Wes Gray (03:20):

If a market’s trending, be willing to own it. If it’s not trending, that’s when you might want to think about being more defensive and risk off. And it’s specific to value investing like our process, our approach. Honestly, the only thing we’ve changed there is made it simpler and easier to understand. But fundamentally we haven’t changed anything, right? Same process. You could take the quantitative value book we wrote in 2012 with Toby, who you probably know, and fundamentally, it’s 99% the same that we talked about back then, that’s what we’re still doing today, unfortunately. It’s of the past 10 years, but we still fundamentally believe in buying cheap, high quality around the globe. And we’ll continue to do that.

Clay Finck (04:06):

One thing that is unique for you relative to many of the other people we bring on the show is your academic background. You got your PhD in finance and worked as a finance professor for a number of years. So I’m curious how you maybe see the world of investing differently than others through that lens.

Wes Gray (04:25):

I would say the key difference is I just had to eat way more humbled pie, because I started off as obviously a fundamental stock picker, totally obsessed with discretionary, try to be Warren Buffet type deals. I think what happens is once you go into the highest levels of academic research, the currency of that realm is not how much money did you make or how’d you beat the market. It’s all about like intellectual heft. And so it’s a great environment to go peer to peer in a place where people just want to tell you you’re an idiot and your ideas suck. And so I think through that experience, I’ve just gotten a lot more used to just recognizing that probably not as smart as I ever thought I was going to be. There’s a lot of really smart folks out there. And for me, it’s just all about keeping it simple and sticking to systems, not trying to outthink it.

Clay Finck (05:14):

One of the things that comes to mind related to that and related to the academic background you have is that investing, after a year, the stock you buy might do really, really well, but it’s difficult to know if it did well because for the reasons you originally thought it would do well or if it was just really based on luck. And I think just looking at the academic side of that is really interesting. I think.

Wes Gray (05:40):

That’s another huge component besides humble pieing is one of the whole points of going to a PhD program is basically to learn how to do good research. And as a lot of people are aware, not just in investing realm, but in every realm, being good at research and understanding how data can be manipulated, studies can be manipulated, and you can basically make the data sing whatever song you want, I think that’s important training to have. So you basically just don’t believe anything anyone puts out there until you replicate it under your own conditions, kind of like doing the good old fashioned scientific method. And a lot of people just don’t have that capability. Like, it’s just too much knowledge, too much data, too much program requirements.

Wes Gray (06:23):

And so we have that luxury where, yeah, great. That’s an interesting idea. I don’t believe it. I don’t care how many Harvard PhDs you have, because guess what? We’re going to go replicate it under our conditions and maybe extend the center pole, beat it up here or there and convince ourselves it’s a good idea where we just haven’t had that unique skillset by being trained in the dark arts of doing academic research.

Clay Finck (06:48):

It’s very interesting. You are a very data-driven investor and we’re going to talk a little bit about momentum investing. But first I wanted to ask you about finding value internationally. There’s a lot of talk of investors looking internationally for value due to how expensive the U.S. market has gotten on a relative basis. For investors that are broadly diversified in the U.S. market and with how widespread companies are becoming, as far as expanding internationally, is owning something like the S&P 500 getting an investor enough international exposure to hedge the risk of the U.S. markets, specifically taking a beating?

Wes Gray (07:31):

There might be an element of that, but the better way to think about this is what do you want to own and what at price? So for example, let’s take the most simple example, Acme company, that trades in the U.S., but has 100%t of its revenue outside of the U.S. And it sells for a PE of 30. Then you got XYZ company that trades in Europe and has 100% of its business in the U.S., but it trades at 20. I would rather own the European one because it’s fundamentally cheaper, even though it has 100% of its revenue in the states, right? So when people make that argument like, “Oh, well, why would I go international? Because I could just own U.S. stocks.” Well, yeah. But you’re paying 30 times earnings versus 20. And international companies, it’s not like they only do business international, they do business in the states, a lot of times at a higher frequency than we do business over there.

Wes Gray (08:29):

I would say from perspective of just a value investor and some stats for you, like right now we run like systematic value U.S., systematic value international. On the U.S. side, the operating and income yield on a U.S. fund’s like probably around 13%, 14%, which is a lot. The U.S. market is 4%, so it’s triple. But in the international market, it’s almost 17%. And the international market itself is probably, I don’t know, 5% to 6% yield. You can just on an absolute basis find way better deals internationally.

Wes Gray (09:03):

And so I think you probably want to invest everywhere, be globally diversified. And it makes sense to just go to where the cheapness is and not rely on the old Warren Buffet quote, which a lot of times he simplifies a lot of things that people get lost in the weeds, that he probably wouldn’t tell you that all the time. A lot of people are like, “Well, Warren buffet said just, oh, 90% U.S.stocks, 10% cash.” Well, yeah. Maybe, but that’s just because some reporter asked for a simple answer to a simple question. Does he do that at? No. He makes a ton of acquisitions outside the state. So watch what people do, not what they say.

