Toby Carlisle (02:39):
And that’s caused some redemptions for them, which is may cause them to do some selling as well. They also have a big exposure to Tesla’s. 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 some of those stocks, which will push down those names. And they’re very sort of behold in to what Tesla does. Tesla is a much bigger stock, but it’s still quite volatile, hasn’t made a great deal of money. And so there’s some risk that creates this sort of cascade of selling, and ARK gets caught in. And then I don’t know what that does to the rest of the market. But it seems to me that there’s a lot of money in Tesla and ARK that is fairly new money and might be a little bit sensitive to what happens.

Wes Gray (03:18):
Ought to say something on that, because it relates to our business a little bit. We have a momentum fund that traffic’s in a lot of the names that Ark funds as a complex trades in. I’ve definitely noticed a correlation in day to day, up and down all around with respect to ARK funds. Which has actually been really cool 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 the case that ARK fund flows they’re driving a lot of demand and supply shocks in these kind of tech firms. I don’t know how big of an issue it is as a broader marketplace, though. But certainly the case in that narrow sector of the marketplace.

Toby Carlisle (04:02):
Somebody joked in ARK sprung a leak over the last few days. Its flows are just amazing. It hoovers up a lot of money and then redeploys it, because they’re active funds, they’re redeployed immediately enter the market as they see fit. And there’s been this weird little wobble over the last few days with some of the frothy and tech names have pulled back. So has Tesla. And so ARK has sort of shifted its portfolio mix a little bit from taking 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 a company they are. And they’re sort of in the 20% plus range in some of these companies.

Stig Brodersen (04:43):
How’s this going to play out? Whenever you own that much of a company, and I don’t know if you are that familiar with ARK, 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?

Toby Carlisle (04:56):
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 plan 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. Somebody’s sort of they’ve got redemptions, or they need the money somewhere else, or they leave, or they’ve got a margin loan or something like that, because they know they’re undervalued. 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, you can’t always try to buy beaten up names. And then you sort of hoping that down the road a year, or two, or three, or five, whatever, at some point, that 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, 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.

Stig Brodersen (06:00):
That’s right. Vanguard has a fund that does it in, I think it’s a firm called Zebra Technologies. It’s started by some group 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.

Toby Carlisle (06:18):
But that doesn’t solve the problem for if you’re 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 it on.

Stig Brodersen (06:27):
All right guys. So another thing I wanted to talk about is whether or not you’ve used the 13F filings in your investment approach. And if you’re sitting out there not completely sure what a 13F filing is, it’s a quarter 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 start with you.

Jake Taylor (06:49):
For 13Fs, I use it as a screening tool. It’s a place to look for ideas, the vast majority 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.

Jake Taylor (07:28):
If you wanted to sort of quantify or use a quantum approach to it in a 13F. I think Meb has written about this a fair amount 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.

Toby Carlisle (08:10):
You can’t see all of the portfolio either because you can’t see international holdings and you can’t see shorts that they have on which you might be looking at half of arbitrage or something like that. And you can’t see any option positions that they have on site. You’re getting one picture of the portfolio. The other [inaudible 00:08:26], that’s a weird one. And I think I learned this from Meb when I read his book was that you shouldn’t buy the biggest holding, because that’s the one that’s run up the most, I think.

Wes Gray (08:33):
As you say, we’ve done our own research on this, because we’ve always had big family offices asked 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 weighed them. You generally want to own their smaller, tiny positions. That’s actually where they get the most mojo. It’s not usually their biggest position, typically, because I like tracking error concerns, or capital allocation concerns, or other things that are actually unrelated to how much actual conviction, and more related, arguably, with the incentives of asset management business.

Toby Carlisle (09:11):
How do you find those? I think I heard somebody say that recently that they look for the weird holding in the portfolio that doesn’t make sense. And that their argument was that some analyst is pushed really hard to get this in and [inaudible 00:09:20] little bit of it in.

