Maybe It Really Is Different This Time! (Part 1)

https://www.youtube.com/watch?v=-cG2BvJQnJU?start=466

During his recent interview with Tobias, Joshua Brown, CEO of Ritholtz Wealth Management, and author at The Reformed Broker Blog, discussed how maybe it really is different this time for investors. It’s a comprehensive and interesting discussion so we broke it down into two parts. Here is Part 1 below. You can find Part 2 here:

Joshua Brown: Well you know what’s different about this though? This is like, the same momentum stocks for 10 years. Do you understand what I mean by that? Like, this is. When most people think of momentum historically, they think of like ebbs and flows, acceptors, and one name is hot for a year and then it gets killed but there’s another hot name. This is like, a small collection of companies that, and it’s not just stock price momentum, they have fundamental momentum.

Tobias Carlisle: Right.

Joshua Brown: Like and I think earnings growth, that is justifying- maybe it doesn’t justify, like valuation, but at least justifies the on-going compounding year after year of these stock prices. It’s not like the fundamentals are shit or they’re low quality, they’re the highest quality companies in the country. They have, like, unbelievable earnings power, they have an endless array of levers they could pull. When one part of their business starts to slow down they pull another lever or they go into another vertical and the whole process starts all over again.

Joshua Brown: We just fucking watched Amazon invent the third largest advertising business in America, overnight. Like they just. People are like “Oh, you’ll see, web services, The Cloud, its going to start to slow.” And they’re like, “Alright, we’re an advertising company now.” It becomes the third largest advertising platform in 12 months. People are like, “Wait, what? Hold on. They’re growing earnings 25% again, how are they doing that?” And they do this over and over and over and over again.

Joshua Brown: And I’m not suggesting it goes on ad infinitum, but it’s like. This is what’s unique about this moment, is that it’s a small group of companies seemingly able to do this. Whereas momentum historically was like “Oh, that’s EPA Biotech, they got an FDA approval, it’s been hot for six months.” “Oh well that’s an oil company, they discovered a new well, stock’s been making new highs every week and you know, it’ll peter out eventually.”

Joshua Brown: When does this stop? So I think part of the answer to that is cheap money. I’ve tried to draw that parallel, but it can’t be just that. Like, I’m very wary of people that have a single explanation for something this big.

Tobias Carlisle: Well what about-

Joshua Brown: It’s got to be multiple factors.

Tobias Carlisle: There’s one suggestion that it’s, that there’s been less enforcement of anti-trust.

Joshua Brown: Yeah, I buy that. I buy that because if somebody stops Facebook from buying Instagram in 2012, which I think they did it like a month before they came public or something. If somebody stops that, in its tracks, arguably, Instagram, I don’t know that it ever gets as big as it is now because Facebook gave it access to its social graph which supercharged its growth. But could it be bigger than Twitter, 300 million users? Yeah. Could it be bigger than LinkedIn, 600 million users? Probably, it could. I’m not saying it would. Certainly it would be bigger than Snap. So if that standalone company, it’s worth $40 billion, and it’s pulling ad dollars away from Facebook the way other social networks are trying to or have failed, yeah. That’s arguably… And then what’s Facebook’s growth x Instagram?

Tobias Carlisle: Well it’s negative I would say.

Joshua Brown: There’s no way, yeah. There’s no way it looks like what it’s looked like over the last three years. So I think there’s probably something to that. But not only are we not enforcing anti-trusts, we’re doing like, after the horses leave the barn, we’re starting to get concerned about this stuff. Like after it’s too late, you know. And now I think maybe we’re at a place where it’s too late. Who could really stop these companies? I don’t know. They’re setting up shop in Washington, they’re hiring the highest priced lobbying and law firms you can, they’re making friends with all the right politicians, no ones going to be able to stop this stuff. So I mean, certainly not this administration. So people are like, “When is this going to end?” I don’t know.

Joshua Brown: So I don’t know if that’s actionable as an investor but, I just feel like it’s hard for me to understand why somebody would buy Macy’s stock right now, knowing what I know about what Amazon wants to do with apparel. Which they are not hiding, they’ve been very open about what their, what their ideas are about the apparel market.