Clay Finck (09:42):

That makes sense to me. Now, let’s dive into a topic that is very unique and something that you know a lot about. And that’s momentum investing. Could you talk to our audience about what momentum investing is?

Wes Gray (09:58):

Sure. So the first thing I would like to highlight is this audience is probably more value-minded. And just so you know, I’m on the same team, right? Like, I am genetically programmed to be a value investor. Totally get it. It makes way more sense to me, but unfortunately after enough beat down, I’ve come around to evidence-based investing as well and just believing in the humans, and they love fear and greed, right? I always tell people the easiest way to think about is value is kind of the fair trade, right? Buy stuff everyone hates, hold your nose, wait for a long time, take the pain, and then eventually it works. But there’s another thing in humans called greed. And why aren’t we exploiting that? Right? Or the beauty contest. The world is not about fundamentals all the time. It’s about selling something for more than you bought it for in the end.

Wes Gray (10:52):

And so that’s just high level background so you don’t think I’m some wacko, technical momentum trade. I’m part of the religion here, people, but momentum is also interesting. And essentially what it is, is it’s just buying winners. So stocks that are doing really well relative to all the other ones. In general, we want to own those securities because they tend to keep on winning. And they’re very different than the exposures you’re going to get from buying value portfolios essentially.

Clay Finck (11:21):

Is momentum investing essentially taking advantage of the psychological side of investing? Where a lot of people want to buy assets that are going up and a momentum strategy essentially rides the wave of new buyers coming in, continually pushing up the prices.

Wes Gray (11:39):

Yeah, I think that’s definitely an element of it. Like, the greed component and the FOMO component. And it’s just like all assets, once they get the ball rolling on FOMO, it just attracts more money because people love shiny rocks. So I would say that’s certainly one aspect of the psychology that contributes to momentum. The other one is ironically under reaction to the positive news that price momentum brings to a security. And I always give the examples of like, it’s called reflexivity. But the concept is, if you’re trying to attract talent, attract buzz, trying to acquire companies, I always say like, Amazon has a way cheaper cost to capital because they can go make a purchase of Whole Foods with their stock and it costs them nothing, whereas a value player that has bad price action, they have to pay cash. And so there’s a lot of benefits to have having fundamentally really strong price action.

Wes Gray (12:36):

Think about, not Cathie Wood anymore, but before Cathie Wood blew up. Like, Cathie Wood, Elon Musk, Amazon, these people have this, a special trump card where they’re against their comrades they compete against. Their cost to capital and ability to get stuff done is just way cheaper when you have great price action, because you can essentially use your stock to like improve your fundamentals, but in like a reflexive way. You could track better talent. There’s a lot of things I think are second level thinking that are actually tied to price momentum that retroactively contribute to fundamentals in a way that value investors never appreciate because they’re so focused on like, what’s going on here and now? Now, I’m not going to say they’re not second level thinkers, but it’s just the nature of humans. Most people are first level thinkers. And I think momentum has some interesting second level effects on fundamentals. And so in many respects, they’re kind of a value trade in that way. Because people underreact to potentially better news than they were expecting.

Clay Finck (13:40):

You mentioned that companies that have a strong price action can have a lower cost of capital. Could you dive a little bit deeper into that and what the cost of capital is and how that works?

Wes Gray (13:52):

So let’s just take an example of Amazon versus Walmart. And Amazon is a great example when they bought Whole Foods, right? When Amazon bought Whole Foods in a stock purchase, their stock went up more than acquisition cost. So it was basically free, whereas Walmart has to go out and pay billions of dollars to buy jet.com with cold hard cash, right? And maybe there’s some stock involved in that deal. And I don’t know all the intricate details. This is just a quick example. But the concept is, example might be like Elon Musk and Tesla versus GM or Ford, right? Let’s say they’re equally going to go out there and try to raise money for EV, electric vehicles. I guarantee that Elon Musk could go raise that capital for basically free because people love everything about it, the price is there, he’s made so many people rich, they’ll throw money at that problem like no other, whereas GM, if they have to go to the market to raise capital, they’re going to have throw hard money at the problem.

Wes Gray (14:55):

When I say by cost of capital, what is the charge that the market kind of imposes on you and the return that they expect for you to use their money? Whereas Elon can go raise capital at valuations and nose bleed levels. They probably expect a return, even though they don’t think it’s probably zero, right? Whereas if GM goes to the marketplace and tries to get money to fund EV, they’re going to have to pay people a return because they’re going to be like, “Well, I don’t trust you enough. You’re ugly. Elon’s way cooler,” which I actually agree with. He is really cool, but I wouldn’t necessarily want to be an investor in his offering versus like GM because I’m sure the GM offering I can extract like, well, I need to get at least 10%, 15%, 20% returns on this investment, whereas if I were to impose that on Elon, he’d be like, “Well, I’m not talking to you. I’m going to go talk to all these other people that I can raise equity at like a thousand times PE ratio.”

