(Ep.10) The Acquirers Podcast: Justin Carbonneau – Guru Stocks, How To Replicate The Strategies Of Value Gurus

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In this episode of The Acquirer’s Podcast Tobias chats with Justin Carbonneau, a Partner at Validea Capital Management. Validea replicate guru strategies and track some other strategies. They have a money management firm, and an ETF. During the interview Justin provides some great insights into:

– How Can Investors Replicate Guru Strategies

– What Is The Best Guru Strategy Over The Past 5 Years

– The Time When Your Strategy Is Really About To Start Working Is Right At The Time You’re Going To Fold Your Hand

– What Can You Do To Avoid Most Value Traps?

– Value Investing Will Turn Around But No-One Can Say When

– Why Is Factor Timing So Difficult

The Acquirers Podcast

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Full Transcript

Tobias Carlisle: Hi. I’m Tobias Carlisle. This is the Acquirers Podcast. My special guest today is Justin Carbonneau of Validea and Validea Capital Management. Validea replicate guru strategies and track some other strategies. They have a money management firm, an ETF. We’re going to talk to Justin right after this.

Speaker 2: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinion of Acquirers Funds or affiliates. For more information, visit Acquirersfunds.com.

Tobias Carlisle: Hi Justin.

Justin Carbonneau: Hey, Toby. How are you?

Tobias Carlisle: I’m really well. We met face to face for the first time. We’ve known each other for a little over a year, but we met face to face for the first time in Hollywood, Florida at the Inside ETS conference where it turns out, you’re the fastest man in ETS.

Justin Carbonneau: The fastest man that no one knows about, apparently. Yeah, that was actually kind of a funny story. They do this fun run down there. It was Tuesday morning. It was 6:30. There was 100 people there, which was cool they organized it. Anytime there’s a run … I ran in college, so anytime there’s a run like that, I’m going to put my feet on the ground and try to work hard.

Justin Carbonneau: Anyway, the run starts and actually they have a celebrity runner there. His name’s Meb. He won the Boston Marathon maybe in 2016.

Tobias Carlisle: Meb Faber. Not Med Faber.

Justin Carbonneau: No, not Meb Faber. They had this celebrity runner. This group of people starts. I went out kind of hard, but I wasn’t running race pace. Anyway, at the two mile mark I’m out in the lead and I’m with the police escort. It’s just me and the police escort, and we get back to the Delmonte, which is the hotel, and no one’s there. The race just ends. I’m looking around saying, “Usually there’s somebody at the finish line to greet you or say, ‘This is the finish line.'” I go up to get my stuff, like the bag and my water bottle or whatever, and then I walk back down and I see people finishing. Then Johnson from Morningstar is finishing and walks by me. He’s like, “Did you see that Meb guy? He was flying. I don’t think anybody caught him.” I’m thinking to myself, “No one even knows that I finished first,” and it doesn’t matter because it wasn’t a race, but it was kind of hilarious.

Justin Carbonneau: Then I texted you and actually texted my wife when the race was done. “The race is done.” She’s like, “How’d you do?” I’m like, “Yeah, I kind of finished first.” She’s like, “Congratulations,” or whatever. I’m like, “Thanks, but no one really even knows.”

Tobias Carlisle: You were too far out in front, but it shouldn’t be any surprise. You’re a division one collegiate athlete at the University of Connecticut. What did you run there?

Justin Carbonneau: I ran middle distance. I ran the 400 and 800 outdoor, and then the 1000 indoor, basically.

Tobias Carlisle: That doesn’t really translate that well to a 5K.

Justin Carbonneau: No, but middle distance runners, you have to have quite a bit of endurance. I still run. I still run maybe a couple times a week, get out there. I did some hill work last night, so that was painful.

Tobias Carlisle: Maybe you should get in contact with Mike, tell him you need to go and run a marathon. You’re going to get Meb. You’re at business school, you did your MBA at the University of Connecticut, and it turns out you’re in the business school hall of fame. How does that happen?

Justin Carbonneau: Yeah, so at UConn in the full time MBA program, which I was very fortunate to attend, I had actually a graduate assistantship, so my tuition was waved and I did work with the marketing department while at UConn. This was 2002-04, so the internet was just, it was there, but schools were trying to figure out how to better utilize the web with their own marketing positioning. I worked with the marketing department on building out some of that as part of my graduate assistantship, and then I think it was a combination of students and faculty that voted for the one business school student that exemplified the characteristics that they wanted to see. I was the one that was selected. It was pretty cool.

Tobias Carlisle: That’s incredible. Now you’re a managing partner at Validea, and there are two parts to the business. One is a website that tracks gurus and also, not factors, but different investment strategies. Then you have a money management firm. Let’s talk about the website first. What does the website do, and what’s the focus?

Justin Carbonneau: The core of the website is basically running a series of strategies or models based on legendary investors, so people like Warren Buffet, Peter Lynch, Benjamin Graham, and in addition to that, we’ve actually rolled out a second set of strategies based on academic papers and books. What we basically do is, in some cases the strategies are very clear. It’s very clear what the actual underlying investment criteria and the factors are. In other cases there had to be some level of interpretation that goes into it. With Buffet for example, Buffet’s never really disclosed his exact stock picking strategy, and he probably doesn’t have an exact stock picking strategy, so we base our Buffet model off the book Buffetology. We can maybe to into that in a little bit.

