In this episode of The Acquirers Podcast, Tobias chats with Dan Rasmussen of Verdad Capital who discusses his new paper Countercyclical Investing. During the interview Dan provided some great insights into:
- Countercyclical Investing
- Four Quadrants For An All-Weather Portfolio
- Own The Trend
- Japan Is A Brilliant Market For Value Investors
- Marrying Baupost And Bridgewater Investing Strategies
- Value Investors Are Too Meta-Analytical
- High Yield Spread Is A Great Recession Indicator
- Crisis Investing
- Buy Illiquid Risky Assets When High Yield Spreads Are Wide
- Japanese Investors Less Optimistic That U.S Counterparts
- Trend Is A Perfectively Effective Low-Cost Hedge
- Predicting Future Trends Using The High Yield Spread And Inflation Indicators
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Tobias: Hi, I’m Tobias Carlisle. This is The Acquirers Podcast. My special guest today is Dan Rasmussen of Verdad Capital. He’s got a new paper out called Countercyclical Investing. We’re going to talk about Dan’s modification to Ray Dalio and Hedgeye’s approach. As a counterpoint to his crisis investing paper, this is going to talk about what you can do through the full cycle. It’s a fascinating discussion is coming up right after this.[intro]
Tobias: You got a new paper out on Countercyclical Investing, what’s the thesis?
Dan: Yeah, so this started from, if folks have been following Verdad or my research for a little while. It started with their idea around Crisis Investing. We’re small cap value investors, microcap deep value investors. We have obviously been plagued by the same thing, everyone has been plagued with, which is small cap value not working for the last few years. It led us to say, “Well, when does small cap value work? Or, how do we know when it works better, how can we be confident?” You can say, “Well, small cap value is the best performing strategy over long periods of time.” We’ll say, “Well, not over the last three years.”
Tobias: Or 10. [laughs]
Dan: Yeah, or 10. You’ve got to have something that says, “Well, this is the reason that hasn’t worked, and this is when it’s going to start working again.” What we found which is really cool was that small cap value seemed to work really well in the beginning stages on economic cycle. If you started from the middle of a recession, until the economy got going in, those periods accounted for about 70% of small cap value excess returns. Small cap value really is all about getting these crises right. You want to buy in at the bottom of a crisis and hold on in that early stage of the cycle. Well, okay, great.
High Yield Spread Is A Great Recession Indicator
Well, how do you know you’re at the bottom of a recession? The cool thing about that is that it’s actually obvious. It’s the one economic condition you know you’re in. You know you’re in the middle of a recession. Well, how? Well, your mom’s calling you, or your dad’s calling you to ask them whether you should sell stock, because it’s about to be a Great Depression, and we get that call, you know you’re in a crisis. You open up the Wall Street Journal, and if the front-page headline is really big, and says something about the market going down, basically you know you’re there.
Now, the indicator we like, which is a really beautiful, wonderful economic indicators, the high yield spread, which measures the cost of borrowing for high-yield borrowers minus the treasury rate on an option-adjusted spread basis. What we found is that that’s a really good recession indicator. In fact, Ben Bernanke did a huge amount of his academic work on it. The Fed is watching these academics, or watching this group at Harvard, he’s obsessed with it. It’s a really wonderful indicator for all sorts of things, that measures liquidity in the economy. How much are people lending? How much are they investing? That’s nice, it’s contemporaneous. It’s like right now, what’s going on with lending.
I have a very credit-oriented view of the economy. The credit is what drives the economy. When the credit markets are ripping, the economy’s ripping. When credit markets are tightening, the economy is going through a tough period. What we found is we looked at just when spreads are above 600, you’re basically in a recession, and that basically is a really good time to buy small cap value. It’s also a really good time to buy virtually anything illiquid. If you’re in bonds, the lower quality bonds, stocks, the smaller and the cheaper. Even if you look globally, going and buying emerging market stocks as opposed to develop market stocks, gets more interesting at times the high yield spread is wide.
All these things are related. Once we figured that out and we’ve been executing on that thesis, and it’s played out perfectly during coronavirus. If you went in March of last year, April, May, anytime in that period and bought small cap value, and the cheaper and smaller the value stocks were, the better you did over the next 12 months. It’s been a massive, massive rally, and just a perfect example of how these types of factors work coming out of recessions.