Wes Gray (15:53):

So that’s what I mean by cost of capital. It’s basically, what do you have to like put out there as fish bait to get the fish to bite so you can like catch them? And a lot of times firms or institutions that have really good price action because it kind of self reinforces how awesome they are, at least in a short term memory sense. They’re capability to raise capital and get things done is just a lot less than people that their stock’s in the shitter. And again, that’s just more of like a human psychology thing.

Wes Gray (16:21):

The other thing you could think about, another just kind of simplifying example is let’s say you’re an engineer and you may not know a lot about finance and like valuation or fundamentals, but you know that when you’re an engineer and you go work for a tech company, you get paid in stock. You’re not a finance person, so you probably use past performance as an indication of how great your option value is going to be. Want to work for the firm that’s had amazing 10x price action. All your friends are getting rich. You’re going to go work for like a firm that had an 80% draw down. And they’re like, “Oh God, who would want in on those options?”

Wes Gray (16:57):

So even though fundamentally, they might want to actually look at the actual valuations on the companies they’re about to work for when they get those options issued to them, most humans don’t think like that. They’re going to be attracted to the shiny rock of, I’m going to go work for whatever, Google or Microsoft right now. And then, I don’t know what tech firms have crappy price action, but like, let’s say there’s some crappy price action tech firm, let’s say Intel. That’s probably not case because they’re a value stock right now, but pretend Intel had bad price performance and they’re competing against like Microsoft right now for talent. And the stock price are diverging. Those engineers are going to want to at the margin, be willing to work less and harder for an opportunity to be at Microsoft versus like Intel. Because it’s just lame.

Wes Gray (17:45):

It’s just, price action creates weird incentives because there’s a lot of people that are not just investors, but constituents that are just performance chasers basically. That’s kind of a fundamental… Humans are like flies, they see light, they just run to it and die. The same thing like people. Like, they see big performance, even though we know what happens, you’re going to die if you chase performance, they did just go to that light and kill themselves. And it happens every single time. It’s just, I don’t know, it just is what it is I would say.

Wes Gray (18:18):

But momentum is a way to try to take advantage of that. Like, essentially you’re selling the light. Great, come on over to my light. We’ll try to catch a little spread along the way. You don’t have to do that. But the problem with momentum, especially for someone like me who’s so wired to be a value investor, if you see what the computer tells you to do, you’re just not going to want to do it. And so there may be other people that are not wired like that and maybe it’s easier. So for example, me, like when I look at the value names, I understand most of the market places be like, “God, why would you run on that turd?”

Wes Gray (18:52):

But to me, that just smells like money, fundamentally, right? I get excited because I’m wired for being a value person, whereas on those momentum names again, I could see someone out there that could probably do this in a discretionary way, but I need the automation of the computer to force me to do it because if I start getting in the weeds, I just know my own biases will prevent me from doing the actual momentum strategy that actually has the data and evidence and the psychology behind it. We’re just fully automated. Not saying that’s for everybody, but definitely for me.

Clay Finck (19:26):

It’s really hard to ignore this idea of momentum because Preston actually, he ended up putting together a momentum tool on our TIP finance tool on our website. So I find this just really, really interesting. Do you think that momentum investing debunks the idea that you can’t time the market?

Wes Gray (19:45):

I mean, there’s so many things that debunk that theory. It’s just a problem with like the don’t, can’t time on the market is that’s through the lens of U.S. investor psychology, who it’s always paid to be a buy and hold. Just think about it intuitively. Like, if I’m a holder in like Zimbabwe equity, are you going to be wired at… Like, I guarantee you ask any Rhodesian, who’s now a Zimbabwean, “Hey, you think you should you just buy and hold equity through thick and thin, no matter what, until it goes to zero?” They’re going to be like, “You should have risk management.”

Wes Gray (20:19):

So I would say the same thing applies in all markets. Like, you should probably trend follow or use momentum or momentum signals because in the end, you don’t want to ride a train to zero. And it’s just happens to be the case. And God bless America, but the U.S. is like the greatest survivor of bias experiment of all time, where every single time we’ve been on the precipice of like potentially dying, we’ve came back even stronger. I believe in freedom in like our systems and everything. I think they make robustness to allow that to happen, but I don’t really know. Like, maybe it was a lucky run. So I would say in general, using momentum, using trend and this idea that you should risk manage and think about your exposures, you should market time is just common sense. I think people that don’t incorporate some element or ability to market time are just crazy. Yeah, I think Meb Faber has a great, [POLI 00:21:15] always does. Would you own the S&P at 50 times? Great. A lot of people would say, “Yeah, yeah, yeah. Buy and hold, baby. Vanguard.”