Justin Carbonneau: But, basically what we do is we computerize these investment strategies, and then on Validea, you can do … That’s the underlying core foundation is these computerized models, and then it’s building things on top of those. Imagine for a minute you have a strategy, let’s say the Peter Lynch model. There’s certain fundamental criteria that goes into that. On Validea, you can type in a ticker symbol and you can see, step by step, how the Lynch method looks at over 6,000 securities. We do that for 22 different models. There’s a lot of what I would call fundamental analysis, but it’s not just lists and screens and portfolios. It’s actually the ability to look inside or look under the hood of a stock and see why a stock passes or fails a particular model. That’s something we call our guru analysis, or that’s an analysis engine if you want to see how your stock stacks up.

Justin Carbonneau: The other side of what I would say we do is running model portfolios and screens. Sticking with the Lynch method for a minute, if you want to see the top names according to our interpretation of the Peter Lynch strategy, we run model portfolios based on that, and then we also run stock screens. There’s a difference between those two things. A model portfolio, we’re sort of tracking the performance, we’re limiting the portfolio to 10 or 20 securities. We follow different rebalancing frequencies. I’ll come back to the portfolios in a minute if we talk about it. The screens are just really an idea generation list. Show me the top stocks today according to the Lynch model, and then you can combine that with other fundamental factors if you want to narrow the list down further. That’s a subscription-based product. People subscribe to that.

Tobias Carlisle: Let’s dig into the different gurus and strategies. Let’s start with Warren Buffet, because there are lots of magic formulas, is a quantitative expression of Buffet’s strategy. The magic formula is return on invested capital on the one hand, and then enterprise value on operating in [inaudible 00:08:35] or operating. How do you guys classify Buffet?

Justin Carbonne: Our Buffet model is based on the book Buffetology. There’s probably been hundreds of books written about Buffet’s approach, but that’s the one that we honed in on as having the clearest set of criteria that we could extract and be computerized. The first step is it starts with looking at trying to determine if earnings are predictable. What our Buffet model does is it looks at ten years worth of earnings, and it says, “Are earnings in this company predictable?” In the book, and I think we we know this to be true, Buffet doesn’t like volatile earnings. The more predictable the earnings are, sort of, in his mind, I think the better. That allows, in our model, that actually comes back full circle when we go to estimate the expected return, which I’ll get to. The first criteria is are earnings predictable.

Justin Carbonneau: The next criteria is, we look at ten years of earnings. The next criteria is does the company have a higher than average long term return on capital and return on total capital? Our strategy looks at 10 years of ROE and ROTC. That’s trying to express if a company has a competitive advantage or a mote around their profitability. When you look at ten years, in the last ten years, most companies … I shouldn’t say most. Many companies have sort of steady ROE or return on capital, but when you get these cycles in the business cycle, most ten year periods, you get to see where the weaknesses are in companies. The profitability dips. Our model doesn’t like to see that. Our model rewards companies that are maintaining that higher degree of profitability over long periods of time.

Justin Carbonneau: Then there’s a whole other set of factors like does the company have the ability to pay off its debt given the earnings its generating? Is management using … Are they generating a solid return on the retained earnings that they’re retaining as a company? Is the company buying back stock? These are all factors that are incorporated in the model, and companies are basically, they basically pass or fail each particular criteria. Only the ones that get passes are the ones that actually score best according to the Buffet model.

Justin Carbonne: In conclusion, there’s a part of the strategy that tries to estimate the expected return for the stock, and it does that using two different methods, the ROE and the EPS method. Our model basically likes to see stocks that have an expected return of at least 15% per year looking out. That’s the Buffet strategy. It’s obviously much more granular and maybe detailed than something like the Greenblat model, which he’s trying to get at some of that.

Tobias Carlisle: That’s where I was going to go next. You track the Greenblat model as well. Do you know how the two have compared?

Justin Carbonneau: Yes. The Greenblat strategy has been very volatile.

Tobias Carlisle: It’s very volatile.

Justin Carbonneau: Yeah, very volatile. It tends to bring us into what we would mostly call the small cap value area. The Buffett strategy tends to, given those criteria, tends to select larger, more quality type companies that tend to exhibit less volatility. One of the interesting things just to note, we also run this system on Canadian equities and South African stocks. We do those with partners in those countries, but the Buffett strategy, interestingly enough, in those separate markets, actually is in the top performing 25% of strategies that we run. It is interesting. That’s not true of the US strategies, but in those other markets, it tends to be a really good performer.

Tobias Carlisle: I watch the Australian market reasonably closely, and a lot of the other stock markets around the world, excluding the US, haven’t crested their 2007 peak. They’re still trailing. They all got very cheap, and then that’s kind of what, if you’re a value guy, that’s what you want to see. It increases the size of your universe and you should do fairly well. The US got back over it in about 2012, got over its 2007 peak in 2012 and has powered on from there.

Justin Carbonneau: I saw a chart yesterday. We’ve talked about this, this under performance of value, but this is kind of amazing. It was talking about, it was either, what was it, Deutsche Bank or one of the big European banks or managers that are basically saying value is finally set to turn. This has been a couple years we’ve been hearing this, waiting for it?

Tobias Carlisle: Five years.

Justin Carbonneau: Right, exactly. But, what it showed, this kind of blew my mind, and I may have even tweeted it, I’m not sure, but the MSCI value index over the past ten years has a negative return.

Tobias Carlisle: No kidding, yeah.

Justin Carbonneau: Think about that for a second. Ten years in international markets, developed international markets of negative performance. Then it was comparing, the chart was comparing the MSCI growth index, which was up like 60 or 70%. That wasn’t that great either, but I was like holy smokes, this is crazy.

Tobias Carlisle: It’s a phenomenon that I have … I look at the MSCI occasionally, too, just to see how it’s doing. It’s only recently, I think it was MSCI developed market, which is about 22 of the biggest developed markets around the world, has only just recently got over its 2007 peak. It’s still not particularly cheap, where it is. That’s true of some of these other countries as well. I think Australia and Canada in particular, I don’t know the South African market as well, but I imagine it’s pretty similar. Australia and Canada are dominated by big financial institutions and basic materials, which is mining, as you’d expect. They’re very cyclical. They really get beaten up.