Then your question though, is, “Well, what do I do, when it’s not a recession?” You answer, prevailing, two governing concerns. One, I want to do something smart when we’re not in a crisis. I want to be choosing assets, they’re going to perform well in that environment. Overriding concern, two is, I want to have money to buy small cap value at the bottom. I want to reduce drawdowns, and I want to eliminate drawdowns– not eliminate, can’t eliminate drawdowns, so we reduce drawdowns. I have capital to deploy when others don’t, and I can go buy small cap value.
Marrying Baupost With Bridgewater
You can think about this, a variety of influences, but one influence for thinking this way is Seth Klarman and Baupost. To simplify Baupost’s model, and I’m sure he would hate to be described this way, but think of a seven-year business cycle. Baupost is holding 30% cash, 40% cash for the first five years. The S&P goes up, and Baupost goes up a little bit less, and then the market crashes, and Baupost doesn’t go down anywhere near as much, and then Seth Klarman goes and buys a crazy amount of distressed securities and bargains, and then he just rips out in year seven, and over that seven-year business cycle, Baupost comes out way ahead, even though they lagged the market for five out of seven years. They were quite conservative in those periods, but that was what allowed them to capitalize on that opportunity.
You take that idea or framework, of be conservative in good times you have cash to deploy. And then, I marry that with Bridgewater, which’s where I worked briefly, when I was younger, of thinking, “Okay, well, can we do better than holding cash trade? Is there something to do better than holding cash?” There’s got to be something that works from middle stages of the business cycle to the end. That’s better than cash, and what might those be, and how can you incorporate other asset classes, whether that’d be treasuries, whether that could be real assets. Then, the next big question I had with that starting what was to say, everybody’s talking about inflation, and I think to have a true full cycle model, or really think through investing over the full business, you’ve got to have an answer for inflation. What causes inflation? When’s it going to happen? What am I going to do about it, if I detected this coming? That was really the genesis of this paper, was to try to answer those questions, and to answer them as simply, thoughtfully, and empirically as possible.
Tobias: Let me just take you back a little bit to the high yield spread. You say 6% or 600 basis points is the trigger point view. I’ve looked at that split, I’m pretty familiar with it. It’s very volatile over an extended period of time. When it spikes, often it does spike very meaningfully. What the significance of that point, and did you have any sense of how much time it spends above that point?
Dan: It’s an arbitrary point, to be honest. It’s a round number, but it’s pretty close to one standard deviation above the mean. You’re talking 15% to 20% of the time, you’re above 600 basis points. It’s an extreme market condition.
Tobias: We’re in a regime with very low rates. Does the signal become less useful in this regime? Have you looked at it over more extended periods?
Dan: Yeah. Well, I think one testament to that not changing is how well it worked in COVID. It was a great indicator during COVID. It spiked up massively, and then it came down, just as the economy started to recover, and the market start– or actually anticipated the market recovering. It remains the best indicator, and remember, it’s a real market indicator. You’re just saying, “Well, how are high yield bonds being priced relative to treasuries?” It’s pretty hard to manipulate that. That’s real lending activity, real investor dollars. Yes, the Fed could go and buy high yield bonds, and maybe they did a little bit of that, really, they threatened to do it, and they didn’t do that much of it. Still, that’s having a real impact. That’s going to reset the prices of borrowing. That has a real-world economic impact. If borrowing is easy, fewer things go bankrupt, and more projects get financed, and there’s more growth, and conversely, when blending is really expensive or limited if things don’t get funded, and again, real world economic implications. It’s called the financial accelerator. It is not diminished once you use it as a signal.
Buy Illiquid Risky Assets When High Yield Spreads Are Wide
The other signal which we found was useful, was when high yield spreads are wide, that’s the governing decision maker. Just go buy illiquid, risky assets when spreads are wide, it’s a really good trade. When spreads are narrow, that’s a more complex set of decisions, and that’s when you have to think more about real rates, and where the yield curve is, and some other economic variables which are less, less predictive than the high yields. The high yield spread is wonderful. It’s really powerful, and it predicts a whole range of asset classes. Other economic variables are much weaker, and predictive signals are less weaker than the high yield spread.
Tobias: This crisis investing was some earlier work that you did, and you recommended when you get into that– when the high yield spreads are spiking, then you go to the things that are the most terrifying assets in the world to be illiquid small caps and high yield bonds. It makes perfect sense that those things would be completely abandoned, and they would recover the fastest. But as you point out, you have this– It’s an infrequent event, and you need something to do any other time. The new paper is this countercyclical look at asset allocation. Using these business cycle indicators, which are interesting, because they’re widely available indicators, and the two you like, again, it’s the high yield spread, and then you’re looking at the shape of the yield curve. Is it the 10 and 2, or are you looking at something more complex than that?