Wes Gray (21:22):

And he says, “What about 500 times?” And they’re like, “Yeah, yeah, yeah. Buy and hold.” And he’s like, “Okay, what about a trillion times earnings? You’re still going to own it?” Like, at some point you just can’t be religious or dogmatic about anything in the marketplace. And so anytime you hear people make the claim that, oh, market timing is a bunch of bonk, it can’t be done, they’re just not thinking straight about it. Now, should you be engaged in trading? Should you like day trade, not consider frictional cost taxes and like your behavioral biases to want to do something all the time? Well, of course, but you shouldn’t also at the same time write off being tactical and being savvy about, “Hey, we might want to avoid the S&P 500 if it’s at a trillion times earnings.” Just saying. Is that market timing? Yeah. But that’s also common sense at some level.

Clay Finck (22:12):

So is it fair to say that some portion of your portfolio is these value picks that in general, you’re just holding, buy and hold for the long term. And these momentum picks are another portion of your portfolio that you are incorporating some sort of market timing and figuring out when to get in and get out.

Wes Gray (22:29):

Even on value, we incorporate elements of risk management, even in like a deep value strategy. So for example, like in Quant value, the fundamentals that process is upfront. We’re going to boot anything out that has like horrific momentum or horrific fundamentals, what have you. So already, let’s say you own some stock that is really cheap, but all of a sudden it’s got like horrific momentum and horrific accounting problems. Well, we’re getting rid of that. We also have like large elements of quality in there.

Wes Gray (23:01):

And so same thing, you can be… The energy patch was like this probably like five or six years ago where it’s like, oh my God, this is really cheap. Oh my God, it’s also total junk. And like, why would you ever invest in this? So we would get rid of that fundamentally, right? So even in our value system, there’s a lot of like fire alarms on there where we’ll be willing either on quality, degrading quality, really crappy momentum to just be like, “You know what? That’s really cheap, but why would I want to mess with that?” Because it’s like playing with fire. So it’s built in there.

Wes Gray (23:32):

And then obviously on the momentum strategy, I mean that one’s obvious. Like, if it has momentum, we own it. If it doesn’t, we get rid of it. And unlike value where you can kind of like take your lumps and you don’t need to trade it a lot to get it to work. In momentum, which is very opposite because it’s much more psychology-based strategy, you can’t rebalance a momentum fund once a year, because you’ll die, right? You need to be able to get out of things that are blowing up because that’s momentum, right? And then when things change it changes quick. It’s just a different strategy. It has a lot less leniency with respect to turnover and trading and needing to move, where value investing kind of, you can sandbag it, go slow, take your time, and you’re not going to get hurt too bad generally.

Clay Finck (24:18):

I’m curious. What did your momentum picks look like in March 2020 once things started to turn? Did your tool figure out yeah, something’s going on with these momentum plays, they’re starting to turn over. So were you able to get out prior to most of the damage was done? And were you getting back in? Tell me a little bit about that.

Wes Gray (24:39):

So in general, in March 2020 we got lucky at momentum, like value got absolutely destroyed, as you can imagine, it just didn’t matter. There was no bids. I think QVAL was down like 50%. And then if you were in smaller names, I know people that run funds like intra month, they had like 75%, 80% drawdowns, which is crazy, right? Momentum also obviously had a big drawdown, but because by nature it was owning high momentum names going into that, and a lot of the high momentum names were like tech, the things that just for whatever reason, got relatively lucky, they didn’t get beat down as hard.

Wes Gray (25:19):

And then also, just by dumb luck, like coming out of that March 2020, we have this fun, it’s called QMOM, the thing went on like the biggest bender of all time. I didn’t even know about it because like, I was an idiot in March it was like, “Hey, I’m doubling down on QVAL and IVAL. This is too crazy.” I was all proud of myself, because like a year later they’re up a lot. But actually I was an idiot because if I had bought like the momentum stuff, it would’ve been 2x that. Momentum on a relative basis did well in March 2020, but that just is what it is, right? Like, it’s all about the luck and what the market gods bring in. Like, momentum in the last year has annihilated, whereas value’s gone the exact opposite. It’s one of those things where, who knows. That’s why I like to own them both, but sometimes they work, sometimes they don’t.

Clay Finck (26:14):

How do you determine which companies to utilize in a momentum strategy?

Wes Gray (26:18):

I mean, so we, again having my own bias and this is not just me, but like Jack, who’s my partner in crime while I’m doing this research, we’re value guys who always think like, God, when we do momentum, we could probably improve that by doing some quality checks or avoiding these obviously total horrific companies from a value perspective. And every time we’ve tried to impose our thoughts, which we never just do thoughts, we always go test them, they just don’t work.

Wes Gray (26:48):

With momentum, if you want to capture the momentum effect and you want to try to exploit greed and exploit like this reflexivity and market price action, you have to focus straight up on either price action, or you could look at fundamental momentum too. Like, if you look at like earnings, keep beating the earning expectation, it’s the same idea, because they’re basically one and the same effectively. But the minute you try to impose like quality or valuation, anything that smells like a value investor was involved, you’re just going to ruin the momentum strategy. Period. I’ve tried to make momentum feel like value, it just doesn’t help the situation. I wish it did. It just doesn’t.

