the window that people look at. But the difference is that you need to trade that a lot. So tax-sensitive investors, people worried about capital gains, that sort of thing. Momentum's not probably nearly as helpful. But it has been a strategy that's worked very, very well, just like value has, so long as you're kind of rebalancing at least annually, typically more often than annual, say every six month or even more frequently. But momentum does work really well, and it works really well in combination with value. And your worst case scenarios historically would have been much better than if you had been 100% value or 100% momentum, that you had some sort of blend.

Starting point is 00:35:23 70-30 works great. 50-50 works great. 40-60 works great. I think the exact blend is less important. The more important idea is that you can use more than just one factor to create a better overall strategy. So Patrick, I think it's important for us to highlight to all the listeners. We're going to have a link in the show notes to the article that Stig's referencing for this 70-30 split so you guys can read more about this. I'm curious because I really don't study anything to do with momentum investing. I'm typically just straight value. And so I'm very curious to talk about this a little bit more. And I think a lot of the people in the audience would be as well. When you say you're looking at this three-month to 12-month horizon and you're talking about price basically going on.

Starting point is 00:36:05 What else are you looking at? Are you looking at the revenue? Are you looking at the net income? What other factors are you looking at in addition to that price? And how is it correlated to price? I guess is where I'm really interested in no more. So we focus pretty exclusively on price momentum, on total return of the stock. There are other versions of momentum, kind of short-term earnings, sales. Sometimes you can even look at the revisions of analysts, sell-side analyst estimates on stocks. It's something I've seen people do when talking about. momentum. There's some efficacy to all of them. What we find is the most predictive or most successful at picking stocks that go on to win in the next year or so is that strict price movement over the last three to nine months. It sounds pathetically simple. And we all know that chasing performance in general is a really bad idea. But the chasing a performance that usually happens is people chasing some asset class or some strategy that's worked over the last three to five years, not over the last three to five months. So momentum is a much shorter term signal.

Starting point is 00:37:08 Certainly don't chase a five-year winner because those tend to mean revert, but that shorter term momentum does seem to be predictive. Now, do you get better results depending on where you're at in the credit cycle? So let's say it's 2008, 2009, you know that you're kind of in the depths of a very deep recession at that point. And basically, you're starting over with the credit expansion at that point. Does this momentum strategy work better during that time period versus where we're at today where you're basically topped out at the end of this credit cycle? You're basically chasing something that might really end bad. Is there a timing in that credit cycle that this strategy works better than other times? It's easier to answer in terms of market cycles than credit cycles,

Starting point is 00:37:50 just because the answer is a little bit more consistent. So when momentum tends to do well is in kind of the rising bowl trending markets. So periods of kind of established and rotating trends, where it tends to do really, really badly, and this is one of the great difficulties with being a momentum investor, is in the initial period following a severe bare market bottom. So if you think back to March 2009, this happened in the early 2000s, in the 1970s, in 1937, coming out of the initial part of a bare market bottom. So go back to March 2009. What happens with momentum, is what we call a factor crash. You can think about a market crash where the market goes down. A factor crash is where what normally works completely gets inverted. So now all of a sudden

Starting point is 00:38:36 it's the low momentum stocks that are killing the market, the high momentum stocks that are going nowhere. A value factor crash would be expensive stocks like what we've seen this year and really expensive stocks outperforming, cheap stocks underperforming. That would be a value crash. So momentum has these factor crashes coming out of bare markets and they're extreme. And they can take years for the momentum strategy to work its way back into positive excess return territory. So it's not for the faint of heart and you have to understand that while that has been pretty consistent, meaning you want to be out of momentum at bottoms, we know that it's impossible to time these things. So sometimes, you know, you have to stick with it through a couple cycles for it to

Starting point is 00:39:16 really be rewarded, but it does really badly coming out of bad bear markets. I'm going to shamelessly advertise myself here because I wrote a few blog posts about momentum investing and value investing and why I am still a value investor and not momentum investor. So I would make sure to link to that in the show notes. But the thing is really, really interesting because if you're really into quantum investing, you might also come to a point where you don't care if it's because of a value factor or if it's because of a momentum factor that you up to up to market. And I'm actually really curious to hear your take, too, because you're, first of all,