Dan: Yeah, we use the 10 and 2, but it’s interesting. The slope of the yield curve, we easily could have substituted out just the short interest rate. That’s really what drives. The slope of the yield curve is very– is all the volatility is driven by the short rate, and so that’s what’s really driving. You could just say, are rates high or rates low, and that would be equivalent to saying, where’s the yield curve?
Tobias: Who is the gentleman who wrote his PhD thesis, is it Kim– I’m blanking on his last name. Do you know who I’m talking about? He did a little tour, he was on Meb Faber’s podcast a little bit before the blowup saying that he had seen the inversion, and he was anticipating it. It’d been very predictive.
Dan: Yes. Inversions are a special case, where rates– Let’s set those aside, because it’ll lead you to some wrong intuitions, but generally, the way to think about this is that, let’s just talk about nominal rates. Nominal treasury rates are a proxy for nominal GDP growth. There are two elements to it. There’s the real rate, which is your GDP expectation, and then there’s your inflation expectation, and those are both priced into treasuries. You can think of when rates are really high, which would mean that short rates are really high, which would mean that the yield curve is flat, your inflation expectations are high, and your growth expectations are high, so those are times again when you’d expect to see inflationary pressures, inflation assets doing well.
The inversion happens when rates react to that inflation expectation, that then they go too high, and that’s when people think that there’s a tip over in the cycle. Mostly, you should think about high short rates or a flat yield curve as the market pricing bullish inflationary things. Conversely, when rates fall, the market is pricing either a collapse in inflation expectations or a collapse in real growth rates. What makes treasuries work really well in an asset allocation framework, or why they’re really interesting is that at least for the last 30 or 40 years, inflation expectations and GDP growth have been very correlated. When there’s a recession, expected inflation falls and GDP falls and treasuries soar, but that’s why there’s such a wonderful countercyclical asset class to own.
There’s a lot of concern now with people saying, “Well, gee, owning treasuries, are they really going to work as they had? Gee, shouldn’t I be selling all my bonds, rates are so low?” I go back– this is Irving Fisher’s idea, brilliant economist. Irving Fisher has this idea that treasuries have a real raising inflation implications. You have to ask yourself, which part of that is wrong? Let’s say, is it that treasuries are predicting too low GDP growth or are they predicting too low inflation? Those are your two choices. If you look at where markets are pricing things, the treasury market is saying growth prospects don’t look very good over the next few years, and inflation looks really dampened and maybe even deflationary over the next few years. That’s what bring crisis in the treasury market. You have to cover the thesis, that’s wrong.
Certainly, if there’s a recession, growth expectations and inflation expectations both are going to go down. There’s still a very important role for treasuries and portfolio, and for using that as a signal. That’s the market signal of growth and inflation, and it’s a very powerful one.
Tobias: Your countercyclical paper proposes an alternative to a 60:40 bond portfolio, though it’s an asset allocation. You said based on the two elements that we discussed, the high yield spread and the shape of the yield curve– sorry, I’m confused a little bit. The two things that you look at growth and inflation, and then high growth, high inflation, low growth, low inflation, and some mix of those two things gets you these four quadrants.
Four Quadrants For An All-Weather Portfolio
Tobias: Do you want to just walk us through the four quadrants? This is based on the Ray Dalio framework.
Dan: Yeah, sure. This is a great, simple framework for thinking about what asset classes do well in different environments. You can think about rising growth or falling growth, rising inflation, falling inflation. All economic environments can be divided into those four quadrants. That’s a really useful way of thinking, because the combination of those economic factors, each decade, you get a different set of cards.
In the 70s, you’re getting a lot of falling growth, rising inflation, stagflation environments. In the 2000s, you had two big recessions, two big falling growth, falling inflation periods. In this decade, you’ve had rising growth, falling inflation. You’ve got these different combinations, but those are the defining parameters, and so what you really want to understand is, “Well, what’s going to do well in those environments.” If I’m thinking, “Gee, I don’t think last decade is going to be–” We’re not always going to be in a falling or rising growth, falling inflation environment. We could see a decade with multiple recessions, we could see a decade with stagflation, we could see all sorts of different combinations of economic conditions. I should be prepared for all of them somehow.