Justin Carbonneau: That’s true. Yep. Sorry, we got off the guru strategies there for a sec.

Tobias Carlisle: We can go wherever we want. There’s no set agenda. How many guru strategies do you track?

Justin Carbonneau: We have 22 now.

Tobias Carlisle: What are the best performers? What’s done the best over the last, say, decade?

Justin Carbonneau: It’s the growth and momentum stuff for the most part. One of the extremely, and we would have never been able to predict this, and it’s not to say the next ten years are going to be like the last ten, but one of the strategies that has really stood out is it’s called the small cap growth investor strategy, and we base it off a model that was outlined by the Motley Fool. We based it off the Motley Fool investor guide. It is what it is. It’s a small cap growth investor strategy, and it has a very strong momentum criteria. Stocks that only have a relative strength of 90% or better are the ones that score highest in the model along with these other growth statistics that it looks at.

Justin Carbonneau: That, surprisingly, it’s been a great performer. This is model portfolio performance. This isn’t actual money management performance. These are model portfolios that are run and tracked on the site. I want to be careful not to say that this is actual money management performance. That’s been a really impressive one. We recently rolled out a whole new set. Of the 22, 12 of them have been on Validea basically since the 2003-2004 timeframe. Just recently we rolled out the ten new models, the Acquirers Multiple based on your book, actually, is one of them, so congratulations.

Tobias Carlisle: Thank you.

Justin Carbonneau: In that set, there’s this twin momentum strategy that has very good performance. That’s basically looking at fundamental momentum, and then it’s looking at price momentum. It’s trying to couple those two things. Companies that are exhibiting and upward trending improvement in various fundamentals and then that are also exhibiting price strength, and selecting the top 10 or 20 stocks based on that. That’s been a very good performer. It’s those types of strategies.

Tobias Carlisle: It’s been a momentum-growth market, I think, for the last decade. When you were talking about the bank, the European bank that had released the MSCI values showing it was down over the decade, I was thinking about the Rob [Annot 00:18:03] of the research affiliates, Meb Faber tweeted out some of his slides from a recent presentation which showed the dominance of growth over value. I think it’s a 20 year chart and I tweeted it out just because I was so blown away by how dominant growth had been over value. It showed that we’re sort of at the levels that we were at in the late 1990’s of this extended decade, and now leading to, I think it’s two or three standard deviations. Having lived through it, it wasn’t fun, but I’m excited for the future because I think that what has happened in the past, assuming that the world is going to look more like it did in the past in the future, and I think it tends to do that, we’re going to see some mean reversion. Hopefully we’ll see some return to value.

Justin Carbonneau: I actually saw that presentation. I downloaded those slides. There’s a lot of good stuff in there. To your point, if you looked at, at least with research affiliates, the expected returns of asset classes, or using categories of stocks, I think it was, the value was where the excess returns are likely to come from given crappy performance.

Tobias Carlisle: We’re at that part in the cycle where everybody’s making fun of value investors because value investors have had such a bad ten years of performance. How do you justify charging a higher fee for active management when you can get basis points for the SNP 500 and ETF that tracks that index and it out performs? It generates these risk-adjusted measures, these Sharpe and Sortino ratios that any kind of hitch front would be happy to have.

Justin Carbonneau: Yeah, for sure.

Tobias Carlisle: What value strategies do you track? You track Buffet, you track Graham, you track Greenblat.

Justin Carbonneau: Yeah, let’s go down the list. Buffet, Graham, a strategy based on Ken Fisher, which is used as a price to sales and has a strong value tilt. O’Shaughnessy’s corner stone value strategy, which he published in What Works on Wallstreet-

Tobias Carlisle: That’s the blend.

Justin Carbonneau: That’s not the blend. That’s just the large cap value strategy. The blend is the … Depends. There’s multiple. What he did in What Works on Wallstreet is he did, basically in the first addition it was a small cap growth momentum model, and then the large cap value. Then he combined the two for the blended, combined optimal portfolio. Since that first edition, he’s come out with different iterations of what looks to work best over time, but we track the cornerstone growth and value models on Validea. One of the new models is also using his value composite model from his book, which looks at five different value metrics and then looks to identify the top stocks according to that. That’s on Validea.

Justin Carbonneau: The John Neff strategy, strategy based on David Dreman, which is a large cap deep value [crosstalk 00:21:15] strategy.

Tobias Carlisle: Let’s dive into Dreman’s for a moment.

Justin Carbonneau: Okay.

Tobias Carlisle: How is his characterized?

Justin Carbonneau: His starts out by … It’s a deep value strategy. Interestingly enough, one of the things that is crazy with the Dreman strategy is from ’03 to ’07, the thing was by far, absolutely our best performer, significantly. It tends to pick up a lot of international stocks, and it always has historically. There’s always been a lot of financials also in there. As you can imagine, since basically the financial crisis, that thing has been in the tank.

Justin Carbonneau: The strategy starts out by looking at the largest 1500 stocks in the market. Oops, sorry. The largest 1500 stocks in the market, and then it looks at four different valuation metrics. It looks at, I think it’s price … PE, price to cash to flow, price to dividend, and another one, and it wants the stock to at least be in two of the four value. It wants the stock to pass at least two of the four value criteria, and then it looks at a series of the current ratio and improvement in underlying financials. That’s essentially what the strategy is in a nutshell.

Tobias Carlisle: Is that from his Contrarian?