Clay Finck (27:31):

Something like Rivian, this company that went public with zero cars sold and ran up to a hundred dollars market cap. I have no idea what the stock’s at now, but for a period of time, it was doing very, very well.

Wes Gray (27:43):

It’s like a lot of things. That’s why it’s important to be able to do research and test ideas you have. You don’t want to go back testing run amok. But if you have ideas and you think there’s like first principles behind them, it’s always good to just test them variety of ways. And we’ve done that, but the issue with momentum is I think the first principle now that we have a much clearer understanding of how and why it works. It’s the same thing with like, if I’m a value guy, why does that work? Well, it’s probably because you’re buying things that are, let’s be honest, probably a little bit riskier, but then also we’re just buying things that no one else wants to own and the expectations are so horrific and so bloody and nasty that you just have that opportunity, but the trade of off is you got to deal with the pain and anguish.

Wes Gray (28:27):

And you’re just tired of taking advantage of fear in the marketplace, where momentum, like the first principles on that is it is a shiny rock greed trade. And to the extent you believe humans like shiny rocks and like greed and like the flies fly into the light and they always die, as long as you believe in that as a first principle, why would you do stuff that takes away from that first principle? And in momentum, if I’m putting quality or valuation bound, like all I’m doing is I’m no longer in the greed trade. Now I’m back in the value trade. But the whole point of doing momentum was to do something different because I already do value investing, right. So investing’s tough. Being lucky is great. I’d just be a lot better just be lucky than overthink this stuff. I like Preston’s Bitcoin move. Not saying that was lucky, Preston’s listening, but Hey, there’s probably a lot of luck involved in a lot of things in life.

Clay Finck (29:22):

One thing you mentioned there is that value investing a lot of times consists of buying companies that are a little bit riskier. Could you expand on why you believe that to be the case?

Wes Gray (29:34):

So this is something that value investors don’t like to admit, because they’re like, I know how the religion works. Like, well, buy margin safety or whatever. And they got a lot of cash in the till blah, blah, blah, right? But, but let’s be honest, like let’s go look at like Kohl’s versus Amazon. Like, okay, Kohl’s, I’m just making this stuff. I don’t know what Kohl’s sells for right now. But it used to sell for like eight times PE. And it’s got out high quality, they make money, blah blah, blah. Amazon obviously sells for like 50 times that and what have you. And so the minute you take that bet on the valuation spread between Amazon and Kohl’s, well, what does Amazon has a low cost of capital, i.e. a high valuation, because fundamentally to execute on their business plan it’s less risky, right? Whereas Kohl’s, to be able to transition to this new world, they got to do a lot of things right. They got to figure out their online presence. They got to figure out how to protect their turf with their stores.

Wes Gray (30:36):

So it’s just fundamentally riskier because also they have assets in place in the ground. They lot more operating leverage there where Amazon doesn’t even have stores, right? So a lot of times just the business models tied to “value stocks,” i.e. cheap, high quality things that sell for less than 10 PE versus other securities that sell for whatever, 50. And I’m not saying that risk explains all that spread, but it would be kind of foolish, and the evidence would suggest that you’re a fool that the differential in the valuation between classic value stocks and growth stocks, it’s not just 100% in this pricing and the market’s stupid because they don’t know that you’re shiny rocks is actually a shiny diamond, it’s you’re just buying more risk.

Wes Gray (31:23):

And so you should get paid. If you’re going to buy companies that are fundamentally riskier, their business model’s more at risk or whatever, yeah. You should earn extra money because you’re doing something that other people don’t want to do. And now that said, I also agree that people throw the baby out with the bath water a lot in these value stocks. And so the difference between like at the 10 PE and the 30 PE, yeah. Part of that is probably for risk, but there also is a part that people are just crazy and they would rather their own Tesla than GM or whatever. Who knows how to quantify like the mix between the risk and mispricing, but I think it would be foolish to not suggest that there’s probably elements of both involved.

Clay Finck (32:04):

Yeah, that makes sense to me, your Kohl’s and Amazon example, because obviously Kohl’s is completely being disrupted and displaced by Amazon. But I think someone could argue, say something like Berkshire Hathaway, I think somebody could argue that it’s a great business at a reasonable price. Do you see that as something that’s riskier than say like tech company or owning like the S&P 500? Or how do you look at that?

Wes Gray (32:29):

It would depend. So I don’t know the exact valuation discount on Berkshire’s whole portfolio versus S&P right now, but regardless the way I would analyze any situation is on the first principles of, okay, there’s a valuation discount. I don’t know what it is. It’s 10%, well does 10% justify… Like, maybe there is an additional risk, right? And maybe there isn’t any mispricing. That’d just be something we have to analyze on a case by case basis. And this is what fundamental discretionary value investors wreck the brains on all day. I do all those quantitatively and in the tails. I immediately am only going to buy stuff that’s in the 10% cheapest of the entire market. So I’m never going to get into these pissing battles between Berkshire and XYZ because Berkshire’s not the 10% cheapest stock, right? Like, clearly it’s probably more market efficiency priced than in the tails.