You’d want to start from saying, first, can I understand what does well in those environments? Then two, I want to understand how to predict them? Or, how to understand which environment I’m in? You can start off with the rising growth, which is– rising growth, think of this as the early stage of economic recovery. We’re in a classic rising growth environment right now, and have been since March of last year, where everything is looking good and getting better. What asset classes do well in that environment? Well, the answer is relatively simple. Stocks. Now, small cap stocks do the best, but large cap stocks, growth, stocks, values stocks, it all does well in these types of environments.
Conversely, bonds don’t do as well, especially treasury bonds. As growth expectations, inflation expectations rise, so do yields, and so treasury bonds fall. Then, I’d say that as you get rising inflation, we’re in this re– people are calling it a reflationary environment, where you’re recovering from it, a recessionary period. You also see certain commodities do well, so the economically linked, the growth-linked commodities, your oil futures, your copper futures etc., as that economic recovery continues, those asset classes all do really well.
When you’re in a growth environment, which you can think of as, “Hey, start from the point where high yield spreads are at 600 bips, and go forward.” Those are the asset classes you want exposure to. You want to get us loaded up on small cap stocks, and value stocks in the extent that you want real assets in your portfolio in the growth commodities, and you want to have a really light bond allocation. If you’re going to own bonds, bias them towards, high yield bonds, which have a big growth component. That first environment which is broadly what Dalio or Hedgeye, I would call quad one and quad two, which are the growth quads. Then you have two other economic environments, which is where things get tricky and more interesting and more complicated.
You have your stagflationary environment where you have rising inflation and falling growth, which is quadrant three in Hedgeye and Bridgewater terminology. That’s an environment where a lot of things that people polled don’t do well. You have rising inflation, so that’s going to hurt your bonds, and your falling growth, and that’s going to hurt your stocks, so you’re in a trap. Your traditional assets just aren’t helping you all that much, and it’s quite painful. What do you do? The answer is that it’s all about real assets. Gold is especially good, but all of yours are real assets. Now, your issue with energy and copper and some of the other growth [unintelligible [00:19:53] is this is a falling growth environment, it depends as the inflationary force is enough to overwhelm the falling growth, what type of inflation do you have? Gold is really good for a lot of different environments like this. Other commodities are good. This is not saying most people own in their portfolios, and there are a lot of reasons I don’t own them, which we can talk about. Those are really the only things that do really well in these environments. Almost every stock and bond portfolio, other than that is going to suffer in this environment to varying degrees.
Then you’ve got quadrant four, which is your falling growth and falling inflation environment. In that environment, it’s all about bonds, especially treasury bonds. Treasury bonds are going to do really well, because as growth falls and inflation falls, real yields and inflation expectations fall, and so bond prices go way up. You really want to own bonds in those environments. You should think of you’ve got your bond-heavy environment, you’ve got your real asset heavy environment, and then you’ve got your stock-heavy environment, and that stock-heavy environment is call it 50% of the time, and then you’ve got your other two environments where you’re going to want to own real assets or bonds.
Predicting Future Trends Using The High Yield Spread And Inflation Indicators
Tobias: How often are you switching from one quadrant to another?
Dan: Yeah. What we looked at as is then these separate signals, okay, now that I know that, “Gee, how do I puzzle through what environment I’m in? How can I predict it?” It’s all well, and good to say, “Wow, exposed, yes, obviously bonds do well in a recession, but if I can’t predict recessions, well, who cares the bonds do well?” Now, I should just have a fixed allocation or fine, real assets do well, but if we have deflationary mind with the last decade, I’m going to be pretty unhappy with the person that told me doing commodities up against inflation. In my view, you’ve got to have a way of predicting these things. That’s where we come to the high yield spread. High yield spread is really good. When the high yield spread is wide, you’re generally in a growth– you’re in a recession, and then the future, the forecast is for a growth environment. You can also look at the direction line of spreads. As the high yield spread is tightening, or that’s generally very bullish, as it’s widening, it’s bearish, you can both look at the absolute level and the direction, that’s going to give you a pretty good growth indicator.
Then for inflation indicators, it gets much really much harder. Inflation is hard to predict. There are different types of inflation. The only people who have lived through an inflationary period are people that grew up in emerging markets, they are not developed market investors who have been investing since 1980 have experienced inflation. It just gets a little bit more complex, if you use a variety of indicators. A simple one is real rates. Sorry, it’s the slope of the yield curve or where short rates are, so higher short rates, a flat yield curve is going to be more inflationary environment, a very steep yield curve, which means low short rates, that tends to be more deflationary environment. Then the other thing you can look at is, you can look at the trend in the high yield spread, quite a good indicator as well. Or, you can look at the trend in commodity prices, which is another indicator.