Wes Gray (09:22):
Yeah, I think that’s one approach. I mean, the other challenge, obviously, to Jake’s point, and this is one that no one’s convinced me of is how do you pick your baseball players? Who’s on the team? Either it’s one thing to go pick their stocks, but it’s most important to figure out who hell is going to be your baseball players and can then they hit homeruns or not?

Toby Carlisle (09:42):
This is going to be familiar enough with the philosophy that you like. So it’s easy to climb 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 can if you get comfortable with it. I can’t get comfortable with it, that process, but if you are that kind of investor, then you can probably figure it out.

Stig Brodersen (10:05):
So now that you bring up Buffett, let’s just say that he would be our butter. So he bought a position for him. I don’t know if you want to define this 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?

Wes Gray (10:21):
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. That’s just something to keep an eye on.

Toby Carlisle (10:42):
I’ve got a position in Amazon or they did at one stage, which is sort of it was optically expensive. I had a 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 Barrick 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 it’s well, or in the world knows that. And so that was a headline for a long time. It was this tiny little position, and then it got sold out in the lightest 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.

Jake Taylor (11:20):
What about snowflake, too, very kind of out of character for what you would expect from Berkshire?

Stig Brodersen (11:27):
Wes, you’re talking about it before that you dig into some of the data on those filings. Could you talk a bit more about that?

Wes Gray (11:34):
Well, there’s always out performance because, generally, to Toby’s point, when people pick their baseball players, they focus on people that are performed well after the fact. So obviously, if you clone holdings of people that you choose as your baseball players, they usually choose baseball players that have hit homeruns, not necessarily those that strike out all the time. So obviously, the back tests are incredible. [inaudible 00:11:57] is a danger in the first place. So then the empirical question is, okay, great, we know they all work, but how do we extract the most, quote unquote, alpha, or kind of ride the cocktail value looking at these 13F positions?

Wes Gray (12:14):
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 Toby at this point, I gave up stock picking. So I always think through quant lens, I would just go grab the baseball players, and just take the ones I liked the best and equal weigh all their positions, not in accordance with their conviction, where Jake might have 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 clone these people to extract the most benefit efficiently and without thinking too hard, that’s basically the conclusion of all the work we did.

Toby Carlisle (12:58):
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, it probably doesn’t matter if you’re a quarter or so behind when they’re buying something. That’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 clone those guys. And you’re just taking a snapshot of the entire portfolio, not what they actually traded.

Wes Gray (13:27):
The other thing we did was, we talked about it in our book, Toby and I’s book, back in the day, then we formally looked at it. You can also look at these names in 13Fs and then map them back to their fundamental factor characteristics. And the question is like, okay, well, if they have 13F conviction, and they happen to look good on whatever you like, value, quality, whatever the heck it is, that’s certainly an additive measure at the margin. You 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 the most expensive stock in the world. That’s probably not a great idea, but using 13F is like potential marginal contributor to a factor portfolio. I want to tell someone that’s a bad idea. That seems reasonable to me.

Jake Taylor (14:15):
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.

Toby Carlisle (14:34):
Yeah, I like that.

Stig Brodersen (14:36):
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 is really interesting to follow would be someone like Mohnish Pabrai. He doesn’t trade a lot. Sometimes it can 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 1,000 reasons why people sell a stock, but there’s typically just one reason why they buy a stock.” And I think that’s definitely a pivot for him, but I can easily see why it might not be applicable for everyone else. And we shouldn’t fall into that trap.

Stig Brodersen (15:14):
I remember I was speaking to Bill Miller about this, and well prepared as I was, I was going into Datorama and talking about different pics, and one of the first thing he said was just like, “Hey, dude, that’s how you’re supposed to look at it.” “We have different funds for different aims, and this is just all summation of all them together, and we have different strategies for that.” So [inaudible 00:15:33] me in the sense if you look at what I do. And I would say that’s correct for Bill Miller’s fun, I wouldn’t necessarily say it’s the same thing if you’re looking at Mohnish, or Guy for that matter. I think we have a very different approach where it makes a lot more sense to go and see not only 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.