Wes Gray (33:25):

I just focus in the tails and then like fundamental discretionary managers, they can go quibble and cobble over the differences in the valuations on things like that. But the principles would still apply. And I would say without how having a forensic deep dive or being up to speed on Buffet at the current time, just knowing how he invests, like fundamentally whatever the heck he’s investing in almost certainly has more risk fundamentally tied to the economy, valuations aside, because he’s going to be buying hard assets, things that free cash flow, energy, stack, like all that kind of stuff, whereas obviously the S&P is 25% in like tech, right? Which is putting valuations aside just on a fundamental first principles of business risk. I see less risk in Apple than it… Well, actually Berkshire our owns Apple, but that’s not a great example, but whatever. Google, then I do in like the railroad station, I don’t know if Buffet still owns that, but like, they’re just different businesses.

Wes Gray (34:26):

Now, risk also is tied to the price you pay railroad at five times earnings might be way less risky than buying Google at 5,000 times earnings. But that’s something that people have to figure out, right? Like, if there is additional risk, is it compensated or are you getting a good deal, right? And so that’d be something a fundamental investor would’ve to determine.

Clay Finck (34:48):

Have you seen momentum investing to be a really successful strategy over the past decade with us being in this really long bull market?

Wes Gray (34:57):

Not really, actually. I was just actually looking up all the factors over the past years for the U.S. international. Basically if [inaudible 00:35:06] familiar to factors, all that’s trying to do is say like, “Hey, if I were to try to synthesize different characteristics of stocks, and we usually look at like value, the momentum, the quality and the size. And I said, “Hey, how have those factors done?” Like, if I tried to best I could isolate just how are those components returned, the interesting thing about the market over the past 10 years is, in the U.S. especially, is the only thing that’s made money is lowish quality, super big beta stocks. Values, over the last 10 year’s been a dog. Momentum’s kind of like, blah. Quality’s kind of like, blah. Like I said, like mega cap, like the size factor’s kind of, blah. It’s really all about just been owning the S&P 500 honestly. And all factors across the board haven’t been great.

Wes Gray (36:01):

And so to the extent, if you ran momentum and it was mega caps, you probably did okay, right? But if you did momentum and you had elements of like small or mid caps in there, because we know small as a strategy up until very recently, it’s been a total dog, maybe the extra momentum juice you got was overcome by like the size anti juice you got. So in general, all factors outside of just owning mega cap U.S. stocks in the S&P at the highest mega cap levels, it hasn’t done that well. In the international markets, it’s a little bit different. Like, you’ve had a little bit more mojo from momentum, but in general it’s the same problem. Like, value sucks, size sucks, quality was okay in international markets. But if you just want to keep quality out of it, because it can co-found things, but if you just look at like size, momentum and value, over the last 10 years globally, I would say none of them have been great and size has been terrible.

Wes Gray (37:02):

It’s kind of all about buying really big stocks that don’t really have great momentum, aren’t really especially cheap. It just kind of owned passive markets basically. And there’s a lot of theories on why that might be. I’m getting more and more open to the idea. Well, I’ve always been idea that flows matter, right? There’s a thing called supply and demand in the market. Initially, I was a skeptic on the idea like, well yeah, everyone just goes passive and they own S&P 500 stocks, no big deal. But at this point it’s such an escalating pace and Vanguard every day is buying billions of dollars a day where they’re literally, their clients or someone is liquidating value, size whatever. And their turnaround go and say and buy S&P 500 stocks.

Wes Gray (37:51):

So if you start doing that at scale and everyone’s doing the same thing, of course you’re going to have influence on asset prices. And I think we have a realization event over the past 10 years. And I don’t know when this will end, but stocks that are in the S&P 500 that get the most capital contributions have obviously kicked butt. And if you did anything that’s not that you underperform, basically. No matter what it was. Like, pretty much everything that wasn’t that underperformed the S&P. Because S&Ps are like, I don’t even know. It’s like 18% annual return for like the past 10 years. It’s crazy. So honestly, nothing’s worked that well. I should have just owned the S&P 500 the past 10 years. It would’ve been a lot better off.

Clay Finck (38:33):

Making a pretty good case for passive investing.

Wes Gray (38:36):

Yeah. I think that’s a case for if I knew what I knew now 10 years ago, and I knew the MOZ would all go to the flame at the same time at scale and just assume that you never have impact on prices and passives of free lunch, but we invest X any on a go for basis. And to me, anytime you have a situation where people perceive something that’s free has infinite supply and always works better than something else, that never leads to outcomes that are favorable. Because those equilibriums are unstable. It’s impossible to have a good that is free, unlimited and always works. Markets are good about mean reversion. And I think the whole passive craze is about to like, I don’t know when, because it’d be full hearted to try to predict human psychology, but fundamentally in 50 years from now, it’ll look like the nifty 50, it’ll look like many other episodes in the marketplace. It’s just crazy.

Clay Finck (39:37):

So how can the typical retail investor use momentum investing in their own strategy?