Tobias: What trend you’re looking for in the in the high yield spread — How are you using them?
Dan: Tightening or widening. As the high yield spread widens, that’s deflationary. You’re limiting the availability of credit in the economy, and as credit gets limited, inflation falls, and then conversely, as spreads tighten, which means you’re increasing the amount of credit in circulation, that’s generally inflationary. If you use that indicator to trade 10-year treasuries, works amazingly. If you use it to trade commodities, it works amazingly. It’s a really, really good indicator for thinking about inflation.
Tobias: You also talk about trend. I don’t know if it’s in this context, you were using even the 200 day in relation to the S&P 500. Do you use it in other contexts as well?
Tobias: How are you using it?
Dan: Yeah, in that context, we’re talking about inflation and thinking about what drives inflation, or how to predict inflation. Trend is valuable. The trend in commodity prices, the trend in the high yield spread, it’s a really good indicator for the direction of inflation expectations. Trend is really important there, and you can use that to trade some of these inflation-linked assets. There are different nuances to it, but gold is a classic one. Gold is a very trending asset. When gold prices are going up, they’re going up, because inflation expectations or devaluation risk, redenomination risk, fears are rising. If you buy gold as they’re going up, you do well. Conversely, when gold starts falling it often, keeps falling. It’s a very trending asset, so trend following gold is a really useful way to think about whether you’re using that as a way to think about when inflation is happening, or whether you’re just using it, because it’s a good strategy that works in gold. It’s an effective way of doing it.
We also talked about trend in another context, which is we talked about one of the big goals of this countercyclical approach is to limit drawdowns, and to limit drawdowns with the intention of having a lot of money at a time of crisis to deploy in a small cap value, and high yield bonds and other risk assets. To have the money, you can’t have had a big drawdown. That’s what’s trend following the S&P 500, that’s where we use it in this context. Trend following just says, when the price falls below the 200-day moving average, sell, and go to treasuries, and wait to get back into the S&P 500, until the price the S&P 500 is above the 200-day moving average.
The 200-day moving average is arbitrary. You could look at 3-month momentum, 6-month momentum, 12-month momentum, the moving average rules basically just saying, let’s pick an average of all the time horizons during this period, but the essence of it is that it kicks you out when volatility really spikes, and the S&P 500 starts in some sharp drop, trend following kicks you out enough of the time to really save your bacon. It’s a dramatic reduction in drawdowns, because you’re getting kicked out after 15% or 20% drop, not getting kicked– you’re just not there for the next 20% drop, because your risk rules kicked you out.
The interesting thing about that, if you run a regression, this doesn’t really show up that well in a regression. Basically, what it would tell you is you’re going to lose a little bit on your expected return. My expectation about trend following and using trend following in this context is not that it’s going to increase your return. It’s not a return enhancement device. It’s entirely about preventing drawdowns in large cap equities. Thus, having money to deploy in a crisis, which if you’re good at crisis investing, and you think you’ve got high conviction in those environments is a very useful thing.
Tobias: I’ve played around with trend following a little bit just to understand how it works. One of the observations that I had when I was doing it was that you’d get different results depending on how often you’re consulting the signal. If the signal is consulted once a month, that sounds like a pretty good period, but you run the risk that the day before or the day of the signal being given when you make that decision, you’re not quite under the 200 day, so you’re on and then you catch that month of drop, and then at the bottom– this is really the only time that trend following, when I look back using that look back on 1-month period, using the 200-day might have been the 10-month, it’s the same signal essentially. Really, it works very well in the US and in other markets like Japan. Really, the only time that didn’t work funnily enough was 1987, when a lot of the trend-following guys seem to have made their name. How do you recommend implementing that kind of idea?
Trend Is A Perfectively Effective Low-Cost Hedge
Dan: Yeah, it’s not a failsafe. You can think of it as a dirty hedge or a low-cost hedge. Is it perfectly effective? No, but does it cost you that much? No. It’s very low cost. In fact, over some periods, it enhances your long-term returns. It at least seems like it’s almost zero-cost hedge, but at the times when volatility is the highest, as long as that drawdown comes over a decent period, or if it comes in a day trend following [unintelligible [00:28:46], if it comes over five days or a month, the longer the drawdown takes, the more likely trend is going to help you.
