We Study Billionaires - The Investor’s Podcast Network - TIP341: Investing Mastermind Q1 2021 w/ Toby Carlisle, Wes Gray, and Jake Taylor

Starting point is 00:00:00 You're listening to TIP. Starting this week, we're introducing a new mastermind group. We're called Investing Mastermind. And every quarter I team up with Tobias Carlisle, West Gray, and Jake Taylor to talk about what we see in the financial markets right now. Today, we're discussing how and why Kathy Wood and I-E-TFs are moving the stock market. We're talking about why it's too simplistic to say that low interest rates are good for stocks.

Starting point is 00:00:24 And we're also looking at whether or not the Schiller PE is a valid measure of the stock market. We'll talk about that and much more. You definitely don't want to miss out on this one. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors Podcast. I'm your host, Dick Bruterson, and what a lineup that we have here today. Toby Carlisle, West Gray and Jake Taylor are joining me for our investing market.

Starting point is 00:01:08 Man Group here in Q1. It's always great to speak with you and even better to speak to all of the same time. So, welcome to the show, Jans. Hey, thanks for having us. Hi, guys. Thanks, Dig. So I'm sure the audience are really going to enjoy this conversation and what you guys see in the financial markets right now. Toby?

Starting point is 00:01:27 Wes and I wrote a book a very long time ago now. It's almost a decade since it came out. And that's a pretty good explanation of sort of the underlying process, which is like to screen. basically. And then I do a few other things on top of that. I just think the most interesting thing in the market at the moment is Kathy Wood and Arc ETFs. You might remember in the early dot-com days there was this fund called Janus and they had great performance and they got great flows. They got a lot of flows as a result and they were focused on smaller illiquid tech names.

Starting point is 00:02:03 So Janus had these great flows into these very illiquid stocks and they got great performance as a result and it was probably them driving up the performance of those stocks. There's been a similar argument made about ARC that they tend to focus on smaller, non-profitable tech stocks and ARC has got sort of gigantically big over the last few years. It's now sort of the third or fourth biggest ETF shop out there and their flows now that go into these small illiquid tech stocks, sort of they control the prices of these tech stocks. Had this little wobble over the last few days and that's caused some redemptions for them, which may cause them to do some selling as well.

Starting point is 00:02:43 They also have a big exposure to Tesla. So I just think that that's the driver of the market at the moment is potentially Ark getting some redemptions and having to sell out of some of those stocks, which will push down those names. And they're very sort of beholden to what Tesla does. Tesla is a much bigger stock, but it's still quite volatile. It hasn't made a great deal of money. And so there's some risk that creates this sort of cascade of selling and ARC gets caught in.

Starting point is 00:03:10 And then I don't know what that does to the rest of the market. It seems to me that there's a lot of money in Tesla and ARC that is fairly new money and might be a little bit sensitive to what happens. I'll just say something on that because it relates to our business a little bit. We have a momentum fund that traffics in a lot of the names that ARC funds as a complex trades in, I've definitely noticed a correlation in day-to-day up and down all around with respect to arc funds, which has actually been really cool the last couple months, but the last couple days, it's been pretty painful. I don't know if it's actually true, but it certainly seems to be

Starting point is 00:03:47 the case that, you know, arc fund flows are driving a lot of demand and supply shocks in, you know, these kind of tech firms. I don't know how big of an issued is as a broader marketplace, though, but certainly the case in that narrow sector of the marketplace. I think somebody joked that Ark had sprung a leak over the last few days. Its flows are just amazing. It's been, it hovers up a lot of money and then it redeploys it because they're active funds. They redeployed immediately into the market as they see fit.

Starting point is 00:04:14 And, you know, there's been this weird little wobble over the last few days where some of the frothier tech names have pulled back. So has Tesla. And so Ark has sort of shifted its portfolio mix a little bit from, it's taken it away from some of those more illiquid names, and it's moved a little bit more into Tesla, which might make it a little bit more liquid. But their holdings in some of these companies are kind of, it's extraordinary how much of the company they own. They're sort of in the 20% plus range in some of these companies. How is this going to play out? Like, whenever you own that much of a

Starting point is 00:04:46 company, and I don't know if you are that familiar with Arc, what's the plan? How can they ever get out, especially for some of the smaller names, I guess, where there's just not enough liquidity? Well, I think it's a perfectly legitimate strategy and value guys do this too. So I'm not criticizing too much, but it's a perfectly legitimate strategy to buy something when it's very illiquid and play on selling it when it becomes more liquid or much less liquid, which is what tends to happen. People don't sell when stocks are down low because they want to get out. They sell typically because they have to get out.

Starting point is 00:05:17 Somebody sort of, you know, they've got redemptions or they need the money somewhere else or they'll leave it. They've got a margin loan or something like that because they know they're under value too. So there's no liquidity when you're trying to buy some of these beaten up names. Not that their names are beaten up. Their names are ahead. I'm just saying as a value cut, you're always trying to buy beaten up names. And then you're sort of hoping that down the road year or two or three or five, whatever,

Starting point is 00:05:38 at some point, the thing that you're buying sort of comes back into fashion and people want to pay a higher multiple for it. And typically that's when you see a little liquidity. And you can probably ask Wes about the research into liquidity as a factor. I think that that's the idea, isn't it worse? that the less liquid it is, there's typically better returns from less liquid stocks than more liquid stocks. You want to be buying illiquid and selling liquid. That's right. Vanguard has a fund that does it in a think there's a firm called Zebra Technologies. It's started by some group

Starting point is 00:06:07 of academics that specifically targets that factor and kind of makes sense. You should earn extra for buying things that are paying the butt to get in and out of. But that doesn't solve the problem for if you kind of forced. And I don't know what they do in that scenario. I think that it's going to be tough to get out. All right, guys. So another thing I wanted to talk about is whether or not you have used the 13F filings in your investment approach. And if you're sitting out there not completely sure what a 13F finding is, it's a quarterly report filed to the SEC if you control more than $100 million in assets. It's something that institutional investment managers have to do. Jake, let's off with you. For 13Fs, I use it as a screening tool. It's a place to look for ideas. The vast majority