Wes Gray (39:44):

Probably the best thing I would say is most people, frankly, are never going to wrap their head around momentum investing, especially value investors. Like, I got a whole book dedicated to value investors trying to convince themselves to do momentum. But it’s like the old saying, you bring a horse to water, they’re not going to drink it. And that’s fine. That’s cool. Like, I always tell people like, “Hey, only do things that you’re convinced of.” And things that Wes does, they could be the worst idea you ever had for you to do it, right? And same thing for, you may have like great ideas and they work amazing for you, but they would be the worst idea ever for me. So in general, I would say most value investors should probably not end up doing momentum, they truly believe in the thing, in their bones, but they could still use it as a tool.

Wes Gray (40:33):

So for example, let’s say you kind of anchored value as a philosophy. Well, then let’s say you’re going to go sell some securities. Let’s say you have a stock, you own your portfolio. And you’re like, “Man, it’s getting a little pricey. It’s like right at my target, but the momentum is like epic.” Well, maybe you don’t sell that. Maybe you hold onto it. And then it hits a point where momentum flat lines or breaks down. Okay, now I’ll blow out of it. So maybe you use it as kind of like a tactical trading tool. Or on the opposite thing, let’s say you’re questionable on selling something. You’re like, “Well, God, it’s like pretty cheap, but I got this other name I kind of like.” Maybe it’s a little bit more expensive, but like the name that’s marginally cheaper has like horrific momentum and the other one that’s margin more expensive has like decent momentum and they’re both candidates for a sale.

Wes Gray (41:24):

Hey, maybe you blow out the one that’s got horrific momentum because we know on average owning baskets of low momentum securities, especially in extreme 10% is like the worst strategy on the planet earth. Even as a value investor, you could probably use these momentum things for like technical indicators when to buy and sell at the margin. But you don’t have to go full sell into the religion if you don’t want to. That might be a way for people in the audience to use momentum as a tool if you’re not going to go all in or go buy ETFs and do these sort of things.

Clay Finck (41:58):

It reminds me of what people would call a value trap. Sometimes value investors will get into a stock because it has fallen so far because it’s something that is not appreciated by the market and looks very cheap. Some of these companies that are falling in price are our value traps because they end up falling another 25% or 50%. And these value investors that thought they were getting a good deal are stuck holding the bag. One of these stocks that fell for years is GameStop. And it’s one that Preston and Stig talked about often well before the short squeeze that eventually happened.

Wes Gray (42:32):

That’s actually a great example of price action affecting fundamentals, right? I’m a big GameStop fan as a user of the product. I got three kids now, so I don’t get to use it as much as I used to, but I used to be a big gamer and still am. And so I liked it. But back in the day, I used to own it, it’s a total value dog because it’s just so cheap on cash flow basis and expectations were so terrible, but those guys couldn’t get out of their own way trying to raise capital to help them out. All of a sudden they go on the short squeeze, price action goes bonkers. And now because they can raise capital for like negative cost to capital, it seems. I don’t know if that’s a concept. Now they’re like fundamentally in a better position as a business than they’ve ever been in the history of their lives because of price action.

Wes Gray (43:23):

Obviously the fundamentals of GameStop have not changed basically one IOTTA on their core business, but now that their price action was so crazy, that actually it did fundamentally change. Because they’ve raise capital at nothing and now they can go do experiments on the cheap with other people’s money. And who knows, they may break out and become like a SaaS… God only knows what they could do now.

Clay Finck (43:47):

Yeah. They’ll probably start getting into the NFT space or something.

Wes Gray (43:50):

Yeah, because now they got free money to go burn on experiments, right? Because their cost to capital’s zero. So price action matters a lot. And if value investors don’t incorporate how price action affects their businesses fundamentally, then they’re missing out on like a key component of value investing, which is cost of capital. It’s like a big variable in your DCF, as you know.

Clay Finck (44:16):

So a momentum strategy, as you mentioned, requires frequent rebalancing with trading in and out of positions. How much of an effect do capital gains taxes have on a momentum fund?

Wes Gray (44:28):

Trying to do momentum as a retail investor, unless you got your act squared away on like your execution frictional costs and or you got like a tax dodge or not dodge, we’ll call it avoidance, it’s silly to do it, right? We never did momentum until we got the ETF rep, because at least the ETF rep probably get rid of the problem. I live in Puerto Rico now, so I can make a case to just do it organically because I don’t pay taxes and cap gains. But outside of living in Puerto Rico or investing in it through an ETF, unless you’re going to use your qualified account, it makes no sense to do a momentum strategy on taxable money because you got to pay your 50% back to Uncle Sam. It’s not that good, right?

Wes Gray (45:13):

And that’s just the tax, not to mention the frictional costs, right? Like, momentum strategies, if you’re going to do them right, on average you’re going to be looking at 200% turnover. And so if you’re not really good at execution, you don’t spend a lot of time thinking about impact costs, like how to execute the trades, and you’re just like winging it, you’re going to get destroyed in frictional cost. So unfortunately, and I hate to say this because I’m a big DIY fan, but momentum is just not for retail investors. Period. There is a system. Unfortunately you should probably go, if you like it, go buy a product, go invest in someone else who’s kind of doing this professionally. They’re just in a better advantage position than you are.