Justin Carbonneau: Yep. It’s actually Contrarian Investment Strategies is the book.

Tobias Carlisle: It’s closely tied to the value factor because it is a combination of value ratios, so when the value factor is doing very well, which it did from the early 2000’s to 2007 it did very well, and when the value factor, not necessarily pressed, just any kind of ratio has struggled over the last mid 2010 to date, it’s been a very rough period.

Justin Carbonneau: Right. Yep.

Tobias Carlisle: You have this choice of all these different strategies that you can use, and then you have this money management firm. That’s managed accounts, and an ETF. Is there anything else in there?

Justin Carbonneau: We threw our hat in the ring in the robo-advisory business, too.

Tobias Carlisle: Robo. When folks come to the firm, do they say, “For a managed account, I want the Buffet strategy,” or do they say, “I want you to give me the best ideas from all of the strategies for this time of the cycle?”

Justin Carbonneau: We have a set of strategies that are based on combinations of the models that we run. But, we have some clients that either we do custom development for, or if somebody feels very strongly like, “I am a Benjamin Graham disciple, and I want deep, deep value exposure,” we can do that. It’s just, everything we’ve seen and we’ve talked about it over the last ten minutes, growth or value, any concentrated portfolio of 10 or 20, 30 securities, especially if it’s just one type of strategy, you can be all over the place. We actually try to be very careful with our investors and say, “Listen, yeah, we understand you’re a believer in value investing and the Benjamin Graham intelligent investor, defensive investor model, but you’ve got to have the thickest skin to be able to stick with that strategy.” We do have some clients that have done it. When that turn in value comes, if they’re disciplined, they’re going to get rewarded, hopefully.

Justin Carbonneau: We generally try to do blends is kind of the answer.

Tobias Carlisle: I’m always talking about my book a little bit on this, but I am a believer in value because it appeals to me intellectually, and probably it’s emotional as well, I don’t know. I think it’s a good idea if you believe in a strategy and it does ultimately end up working to stick in, to have this … I met this guy recently. He’s an investor in, he was one of Monish Pabrai’s early investors. He has a record that’s better than Monish Pabrai because every time Monish is down he gives him more money.

Justin Carbonneau: Oh, really. He kind of dollar cost averages it in, but when the strategy’s underperforming … Good approach.

Tobias Carlisle: Monish has got a phenomenal record.

Justin Carbonneau: Do you know what’s his long term? Is it in the 20’s or something in terms of return?

Tobias Carlisle: I don’t know. The sort of numbers I thought I had saw, it was thousands of percent. Maybe tens of thousands of percent over a couple of decades, something like that.

Justin Carbonneau: Yeah. The reason I … You guys, it was a chart that you put in your weekly content recap.

Tobias Carlisle: Roundup.

Justin Carbonneau: Actually last week. It’s a chart that I encourage everyone that’s watching this, which hopefully some people watch it, right? To look at, but it’s the chart of it has returns on the y-axis and the number of years on the x-axis, and it shows all these great superstar investors, and where they would be. If you have Buffett, Buffett has 65 years at basically 22% annualized return. He’s way out to the right and pretty high up in terms of the return. Then you have even guys like Greenblat and like Lynch. Lynch was 29%, which was phenomenal, but it was 13 years. In terms of the time frame, it’s far less, obviously, than Buffett. I find that chart really fascinating. It does go to show, and we know this, it’s obvious, but how crazy Buffett’s long term performance is. With that being said, if you take the last 20 years for Buffett, it hasn’t been anywhere close to that, but there’s a lot of factors that play into that. I find that chart very interesting. It circulates around. Once every couple years, I see that pop back up.

Tobias Carlisle: Right, I remember it. I had to put on an update because I think everybody’s seen it. There’s another version of it that has guys who aren’t necessarily value investors and there’s some absolutely phenomenal returns on that as well.

Justin Carbonneau: I would be curious to see Jim … I don’t think Jim Simons from Renaissance was on there.

Tobias Carlisle: I think one of the ways that folks generate very good returns is by having a strategy that starts right at the beginning of a good run for their strategy. If you’re a value guy and you get started in the early 2000’s, you get the first 7 or 8 years, you get phenomenal performance. If you even just market perform for another decade, you get a pretty good looking track record. It’s the guys who invest through multiple cycles and out perform through multiple cycles as their asset base is getting bigger and bigger. Basically, we’re really only talking about a very small handful of guys here. It’s probably Buffett and Soros and maybe [inaudible 00:28:47] and a few other guys like that who have got some genuine skill. The really hard thing is that if you underperform for a few years and you’re a manager and you don’t have enough equity in the manager to control it, you can be fired from your role. There goes your track record. 13 years is actually a pretty long track record.

Justin Carbonneau: That’s true. That’s a good point. You’re right.

Tobias Carlisle: It takes a long time to get into the seat. You might not get into the seat until you’re in your 40’s. You run it for 13 years, you’re in your late 50’s and it’s time to hand it off to some other young guy in his 40’s.

Justin Carbonneau: There’s so many things that you said that I really agree with. You don’t know, if you were a value … Even with Validea, when we launched our models initially in ’03 tracking these portfolios, that set the stage for the asset management business. The models are sound. They’re based on things that have worked over long periods of time, but we launched it in ’03. We were coming right out of that bare market, and value went on a great run. Our models were tearing it up. We definitely benefited from that. The people that were investing with us benefited from that. But, then you have the cyclicality and the under performance of value, so now it’s like we’re not benefiting from it. That’s why it’s very important to believe and have conviction in the strategy that you’re invested in.