Starting point is 00:06:55 of the time, when I kick the tires on something that I look at, it doesn't make any sense to me. And that's okay. You don't have to understand everything. But every once in a while, there'll be an idea that I'll find that is worth digging into more. And those make up for all the other times where it's a fool's errand. I think one of the biggest problems that I think I see in that when people are kind of 13F cloners, if you will, it's really easy to clone the portfolio, but it's really hard to clone the conviction. And the conviction doesn't come until you've actually done some of the work yourself. You know, if you wanted to sort of quantify or use a quant approach to it in a 13F, like, I think Meb has written about this a fair amount,

Starting point is 00:07:35 Meb Faber. You can do that. And I think that probably works over a long period of time. But the periods of time where it doesn't work, I bet are really hard to get through because you just don't have the conviction to hold in there. The other thing I would say is that you have to be really careful about who you choose to follow in the 13F space because some people turn over their portfolios in such a way that that information by the time it comes out might be really stale. It might not look like their portfolio at all. So you can figure out who the ones are who are the long-term holders and those tend to be better places to look. That's been my experience. You can't see all of a portfolio either because you can't see international holdings

Starting point is 00:08:14 and you can't see shorts that they have on, which you might be looking at half of a arbitrage or something like that. And you can't see any option positions that they have on. So you're getting one picture of the portfolio. The other record, that's a weird one. And I think I learned this from me when I read this book was that you shouldn't buy the biggest holding because that's the one that's run up the most, I think. I was going to say, we've done our own research on this because we've always had big family

Starting point is 00:08:39 officers ask about doing this strategy. And to your point, Toby, the irony is you don't. want to actually conviction weight in accordance with how the actual managers weight them, you generally want to own like their smaller tiny positions that are, that's actually where they get the most mojo. It's not usually their biggest position, typically because of like tracking area concerns or capital allocation concerns or other things that are actually unrelated to how much actual conviction

Starting point is 00:09:05 and more related arguably with the incentives of asset management business. How do you find those? I think I heard somebody said that recently that they look for the weird, holding in the portfolio that doesn't make sense and that their argument was that some analysts who's pushed really hard to get this in and then like yeah we'll stick a little bit of it in. Yeah, I think that's one approach. I mean, the other challenge obviously to Jake's point, and this is the one that no one's convinced me of is how do you pick your baseball players? Who's on the team? It's one thing to like go pick their stocks, but it's most important to

Starting point is 00:09:37 figure out who the hell is going to be your baseball players and can they hit home runs or not. I guess you've got to be familiar enough with the philosophy that you like. So it's easy to clone Buffett because we all kind of know his philosophy pretty well. And there's a whole lot of Buffett-type dudes out there who I'd be reasonably comfortable. Probably there's some tech guys so you could like, if you get comfortable with it, I can't get comfortable with their process. But if you are that kind of investor, then you can probably figure it out. So now that you bring up Buffett, let's just say that he would be our batter.

Starting point is 00:10:08 So he bought a position for him. I don't know if you want to define it as a big position. He put in 8.6 billion in Verizon. I think he put around $3 billion in Chevron. Do you guys have any thoughts on those two picks? Berkshire's 13F, you have to be a little bit more careful with now that he has lieutenants who are managing bigger sums of money. So you don't really necessarily know if it's Buffett. Then you have to understand their process. They don't really talk much. They're pretty quiet. So it's not quite as clear that that. was Buffett anymore. And that's just something to keep an eye on. 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

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Starting point is 00:14:52 They've got a position in Amazon or they did at one stage, which is sort of, it was optically expensive. I had to look at it at the time they put it on and I couldn't kind of figure it out. And then a year ago, maybe they put the position on in Barrett Gold. And I know from running a blog that if you put Buffett and Gold in the headline of a post, it's going to go bananas. And I think every other news outlet in the States knows that as well or in the world knows that. And so that was like a headline for a long time. It was this tiny little position and then it got sold out in the latest 13F. And I didn't hear anybody say anything about that. at all. It was like, it just didn't happen. It didn't exist.

Starting point is 00:15:30 What about Snowflake, too? Very kind of out of character for what you would expect from Berkshire. Wes, you were talking about it before that you dig into some of the data on those filings. Could you talk a bit more about that? Well, there's always outperformance because generally, to Toby's point, when people pick their baseball players, they focus on people that have performed well after the fact. So obviously, if you clone holdings of people, that you choose as your baseball players. You usually choose baseball players that have hit home runs, not necessarily those that strike out all the time. So obviously, the back tests are incredible on all these things, which is a danger in the first place. But then, so then the empirical question is,

Starting point is 00:16:13 okay, great. We know they all work. But how do we extract the most quote unquote alpha or kind of ride the coat tail value from, you know, looking at these 13F positions? And I think the broad idea is do not weigh them in accordance to how they weigh them. And if anything, if you're going to do it, equal weight the things. Again, I'm like, I'm like Toby at this point. I gave up stock picking. So I always think through a quant lens. I would just go grab the baseball players and just take the ones I like the best and equal weight all their positions, not in accordance with their conviction, where, you know, Jake might have a little better qualitative insights and he may do a different approach. But I just thought about that through the lens of if I were going to try to

Starting point is 00:16:57 clone these people to extract the most benefit, you know, efficiently and without thinking too hard, that's basically the conclusion of all the work we did. You can also use those services that show when somebody is buying or selling. And if it's someone who tends to hold for a very long period of time, then it probably doesn't matter if you're a quarter or so behind when they're buying something. It's when you get the guys who are trading all the time in and out it's a snapshot of chaos every quarter and you don't know what's happened in the days or weeks since or before. It's kind of useless trying to climb those guys. And you're just taking a snapshot of the entire portfolio and not what they're actually trading. The other thing we did was we talked

Starting point is 00:17:39 about it in our book, Toby and I's book back in a day, but then we formally looked at it. You can also look at these names in 13Fs and then map them back to like their fundamental factor characteristics. And the question is like, okay, well, if they have 13, you, F conviction and they happen to look good on whatever you like, you know, value, quality, whatever the heck it is. That's certainly an additive measure at the margin. Like, you wouldn't want to do a 13F name, but then also identify that it has low momentum and it's a total piece of junk and it's like the most expensive stock in the world. That's probably not a great idea. But using 13F as like potential marginal contributor to like a factor portfolio, I want to tell someone