Starting point is 00:39:51 you're smarter than I am and you've been studying momentum a lot more than me. So being a 100% value guys, in my opinion, have you changed your approach to quantum investing and included momentum investing? Thanks, Stig. I don't think that I'm smarter than you at all, but I'll tell you what I, I've had a little bit of an evolution, mainly from spending time with Pat and Wes and Meb Faber as well. The thing that you find when you're running a value portfolio, it does have these periods of underperformance. And this is a good year to illustrate that where the market is very strong, I say it's the tail end of a ball market, but there's no evidence yet that that is in fact the case. It's just a market that's gone up a lot and has sort of seemed to slow down. I think you see value starting to sell off. So value sort of started selling off six to 12 months ago.

Starting point is 00:40:38 And I sort of attribute that to value guys serve this mean reversion function where they buy these stocks that have beaten up. But there's a point where the market just gets too expensive. Individual stocks become too expensive and they don't perform. that mean reversion function because they don't buy those stocks because for them they're still not sufficiently cheap. And so I think that's why you see the drop in the value stocks. And so it's very helpful to a pure value strategy to have some momentum in it in a period like this because the momentum stocks have worked over the last six to 12 months. Is that right? Pat, have you seen that? Yeah, for sure. I mean, it's been, now a lot of it is concentrated in just a handful of names,

Starting point is 00:41:15 you know, Facebook, Netflix, Amazon, and so on. But definitely, value has gotten crushed. And the more value your portfolio, the worse you've likely done. The more kind of trend following momentum, your portfolio, the better you've probably gone. So this has been one of the starker years since the late 90s for that inversion. It's a phenomenon that happens regularly enough that a portfolio that has that blend. So that particular article that Stig was talking about of yours, that was long only, right? That wasn't long short? Yes, long only.

Starting point is 00:41:42 So just being long only and using, I don't think you were necessarily taking 70% stocks, you were just using 70% factor blend versus value versus momentum, right? 30% momentum. That was the one that gave you the best sharp ratio. But it also had this effect that where value did really all in the late 1990s, the momentum kind of picked up that blend. So it didn't crash as badly. And similarly, when late 2009, when momentum had the big crash,

Starting point is 00:42:08 momentum underperform value sort of picked it up. And so it doesn't ever seem to win, but it doesn't ever lose very much either. and it's always in the best-performed sort of group. So over a period of time, it works the best. Yeah, I mean, the basic idea here is, as investors, what we're trying to do is find stuff that works that has low correlations with one another, right? If you can find two things that work that work at different times, and that seems to be the case for value momentum, that they are negatively correlated, meaning kind of on a rolling

Starting point is 00:42:37 three-year basis. When one's working, odds are the other one is not. That tends to be long short run. It works. If you look just at excess returns of like a top, if you bought just the top 10% of the market by value and the top 10% by momentum, it just went along only those two strategies. The excess return would have a negative correlation typically on a rolling three-year basis. So there are dissimilar strategies. When you can find a stock that has really good valuations, but it also has decent recent recent trends. So kind of a chief stock that the market is just beginning to notice, some sort of catalyst. That's tended to work pretty well. in combination. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI powered platform. So whether you're prepping for

Starting point is 00:43:37 a SOC two or running an enterprise GRC program, VANTA keeps you secure and keeps your deals moving. Instead of chasing spreadsheets and screenshots, Vanta gives you continuous automation across more than 35 security and privacy frameworks. Companies like Ramp and Ryder spend 82% less time on audits with Vanta. That's not just faster compliance, it's more time for growth. If I were running a startup or scaling a team today, this is exactly the type of platform I'd want in place. Get started at Vanta.com slash billionaires. That's Vanta.com.com. Ever wanted to explore the world of online trading, but haven't dared try? The futures market is more active now than ever before, and Plus 500 futures is the perfect

Starting point is 00:44:26 place to start. Plus 500 gives you access to a wide range of instruments, the S&B 500, NASDAQ, Bitcoin, gas, and much more. Explore equity indices, energy, metals, 4X, crypto, and beyond. With a simple and intuitive platform, you can trade from anywhere, right from your phone. Deposit with a minimum of $100 and experience the fast, accessible futures trading you've been waiting for. See a trading opportunity. You'll be able to trade it in just two clicks once your account is open.