Stig Brodersen (15:56):
So another guy I would like to talk about here is, is Ray Dalio. And this is a quote from Ray Dalio that we talked quite a lot about here on the show. I think I even mentioned it during the last mastermind group meeting we had here with Toby Wallace. And it’s a quote from Ray Dalio where he said that in these current market conditions, you have to diversify into many different asset classes, currencies, and countries for market conditions 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 the bid more traditional portfolio sense, how many percent of my portfolio should I hold in stocks, given 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 like these, how big a percentage of equity should I hold?

Jake Taylor (16:55):
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, then Wes and Toby, obviously. Sometimes I’m jealous of their 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 if 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 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.

Jake Taylor (17:54):
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 can 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 1997 to today, it’s 95% less than it was. There’s a saying that everything in the long run is a toaster. And you can 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 and so that you have money to put to work if the market was to correct really hard. You want the optionality on that deflation. Okay, so that’s on one side.

Jake Taylor (18:48):
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 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 of the equities owning businesses, for me, I kinda 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 I think it’s a very anti fragile bet on their capital allocation. So if things go really wrong, I know they’re going to be making a bunch of smart moves on my behalf as an owner. And that’s I’m trying to protect my downside.

Jake Taylor (19:41):
So we have this incredible rainbow of how the future might unfold. And I’m just trying to be the least wrong across that whole rainbow. It’s really hard to do right now 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. Like I said, I’m a little jealous of these two other guys who maybe don’t have to think about that much 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 round in my head on walks about, god, what the heck are we going to get in the next five years?

Wes Gray (20:20):
I agree with Jake. The level of brain damage potential here is infinite, 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 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, and/or you have liquidity risk, you might need capital at a certain point, and there’s no other way to get around it.

Wes Gray (21:17):
So for me personally, I’m all in all the time, global equities. And then we use some fancy things like, I know Toby does to, like what 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 operating costs as an individual, or you can work harder to make more money. But 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.

Stig Brodersen (21:52):
Wes, could you talk a bit more about global equities. 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.

Wes Gray (22:06):
So the baseline is like, hey, let’s just allocate like an indexer, and buying in their market cap weights, right? So that’s roughly, let’s say 50% US, 40% Dev, 10% 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’ve mentioned up front that you can control, fees, and taxes. Because you can go by 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.

Wes Gray (22:40):
So if, let’s say, a certain country like EM, I’m making this up, let’s say the P on EM is 10. And the P on US stocks is 500, I’m not going to shame someone who’s targeting higher expected 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 someone that just kind of shifted based on momentum. So EM is outperforming the US 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 an 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 US frankly, even I know Buffett talks about that. This seems like bad risk management.

Stig Brodersen (23:39):
Yeah. And I just want to say for the listener out there if you’re like, “This cool Wes dude, he came up with all his dev EM thing.” Correct me if I’m wrong, Wes, here, so dev that would be developed markets?

Wes Gray (23:50):
Yeah, like Europe, Japan. And then eM would be all the people on the fringes, arguably, like Philippines, Thailand, Brazil, kind of the up and comers would be generically called emerging markets, I guess.

Stig Brodersen (24:06):
So Toby, now everyone’s looking at you. So what’s the case for being 100% in equities right now?

Toby Carlisle (24:13):
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 the whether that implemented. I do it long short in a mid cap, large cap universe, and long only in a small cap universe. The two things that I managed are both US focus. 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 I don’t think that they’re anywhere near this. If you look at a DSR breakdown, you take the French data.