Starting point is 00:18:22 that's a bad idea. That seems reasonable to me. One other point that I think is important is I will often kind of bias towards managers who I know have an activist bent because then there are other levers to be going on at the corporate level that can make a difference and it's not necessarily just a sort of passive holding. Yeah, I like that. Yeah, going into this, I was so excited about asking that question. I'm really happy you guys are setting me straight. So I do want to say for the record, though, to, I think it was Toby's point, about how much the trader, if not it was Jake. I would say that if you do that, someone who's

Starting point is 00:19:00 really interesting to follow would be someone like Monis Paparai. He doesn't trade a lot. Sometimes he could even go years in between. And he has a huge international portfolio and not a lot of US stocks. And like he used to say, there's a thousand reasons why people sell a stock, but there's typically just one reason why the buyer stock. And I think that's definitely applicable for him, but I can easily see why it might not be applicable for everyone else. And we shouldn't fall into that trap. I remember I was speaking to Bill Miller about this and, you know, well prepared as it was, I was going into Deuteroma and talking about different picks.

Starting point is 00:19:31 And, you know, one of the first things he said was just like, hey, dude, that's how you're supposed to look at it. We have different funds with different aims, and this is just all the summation of all them together, and we have different strategies for that. It really doesn't make any sense if you look at what I do. And I would say that's correct for Bill Miller's fund. I wouldn't necessarily say it's the same thing if you're looking at Moneish or Guy from that matter. I think you have a very different approach where it makes a lot more sense to go and see not only

Starting point is 00:19:58 what they bought, but you can also reverse engineer and see what price did they buy something at, which could also give you some help in terms of conviction. So another guy I would like to talk about here is Red Alio. And this is a quote from Red Alio that we talked quite a lot about here on the show. I think I even mentioned during the last mastermind group meeting we had here, where Toby was. And it's a quote from Redalia where he said that in these current market conditions, you had to diversify into many different asset classes, currencies, and countries for market conditions

Starting point is 00:20:31 like these. And so one of the things I wanted to talk about specifically here is equities. That is what we know most of our listeners are really interested in, that is equities. And many of them are not looking at individual stock picks. A lot of them are thinking, perhaps in a bit more traditional things. portfolio sense, how many percent of my portfolio should I hold in stocks, giving the market conditions? So let me try and ask you guys that same question. So what do you do personally and perhaps more importantly, starting with you, Jake, how do you think about this question of in market conditions

Starting point is 00:21:02 like these, how big a percentage of equity should I hold? Personally, it's easier for me to answer this question because I put my exact money and percentages into the same thing that I do with my clients. So this is what we execute as well for the firm. I have a little bit more discretion than Wes and Toby, obviously. Sometimes I'm jealous of their, you know, sort of tying themselves to the mass. I think it's very smart, actually, because I can just go round and round in circles in my head, especially where we are right now. And I'm sure every time period feels like it's the hardest time period to be an investor. But right now, there are such large tides in the marketplace and in the world, really, that it's a really difficult time to figure out asset allocation. Maybe this is just

Starting point is 00:21:47 my own shortfalls and having too much discretion. But when I think about the world, I feel like tails have gotten quite a bit fatter than they were at previous times. And what I mean by that is the very extreme outcomes that we might expect in a given year or five years. So, for instance, on one side, I can make a pretty convincing argument that markets are too expensive, that we have too much debt and that we should expect a lot of maybe debt deflation. We could have tremendous amount of bankruptcies potentially. There's so many zombie companies, right? The other thing, too, is you have technology that's pulling down the prices of things in a pretty extreme way as technology is accelerating. You look at the price of a TV from like 1997 to today, it's 95% less

Starting point is 00:22:33 than it was. There's a saying that everything in the long run is a toaster, and you could maybe make the argument that everything in the long run is a TV and that technology wants to do more with less. And if that's the case, then that's incredibly deflationary. In which case, I think you want to actually own quite a bit of cash so that you have money to put to work if a market was to correct really hard. You want the optionality on that deflation. Okay, so that's on one side. On the other side, we have tremendous amount of stimulus, money printing, government intervention, perhaps indexation that kind of never lets the market correct. That's one theory. In that instance, maybe rates are lower forever, who knows, you really need to own businesses at that

Starting point is 00:23:16 point, especially if we see a tremendous amount of inflation, right? Your cash is going to be a terrible thing. When it comes to that part, the equities owning businesses, for me, I kind of have two prongs that I approach from that. I'm looking to just buy things that are unloved, cheap, kind of misunderstood assets or industries. And then on the other side, buy companies that I know the team who's running it to the point where, like, I think it's a very anti-fragile bet on their capital allocation. So if things go really wrong, like, I know they're going to be making a bunch of smart moves on my behalf as an owner. And that's how I'm trying to protect my downside. So we have this incredible rainbow of how the future might unfold. And I'm just trying to be the

Starting point is 00:23:57 least wrong across that whole rainbow. It's really hard to do right now, because because the tails are so fat, you're doing things that look very contradictory. That's a really long-winded answer to how I'm thinking about it right now. And like I said, I'm a little jealous of these two other guys who maybe don't have to think about that much of stuff as much and just execute the strategy that I think is very smart what they're doing. And they get to maybe sleep a little easier. I don't know, you guys can tell me if that's true or not. But I spent a lot of time going around and rounding my head on walks about, God, what the heck are we going to get in the next five years. I agree with Jake. The level of brain damage potential here is infinite.