Starting point is 00:44:58 Not sure if you're ready, not a problem. Plus 500 gives you an unlimited, risk-free demo account with charts and analytic tools for you to practice on. With over 20 years of experience, Plus 500 is your gateway to the markets. Visit Plus500.com to learn more. Trading in futures involves risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus 500, it's trading with a plus. Billion dollar investors don't typically park their cash in high-yield savings accounts.

Starting point is 00:45:31 Instead, they often use one of the premier passive income strategies for institutional investors. private credit. Now, the same passive income strategy is available to investors of all sizes thanks to the Fundrise income fund, which has more than $600 million invested in a 7.97% distribution rate. With traditional savings yields falling, it's no wonder private credit has grown to be a trillion dollar asset class in the last few years. Visit fundrise.com slash WSB to invest in the Fundrise income fund in just minutes. The fund's total return in 2025 was 8%, and the average annual total return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before

Starting point is 00:46:22 investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. And I just want to highlight one other thing here, Patrick. So what I find fascinating about what you guys are talking about is right now where we're at in the cycle, momentum is doing really well, values not doing nearly as well. But we're at that point in time where maybe you could have this market completely change around very quickly. And you could see those two strategies flip very quickly and very drastically. So for that person who's listening and hearing momentum's doing really good and you're kind of late to the game and you start jumping on that bandwagon,

Starting point is 00:47:07 you have to realize this is the point where cycles can potentially shift very drastically and what could turn out to be the strategy that works really well, could actually be the strategy that really you get punished with if you get into it too late and it comes down to this timing piece. So where I think that, and this goes at the heart of Stig's original question, when you're combining these two strategies, together and you're just doing it from a quant and you're doing this across a multitude of different picks and you're not trying to time it. You're just saying whatever happens, I'm going to stick with this strategy. That's how you can implement it successfully, but not picking one or the other or trying to do this timing piece.

Starting point is 00:47:48 That's where I think people can really get themselves on a lot of trouble as they're hearing this conversation. So I just love that exchange. It's the first I've really dove into any of this before. And I'm assuming a lot of people in our audience have never heard this either, but just an amazing amount of information. So with that said, Toby, go ahead with your next question. Backtests are kind of, I think, Stig, you had a great quote yesterday. It was a Henry Ford quote where it was something like imagination without execution as hallucination, something like that.

Starting point is 00:48:17 Kind of like that's, back testing is just pure sandbox toy playing and the rubber only hits the road when you start implementing the strategy. So the question that I had is, did you have any back tests that you were confident in that when you traded them, they didn't work? And did it sort of reveal something about either the back test or the factor or that's kind of interesting? Yeah. So there's a few things. And it's a great quote that well describes back testing because maybe the worst sin of back testing is the false sense of security that it imparts on potential investors. You see one of these four or five decade tests that shows five percent a year out performance and really consistent win rates and all these great stats.

Starting point is 00:49:06 And it just makes it seem easy, right? And markets are just way too efficient for that. None of this is easy. It takes a tremendous amount of discipline and metal for any of this stuff to work. And, you know, a three-year period or a five-year period of underperformance seems like nothing if it's, you know, between 1980 and 1985 and it's in your back test. But having now been doing this for, you know, almost a decade and having lived through myself, a lot of money professionally managed in these strategies and having lived through periods of underperformance,

Starting point is 00:49:35 I can tell you it is extremely difficult to stick to your strategy when it's not working. And because there's more and more back testing coming on and more strategies that seem like they work historically, it's going to be easy for investors to hear the hot new backtest. Now it's not going to be the hot new stock. It's going to be the hot new back tested strategy that people will jump between and overtrade and do all the same sins they did with individual stocks. So for anyone listening, I would urge you that to use back testing as a useful tool, and it's a great way to find good strategies.