Toby Carlisle (25:01):
So Ken French is part of the Fama–French, who came up with many of the factors that Wes was discussing before. Ken French publishes all his data on his website, you can pull it down and take a look at it yourself. But basically, they break down my cash flow basis, because you’re not allowed to talk about price 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 thirds into fifths into tenths, so 10 buckets. The most expensive bucket is as expensive as it has ever been, maybe exceeding, I can’t remember exactly, but I think it might have exceeded 2,000 now on that basis. And the cheap stuff is expensive, relative to its long run mean, but it’s nowhere near as overvalued as the real 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, that’s unusual and could be some problem with the way that we’re accounting for these stuff. It could be a change in the underlying business, the nature of businesses that we’re sort of more tech focused now rather than more heavy industry, or it might just be plain old kind of speculation in the market.

Toby Carlisle (26:10):
And 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 the money away from the other parts of the market, and then at some point, there’s a reckoning. So if you look at cyclically adjusted P/E, it’s kind of very unpopular at the moment, because it tells everybody that the market is 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 forward returns look pretty low. And when you get that kind of market, low forward 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 draw down increases through that period of time.

Toby Carlisle (26:54):
So I personally I’ve got some shorts on in the market that I short junky, overvalued stuff that has broken down momentum, and I just try to get long, cheap, strong stuff that generates lots of cash flows for us through a bust. I prefer stocks that buy back 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, that much more expensive, more speculative, heavily leveraged 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 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 over the long run small and micro value will outperform it. And then if it gets really big enough, then the long short should provide less of a draw down than then the broader market.

Stig Brodersen (27:56):
Jake, Toby mentioned the CAPE before so, [inaudible 00:28:00] you talked about multiple times here on the show. So you’re looking at what are you paying for the earnings, and then because it’s over the past 10 years is just for cyclicality and also for inflation. And so it’s a very problematic. I’m sort of curious to hear your thoughts on that. Because whenever you look at the ratio, and we’ll make sure to link to that here on the show notes, it goes back to call it 1870. Right? So it looks like it’s a very, very long time serious. So it should be somewhat able to predict what’s going to happen, because it’s after looking at the valuations.

Stig Brodersen (28:30):
And then at 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 right now. It’s also question of what will it 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 Ray Dalio saying, “Well, P of 50 might be applicable.” I think he was talking more about conventional P and not necessarily about the CAPE here. But you’re saying because of the low interest rates. So what are your thoughts on that, Jake?

Jake Taylor (29:06):
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 times neighborhood, which is pretty rich on the data set. I think they got up to 44 times in ’99. But Japan in 1987, I think got up to 66 times CAPE or something like that. And before that it had not been over 25. I find it to be very logical. But as a timing mechanism, 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, the distribution is all over the place, there’s no value to it at all.

Jake Taylor (30:03):
By the time you got to a five year, it starts to tighten up along the line that tells you like, “Hey, the cheaper the starting the better the returns.” And then over the 10 year, it was actually pretty market, 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 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’ve had 20 years from a good starting point of cheap, the quality of whatever it was starts to then be what dictates how it turns out, maybe return on equity instead of just starting price, which sort of matches what I think you would expect if you were being logical about it.

Wes Gray (30:59):
I find it very interesting, but not very useful, what the CAPE ratio doesn’t really change anything I do strategically or tactically, but it’s definitely interesting to think about, for sure.

Toby Carlisle (31:11):
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. 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 has got a great line where he says something, like the fact that something’s two times overvalued is no less silly than something been three times overvalued or five times overvalued. I think you just have to look at something like Tesla, I think 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 the last year. So definitely the wrong person to be asking about that kind of stuff.

Stig Brodersen (32:07):
Jake, why don’t you go ahead and then pitch your topic.

Jake Taylor (32:10):
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 I mean, is it unique data sets? Is it AI or machine learning? Is it a better thin slicing of factors? Is it something else? Maybe even a return to basics like, much maligned, price to book. 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.