Since most of the really big moves have taken a little bit of time, trend has really, really helped you. Again, I don’t think you could do– my view is you don’t want to get too much into data mining. You want really simple ones. Oh, we tested 3-month, 6-month, 9-month, 12-month momentum. Is the price below where it was 3 months ago? Was it below 6 months? Was it below 9 months, 12 months? You’re getting virtually the same answer. The 200-day moving average is nice, just because it blends all of them. It just says, “Hey, you’re looking at the whole past 12-month period and roughly where you are relative to the average.” That’s why I like it. Again, you could try to data mine it and say, “The three-month is so much better than the six-month,” it’s so much better than that. It’s BS. You’re just looking, what’s the point of what you’re trying to do. You’re trying to get out of this low conviction trade when volatility spikes and that’s it.
Tobias: One place that it did work really well, and I know that this is a fund that you run. I looked at it in Japan, because I always thought the challenge with Japan was that it was probably obvious in real time that the market was extremely expensive, in much the same way that everybody knew in 2000 that there was a bubble in the States. It was hundred times in Japan. I thought that the beauty of it was that it allowed you to stay invested through that entire runup. Then as Japan fell over in the late 1980s, it did take you out, and the difference in returns is striking, because the market fell so far and has taken so long to recover.
Tobias: The return line goes up to the very peak, and then plucks you out, and then allows you to remain above the fray until you get that opportunity to reinvest.
Own The Trend
Dan: Yeah, this is such a good point, Toby. I should have thought to go there earlier, but if you think about the two big problems, I think facing investors today, it’s overvalued equity markets. We’re all looking at these multiples, we’re all concerned. If you’re not concerned, you’re either not paying attention or half your portfolio’s in Bitcoin, and whatever. The other big concern is thinking about potential inflationary risk. You’ve got to ask yourself, what am I doing to prepare? What is my strategy for dealing with these things? The thing I love about trend following, and I did this piece about bubbles, and I actually went back, and I had an intern look back at the macro-commentary of 10 great investors. Dalio, Peter Lynch, all these guys, Seth Klarman. They all started calling a bubble in 1995. If you’re smart, you see these things way early, like, “Oh, God value.” Tesla’s way too expensive. “Gee, FANGs, oh, my God, who would pay that multiple of sales?” Adobe, MasterCard, Visa. You go through the list. You would have said these things were too expensive in 2018, or 2019, or 2017, and they’ve just kept going up.
The beauty of trend following is that trend following says, “You know what? Just own the trend.” Just own the NASDAQ. What allows you to do that is you’re acknowledging explicitly that the reason you’re owning it is because it’s trending. The reason I own Visa or MasterCard is they’ve gone from trading at 6 times sales to 9 times sales, they might well go up to 12 times sales or that type of trade. You’re just saying, “But if they start going from 12 to 11, I should probably get the hell out, because this isn’t a fundamental conviction thing, and I am worried about valuations.” Trend following whether you’re talking about Japan in the 1980s, the NASDAQ in the 90s, I think it’s just such a beautiful tool for exactly this moment in our market economy.
Toby, you and I, who are value-oriented investors, value’s at a dark winter. Now, it seems like we’re in the spring for value. If you think about that period from Q1 of ‘18 through Q1 of ‘20 when value is just the worst possible thing to own–
Tobias: Rather not. [chuckles]
Dan: You would have said, “Well, all these guys that are owning the S&P 500 or the NASDAQ, or just a software-focused fund are just doing so well, and I’m doing so badly. Why not just own some of that?” Explicitly say, “You know what, I’m going to be the first to get out when it stops working, because the only reason I’m owning it is because it is working, because I don’t have conviction around these multiples,” and how could you it’s just too expensive, but trend is a great way to rationally participate in the market, well knowing that you’ve got protection in the event or a plan to protect your portfolio in the event that cycle in that valuation cycle turns.
Japan Is A Brilliant Market For Value Investors
Tobias: Let’s talk about Japan a little bit, because you have a Japan value fund, what’s your approach there? What are you looking for, and how is that portfolio constructed? How do you think about Japan?
Dan: Japan is a really fascinating market. It’s a big market, same number of listed tickers as the United States, but many, many more small micro caps. They’re called 2000 small micro caps. Really big deep market. It’s also really, really cheap. Whether you look at the large caps or the small caps, Activision Blizzard trades at 22 times EBITDA, Nintendo trades at eight times EBITDA. Virtually anything you look for, has an alternative in Japan that trades at half the multiple. So, if you like small cap value at six or seven times EBITDA in the United States, you’re going to love it, in Japan, three or four times EBITDA. It’s just a brilliant market for value. Part of that it’s just that they’re such a plentiful abundance of stocks to choose from. Part of it is that they’ve had this bubble in the 1980s, and then this last set of decades where the stock market has gone sideways.