Starting point is 00:50:06 But the more important thing is to come up with a basic strategy that you can stick with and believe in, and then just never change it. Because I guarantee in three years a guy like me is going to publish some great new factor or some great new strategy, and it's going to be tempting to say, well, I liked value and momentum combo, but it hasn't worked for the last five years, and this seems more interesting. So let's roll into that. And I guarantee it'll be missed time. So back testing is useful, but just be careful.

Starting point is 00:50:31 It's more about finding something that makes sense, that's worked historically, and then just sticking to your guns for 20 years. So just that big caveat because I think that's so important for potential investors in these strategies. In terms of stuff that hasn't worked when we've expected it to, I think a lot of quants would give a similar answer, even though it's become a popular new category. And I'll call it broadly quality factors. So things like return on capital.

Starting point is 00:50:59 or return on assets or return on equity, different measures of margin. There's a lot of different ways of looking at quality, low volatility of earnings, things like that. And what we find is that these factors are somewhat useful, but they're not useful in the way that sounds good. So you often hear people say like the Warren Buffett, you know, your guys' expertise is around famous billionaires who have been really successful investors. So Warren Buffett's mantra is buy good companies at good prices, or at least the, that's the major stage of his investing strategy after he got over the early Ben Graham stuff. And it doesn't really work as well as just pure value, momentum type investing. Quality, what we find useful is to avoid the absolute worst stuff out there.

Starting point is 00:51:45 So companies who have horrendously suspicious cash flows. So they've got, you know, say great earnings, huge earnings growth, but no cash flow growth. So it's all coming from accruals or something like that. Weird stuff going on with their inventories. There's all sorts of these little earnings quality things you can screen for that it's helpful to avoid a very small group of stocks, but it's really not helpful historically or hasn't been to buy the absolute best balance sheets, the absolute best return on capital companies, the absolute best earnings quality.

Starting point is 00:52:17 That sounds like a good strategy, and you hear a million value investors say good companies at good prices, but it would probably be better served just going with the good prices part. Hey, so Patrick, you have this fantastic blog called The Investors Field Guide. And for anybody that wants to look this up, it's the investorsfield guide.com. The site is 100% free and full of comprehensive ideas and thoughts on quant investing, among many other topics that you cover. Tell our audience about your site, but more importantly, why do you do it for free? I mean, why do you put all this information out there on the net and share everything that you know

Starting point is 00:52:52 and just to help people out? I'm just really curious what motivated you and what put this passion that you have for investing into this website? Well, people learn a lot of different ways. I happen to learn by writing. So my passion is reading. I love to read. I'm a huge reader.

Starting point is 00:53:08 We'll talk about books in a few minutes here. You always do it on your show, which is great. But really, where I learned something and it can really get a concept or an idea down is by reading a lot or doing a lot of, you know, hands-on research and then trying to put it into a cohesive, comprehensive, and understandable narrative. And so really it's just like an outlet for me to kind of do that in public. And it creates a fun interaction with other smart, interested investors who want to talk about these ideas because, you know, it creates a forum for engaging with other smart people. So it's really just, I just think about it as like my learning in public.

Starting point is 00:53:45 And sure, it's all free, but I'm getting a lot out of it. And I also don't publish everything, you know. So there's certainly with more and more people doing these kinds of strategies, I don't want to say that value has been. become a commodity because it hasn't. There's a lot of nuance to value investing. But with more and more people doing kind of plain vanilla value investing, you know, you don't want that as a value investor. You want as few people doing your strategy as possible. So I'm not published, I say me, this is me and this is our whole firm. It's a big firm and I'm guilty of using the word I too often. But our firm in general is going to, you know, keep some stuff close to the best.