Starting point is 00:24:35 So you generally don't want to walk around the world with a lot of brain damage. So I try to avoid that. I just focus on things you can control, taxes, fees, and diversification. And, you know, I'm going to channel some inner Jack Bogle here. But I think that equities globally diversified, and if you can handle the tracking error, buying the cheaper ones and buying the stronger ones, is generally a pretty good evergreen bet if you've got long 10, 20 year horizon. And the only reason you would ever add in things that pay you nothing, like bonds, and if they do pay you, they pay you an income, which is tax inefficient, so you give half of it back to the government, is if you have an extreme risk aversion problem

Starting point is 00:25:19 and or you have liquidity risk, like you might need capital at a certain point and there's no other way to get around it. So for me personally, I'm all in all the time, global equities. And then, you know, we use some fancy things. Like, I know Toby does too. Like, we'll trend follow the beta risk a little. But in general, I think it's fine to just have a huge amount of equity risk. If you've got the capacity to hold it for 10, 20 years and you can either cut your

Starting point is 00:25:47 operating costs as an individual or you can work harder to make more money. But, you know, burning your capital on things that pay you zero, anything they do pay is got to go to a fund manager or the government, that just seems like a bad idea to me. I like stocks. Wes, could you talk a bit more about global acreages? One thing I wanted to talk about is whenever you look at Vanguard, for instance, and you see how they do their global stock market, there is a disconnect between GDP and the allocation. So the baseline is like, hey, let's just allocate like an indexer and buy them in the market

Starting point is 00:26:21 cap weights, right? So that's like roughly, let's say, 50% U.S., 40%. percent dev, 10 percent, EM, plus or minus, whatever. I think that's a fine place to start is a baseline because you can do it really cheap, really efficient, and you can deal with the things I mentioned up front that you can control fees and taxes because you can go buy VT or something like that. If you want to get fancy and you want to do it in an evidence-based way, there's probably arguments that you can use components of value and momentum. So, you know, if let's say a certain country like EM, I'm making a stop. Let's say the P on EM is 10 and the P on US stocks is

Starting point is 00:26:59 500. I'm not going to shame someone who's targeting higher expect of returns if they tilt more towards EM to the extent they can handle the potential swing in the short run, nor would I fault someone who also looked at relative strength. So, you know, someone that just kind of shifted based on momentum. So, you know, EM is outperforming the U.S. stocks over the past year. They want to take a bet more towards the momentum. Great. I think those are two tactical ideas where to the extent you can manage, again, the taxes and the fees of engaging in that activity make a lot of sense. Otherwise, you should just probably do the market cap roughly diversification thing. And you probably shouldn't be all in on the U.S., frankly, even though I know Buffett talks about that.

Starting point is 00:27:47 This seems like bad risk management. Yeah. And I just want to say for the listener out there, if you're like, this cool West dude, he came all with all his deaf EM thing, correct me if I'm wrong, Wes here. So, deaf, that would be developed markets. Yeah, like Europe, Japan. And then EM would be like all the people on the fringes, arguably. Like, you know, Philippines, Thailand, Brazil, like kind of the up-and-comers would be

Starting point is 00:28:12 generically called emerging markets, I guess. So Toby, now everyone's looking at you. So what's the case for being 100% in equities right now? That's a personal question, I think, for a lot of people, depending on where they are in their cycle. I am personally young enough that I think that it's okay for me to be fully exposed to equities. And particularly where I implemented, I do it long short in a mid-cap, large-cap universe,

Starting point is 00:28:39 and long only in a small camp universe. The two things that I manage are both US focused. So at the moment, all I think about is the US. When I look at the US, I'm sort of with Jake that really, really hard. It's been kind of baffling to me as a value guy for a very extended period of time that the market seems to be extremely expensive. Value stocks are sort of, they're a little bit rich to their long run mean now, but they're not.

Starting point is 00:29:05 I don't think that they're anywhere near this. If you look at a desal breakdown, you take the French data. So Ken French is part of the Famer French who came up with all the factors that Wes was discussing, many of the factors that Wes was discussing before. Ken French publishes all this data on his website and you can pull it down and take a look at it yourself. But basically, they break down on a cash flow basis because you're not allowed to talk about price to book anymore because it's such a dead factor. But let's talk about cash flow because that's sort of acceptable. He breaks them down into all of these different.

Starting point is 00:29:35 He breaks him down into thirds, into fifths, into tenths, so ten buckets. The most expensive bucket is as expensive as it has ever been. It may be exceeding, I can't remember exactly, but I think it might have exceeded 2000 now on that basis. And the cheap stuff is, it's expensive relative to its long run mean, but it's nowhere near as overvalued as the really expensive stuff. The problem is that that's been true for an extended period of time. It's just the difference between the two has just kept on widening and widening.

Starting point is 00:30:04 that's unusual and could be some problem with the way that we're accounting for this stuff. It could be a change in the underlying business, you know, the nature of businesses that we're sort of more tech focus now rather than more heavy industry. Or it might just be plain old kind of speculation in the market and that these things happen every now and again that people get too excited about new technologies and they pay too much for them. That sucks all of the money away from the other parts of the market. And then at some point there's a reckoning.

Starting point is 00:30:31 So if you look at cyclically adjusted PE, it's kind of very unpopular at the moment because it tells everybody that the market's really expensive and hasn't been particularly predictive for an extended period of time. And it's not over sort of short periods of time. But all you can say looking at the Cape at the moment is that the Ford returns look pretty low. And when you get that kind of market, low Ford returns, it's often accompanied by a lot of volatility. And so you're kind of getting the worst of both worlds terrible returns and likely a lot of the likelihood of a big. drawdown increases through that period of time. So personally like to have, I've got some shorts on in the market that I short junkie overvalued stuff that has broken down momentum. And I just try to get long, cheap, strong stuff that generates lots of cash flows. So through a bust,

Starting point is 00:31:19 I prefer stocks at buyback stock. So if they go down, they get a better opportunity to buy back more stock. It's great if they stay cheap. They just keep on buying back more stock. The intrinsic value gets concentrated and you hope that if they go through a big bust, it's the stuff that's more sensitive, but much more expensive, more speculative, heavily leavened stuff that gets dinged up more. And so that sort of protects the portfolio through something like that. So I'm 100% exposed to the US market, but I do it in that way through basically long, only small and micro, which is, you know, if the market rips, small and micro does pretty well, small and micro value sort of keeps up with it at the moment. But I think I have a long and small and micro

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Starting point is 00:35:24 slash income. This is a paid advertisement. All right. Back to the show. Jake, Toby mentioned the Cape before. So it's a metric that we talked about multiple times here on the show. So you're looking at what are you paying for your earnings? And then because it's over the past 10 years, it's just for cyclicality and also for inflation.