Joshua Brown: So now you look at something like Macy’s, stock was $60 four years ago, it’s $19 as we’re recording. $6 billion market cap, $13 billion in enterprise value. So a lot of debt. It’s trading six times forward earnings. So if you’re running one of these screens and you’re like, “I want to own the cheapest stock, it’s trading four times last year’s earnings or whatever it is.” So that’s going to end up in your bucket unless you’re doing some kind of a debt screen like. Okay, so I understand, historically it’s cheap, you’re a contrarian, I’m so impressed. Blah, blah, okay. You fuckin’ buy it. You, go buy Macy’s! Tell me, tell me how this story ends. Maybe you’ll be right or maybe there’ll be a short squeeze and it’ll rally 12% and you’ll take that profit. I don’t know! But it’s just like, that is one example, there are like hundreds of those examples in the market right now. And yes I understand, things don’t go on forever, but it’s been a pretty long goddamn time. And on a secular basis, many of these companies are going away.

Joshua Brown: Looking at Bed Bath and Beyond the other day, how is this still around? Who are the investors with capital in this stock?

Tobias Carlisle: There’s still boomers shopping there.

Joshua Brown: Well there are activist hedge funds trying to get board seats at fucking Bed Bath and Beyond! Get a, you don’t need a seat, you need a life raft! So like, I’m fascinated by this moment that we’re in and I’m not saying like I have the answers but I think I’ve come up with some pretty good ways of thinking and writing about it.

Tobias Carlisle: I agree with you, it’s an extremely difficult time. Like, I’m a value guy, I’m a deep value guy. So I’m a guy who’s just missed the entire rally so. I fully own up to that, you can look at it in my returns. But I, and the thing that makes it so hard is that the undervalued businesses are really terrible businesses. And the businesses that I really want to own are just-

Joshua Brown: Extremely expensive.

Tobias Carlisle: Nose-bleed, eye-popping valuations.

Joshua Brown: Yeah.

Tobias Carlisle: So there’s no entry point for any of these things, it makes it difficult.

Joshua Brown: Alright, let me ask you this. What is the mechanism by which all of a sudden that would shift? And the cheapest businesses start going up and the best businesses, that are expensive, start falling. Is it like a silver bullet type of thing that starts that? Is it one by one? Or does it never happen?

Tobias Carlisle: Well I can tell you that the problem… Like I can look at my portfolio and my portfolio’s public and you can see that, you can go to a site like Morningstar and look at the growth rate of the underlying stocks. Like the underlying stocks, the growth rate of the underlying stocks is higher than the rest of the market. They’re cheap and they’re growing faster than the rest of the market, which is not something I typically like, I prefer them to grow slower because those returns are better. That doesn’t make any sense but that’s the case. As it happens-

Joshua Brown: The dirt cheap stocks are growing faster than the market?

Tobias Carlisle: Correct.

Joshua Brown: So, okay. Like you don’t have to say a ticker if you’re not allowed to but like give me an example. Like what sector do you find below-market valuations with higher than market growth rates?

Tobias Carlisle: I would need to look at that specifically, but I’ll put something into the notes of this one. But across the entire portfolio, that’s the case on a uh. The name, the individual names, the revenues, earnings, etc., are growing faster than the market and they’re below market valuations. But they still don’t get any love. I mean that’s the pain for a value investor.

Joshua Brown: So at the beginning of my career, like the first thing I saw was the dot com boom and crash. I wasn’t really managing money at the time, I was a kid. I was like cold-calling for brokers who were buying all these tech stocks and IPOs. It was an IPO every day, some days there were two or three. And none of the companies had… People are like, “Oh they were expensive.” No, no, no. They didn’t even have businesses.

Tobias Carlisle: Right.

Joshua Brown: It’s not like, “Oh, they were selling 40 times earnings, how egregious!” They had no earnings, they had no revenue. There was no multiple… You couldn’t put a multiple on a company-

Tobias Carlisle: They’re the per-

Joshua Brown: If they don’t have any revenue. They had a fucking domain name.

Tobias Carlisle: It’s the perfect business.

Joshua Brown: But fine, but a lot of them made it into the NASDAQ. And not just the worthless dot coms but. I know I’m telling you things you already know but I’m setting something up here. Like Sun Microsystems and Lucent and Cisco and. These companies who were selling equipment to companies that were funded by equity, and equity that was outrageously overvalue but. At least all this cash that they raised, they were like buying equipment. So these were like real, fundamental businesses that made up the NASDAQ 100. It wasn’t like all these fake dot coms, they weren’t in that index. But then when the music stopped for all the equity financing and the IPOs went away, because the NASDAQ started to crash, all of these companies where people were like, “Oh well I’m investing in a real business, like Lucent. They actually earn money.” Well their shit went away too because their customers disappeared.