Starting point is 00:54:20 But I think that sharing information and educating investors is a good thing because we've also learned that no one is going to be able to stick with these kinds of strategies unless they know a lot about them and are well informed. And that's our responsibility as asset managers is not just to pitch a track record, many of which are really good, but to say, here's why it's going to keep working. Here's what we're thinking about. Here's all the psychology behind why this stuff works. So I think sharing all that is actually self-serving. It's a way for us to learn. And it's a way for investors in these kinds of strategies to, build the confidence to stick with them when they be battling.

Starting point is 00:55:00 And this year is a great example. It's very Buffett. Like Buffett has said about his end of year, his shareholder letters, that he doesn't know what he thinks until he writes it down, which I always found really interesting because they're so insightful, but he doesn't order his thoughts until he puts them down on paper. Yeah, we're really the enemy of Patrick here. Like the three of us, we really promote value investing and tell everyone to start their own value investing career.

Starting point is 00:55:24 So we're not good friends of Patrick, I'm sure. No, so Patrick, speaking about books, we'd love to provide great book recommendations to our audience. And if you could recommend one or perhaps more books to an audience that is not your own, linear money, or your dad's what works on Wall Street, do you have any great book recommendations? So this is a hard question for me because maybe the most successful part of the whole website that I started was a little side project within the website that's called the book club. And I've always read probably, you know, I have one and a half kids now, but before I had kids, I probably read 150 books a year. And even now I probably read, you know, 80, 90, 100. So I've always

Starting point is 00:56:08 read a lot and people have always asked me for book recommendations. And so I figured that I would create like an email list and just once a month send out, you know, three, four, five different books that I've really liked and some reasons why and kind of build a little narrative around it. it's become really interesting because it's about 5,000 people now. And whereas it had started with me pushing recommendations, it's actually now become my main source of getting recommendations for books myself. So it's completely inverted where I don't have to search for books anymore because every month I ask, you know, if you're reading something good, let's email about it. So it's very hard for me to pick just one. So maybe what I'll do is I'll cheat a little bit

Starting point is 00:56:47 and inspired to do so based on something that Toby just said or about Buffett. And so what I'll recommend is a group of essays by a guy named Paul Graham. So Paul Graham is an entrepreneur kind of philosopher and started a company called Y Combinator and earlier in the 90s, a company that helped businesses put their businesses online, like early e-commerce stuff. All of these essays are free. And a small portion of them are actually collected in a book that's called hackers and painters. So he's been doing this for a long time. And he is probably my favorite writer over the, at least of people that I've discovered in the last three or four years. And the reason is that he's really a philosopher. He's teaching people how to think about business,

Starting point is 00:57:34 about competitive advantage. Probably the best essay to get people started to see if they like his style is one called What You Can't Say. So it's like him walking you through basically a way to find contrarian ideas. So, you know, this whole thing about Peter Thiel and zero to one, which is another good book, is you want to find a contrarian idea. Same thing with investing. You want to find a strategy that nobody else is doing. How do you do that? You know, Patrick, it's funny because I think it was in Tren Griffin's book on Charlie Munger that I read this. They were talking about how profound Charlie Munger is and his ability to just dissect things and just intuitively understand how things function and work. And they attributed it to this

Starting point is 00:58:14 idea that you're talking about where Charlie studies so many other things outside of value investing in finance and things like that. And so he studies physics. He studies, you know, law. He studies all these other things. And he really, and a lot of people attribute his ability to understand how finance and business works so well because he's ventured out and thought about things in that same exact manner. So I love those book recommendations. I'm really excited that your first recommendation is for free online. So just go to our show notes. You can click on that link and we'll have exactly what Patrick was talking about so people can go directly to that. So something we want to throw out to everyone in our audience is we offer a free

Starting point is 00:58:52 audio book download if you go and use our link on our show. Anywhere on our website, you'll see that we have this link where you can go to the source called audibles.com, and this is the platform that Amazon uses. So if there's a book that you want to listen to, this is how Stig and I read all of our books when we're driving in our car or traveling. We can listen to our books and do multiple things at the same time. You can get your very first book for free. And some books are $30.