Starting point is 00:35:44 And so it's a very popular metric. And I'm sort of like curious to hear your thoughts on that. Because whenever you, whenever you look at the ratio, and we'll make sure to link to that here in the show notes, you know, it goes back to call it 1870, right? So it looks like it's a very, very long time series. So it should be somewhat able to predict what's going to happen because it's, after all, look at the valuations. And then in the same time, you'll probably hear people arguing that, well, we at the very end of a long-term interest rate cycle. So how much can we use that historical data, especially considering that it's not just a question of interest rate being as low as they are

Starting point is 00:36:17 right now. It's also a question of what will they be in the future? And I guess there is a consensus in the market right now that is probably going to stay there for some time. And you have people like Redale are saying, well, P of 50 might be applicable. I think he was talking more about conventional P, not necessarily about the Cape here. But he was saying because of the low interest rates. So what are your thoughts on that, Jake? I find Cape to be very compelling as an idea. I mean, I like the smoothing over a 10-year time period. We're currently in the 35-time neighborhood, which is pretty rich on the data set. I think it got up to 44 times in 99.

Starting point is 00:36:54 But Japan in 1987, I think, got up to what, 66 times Cape, something like that. And before that, it had not been over 25. I find it to be very logical, but as a timing mechanism, I don't think it has a lot of, it can't do a lot for you. Although maybe you make the argument that maybe we just have the wrong timelines when we're thinking about these things. I saw this study that looked at starting Cape ratio and then how did that perform over the next one year, five year, 10 year, and 20 year. And the one year, it is just a complete scatter plot, right? Like the distribution is all over the place. There is no, there's no value to it at all.

Starting point is 00:37:36 By the time you got to five year, it starts to tighten up along a line that looks like, tells you like, hey, this. the cheaper the starting, the better the returns. And then over the 10 year, it was actually pretty marked. Like, it tightens up quite a bit. There's a lot of value to it. So if you are thinking in five to 10 year increments, I think the Cape is very useful. But if you're like most investors, I think these days, you're thinking quarter to quarter, it doesn't really tell you anything. It's not going to help you there. What's interesting is that over the, by the time you get out to the 15 or 20 year mark, that slope of cheaper starting price to return actually starts to flatten out. And I think that has to do with, you know, you've had 20 years from a good starting

Starting point is 00:38:17 point of cheap. The quality of whatever it was starts to then be what dictates how it turns out, maybe like return on equity instead of just starting price. So which sort of matches what I think you would expect if you were being logical about it? I find it very interesting, but not very useful. tape ratio doesn't really change anything I do strategically or tactically. But it's definitely interesting to think about for sure. I'm basically in the same boat as Wes, so I kind of watch it and it makes me feel sick when I watch it when I see how high it is. It doesn't impact how I invest in the market. The problem that you have is that I think that Japan, I think, got to 100 times. I might be wrong about that. That's my recollection that it got to 100 times.

Starting point is 00:39:03 China got to 100 times. So the US at 44 times at the peak of the dot-com bubble wasn't really trying. It could have gone up two and a half times from there to really ring the bell. And the fact that something is, I think David Einhorn's got a great line where he says something like the fact that something's two times overvalued is no less silly than something being three times over value or five times overvalued. I think you just have to look at something like Tesla. I think that Tesla could be 20 times overvalued. And I would have said it was insane at 10 times overvalued. So it doubled from there and it's gone up 10 times over last year. So definitely the wrong person to be asking about that kind of stuff. Jay, why don't you go ahead and pitch your topic?

Starting point is 00:39:44 Oh, well, I just very selfishly, since I had two guys who are kind of quantitatively minded, writing a terrific book together, quantitative value. I wanted to know for myself, if you guys had any thoughts about sort of the future of what Quant looks like, however you define it, your definition. But, you know, I mean, is it unique data sets? Is it AI or machine learning? Is it a better thin slicing of factors? Is it, I don't know, something else? Maybe even like a return to basics, like much malign price to book. Like, if everyone thinks it's crap, does that mean it might start working again? I'd be curious to hear two experts talk about it. I have respect for the behavioral errors that we all make in the markets, particularly when we're stressed and we're typically stressed at the times when you need quant most, which is. when the market's down a lot and you should be behaving in a particular way. So I think that the description that you gave at the start of me tying my hands to the mast, that's really what I have tried to do. I wrote a book with Wes, got the benefit of Wes's great insights into all

Starting point is 00:40:42 that stuff and then said, that's a really good approach. I'm going to do that and then I'm not going to mess with it at all. And so I tied myself to the mast and that I kind of implement the strategy without fear of favor as to where the world goes after that or where it's already gone. Wes is a better man to ask about that. So I would say I would break it into two pieces. How will that stuff affect the business of Quant? I think it'll have dramatic effects in the sense that you've got to pretend like you're doing something if you want to get paid extra fees. So I think people will do a lot of this activity, add complexity, add whatever, as part of a sales pitch. But that's the whole game of like how do I get like some sort of information advantage before Joe Blow's supercomputer,

Starting point is 00:41:27 versus Susie's supercomputer. I don't know if that's really a great long-term game to win in. But I know it's a great game for people to sell, and people continue to do that. I know a lot about it. I don't know a lot about it, but I deal with a lot of people, and we hire a lot of people that I'm at least open to letting them explore their crazy ideas to try to beat the brain-dead versions of these models. But no one's convinced me that they actually add any real value beyond just marketing stuff.

Starting point is 00:41:56 And I'm much more in the camp of Toby, where in the end, like, fundamentals matter. It's humans buying and selling in the marketplace. The only edge you really have is just being less human and less crazy. And to the extent you can rely on systems to minimize that behavioral baggage, I think that's evergreen. So I don't think all this stuff matters for that component. It's just follow your system and tie yourself to the mast and you'll probably be okay. If you don't, you'll probably screw things up.