Justin Carbonneau: From my experience, and I’ve worked with hundreds of investors at this point, we’re human. It’s how we’re wired. There’s a lot of things that play into it, but as soon as you lose conviction or doubt starts to creep into your mind about, “Is this strategy the one that I believe in,” pretty much it’s over. I’ve almost never been able to convince, if a client or an investor starts to doubt and not believe in what we’re doing, then they’re probably not going to be a client for the long run. That’s going to happen. That’s part of running money and being an active manager is you hope to get the right people on the bus. You won’t all the time. You try to educate along the way. Some people will listen, and some people won’t. You know that.

Tobias Carlisle: I absolutely do, which is why all of the books that I have written have focused on the behavioral elements of it. I do think it is crucial to out performing. It’s often that it’s tried, and it’s sort of a cliché to say it, but it is darkest before the dawn. The time when your strategy is really about to start working is right at the time you’re going to fold your hand. Often it’s because the other people with less conviction are folding their hands. All of a sudden, the capital drains away from the strategy, and that sets it up for a really good return.

Justin Carbonneau: One thing that sort of, that I wonder is you have, obviously with ETFs and quantitative strategies, I think Black Rock is … Vanguard has their value ETF now. This capitulation in the value investing arena, I don’t know if just given the proliferation of these value strategies if you’re going to get as much as you would have when maybe those didn’t exist. It’s just a question I have in my mind. We talk about everyone folding. Clearly, if growth continues to outperform, more and more people will gravitate and assets will follow the performance. At some point, you like to think there’s this tipping point where that changes and the regime changes, but I almost feel like you need some, and maybe this will happen. Maybe there will be consolidation, some of these value strategies won’t be around in five years because value will continue to underperform and firms will shut down those strategies. Maybe that’s how it will play out. I don’t know.

Tobias Carlisle: There’s lots of data to suggest that ratio values is potentially going to struggle for that reason, that there’s a lot of money in it. The only thing that I would say is when you look at any list of the flows to ETFs, for example, I think it might have even been Ben Johnson from Morningstar, or it could have been Eric Balchunas from Bloomberg had tweeted this out, but it showed the top 10, the flows to the top 10 ETFs that have launched in 2019. The top ETF was an ESG. That’s environment/government focused ETF. It raised $850 million since the start of 2019. Phenomenal performance. Then if you go down that list, number 10 on that list was a focus value ETF, which is somebody’s doing a little play on [inaudible 00:33:48], I think, which has done fairly well. It had $30 million in it.

Justin Carbonneau: That was number 10.

Tobias Carlisle: Right. I don’t know that there’s that much money chasing. I don’t talk to anybody who’s just chomping at the bit to get into a value fund because it’s so hot right now. [crosstalk 00:34:08]

Justin Carbonneau: It just goes to show if you can raise $30 million in an ETF, you’ll be a top ten.

Tobias Carlisle: Since the start of 2019. It’s a short period of time.

Justin Carbonneau: Right. Yeah.

Tobias Carlisle: That’s good performance, but it demonstrates to me that I think that there are a lot of folks who see that value has had that very extended period of under performance. It’s underperforming by so much now that if you’re a [inaudible 00:34:35], it is a good start to allocating to value strategies. I think there’s a lot of people who know that intellectually, but really, on an emotional level, they’re like maybe St. Augustine give me chastity and give me whatever it is, whatever else, but not yet. I just want to see a little upturn in value before I start allocating to it.

Justin Carbonneau: There’s so many different ways that you can define and express value. You have your Acquirers multiple. All the strategies we’ve talked about, they’re different. They’re all getting the value, they’re all getting their value tilt or their value bias through a different set of criteria. If you’re running a very focused value strategy, I think that it’s … I just think that you can get really, really strong returns when the reversion happens.

Tobias Carlisle: Even if if you’re a value investor who’s more like Buffett who’s looking at the individual businesses and not caring so much about the ratios, and Buffett’s explicitly saying that low P and low price to [inaudible 00:35:47], that can be associated with a value buy, but it’s not necessarily associated with a value buy. Even those guys who do that sort of stuff look at the growth, try to find the steady growth rate, they are still tied to the value factor in some way. They’re not spending this last decade massively outperforming by mere virtue of the fact that they’re doing a DCF.

Justin Carbonneau: Right.

Tobias Carlisle: That’s one of the things that I always think is most telling, that a lot of guys who are my vantage, who have been in the markets for the last 10 years running value strategies for the last 10 years, nobody’s particularly well know. Maybe Allan Mecham at Arlington, but there’s nobody else. Even Allan’s not particularly well known. There are lots of guys who are out there who are running strategies, but it’s just because everybody has struggled to keep up with the market, even doing that additional work and the list of private equity. You can do a whole lot of work to make sure that each, polish each stone before we put it up on the shelf, but it doesn’t help anymore than the guys like me who are just shoveling all of the rubble into it and hoping that there’s a gem in there.

Justin Carbonneau: Doesn’t matter. For sure. Yep.

Tobias Carlisle: In your ETF, how’s the ETF constructed? What’s the process for selecting the strategy or stocks, or how does that work?

Justin Carbonneau: Yeah. I guess I can talk mostly about the index. We’re the passive fund. The way our index is constructed is we select ten different investment strategies and allow each strategy to select the top ten stocks. Our index is 100 securities, 10 different models selecting the 10 top scoring issues. There’s a review proceeds at the end of every year where we look at our model lineup and we look at what we know about the performance and correlation of the various models, and select the models that we feel like are best positioned when combined together as these ten different strategies. The way right now, the index is certainly a … It is effectively a small cap value fund if you were to put us in Morningstar style and size box. Our index is actually rebalanced monthly.