The other two really interesting things to think about with regards to Japan. One is there’s no bankruptcy or essentially no bankruptcy. You think of the downside risk in owning smaller micro-cap value in the United States being, okay, you get to zero, you’re just wrong, the company blows up and you lose all your money. It doesn’t happen in Japan. Companies live forever. The average age of a company on the market is 50 years. They’re just around forever. The government will bail you out, the government will really bail you out. In the US, we talk about bailouts, but government doesn’t actually like– that crappy industrial company that you own that goes through a troubled period, the government doesn’t actually step in and give them a zero-interest rate loan to bail out their operations and go buy a competitor. That company goes bankrupt, and goes through restructuring, and that’s creative destruction. It’s great for the US economy at large, but it also is really screwy for your portfolio risk management as a small cap investor.
The second thing about Japan is that it’s an export. It’s a cyclical export-driven economy, exporting into Asia. Big exports to the US, to Europe, to China, all over Asia. So, it’s really linked to the global macro-economic cycle. When the cycle is ripping, these Japanese net export companies are ripping as well. When the economy suffers, you get big drawdowns, but again, because the lack of bankruptcy, those draw downs and earnings don’t translate into draw downs, and the equity market the look anything like what you see in the US, and you also get this flight to safety impact at the end where the end spikes in times of volatility, so you’re really cushioned by the currency, which also provides this really nice balance to the portfolio. So, Japan, really cool, really interesting diversifying place for value investors and a big, big focus area for me.
Tobias: I saw some research. It’s a while ago, it might be a decade old, I had it on the old Greenbackd website, but it was a study conducted in Japan, just using simple price multiple, price to sales, price to earnings, those sorts of metrics. I had found that value worked really well through the entire period that it’s been a real nuclear, a very long nuclear winter for that index. But underlying that index, there’s been some great performance that if you’re a value guy there, you’ve done fairly well. That research is probably 10 years old now. Maybe even more– [crosstalk]
Tobias: Is that still the case?
Dan: It’s still holds with the exception of where everywhere else where value didn’t work, this Q1 of ‘18 through Q1 of ‘20 period where– In Japan, you had the trade wars with China, and then you had coronavirus. Those hit real earnings. Japanese corporate earnings were down 50% from 2018 to 2020.
Tobias: That’s a big hit.
Dan: Brutal, brutal. Yes, buying value which tends to be cyclical companies that are– you’re betting on mean reversion of earnings. Earnings didn’t mean revert, they just went down. They just got punched twice in the face. Now, you say, “Well, gee, is coronavirus getting better? Yeah, probably right. Our trade tensions with China going up or down? Probably down. Is the global economy rebounding? Could we expect to see Japanese corporate earnings rebound in 2018 levels? Yeah. Or, would that look like a doubling of earnings? Would that be good for value stocks? Yeah, probably.” It’s a very interesting time to be investing in Japan.
Tobias: You alluded to it earlier, but the criticism of Japan was that cross shareholding and that inability to release any other capital, or have any rationalization of capital structures and businesses, but there seems to have been this– I haven’t followed it that closely, but I’ve just read enough articles over the last maybe five years or so, perhaps that culture is changing. I don’t want to suggest that it’s as a result of Americans, like activists moving in there, but there might be some of that happening that they’ve had to– I’m sure I’ve read a number of articles where they said they’ve had to modify their approach, but they are finding some success. Are you seeing that happening?
Dan: Yeah, that’s definitely true. Look, Japanese CEOs want to make their stocks go up too. There’s a method for making their stock goes up, which is to follow these shareholder-friendly practices, and they want to do it too. They’re not idiots, and so that is happening now. You have to remember that that’s still a second priority. Yes, it is a priority. Yes, they do care. Yes, they are moving in that direction. The first priority is lifetime employment guarantees and stability. Yes, they’ll move in this direction, but without sacrificing core Japanese values, like lifetime employment guarantees, you’re not going to see Japan wholesale adopt like US incentive comp and have some family-owned Japanese microcap paying their CEO $20 million a year. It’s just not going to happen. Those aren’t Japanese values.