Toby Carlisle (32:45):
I have a 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 markets down a lot, and you should be behaving in a particular way. So I think that the description that you gave started with 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 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 I kind of implement the strategy without fear of failure as to where the world goes after that or where it’s already gone. Wes is a better man to ask about that.

Wes Gray (33:25):
So I would break it into two pieces. How will that stuff affect the business of quant? I think they’ll have dramatic effects, insensate, you got to pretend 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 some sort of information advantage before Joe Blow’s supercomputer versus Susie’s super computer?” 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 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 stock.

Wes Gray (34:23):
And I’m much more in the camp of Toby where in the end 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. And if you buy sales pitch about how the random forest trip leverage Zimbabwe swap machine learning algorithm is going to add value to your portfolio, you’re probably going to get the fund manager rich, but [inaudible 00:35:08] could work out too well for you. That’s my basic take on all the craziness and complexity out there.

Toby Carlisle (35:15):
I think one of 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 value guy to drift into a more growth kind of style because that’s been what has been working for about the last five years probably. And it’s been accelerating, 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 just to take the pain away for a moment.

Toby Carlisle (35:48):
I would 100% 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 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 it. 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 that I should say.

Wes Gray (36:25):
Yeah, I think what Toby is saying is very, very important, because all that times when you see people that have the machine learning model that works, or this model, or my value is bigger than your value, or whatever the heck people are out there saying, 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 high momentum, or intense quality buying.

Wes Gray (36:59):
And no kidding, it outperforms hardcore Toby’s strategy, because it’s fundamentally different. It’s not better, it’s just different. And most of the time, especially people who 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, 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 back tests better.” “But do you think your machine learning algorithm is going to be able to robustly time that the next time?”

Toby Carlisle (37:43):
I just want deep value to become momentum so I don’t have to change.

Wes Gray (37:48):
Yeah. Yeah, there you go. Yeah.

Stig Brodersen (37:51):
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?

Toby Carlisle (38:03):
I might just die of pleasure if that happens. I don’t know, I’ve never sort of experienced that. I’ve only been in investing sort of professionally or semi professionally since 2010. So it’s been a long kind of hole since then for value, it hasn’t really caught any massive out performance since then. It sort of was a phenomenon of the early 2000s. And I’m embarrassed that I sort of I’m a momentum value guy, I jumped on the bandwagon after I’d been working. And now there’s a great paper by Mikhail Samonov, where he says it’s the worst draw down in 200 years of value. It certainly feels that way. And he’s basing that on price to book. And priced to book don’t got very many friends these days. And 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.

Toby Carlisle (38:57):
And so I think that’s the sort of stock that I would buy, expecting that stock to outperform. 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.

Wes Gray (39:14):
I’m kind of with Toby, I had bad timing. I was a value investor in early 2000s, and I mixed that up for scale. 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 haven’t have a value philosophy around 2000. You think it’s amazing strategy, you’re trying to systematically, “Can I predict when the premium is 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. In theory, fundamentals should matter. 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.

Jake Taylor (40:07):
Charlie Munger has 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 Rembrandt’s. 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 what market, are you in a Rembrandt market right now, helps you to be a little bit more patient

Toby Carlisle (40:34):
As a discretionary value guy, Jake, what do you think it takes for value to sort of start working? Or are we already there?

Jake Taylor (40:42):
I don’t know. I mean, there’s been so many head fakes, it makes it… You just don’t even want to 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? And then maybe what was value, like you said earlier, is not historically against the cheapest decile, the most absolute layup cheap that it’s ever been. It’s sort of middling as far as the 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.

Jake Taylor (41:24):
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 I think this is where, to me, I try to keep absolute value in my mind and not just relative value. 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, was 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.

Toby Carlisle (42:03):
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, and I found this discussion of the Deutsche Bank, he’s one of the heads of economics or something like that, and they were talking to him about the rates spread argument that low rates justify high valuations. I’ve never really been able to… Wes, sorry, pre fastness. You’re welcome, Wes. Just mixing you two up.