Justin Carbonneau: One of the things with managed accounts or with an ETF, the turnover, you don’t want to be turning 50% of the portfolio every month, which some of these models, if you just let them run, you need a way to manage that turnover. The way we do it is we layer in an additional component, and we call it our intelligent tax management system. Hopefully it’s intelligent, but basically about 10% of the index is changing on a monthly basis. The way it works is we’re holding … It’s the same process for the index and also the managed accounts. We’re holding our winning positions until at least 12 months, and our losing positions that don’t meet the models, that have fallen in score, are the ones that are removed from the model or from the index. What that translates into our strategy that still follow this rules-based systematic sense of strategies, and they still hold true to following and selecting the stocks that pass the gurus, but we’re harvesting losing positions and we’re holding on to winning positions. It creates a much lower turnover strategy and it becomes much more tax efficient.

Justin Carbonneau: Obviously with the passive vehicle, passive ETF, the custom create and redeem process allows you to forgo capital gains, but with managed accounts, obviously with taxable money, it’s important. Trying to figure out a way to manage that turnover without giving up too much performance is what that tax system is effectively trying to do. Did that answer your question?

Tobias Carlisle: Yeah. Do you find this overlap between the strategies, do they try to buy the same stocks sometimes?

Justin Carbonneau: We don’t allow it, but there will be. We just go down to the next. Baked into the system is if we’re already holding the stock, it’ll go down to the next highest scoring security to fill the portfolio.

Tobias Carlisle: It’s possible that one strategy could be selling and one strategy could be buying, in which case you just don’t move the position.

Justin Carbonneau: Let me think about that. One strategy … Well-

Tobias Carlisle: The very deep value guy, I see this happening all the time, particularly in the early … In 2008 and 9, I’d buy all of this junk and I was buying it because at that time I was only doing net-nets. I would buy these things that were … For people who don’t know, net-net is you’re looking at the most liquid portion of the balance sheet, net current asset value. It’s just the cash in [inaudible 00:41:05] and receivables. Then you’re discounting all of the liabilities, deducting the liabilities from them. Then you’re trying to find stuff that’s trying to get a discount to that. This stuff is really, really cheap. The reason it’s cheap is because they’ve got terrible businesses, or the businesses look terrible at that time. They look like they’re going out of business, often. I would buy these things.

Tobias Carlisle: It’s just the way that deep value works. The management team doesn’t want to go out of business, so they start doing whatever they’re supposed to be doing, or competitors leave and the business improves a little bit. When that business improves, all of a sudden it starts popping up on other value investors’ screens because these earnings are, now you’ve got one or two or three years of good earnings in a row. It’s possible that a very deep value investor can buy something and flip it somebody who’s a more franchised or earnings power style investor. Do you see that?

Justin Carbonneau: Yes. It certainly can happen. I think it does happen. What you’re really getting at, at least in our world, is the intricacy of running these models, which is, on the surface, these things seem very easy. You have a screen, you have a set of criteria. You find the stocks. How do you manage turnover? How do you manage the situations that you’re talking about where you’re selling a stock and then buying it right back? How do you break ties? Do you have a stop loss procedure in place? What happens if the fundamentals are fraudulent or there’s some type of fraud? What is your … What sort of rules do you have in place to actually take a quantitative strategy and implement it in an actual money management portfolio?

Justin Carbonneau: What I’m really trying to say is that there’s a lot more that goes into that and that needs to be thought about. Then you get into how is our investment process different from your investment process, and how is your investment process different than the other quantitative guy down the street that’s running … In all of that, we like to think ours makes sense. It doesn’t always mean it’s the best or it’s perfect, but it is the reality of running models. We’ve kind of learned a lot over the years about what needs to go into that, what needs to go into actually implementing a quantitative strategy in the real world.

Tobias Carlisle: Do you do any additional fraud, financial distress type screens on top of the hundred, or do you rely on the individual strategy to do that?

Justin Carbonneau: We have something similar to … One of my partners, Jack, wrote a good article. We have a quality composite score. There’s four different things that goes into it. We were just talking about it, too. Do you have show notes that we can post or whatever? Links?

Tobias Carlisle: Yeah.

Justin Carbonneau: I can post it afterward. We’ll post the article. It’s really good. It’s how we actually implement our quality score. What we’re doing there, and I think you might do this with Acquirers multiple, we don’t use short interest. We use a couple of other factors. We’re just removing the bottom five percent of those quality … We want to make sure that we’re not missing something huge. For example, I know one of the things is current year earnings versus analyst 12 month earnings. Let’s take energy. The price of crude fell from whatever, 100 to 30, analysts were quickly cutting their earning estimates. Probably not even fast enough, but you would have caught really hard with value traps because the prices were moving so quickly and the earnings weren’t reflective of the decline and the commodity.

Justin Carbonneau: What our quality thing is trying to do, and it wouldn’t have protected us that well, honestly, in that, because we held a lot of energy in late 2015, early 2016. It’s just a lot of our value strategies were bringing us there. I think it would have saved some of the pain in that. The quality measure that we’re implementing, this quality component, is a little bit of a newer integration into our models, I’d say, in the last year or so. We’re just really cutting off the bottom, the very worst scores, on the quality. My partner, Jack, would say, what it’s trying to do is avoid value traps. There’s no way you can ever avoid all value traps. It’s impossible.

Tobias Carlisle: I was going to say, you don’t know it’s a value trap until after you’ve bought it and you’ve held it for two years and it’s not up.

Justin Carbonneau: Right. That’s true. The only way you know is after the fact.

