During his recent interview with Tobias, Cliff Asness, Co-Founder of AQR discussed Do Fundamentals Still Matter? Here’s an excerpt from the interview:
Tobias: That’s a good segue into– one of the questions that they ask is, do fundamentals still matter? They have a very interesting approach to assessing that– create this look– it’s completely cheating, which they say in the paper. The point is that you take the forward earnings estimates for a year in advance. So, for 2020, we get the 2021 estimates of 2022, and we’re able to trade on that basis. And then you can look at– of course, that generates an incredible Sharpe ratio. It’s a great strategy.
Cliff: It’s really good.
Tobias: If I could get those forward estimates, I’d be very happy. But you’re not able to do that, of course, in the real world, but it shows that there are periods of time where even with those forward estimates, you still can’t generate good returns and the two that really stand out, ‘98, ‘99 and 2019 and 2020. So, do fundamentals still matter?
Cliff: Not so much currently. When I say I think ‘99, 2000 was a bubble and I do think at least cross-sectionally among stocks, I’m willing to use that word now. I am making a statement that again– I don’t want to go irrational versus not perfectly rational, do fundamentals not matter? I think they matter considerably less than they normally do or than they should. I won’t say that the expensive companies aren’t better companies. I include this in my latest blog, one of the final tests I do is looking at some of the quality measures the literature looks at. The most famous one, I think, being Robert Novy-Marx’s gross profitability to assets.
There’s no magic to that. I think, again, just like value, there are other ways to measure it. But I chose something very obvious that cheap companies on average have lower margins. World is not perfectly rational, but it’s not totally insane. You’re normally giving up—so, if you’re pure value investor– and a Graham and Dodd style value investor can look at more things than just price, so they can account for this. But if you’re only trying to buy low price to fundamental assets, you are going to be buying worse companies almost always.
The very brief period at the peak of the tech bubble, where you had maybe value investor nirvana, the spreads were not quite as wide as today but you were actually able to buy companies without giving up any quality. For the few on the call who remember that as adults, there were a lot of crazy companies, by no means do I say the expected companies today aren’t great companies that deserve to be expensive. I say they’ve gone too far, which is very different. In the tech bubble, there were a fair amount of companies that were gigantically expensive, that weren’t even the better companies.
But the simple result today, if we don’t have that– though we do have even wider spreads, but we don’t have the opposite either. Another thing that might give me pause as a value investor is cheap versus expensive, well, you generally give up some quality. If you normally gave up 10% on gross profitability of a portfolio of cheap against a portfolio of expensive, the most you ever gave up was 18%.
The tech bubble, you were giving up zero percent. Yay, you’re almost there. If today you were giving up 40% and it looked like an unprecedented drop and then it stayed there, you would really have to step back and say, maybe at the end of the day, we still believe in value. Maybe we think the world believes this is prominent and we don’t, but now you have to make tougher calls. Now you have to say this is something dramatically different than we’ve seen in the past, just not seeing it.
Again, so many of my stories, I know they start out sounding like they’re going to be interesting and the conclusion is always, and we don’t see that. But that is the point. We’re trying to investigate with an open mind every possible story. If we do find it, we will report it. But we repeatedly keep finding, that’s not it. I won’t tell you buying cheap stocks are suddenly the nirvana of the cheapest ever, and they’re actually just better companies, they are worse companies. There’s a price for everything. The price for the companies is way lower and way higher on the expensive ones than history and that is not because of any larger fundamental difference that we can discover.
And to be humble doesn’t mean it doesn’t exist and we’ve just failed to find it. We live in a world not of arbitrages but bets we think are smart, the same world you live in. We think when you’ve investigated everything that you can think of that anyone else can think of, that anything you’ve heard and not found the answer, and you’re facing wider spreads than ever in history, Occam’s razor says that’s probably a pretty good bet. Occam’s razors never approve. It says the simplest explanation is usually best.
So, I do try to stay humble, that’s why we keep looking. Is there something else out there? If so, I’ll admit, I’ll be disappointed. It would be hard for me to have to go tell the world, “Uh, we found it, this is why we–” [crosstalk] But I would do it, I would absolutely do it because anything else wouldn’t be ethical.
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