Starting point is 00:42:28 And if you buy sales pitch about how the random forest triple levered Zimbabwe swap machine learning algorithm is going to add value to your portfolio, you know, you're probably going to get the fund manager rich, but I'm not going to work out too well for you. That's my basic take on all the craziness and complexity out there. I think what are the big risks for guys for fund managers and people investing with fund managers is when fund managers get behind a little bit, they start changing what they're doing. So they drift a little bit. And it's very tempting in this market in particular, if you're a valued guy, to drift into a

Starting point is 00:43:03 more growthy kind of style, because that's been what has been working for about the last five years probably. And it's been accelerating. It's been getting the distance between the two has been getting wider and wider. And so at some stage, you just sort of can't take the pain anymore and you want to jump into something that just to take the pain away for a moment, I would 100% do. do that. I just know that the moment that I personally do that, the whole game is over and it will reverse course and go back to where I should have been in the first place. So I just keep that in

Starting point is 00:43:32 my mind that the only thing you can do to outperform is to do those things that deviate from performance. You have to sort of stand apart from the crowd if you hope to outperform. If you're not prepared to do that and you just want to get the market return, then just go and buy the market and just don't worry about it. But I sort of flatter myself that if I stick closely enough to a good value strategy, it will eventually turn around and outperform. There's been no evidence of that so far, though, I should say. Yeah, I think what Toby's saying is, like, very, very important because a lot of times when you see people that have, like, the machine learning model that works or this model, or my value is bigger than your value, or, you know, whatever the heck people are out there saying,

Starting point is 00:44:13 a lot of times when you actually forensically look at, well, what is this thing doing? It's implicitly adding stuff that has been winning. So like, oh, well, you know your value strategy is not Toby's value strategy. It's actually different. This is half like high momentum or like intense quality buying and no kidding it outperforms like hardcore Toby's strategy because it's fundamentally different. It's not better. It's just different. And most of the time, especially people like machine learning space, because they can't really understand what their systems are doing, they're indirectly catching dynamically different factors that have worked. So it looks better on the back test.

Starting point is 00:44:54 But now you have to have high reliance on that system being able to regime shift in a robust way. Like, okay, yeah, you switch from deep value to deep value, but with a lot more momentum or whatever it is. That's awesome because it backtest better. But do you think your machine learning algorithm is going to be able to robustly time that? The next time... I just want deep value to become momentum so I don't have to change.

Starting point is 00:45:21 Yeah, yeah, there you go. That's a good question. What do you guys think of the sort of value rotation thesis that may or may not ever come to pass? In which case, maybe value does become momentum? I might just die of pleasure if that happens. I don't know. I've never sort of experienced it. I've only been in investing, you know, sort of professionally, semi-professionally since 2010.

Starting point is 00:45:45 And so it's been a long kind of haul since then for value. It hasn't really caught any massive outperformance since then. It sort of was a phenomenon of the early 2000s. And I'm embarrassed that I'm sort of, I'm a momentum value guy. Like I jumped on the bandwagon after it been working. And now it's like, you know, there's a great paper by Mikhail Seminov where he says it's like, it's the worst drawdown in 200 years of value. It certainly feels that way.

Starting point is 00:46:09 And he's basing that on price the book. And we price the book's not got very many friends these days. but I sort of think that at some stage, you know, when I look at the portfolios as a value guy, if I roll up the portfolio and I look at my portfolio compared to the market, I think on every metric, it's cheaper on every metric. It's growing faster on every metric and it's got a higher dividend yield. And so I think at some, like that's the sort of stock that I would buy expecting that stock to outperform.

Starting point is 00:46:35 I think at some stage that happens. It's just there's a lot of momentum in this market at the moment. There's a lot of tech momentum in this market at the moment. And that will persist until it goes away. And there's really nothing that you can say about it. I'm kind of with Toby. Like, I had bad timing. I was a value investor in early 2000s, and I mixed that up for skill.

Starting point is 00:46:55 And then after the fact, I realized like, oh, can you actually time the value premium? My opinion is not really unless you got lucky to start stock picking and you happen to have a value philosophy around 2000. You think it's amazing strategy. you try to systematically, can I predict when the premium's going to outperform the next premium? That seems unclear to me. But I do like it as a strategic allocation, because to Toby's point, gravity should matter at some point. Cash flows, all that stuff, you know, in theory, fundamentals should matter.

Starting point is 00:47:28 But markets, as we're seeing, and you've seen throughout the history of the world, sentiment, animal spirits a lot of times matter a lot more than gravity. That's just the nature of the beast, I guess. Charlie Munger has a really something I think about a lot, a quote about this. And he said that sometimes stocks will trade on the value of their use of cash flow and as an actual business. And sometimes they will trade as Rembrandts. There are markets where it's a Rembrandt and there are markets where it's the use of the cash flow. And I think just recognizing kind of which market, are you in a Rembrandt market right now, helps you to be a little bit more patient.

Starting point is 00:48:06 As a discretionary value guy, Jake, what do you think it takes for value to sort of start working? Or are we already there? I don't know. I mean, there's been so many headfakes. It makes it. You just don't even want to, like, whisper it for fear that it would disappear on you, right? But, I mean, I agree. I think the question that I struggle with is, does it happen because it's a crash across everything?

Starting point is 00:48:31 And then maybe what was value, like you said earlier, is not. historically against the cheapest desile, the most absolute layup cheap that it's ever been. It's sort of middling as far as the historical data set of how cheap the cheapest is. Does that get a little bit cheaper and everything else kind of catches down? In which case, that's where I like having some cash on hand for that kind of scenario. But if the jaws close, it sure would hurt to miss that value rotation when you have been waiting for it for so long. And, you know, I think this is where, to me, I try to keep absolute value in my mind and not just relative value.

Starting point is 00:49:11 I see a lot of, I would call slippage in what someone thinks is cheap based on, well, it's cheap compared to this other thing today that is not cheap at all. Whereas if you go and try to use a little bit longer term kind of historical, is this cheap relative to all of the opportunity sets that have existed in time, the pickings get quite a bit slimmer. but I think you're a little bit more disciplined about what you buy. The problem is rates, right? I was just randomly watching some of the, I think it was Bloomberg, has some tiles on the TV last night after everybody had gone to bed. I found this discussion of the Deutsche Bank, like he's one of their heads of economics or something like that.

Starting point is 00:49:49 And I were talking to him about, you know, the rates pro argument that low rates justify high valuations. Like I've never really been able to, Wes, sorry, clear fastness. You're welcome, Wes, just mixing you two up. Yeah, yeah, yeah. Wow. I'm way better looking. It's a lot dumber.

Starting point is 00:50:07 And then I talked to Cliff and he said something like, I think that I can show, like I can brute force a connection. And he was going to write a paper to that effect, or like his little blog post Cliff's perspectives, but it never, or it hasn't come out yet. And then I just looked at the cape against interest rates like this, just eyeballing it.