Tobias Carlisle: It’s very hard. In quantitative value, we talked about some of the hygiene of the universe that you’re going to draw from. We excluded things that have got financial distress risk, which is sort of … Bankruptcy is something that it’s an event that it happens or it doesn’t happen, but financial distress risk is a continuum. As they get riskier and riskier, they get more likely to be in bankruptcy, so you want to exclude them. You want to exclude earnings manipulation because it gives you a misleading picture about what the company’s actually doing, and it’s also a gateway drug into fraud. Fraud is the thing that we’re trying to avoid. Statistical fraud measures as well.

Tobias Carlisle: The funny thing that I always find is when I look at the … That does great things for the entire universe of stocks. If you look at whatever universe it is, say the Russell 1000, if you exclude the 5% that score worst on those, that universe does then do better. You can improve the performance of the Russ 1000 doing that. It doesn’t actually do much for the portfolios because the Venn Diagram of the stocks that are ultimately selected and the stocks that are going to be excluded anyway, they don’t overlap.

Justin Carbonneau: Okay.

Tobias Carlisle: Do you know what I mean? It’s already looking for it. It wants a cash rich balance sheet. It wants cash flow earnings.

Justin Carbonneau: Those kinds of factors are you’re not really excluding the companies that would be in the portfolio.

Tobias Carlisle: You wouldn’t buy them anyway.

Justin Carbonneau: Right. Right.

Tobias Carlisle: The sort of stuff that gets picked up by those things is the stuff that you would expect. Most of the time you can eyeball them. They tend to be companies that are quite expensive anyway because they have to create that illusion. The only way they’re going to survive is raising capital. They’ve got to sell shares. They’ve got to sell some debt, and that’s where the fraud comes in. I think they really work best all together because often you find when it scores badly on one, it scores badly on all three. They all go hand in hand.

Tobias Carlisle: We’ve seen this really difficult time for value. I get the feeling that you’re not necessarily a believer that value can turn around. You don’t think it can do it again?

Justin Carbonneau: You don’t think that? No. I strongly believe, to your point earlier, I think value investing, there’s the underpinnings of what makes value stocks work. I believe very strongly in that. I just don’t believe anyone can time the turn in value or the turn in any of these factors. But, mean reversion is a very powerful thing in the market. Looking out over the next ten years, I do think value stands a very good chance of certainly improving its relative performance. But, you also have to always question your beliefs to some extent and just try to be … That’s one thing I’ve tried to do more of and my partner, Jack, he does a really good job at it. I don’t. I tend to, on Twitter and the articles I read and stuff, I read the things I agree with. When I hear fundamental investing is dead or somebody that’s bashing Buffett for his performance over the last 15 years, I don’t agree with that stuff. But, I also want to be open minded to that in the markets, things change and things can go on a lot longer than we think, and they have been for a couple years now.

Tobias Carlisle: I think value investors have been doing a lot of introspection. The last decade’s been rough, but the last five years in particular. I thought five years into the under performance was enough.

Justin Carbonneau: Yeah. I think we were writing about it five years ago. Turn in value.

Tobias Carlisle: Here it comes.

Justin Carbonneau: I think we might have been one of the earlier ones, and we were wrong. It kind of humbled us, I think, in that sense.

Tobias Carlisle: I’ve been saying, “It’s five years,” for so long that it’s longer than five years now. I’ve been saying it for six or seven years. I’m actually going to say it’s seven years. It’s so long.

Justin Carbonneau: Exactly.

Tobias Carlisle: I always think of that article that Malcolm Gladwell wrote about Nassim Taleb. Nassim Tableb used to say used to say to his trader, “Have you introspected today? Introspect. Introspect.”

Justin Carbonneau: Yeah. Right.

Tobias Carlisle: Every value investor out there, there’s so much introspect going on. Why aren’t these strategies working? If you were a value investor who’s kept up with the market over the last decade, you’re a genius. You’re just undiscovered. Having lived through it, I remember all the … There’s a suggestion that the problem with the value strategy at the moment is it’s so focused in bad sectors. It’s focused in energy, it’s focused in financials. Having lived through it, I can point at each stage along the way. All of these disasters like Chinese reverse takeovers, they all came on. They looked pretty cheap. They all floated down into the value stuff if you bought them, you got carted out. Then there was the for-profit colleges.

Justin Carbonneau: What was the Corinthian college and-

Tobias Carlisle: I remember it well.

Justin Carbonneau: Yeah. These things were trading at PE of four or something, you know?

Tobias Carlisle: You backed out the cash, though, free.

Justin Carbonneau: Right.

Tobias Carlisle: Then energy more recently. At every stage along the line, you’ve just walked into a value trap industry.

Justin Carbonneau: I sort of feel like we’ve had these little bumps. What was it, was it 2017 that value had pretty decent performance?

Tobias Carlisle: 2016. 2015 it sold off really hard at the end of the year, and then it bounced at the start of 2016.

Justin Carbonneau: We’ve gotten these little bursts of strong performance out of value, and you think it’s like, okay, now we’re set up for the run, right? Then the next month, it’s like, look at this year. It started off decent. January was good. Now look. Apple, Microsoft, it’s the big mega tech names that are driving a lot of the market performance.

Tobias Carlisle: There’s an enormous amount of timing luck in all these strategies. I think about 2012 in particular. That was one I remember fairly vividly, but at the beginning of 2012, value got hosed, and then midway through 2012, it did start working. In 2013, the market had a very good year. The market was up 30% with very little volatility. I forget which is the last … Chris [Call 00:52:30], who I’ve had on the show and is a buddy of mine, he tracked these and we used to talk about this a little bit. He’d show me these periods of time in the market where the market just goes up at a 45 degree angle without any volatility. You get these incredible risk-adjusted … 2013 was one of those years where the market was just straight up with no wobble through the year. I think it was one of the best on record in risk adjusted terms, and one of the more recent years beat it again. I don’t know which year. Maybe it was 2015, or 2016 beat it. It was just a better year again.