Clay Finck (45:56):

So do you think of your momentum strategy to try and enhance returns or diversify your equity exposure?

Wes Gray (46:04):

I think it’s highly contingent on the circumstance of the investor, right? So for example, if I go to Cathie Wood and I say, “Hey Cathie, do you want a momentum strategy?” She might say, “Well, I don’t know if that’s a diversifier or a return enhancer.” Right? She’s already got like banked up risk as far as the eye could see. So stock could do anything, whereas let’s say you’re a value investor that’s hardcore, I’d say, okay, you probably got higher, expect returns in the market. And momentum’s probably also an expectation, got higher, expect returns in the market. But from a diversification standpoint, it’s a slam duck, right? Because when your stuff’s yining this thing’s yanging and if you have two positive expected bets, but they’re uncorrelated, there’s going to be a benefit from a portfolio standpoint. So in that case, diversification would be great.

Wes Gray (46:56):

And then on a third example might be like, okay, let’s say you just hate stocks. They’re too risky. You’re like 20% stocks, 80% bonds. Or you put your money under your mattress. You’re basically underinvested in equities, but you need kind of like higher octane. I might say, well, instead of sandbagging it on like S&P for 20%, because you already got 80% of your money under your pillow, something like that, a momentum strategy is going to be able to kind of amp your exposure with the same dollars. So there might be an expect a return booster and probably maybe a little bit of a diversifier. So again, it can go either way. It just really depends on the situation and how you use it as a tool.

Clay Finck (47:38):

Now, you’ve mentioned trend following a few times during this episode, which sounds a lot like momentum and I’m not really familiar with trend following. So how does a trend following strategy differ from a momentum strategy?

Wes Gray (47:52):

Great question. I wish you had flagged me down earlier. Because it’s all about semantics, unfortunately. So when I talk about momentum, I am speaking specifically to relative strength momentum in the context of stock selection. The best example is I see two stocks, stock A and B, stock A is down 10%. Stock B is down 20%. When I say momentum, it would suggest that I would prefer A to B, right? Because on a relative basis, A is doing better than B. That’s what they call momentum, it’s used for stocks selection. Trend following is not about comparing things that like, at the same point in time across each other, it’s about comparing the same thing over time. So for example, we had those same two stocks, A and B. A was down 10%, B was down 20%. With momentum, I would say, “Great, A’s awesome, B sucks. I’m going to buy A and not buy B.”

Wes Gray (48:55):

With trend following, I would say, “I’m not buying any of these things.” Because A’s trend sucks, A and B’s trend sucks. So trend following is in reference to basically the absolute momentum on an individual security relative to itself, whereas momentum, at least how I use it is in reference to a stock picking strategy that’s all about picking the relative best. But it still could have terrible trend. And so when I talk about trend following, it’s usually in reference to like broad asset classes, right? So if the S&P is over it’s, whatever, 12 month moving average, own it. Otherwise, consider risk managing it, right? But it doesn’t have anything to do with about what stocks to own in the S&P, do I own GameStop? Or do I own GM? That’d be more like in the realm of what I call momentum. It’s a great question. And the problem is you need people to define it because some people will call momentum. And so it’s really just dependent on the definition and making sure you get down to brass tacks what people are referring to.

Clay Finck (50:01):

Wes, thank you so much for coming onto the Millennial Investing Podcast. You have your own momentum funds that if the listeners are interested in learning more about momentum, I highly recommend you check out his website. Before we close out the episode, Wes, tell us a little bit about your company, Alpha Architect and where the audience can go to connect with you.

Wes Gray (50:22):

So we kind of have two companies now. So Alpha Architect has a firm mission in power investment through education, and it’s alphaarchitect.com. And that’s where you can learn about all the strategies and like all kinds of things, related factors. And then we have another business called etfarchitect.com, where the mission there is to help ETF sponsors win. And that business is focused on bringing other people market who want to participate in the ETF game. So if any of your listeners want to convert into an ETF, launch an ETF, that’s where they go. And then you can always follow me on Twitter, just @alphaarchitect. And those are kind of three good places to find us. Depends on what you’re looking for.

Clay Finck (51:02):

Awesome. Thanks again for coming on. Wes, I really appreciate it.

Wes Gray (51:05):

Yeah. Appreciate it, Clay. Good chatting.

Clay Finck (51:08):

All right, everybody. I hope you enjoyed today’s episode. Please go ahead and follow us on your favorite podcast app so you can get these episodes delivered automatically. And if you haven’t already done, be sure to check out our website, theinvestorspodcast.com. There you’ll find all of our episodes, some educational resources we have, as well as some tools you can use as an investor. And with that, we’ll see you again next time.

Outro (51:31):

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