Wes Gray (42:27):
Yeah, yeah, yeah. [crosstalk 00:42:29]. I’m way better looking, [crosstalk 00:42:32] is a lot dumber.

Toby Carlisle (42:34):
And then I talked to cliff and he said something like, “I think that I can brute force a connection.” And he was going to write a paper to that effect, or his little blog post clips perspectives, but it hasn’t come out yet. And then I just looked at the CAPE against interest rates, just eyeballing it. You can see interest rates start high in 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 that doesn’t make any sense at all, just looking at interest rates. So that’s not helpful. And then the Deutsche Bank, I pointed out, they had lower interest rates in Japan, and they’ve had low interest rates in Europe, and they get low multiples in both of those countries. So I have no idea. Anything I used to know, I don’t know anymore.

Wes Gray (43:22):
The confusion is stems from just the DCF math and the problem that interest rates are highly correlated with cash flow growth. And so the issue is all else equal, you have low interest rates, obviously, stocks are cheap. However, if low interest rates are also highly correlated with poor cash flows, well, now its not all else equal. So the issue is if the value stocks, 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. Because when interest rates are going down, it’s usually because it means there’s poor cash flow opportunity sets. And same thing when interest rates are going up, well, that’s indicative of real cash flow growth. Maybe that’s good. It’s just the intuition of all else equal or the assumption of all is equal is what I think trips people up on that logical trap of interest rates. I mean, now you can pay 100 times for stocks. Well, not really, unless you’re an idiot. It doesn’t make logical sense at all. You got to stay what’s the cash flow growth profile?

Jake Taylor (44:32):
Chris Giles this morning tweeted that if interest rates would rise to the level that they were pre 2008, like around that timeframe, 50% of corporate profits would disappear into interest expense. And then 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 how much pie is leftover, 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.

Wes Gray (45:10):
See those kind of comments, though, are an all else equal 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 or real price power or something. So to the extent that the corporations we go from 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, it’s because their economic profits and free cash flow growth is got a really good profile, which means that it would kind of offset the scare story that the kind of the insurance salesman story, our buddy Chris’s insurance salesman, basically. this is an insurance sell 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.

Toby Carlisle (46:03):
Great point.

Stig Brodersen (46:05):
Hey, guys. 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 been famous in the value investing community, because the saying goes that you got to have a somewhat bull market for 17 years, then it was going to be flat, and then you’re going to have another 17 years. And we’re really talking 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 1965, and you had 17 years. And then from the early ’80s and up till 1999, you had another 17 years. And the market went 15.1% from the early ’80s, then you had 12 years with around 0%, and then the past nine 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 nine years, and it’s around 17, so it’s probably got to run for another eight years.” That’s not so much my point.

Stig Brodersen (47:05):
The reason why I’m saying this is that I was watching a video with Mohnish Pabrai 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 being he was really trying to find like really cheap bargains that they would then go to the intrinsic value, say two, three years. Those two, I wouldn’t necessarily call them posing while you’re thinking, but it is like two different ways of looking at stock investing. And I might be paraphrasing here, we’re speaking with Mohnish here next month, so he’ll probably set this straight. But his point was that you would have compounders in bull markets, that’s what you should focus specifically on. And then whenever you’re entering a territory of quality flat markets, that’s when then you’re 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?

Jake Taylor (48:04):
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 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 interest rate changes that kind of maybe move on some of these cycles. 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?

Jake Taylor (48:45):
Whether that means if I’m classifying how I think Mohnish is a 50 cent dollar that is going to rerate from a 50 cents to $1. Or is it a compound or 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. I like to have that edge always. And 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.

Toby Carlisle (49:26):
The article that Buffett wrote where he was comparing two periods that were about 17 years, 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 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 Vitaly Katz and Nelson to use CAPE to sort of divide the market up into these periods where Vitaly call them sideways markets. And basically sideways markets, the market starts at a very high valuation on a CAPE basis, and it’s sort of drift 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. There’s no way you can really do that quantitatively, you have to know where the CAPE is, and then go through and identify the low dates in the charts. It’s not an easy thing to do, it’s not something that you can just tell a computer to do.