Starting point is 00:50:25 You can see interest rates start high in like 1980. And they're low as they've ever been now. And then you have a look at Cape through that. Cape peaks in 2000, and there's another little bump in 2007, and there's another little bump today. And like, that doesn't make any sense at all, just looking at interest rates. So that's not, that's not helpful. And then the Deutsche Bank guy pointed out, like they've had low interest rates in Japan and they've had low interest rates in Europe and they've got low multiples in both of those countries. So I have no idea. Anything I used to know, I don't know anymore. Yeah, the confusion stems from just the DCF math and

Starting point is 00:50:59 the problem that interest rates are highly correlated with cash flow growth. And so the issue is all else equal. If you have low interest rates, obviously stocks are cheap. However, if low interest rates are also highly correlated with poor cash flows, well, now it is, it's not all else equal. So the issue is if the value stock's cash flow growth is coming down and the discount rate is going down, it's hard to assess whether it's good or bad for value, which is why empirically you see no relationship. ship because when interest rates are going down, it's used because it means there's, you know, poor cash flow opportunity sets. And same thing when interest rates are going up, well, if that's indicative of real cash flow growth, you know, maybe that's good. It's just the intuition of

Starting point is 00:51:46 all else equal or the assumption of all as equals what I think trips people up on that logical trap of interest rates mean, oh, you can pay a hundred times for stocks. Well, not really, unless you're an idiot. That doesn't make logical sense at all. You got to understand what's the cash flow growth profile. Chris Cole this morning tweeted that if interest rates were eyes to the level that they were pre-2008, like around that time frame, 50% of corporate profits would disappear into interest expense. And then, you know, if you think about if government had that exact same kind of dynamic, the load to pay that interest expense would also go up, which then theoretically would mean there's more taxes due, which would also probably put a crimp into

Starting point is 00:52:31 how much pie is left over as a business owner. We can't afford to have rates go up at all from these prices without, I think, some pretty severe damage. See, those kind of comments, though, are an all-out sequel argument, right? Because the problem with that logic is what would cause interest rates to go up, especially real interest rates? Well, probably real economic growth, a real price power or something. So to the extent that the corporations, we go from like current rates and it goes up to 10, well, there's probably going to be a fundamental economic reason for that. And a lot of that could, I'm not saying this is the case, but it could be the case.

Starting point is 00:53:11 It's because their economic profits and like free cash flow growth has got a really good profile, which means that it would kind of offset like the scare story, the kind of the insurance salesman story, her buddy Chris is an insurance salesman basically. This is an insurance cell story, which may or may not be true, but a lot of times things in extremes tend to mean revert naturally. And so you don't want to be too scared of them, I think. That's a great point. Hey, guys.

Starting point is 00:53:38 So one thing I wanted to talk to you about here today is these so-called 17-year cycles. And so they're not always 17 years. I do want to say that for the record. But they're sort of like being famous in the value investing community because the saying goes that you've got to have a somewhat bull market for 17 years, then it's going to be flat, and then you're going to have another 17 years. And we're really talking like long stretches, so it's not going to be like bull market every single year and then flat for 17 years straight. Obviously, that's not going to be the case. But perhaps the most famous one would be from

Starting point is 00:54:09 1965 and you had 17 years. And then from the early 80s and up until 1999, you had another 17 years. And the market went 15.1 percent from the early 80s. And then you had 12 years with around 0% and then the past 9 years you have 9.8%. So some might be thinking about that. And I know this is horrible to try and extrapolate and be like, oh, yeah, that's been going on for like 9 years and it's around 17. So it's probably got to run for another 8 years. That's not so much my point. The reason why I'm saying this is that I was watching a video with Monis Papright the other day and he was talking about these cycles. And in reference to being a value investor and looking at the market trying to find compounders, that being one strategy, and then the other strategy

Starting point is 00:54:53 being, you're really trying to find, like, really cheap bargains that they would then, you know, go to the intrinsic value, say, two to three years. Like, those two, I wouldn't necessarily call it a opposing way of thinking, but it is like two different ways of looking at stock investing. And so his point was that, and I might be paraphrasing here, we're speaking with Monashire next month, so he probably set me straight. But his point was that you would have compounders in bull market. That's what you should focus specifically on. And then whenever you're entering a territory of, call it flat markets, that's whenever you're

Starting point is 00:55:26 going to look for really, really cheap companies that would then revert to the intrinsic value. Do you think that has any kind of validity thinking about those cycles like that? Jake, you want to go first? Yeah, thanks for letting me take the easy ones. I mean, I do find it interesting that Buffett has written about this before when he is generally kind of macro and like bigger market agnostic, but he's pointed this out multiple times, these 17-year cycles. I don't know if it is a generational thing that it's sort of an emergent property of a new generation has to learn the same lessons over again. I don't know if it's

Starting point is 00:56:02 interest rate changes that kind of like maybe move on some of these cycles. I don't have a lot of, let's just say that's not a big part of my process. I try to simplify it a little bit more of, are there things that as a business owner makes sense to me to buy that I think I'm getting a good deal on it, whether that means if I'm classifying how I think Monish is a 50 cent dollar that is going to rewrite from a 50 cents to a dollar, or is it a compounder where I want to own it for a long time to the point where the multiples entering and exiting don't matter as much as the return on equity along the ownership. And I personally am drawn more to the 50 cent dollar approach just as a, I think it's, I like to have that edge always and I'm,

Starting point is 00:56:45 I'm not as confident in my ability to predict a business and the business's ability to earn 20% return on equity for 20 years. I think that's really hard to do. I think it's much harder to do than people think it is right now. The article that Buffett wrote where he was comparing two periods that were about 17 years, I think it was kind of, I don't know that there was anything special about the number of the years. I think he was just saying, if we look at it. at the last 17 years, interest rates went from a low number to a high number and the stock market did this. And if we look at the preceding period, interest rates went from the reverse and the market was sort of flat for that period. And that inspired Vateli Ketsonelson to use the,

Starting point is 00:57:23 to use Cape to sort of divide the market up into these periods where Vatali calls them sideways markets. And basically sideways markets, the market starts at a very high valuation on a Cape basis. And it sort of drifts sideways with lots of volatility in the interim. And it sort of doesn't really go anywhere for extended periods of time, like 13, 15, 17, something like that, those periods of time. I've tried to reconstruct those charts using Cape. It's really hard to find the bottom. Like, there's no way you can really do that quantitatively. You have to kind of, you have to know where the Cape is and then go through and identify the low dates in the charts.