Starting point is 00:59:16 So you could get that completely for free if you use our link on the show. So at this point in time, we want to go ahead and transition into the question from our audience. And this week's question comes from Hugh Wynne. Good morning, Preston and Stig. This is Hugh Nguyen, second year mathematics students in University of Waterloo, Canada. Thank you so very much for providing such high quality information about the investment world. I truly appreciate your work. Today, my question is about the importance of the interest rate in the current economic

Starting point is 00:59:47 condition. According to what I read, in the Bloomberg lab in my school, the U.S. inflation rate is struggling to meet the 1% range, which is abnormal compared to the ideal inflation rate of 2% to 3% annually. What is some good reason for the Fed to raise or not to raise the interest rate at this point in time? How does it affect businesses within the country as well as the global economy? Can you also explain why the dollar will get stronger as the Fed height the interest rate? Thank you so very much for your time and I look forward to hearing your answer.

Starting point is 01:00:25 All right, Hugh, this is a fantastic question and I'll tell you, you got the smartest people in the world trying to figure out the answer to it. I can tell you this. This is my concern. If rates continue to get polarized to zero, my concern is that you have a total manipulation in the markets for basically accounting for risk and paying a premium for risk. So as that continues to happen and you look over Japan as a perfect example of rates that have literally been at zero percent for a decade at this point, how are people able to lend money and assume what risk is occurring appropriately whenever you have so much government interaction manipulating the markets? That's my concern. I don't know what the right answer is. And I know that if the Fed would start raising rates because you

Starting point is 01:01:11 don't have much growth and you don't have much investment coming from, basically you don't have that growth percent occurring within the country. If you do raise rates above that growth rate, you're going to cause a major downturn in the market. And that's the big concern at this point. And that's why the Fed is so hesitant to raise rates. But I do know that you can't let it continue to go to zero because you're throwing things completely out of whack. And this is a concern that everyone has in the world.

Starting point is 01:01:35 And I don't know if we really have a good answer for you. But I want to hear Toby Stig and Patrick's comments. And we'll start off with Patrick. Sure. So this is the topic that we get asked about the most. And it's probably the one that we have the least to say about because I think it's very difficult to predict what's going to happen. So all we can do is kind of position ourselves to be diversified in our portfolios in a way that will react well to a steadily rising rate environment or to one that just is status quo that continues to look like what we've seen. I think one of the dangerous. with debt being as cheap or money being as cheap as it is, is big reversals in the kinds of companies that do well in terms of how they use debt. So over the longer term, companies that are aggressively using debt, issuing a ton of net new debt in the market relative to their cash from operations and other cash flows, have tended to underperform pretty badly. That has

Starting point is 01:02:34 gone away in the last five years. So those companies have actually outperformed because money has been so cheap, it's actually been smart to aggressively use very low interest rates from a company's standpoint. We don't think that that means you should go buy high, high levered companies, but it does show that different strategies work at different time and you should be diversified. So the good thing to know is that in, let's say we get one of those rising rate environments, we have 17 or so of them that we can study back to the 1930s. Of those 17, across those 17, the way we defined it was a move of 1% up or more by the change and the yield on the 10-year treasury, U.S. 10-year treasury, and said during those period, those 17 periods, how often did

Starting point is 01:03:15 value investing do well? Value just simply defined, like the cheapest 10% of stocks versus the market. And it outperformed in about 14 of those 17 periods by an average of about 4% or so annualized. So pretty consistent with its long-term outperformance numbers, but quite consistent numbers. 14 out of 17 is pretty good. the major one where it lost was the period ending 1999. We all know what was happening then with value investing. So I think having some value in your portfolio would be smart. And I think that momentum, which has done really well in this kind of lower interest rate,

Starting point is 01:03:48 recent market past, momentum's done really well in the opposite scenario, would be a great ballast. This is just my own personal opinion. I think macro is really, really hard. And there are two reasons why it's really hard. One is, I think it's kind of, it reveals politics more than anything else. It's kind of politics dressed up with numbers dressed up as math and sort of made to appear more rigorous than it really is.