On the margin, are they going to move towards maybe having some independent board directors or maybe do an increase in the dividend? Yes, and those things are happening, and they’re good. Even without those things, sorting by price to book multiple works really well. You don’t need those things to happen. You just need value to work, and Japan has been a great, great market for value, and I think will continue to be.
Tobias: Cliff Asness had some research where Japan had been one of the places where momentum didn’t work. AQR looked at some of that research to say– I think that they decided ultimately that it was just– it’s a statistical outlier. You would expect that if you have something that is imperfect, but predictive that means it’s not going to work everywhere. They decided it was a statistical anomaly. Is there any concern that value might start working for that reason that it might be some sort of statistical outlier, or there might be some other reason that we just haven’t yet uncovered for why momentum for whatever reason hasn’t worked there?
Japanese Investors Less Optimistic That U.S Counterparts
Dan: Yeah. This is unlike many of my views entirely unempirical and totally a stereotype based on my own experience, but I’ll offer it with that full disclosure, which is that trading Japanese stocks, it seems to me that the US is very anticipatory. If you start to see some economic development, you say, “Holy smokes,” two quarters from now, that company is really going to benefit. The stock starts to go up. It goes up way in advance of the actual fundamentals. Whereas in Japan, it just seems like until you actually see the quarterly earnings statement where the earnings actually have gone up, the price doesn’t move. If you think of momentum as a proxy for real earnings momentum, or change in analyst expectations, that sort of early updating of information before the actual news comes out, which I think how it works in the US.
Well, imagine a market with no analyst coverage, really pessimistic. If you look at surveys, Japanese investor surveys, or Japanese CEO surveys, they’re really pessimistic. They’re saying, until you actually show them the numbers, they’re not going to believe, they’re going to worry something bad’s going to happen. To me, that’s why momentum doesn’t work. To me, that’s also why value works really well, that same set of things, which is, you’re penalizing a company too long for something that happened in the past that take into account, the mean reverting or recovery potential that’s embedded in the stock.
Tobias: It makes perfect sense that it’s been moribund for so long that you would require– You’ve got to show me the earnings, rather than suggesting that they’re going to happen, that it makes complete intuitive sense.
Dan: Whereas here in the US, I’m going to produce half the world’s cars in 10 years, maybe electric, and I’m 100% market share of that, and my margins are going to be amazing, like, “Oh, great. Well, that’s such a good plan.” “Absolutely. Let’s underwrite that.” Don’t you think you could get 60% market share?
Dan: That’s the US market.
Tobias: Well, I guess the risk in the US is that it moves so quickly, that you feel the need to be in front of it. Otherwise, you missed the move, because it’s so closely scrutinized, and really the way that you’ve missed over the last decade is just by not paying enough, really by not believing.
Dan: I know. Again, it goes against every bone in my value [crosstalk] about it.
Value Investors Too Meta-Analytical
Tobias: When you say that there was a lot of pessimism in Japan, it did excite me a little bit. It made me to think that I should have a closer look.
Dan: Yeah, as we were talking about, value investing is meta-analytical. Value investors think it’s not about first order thinking, do I like the stock or not. It’s what consensus is embedded in the price and how likely is our events to come out ahead or behind that consensus? Value investors think, “Well, the higher consensus is, the more likely it is to be disappointed.” That’s our meta thinking. As we both talked about, that’s not been the right– You don’t want it to be meta-analytical. You just wanted to be a first order thinker. If you like the product, you like the company, just go buy it. Buy it today in size, if you like the brand, or if you come up with an idea like, “I like payments.” If you like payments, just buy payments stocks as soon as possible, that’s been the lesson.
All of the clever things that we’ve thought out of like, “Well, what about the expectations investing? What about fundamental earnings momentum? What about quality filters?” None of that stuff has worked in the US of late. With the exception of since now we’re entering a new phase, where we can start saying, until Q1 of 21, we’re now where this blissful world where value is back. Hopefully, now we’ll get to start talking about why we’re right all the time and how we’ve been right for years. We were just too early.
Tobias: Well, I hope you right. I don’t trust it at all but that’s just–
Dan: Yeah. Well, you’re a value investor, you’re supposed to be somewhat pessimistic.
Tobias: Dan, the paper is Countercyclical Investing. Where can folks find it or track you down, and follow along with what you’re doing?
Tobias: Yeah, I receive it. I can attest to that. I’m a big fan. Dan Rasmussen, Verdad Capital, thank you very much.
Dan: Thanks so much, Toby.
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