Toby Carlisle (50:31):
Because there are lots of these little bull markets and bear markets. I don’t know what you call them, two or three of five year bull and bear 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 they 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 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 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 where it does really badly, and periods where it does okay. And you sort of come out at the end with some reasonable performance.

Toby Carlisle (51:28):
And when you look at the model that we created, it draws a lot on what Buffett says, one of the things it looks for is does it have pretty good margins that indicates that the company has some pricing power? Are they stable? Are they growing? And then are you buying it cheaply? 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. 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 rerate 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 compound, and which one isn’t. 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, like 2011, ’12, ’13, hadn’t gone anywhere since 2000. Was this received kind of common wisdom that Steve Ballmer didn’t really know what he was doing. And Microsoft had its first year of revenue dropping, and then they had this new guy, and there’s Sachin Adela. And everybody’s like, “Well, where’s this thing going?” And here you are almost 10 years later.

Toby Carlisle (52:38):
Microsoft [inaudible 00:52:39] absolute test, software as a service. Sachin Adela is a genius. I think part of it as it came from a low valuation. Part of it is that they have done some amazing things in that business. They’ve got Azure which just didn’t exist before. 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? It’s not going to get hurt that way. You can identify all of the things that will blow it up, make sure they’re not there. Then 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? Yes, it does. If you put all those things together, good things can happen. Also, there are lots of doughnuts out of that group, you find stuff like that, 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.

Toby Carlisle (53:29):
I see all these guys running 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 suspect about whether they can, too. The one thing that I have done, I just want to find stuff that you can hold for… This, 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 out performance. And I’ve just been tried to fit different, what is the thing that predicts the out performance of these things. 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 about performance over an extended period of time.

Wes Gray (54:11):
We did that God study on our fields from merit that, we did the five year winners. So I run a bunch of factor regressions and try to do it like Toby saying like, “Hey, can we reverse engineer out these winners?” And literally, you can’t. You get beta, obviously, because you’re buying stocks, but there’s no momentum value. There’s no obvious characteristic set to identify long term, quote unquote, five year look ahead winners, you just got to know. But to Toby point, who the hell would have known that new Microsoft CEO would have turned it from… Not many people.

Toby Carlisle (54:47):
To be fair, there were people pitching at the value investing Congress, but their thesis was it’s cheap. It’s an 11% free cash flow yield, that was the pitch. Not this is a compound that it’s going to be taking over the world over the next decade.

Wes Gray (54:55):
Yeah, yeah. This is not Google.

Stig Brodersen (55:01):
All right, gents, what a fantastic discussion. Thank you so much for taking the time to join this mastermind discussion here today. I’d like to give all 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?

Wes Gray (55:17):
Just alphaarchitect.com. Follow the blog. Follow us on Twitter.

Stig Brodersen (55:21):
Jake?

Jake Taylor (55:24):
theinvestingsidefarnam-street.com is our firm. And then Toby and I do, along with Bill Brewster, Value: After Hours once a week. It’s supposed to be more for entertainment than necessarily investment purposes. And then I guess on twitter @farnamjake1.

Stig Brodersen (55:40):
Toby?

Toby Carlisle (55:42):
You can hear more complaining about the under performance of value on Value: After Hours with Jake and I. Wes and I wrote a book a long time ago, Quantitative Value and I’ve got some other books in there, too, if you search my name in Amazon. And I run acquirersmultiple.com and acquirersfunds.com, there are the two sides where you can kind of follow along with if you want to do it yourself or if you want to let us do it for you.

Stig Brodersen (56:04):
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 over the weekend.

Outro (56:23):
Thank you for listening to TIP. 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.