Starting point is 01:04:13 But there are guys who are still trying to invest on the basis of macroeconomics and so best interested in the politics of it and looking at what the data underlying reveal. And you have to get so many things right in series that if you get nine of these difficult questions right and you get the 10th one wrong, then you still end up being. wrong on a sort of trade like that. And you can look at lots of examples. So Kyle Bass with Japan has this phenomenal analysis a few years ago where he worked out that the B.A.J would have to stop dissaving. The Japanese household would stop saving and buying Bank of Japan notes. And so they'd start selling at that stage and it would cause weakness for the yen. And

Starting point is 01:04:52 he came up with this great theory for shorting the yen at that stage. And it didn't work. And the reason is that the BAJ stepped in and started buying Bank of Japan notes at that stage. So the difficulty, that sort of reveals the difficulty of it, that most people in positions of power, politicians and central bankers don't just stand there and let these things happen. In relation to the US, interest rates are close to zero. The question is, is the data correct? Is the data correct that the inflation rate is that low? Perhaps the way that the CPI is measured.

Starting point is 01:05:20 The CPI is just a measure of inflation. It's not inflation itself. Inflation is a much broader measure than that. I really have no idea what they're going to do or how they're going to do it or what the impact will be if it occurs. And I just think sometimes time spent worrying about it is time that you could be better served trying to work out undervalued stocks or finding a strategy that you can stick to, my two cents. My take is not so much about whether or not the Fed will hike rates or not. Obviously, they must do that some part of time. I don't know if it will be December or whenever there will be.

Starting point is 01:05:50 But I think I will respond to the last question you have, Hugh, about why the dollar would, It gets stronger if the Fed started to hike rates. And it's basically a question about, like, where can people get the highest return? And everything else equal. People would be able to get a higher return if there was a higher interest rate in America. And the way to think about this is that the demand for the dollar will increase. And the currency is really just a supply and demand thing. So if there's a higher demand, then the price, which will be the exchange rate, will increase as well.

Starting point is 01:06:20 But again, that's something we teach in macroeconomics. A lot of things can happen. So you won't necessarily see that the dollar will strengthen. You might as well argue that if it didn't, the economy would be better off, which was also increased the demand for dollars. And then you have a stronger currency. So there are so many things happening. But everything else is equal.

Starting point is 01:06:40 Yes, Hugh, you're right. The dollar should get stronger if the high rates. All right, guys. That's all we have for this question here. Hugh, we're going to send you a free signed copy of our book, the Warren Buffett accounting book. And for anybody else out there, if you want to get your question, play a question, on our show, go to Asktheinvestors.com, and you can record your question there. And for anybody

Starting point is 01:06:59 who gets their question played on the air, we'll send you a free signed copy of our book. So we really want to thank Patrick for coming on the show. Patrick, if people want to learn more about you or dig into some of the things you've done, how can they reach out to you and find you on the net? Probably the easiest way is go to investor field guide.com or to search for investors field guide should be, you know, one of the first couple hits on Google. That will have a lot of writing, links to that book club I was talking about, links to the book. And I think I even had my email address on there, so my personal one. So if people want to get in touch with me, that's the best way. And Toby, how about yourself? The best way is either through greenbacked.com, acquireasmultable.com.

Starting point is 01:07:39 There are forums on Acquires Multiple that I weighed into and chat about individual names and strategies and other things like that. Fantastic. That's all we have for you guys and we'll see you guys next week. Thanks for listening to The Investors Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.com. Submit your questions or request a guest appearance to The Investors Podcast by going to www.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP network and must have written approval before a commercial application.

We Study Billionaires - The Investor’s Podcast Network - TIP 063 : Quant Investing with Patrick O'Shaughnessy (Business Podcast)

There aren't comments yet for this episode. Click on any sentence in the transcript to leave a comment.