Starting point is 00:58:01 It's not an easy thing to do. It's not something that you can just tell the computer to do because there are lots of these little ball markets and bear marks. I don't know what you call them like two or three. or five-year bull and bare markets where the market does these little round trips and sometimes it goes on. And it's not clear where the low of the cyclically adjusted P is in that market. It's not clear to me whether how you divide the two. So they're just really hard to identify. I would say so if you know prospectively that you're going into one of these regimes, it may make more sense to do one thing over another, but I don't think you ever know prospectively

Starting point is 00:58:34 what regime you're going into. You kind of just get the opportunity set that you have in front of you and then you have to decide what you're going to do. And so the solution that Wes and I have both sort of come up with is to go and test a whole lot of different, test one model through a whole lot of different regimes and see which model sort of did the best without any foreknowledge. And there are periods when it does really badly and periods where it does okay. And you sort of come out at the end with some reasonable performance. And when you look at the model that we created, it draws a lot on what Buffett says. So one of the things it looks for is does it have pretty good margins?

Starting point is 00:59:10 That indicates that the company has some pricing power. They stable? Are they growing? And then are you buying it cheaply? Is it not too heavily? There's a whole lot of criteria that you look at to make sure this is a safe business. This is a good business. It's earning lots of money and it's pretty cheap.

Starting point is 00:59:24 And if you do that over time, some of those companies are going to turn into compounders. And some of those companies are just going to rewrite and get sold out of the portfolio. I think it's incredibly difficult to predict prospectively, which one of them is going to be a compounder and which one isn't like. I talk about this all the time because Microsoft has been a great performer over the last decade, but I remember vividly going to the value investing Congresses and hearing people pitching Microsoft at the time. And Microsoft at the time, it's like 2011, 12, 13, hadn't gone anywhere since 2000. It was this like received kind of common wisdom that Steve Barmer didn't really know what he was doing. And Microsoft had had its first

Starting point is 01:00:00 year of revenue dropping. And then they had this new guy in there, Satya Nadella. And everybody's like, well, where's this thing going? Like, what's the, and here you are, like, 10 years later, almost 10 years later, Microsoft's gone on this absolute tear. Software as a service, Satchi and Dell is a genius. And I think part of it is it came from a low valuation. Part of it is that they have done some, like, amazing things in that business. Like, they've got Azure, which just didn't exist before.

Starting point is 01:00:26 That's a multi, multi-billion dollar business. I think it's really, really hard to predict. I think the things that you can predict is it safe right now based on its balance sheet? Like, it's not going to get hurt that way. You can identify all the things that will blow it up, make sure they're not there. And is it cheap? Because if it's too expensive, you can lose money that way too. Does it have some pricing power at the moment?

Starting point is 01:00:45 Yes, it does. If you put all those things together, good things can happen. Also, there are lots of donuts out of that group. You find stuff like that, you know, wind the clock forward five years. It's down 99%. Just like on balance over the portfolio, if you have enough positions, you do get pretty good performance out of it. That's my naive approach to the market.

Starting point is 01:01:02 I see these guys writing great arguments for positions. And I'm like, that's a brilliant insight. That's really great. It's just that I can't do it and I'm suspect about whether they can to. The one thing that I have done, I just want to find stuff that you can hold for it. Let's go as far back in the data set as you can and then buy stuff and see how long you can hold it for and how long you get the outperformance. And I've just then tried to fit different what is the thing that predicts the outperformance of these things.

Starting point is 01:01:28 And it's not, I can never find any quality metric that gives you any that works over that period. the only thing that I've ever found is the starting price relative to a fundamental. And it almost doesn't matter which fundamental. If it's cheap, that's your best bet of our performance over an extended period of time. We did that God study. I don't know if you guys remember with that where you just, you get like the five-year winners. And so I run a bunch of factor regressions and try to do what Toby saying like, hey, can we reverse engineer out these winners?

Starting point is 01:01:57 And literally, you can't. You get beta, obviously, because you're buying stocks, but there's no momentum, value. There's no obvious characteristics set to identify like long-term, quote-unquote, like five-year look-ahead winners. You just got to know. But to totally point, you the hell would have known that new Microsoft CEO would have turned it from not many people. To be fair, there were people pitching it at the value investing Congress.

Starting point is 01:02:23 But their thesis was, it's cheap. It's like an 11% free cash flow yield. That was the pitch. Not this as a compounder that's going to be taking over the world over the next decade. Yeah, yeah. This is not Google. All right, jens, what a fantastic discussion. Thank you so much for taking the time to join this mastermind discussion here today.

Starting point is 01:02:42 I'd like to give all of you the opportunity to tell the audience where they can learn more about you. Wes, why don't we go ahead and stop with you? Just alfarchitect.com, follow the blog, follow us on Twitter. Jake? The investing side, Farnum-street.com, is our firm. And then Toby and I do, along with Bill Brewster, value after hours once a week, supposed to be more for entertainment than necessarily investment purposes. And then I guess on Twitter at Farnham, Jake 1.

Starting point is 01:03:14 Toby? You can hear more complaining about the underperformance of value. I was with Jake and I. And then Wes and I wrote a book a long time. I got quantitative value. And I've got some other books in there, too, if you search my name and Amazon. and I run Acquireasmultable.com and Acquireasfunds.com. They're the two sites we can kind of follow along with if you want to do it yourself

Starting point is 01:03:34 or if you want to let us do it for you. Fantastic. And just a quick message to our listeners out there. If you like our mastermind episodes, make sure to subscribe to our show and your favorite podcast app so you don't miss out on future episodes like this. Preston will be back with a new episode on Wednesdays and then Trey and I are typically hosting the episodes all the weekend. Thank you for listening to TIP.

Starting point is 01:03:59 Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting. Thank you.

We Study Billionaires - The Investor’s Podcast Network - TIP341: Investing Mastermind Q1 2021 w/ Toby Carlisle, Wes Gray, and Jake Taylor

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