Tobias Carlisle: Right.

Joshua Brown: So but you have that moment, right? And who looks better, 18 months later? So that the NASDAQ peaks in March, 2000, and the people who looked better were the people who just, their mandate would never have let them own NASDAQ 100 stocks. But they own bowling alleys and you know, we make Winnebagos and oh, this stock I’m invested in makes house paint, and this is a carpeting company. Like those stocks look amazing, relative to the S&P 500, which had become dominated by tech stocks and or high multiple consumer staples like Coca Cola and all that. Alright, so who owned those stocks? Well Buffett, but also like David Einhorn, and like a lot of the people who became like famous value practitioners. Their entire career was made in an 18 month period of time.

Tobias Carlisle: Right.

Joshua Brown: And that like. So by 2002, if you had a positive track record, which like, Berkshire did, while the people who had been chasing the NASDAQ names were down 70%, 80%-

Tobias Carlisle: Right.

Joshua Brown: That track record in print, you could dine out on that for the next 15 years. Because there would just be no way for the market to catch up to you. So you would just like, I feel like that was what, what’s it called, the Cambrian Explosion? Where like, all the fossils of all this life were found in one place at one time? Like that is the origin story of nine out of 10 of the most famous value investors.

Tobias Carlisle: I agree, 100%.

Joshua Brown: Okay, okay. So now here’s the problem though. 15 years goes by, there was never a repeat of that. In fact, the cheapest stocks got hit the hardest in the next crisis.

Tobias Carlisle: Right.

Joshua Brown: The next crisis didn’t look like dot com. So you had home builders selling at seven times earnings, they end up going to seven times earnings, or three times earnings because those earnings never show up. And then of course we found out they’re losing money. Banks, mortgage lenders, they were all quote, unquote cheap on paper. So a lot of those value investors who looked like geniuses after dot com, there was a little bit of tarnish after the housing crisis, okay. That’s fine, it’s okay. Everyone has draw downs. But you never had another dot com moment with that much dispersion that would help the value track records-

Tobias Carlisle: 100%.

Joshua Brown: So are you going to have that? Like is that the thing that resurrects all of these funds and all of these strategies? And makes the research look better on buying cheap stocks? Like is that going to come along at some point, or, do we go into the next recession, have a market crash, and a lot of these quote, unquote cheap stocks, get just as badly killed as the Amazons and the Googles and the Netflixes. Because that scenario is also feasible. It’s highly feasible that some of the cheapest stocks…So I understand margin of safety, blah, blah, blah, I just, I’m not convinced that it really will matter. What do you think about that?

Tobias Carlisle: I think that the long-term track record for value is extremely good. Like if you pull down that FamaFrench data which is available on French’s website, it’s all free, you can pull it down, you can take a look at cash flow to price. I mean I put it on my blog, I put it in my Twitter all the time, I put it up on Friday. I’ll tweet it out again. The long-term track record to that most undervalue portfolio of stocks on a price to cash flow basis, equal weighted. Which is basically how a lot of value investors are constructing their portfolios. It has more than doubled the return to the more expensive stuff.

Joshua Brown: Over what period of time?

Tobias Carlisle: Since 1951, for the price to cash flow. Since 1928, for the-

Joshua Brown: What is the longest stretch-

Tobias Carlisle: The current one.

Joshua Brown: In the years? The current one is the longest stretch where-

Tobias Carlisle: Yes.

Joshua Brown: Underperformed market cap benchmark?

Tobias Carlisle: And the deepest under performance, yes.

Joshua Brown: So it is both the longest duration of under performance for value and the worst showing-

Tobias Carlisle: Correct.

Joshua Brown: Relative to-

Tobias Carlisle: Correct.

Joshua Brown: Okay.

Tobias Carlisle: For price to cash flow, on an equal weight basis.

Joshua Brown: Now so not to be a dick, but like what if something in the economy has so materially changed, relative to the 1950s, 60s, and 70s, that it no longer matters, and it will never revert? Doesn’t that, like does that bother you?

Tobias Carlisle: 100%.

Joshua Brown: If it was me, because we have funds where we’re tilting toward value. We are invested in that too like, not all of our money but-

Tobias Carlisle: My condolences.

Joshua Brown: Well I’m saying like is that something that you think about? I think about it all the time.

Tobias Carlisle: That’s the singular question, and if you can answer that question correctly then you’re probably a billionaire.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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