Justin Carbonneau: Right. Most stocks were participating, I think. When you have your average stock doing well, just statistically the odds, these more concentrated value strategies I think have a chance to really perform well. One of the things, I don’t know what you feel about this, but I almost feel like it might be, a bare market might be what we need to change the psyche of investors for this style to come back into favor. If you go back to the 2000 to 2002 bare market, that was obviously … There was craze evaluations and a lot of those companies, that’s when you saw value. I don’t think we’re at, it’s not the similar type of story from that point in the sense that you don’t have as much overvaluation, let’s say, but maybe the bare market will get some of the flow that has gone into all these large megacaps and growthy like names, and you’ll see a reversion in value. I don’t know.

Justin Carbonneau: I just think it’s kind of interesting to think about that way. The turn might not come until you have pain at the market level, like a bare market type environment, maybe. But with that being said, look, we’ve had, even though we talk about it and the [inaudible 00:54:32] guy has talked about this recently, there has been three mild bare markets in this since the end of, beginning of ’09. Really 2011.

Tobias Carlisle: Right.

Justin Carbonneau: ’15, and then the end of last year. If you look at something like the Russell 2000 or any of these equally weighted, stuff was down more than 20%. [crosstalk 00:55:00]

Tobias Carlisle: The question is is that enough of a market clearing? One of the things that I always say is you have to understand where your strategy is going to work well. I think this is a bit of a myth about value that people think it does better in a draw down. I’m not entirely dissuaded that that’s the case. I think that’s only I the strategy itself is under valued. One of the things that it does do very well is it recovers before the bottom in the rest of the market. It should bounce fairly hard out of the bottom, whereas momentum, it works hard at the end of the cycle. It’ll always be running very strongly. In the draw down, the last time that we had a big draw down, 2007, 2009, momentum was down 90% [crosstalk 00:55:47].

Justin Carbonneau: Was it really? 90%? Wow.

Tobias Carlisle: It takes 12 months for the signal to even start working. For that 12 months, you can’t use the signal. Momentum, that’s a really tough one. You’ve got to be in it up to the end of the cycle. Somehow you’ve got to pull your chestnuts out of the fire just as it tips over, and then you’ve got to stay out for a while.

Justin Carbonneau: Yeah. I think it’s called crash risk with momentum. Once it’s done, it’s done. It just completely collapses.

Tobias Carlisle: At that stage, you switch into value and you ride that for the next decade, or the next month as it happens.

Justin Carbonneau: The factor timing. Maybe next time I come on, we’ll do the factor timing discussion.

Tobias Carlisle: What’s your intuition without having tested it? Have you tested it?

Justin Carbonneau: Factor timing?

Tobias Carlisle: Yeah.

Justin Carbonneau: Yeah, we’ve looked at it. I think generally we still think it’s extremely difficult to do successfully. I don’t think we’ve … We tend to think tilting towards a factor is better than a light switch going on and off. Let’s just take the Validea models, for example. If we combine 10 of them and let’s say if you wanted to have a blend of value of growth, let’s just say 50/50, the longer value under performs, the more you want to try to more tilt towards value. You want to start sprinkling, go stronger towards value. But, with that being said, it doesn’t necessarily mean, like I mentioned earlier, that’s sort of making a call that value’s going to turn, and it might not in the short run.

Tobias Carlisle: Right.

Tobias Carlisle: The problem that I have seen when I look at the, if you look at growth versus value, for example, when value’s out performing, they get this sort of expen- Expense is probably the wrong word, but it’s this cascading. When value’s underperforming, the bulk of the under performance happens right at the end. The most rapid portion of the under performance happens right at the very end. Same when it’s the other way. The biggest chunk of the up performance happens right at the very end. It’s very hard to time it because as you’re slowly switching into it, you’re getting this worse and worse performance. For one thing, it makes you think that you’re doing the wrong thing. Particularly in a period where it’s extended like this, the more value exposure you have, the more risk adjusted, risk hedged or risk managed exposure you have, the worse you’re doing relative to the market.

Tobias Carlisle: I think we’re coming right up to the very end of our time. It’s flown by. If folks want to get in contact with you, what’s the best way to do that?

Justin Carbonneau: Follow me on twitter at JJCarbonneau. That’s my twitter handle. Obviously you can come to Validea and look at the research and the models that we’re running there. From there, if anybody wanted to ever just have a call with us and learn more about what we’re doing, we’re always available. Pretty responsive. Like you, probably, we’re working seven days a week most of the time.

Tobias Carlisle: I don’t regard it as work, I love it.

Justin Carbonneau: Exactly. That’s a great way to really end it, though, is I feel really lucky to do what I’ve done and have this opportunity at Validea. We sit here and work hard day in and day out. I have one foot in this internet company and the other foot in an asset management company, and I get to meet cool guys like you and do podcasts like this, videocasts. What are we calling this, actually?

Tobias Carlisle: A vlog, maybe. Vlog Acquirers podcast.

Justin Carbonneau: Nice. There you go.

Tobias Carlisle: There is a video component to it. For people who don’t know. If you’re listening to this on the audio version, you can go to YouTube and you can see Justin and I talking and see the hilarious facial expressions we make at each other.

Justin Carbonneau: Yeah, exactly. I think that’s a great way to … I appreciate you having me on. This has been really fun. Hopefully we can do it again soon. Let’s hope for the turn in value.

Tobias Carlisle: Yeah, for sure. Justin Carbonneau:, Validea. Thank you very much.

Justin Carbonneau: Thanks, Toby.

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