In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Vitaliy Katsenelson discuss:
- Don’t Be Fooled by Popularity: The Danger of One-Decision Stocks
- Tesla’s Future: Beyond the Hype? A Look at Battery Tech and Infrastructure
- How Social Media Creates a Global FOMO Frenzy
- Can Physics Explain Markets? A Look at EMH Through Four Forces
- Why Behavioral Biases Challenge Market Efficiency
- Forget Market Timing: Savvy Investors Focus on Individual Stocks
- Sideways Market Investment Strategies: Adapting to a New Economic Reality
- Pain vs. Gain: The Price of Value Investing in Inefficient Markets
- Gravity vs. The Market: How Interest Rates Can Upend Investment Strategies
- Value Investing vs. Market Reality: Can High Valuations Persist Despite Rate Hikes?
- Understanding Market Cycles: Despair and Bull Markets
- Defense Stock Investment Strategy: Betting Big on European Companies
- The Dichotomy of Control: A Stoic Approach to Investing
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Breaker
Overcast
RadioPublic
Stitcher
Transcript
Vitaliy: All right.
Tobias: This meeting is being livestreamed. This is Value: After Hours. I’m Tobias Carlisle, joined, as always, by my cohost, Jake Taylor. Our special guest today is Vitaliy Katsenelson. How are you, sir?
Vitaliy: Hey, Toby, Jake. Great. I’m a big fan. Actually, no, this is the first time I ever did a live podcast ever.
Tobas: Well, that’s cool.
Vitaliy: I did live TV, which I really don’t like doing. This is the first time I do live podcast.
Jake: Try to keep the F-bombs to a minimum, Vitaliy.
Vitaliy: Oh, it’s very difficult for me to do that, obviously. But yes.
Jake: [laughs] Welcome.
Vitaliy: Well, thank you, guys. I’m really excited.
Tobias: Your book’s been out for a little while. But congrats on the new book. I’ve been meaning to get you on to talk about. What’s it called, Vitaliy? Do you have one within reach? Soul in the Game?
Vitaliy: It’s funny that you mentioned that I have a copy right here.
Jake: [laughs] What were the odds?
Tobias: Upside down. Upside down. Turn it around the right way.
Vitaliy: Huh?
Tobias: I know. It seems it’s your camera–
Vitaliy: The camera is rolling– yeah, no, it’s Soul in the Game. But by the way, we don’t have to talk about the book. We can talk about anything you want, because I’ll be honest– If you think about Eagles for a second, when you think about them, you probably only thing about one song, right, Hotel California. So, I want to be known for more than just my books. And so, we don’t have to talk about my books. We can talk about anything else you guys want to talk about.
Tobias: Well, let’s start with the book.
Vitaliy: Okay.
Tobias: What’s the book about? Just tell us a little bit about what the book’s about.
Vitaliy: Yes. Over the years, I’ve written a lot of articles about investing, but I also ended up writing many articles about topics that unrelated to investing completely, about parenting, travel, philosophy, classical music. And the problem when you write articles, people read them and then they disappear. So, I wanted to leave something more permanent behind me. So, original idea was to take these articles and edit them and put them into a book. But Toby and Jake, you guys know, because you both write.
Jake: Poorly.
Vitaliy: When you start working on something, you start writing—[Jake laughs] Well, Toby obviously wrote many books. Jake, you should write a book.
Tobias: Jake wrote one good one.
Vitaliy: Oh, did he did just write a book? Jake– [crosstalk]
Tobias: Jake didn’t take 10 guys to get it right. He just did one good one.
Vitaliy: [crosstalk] Jake wrote a book.
Jake: One and done. [laughs]
Vitaliy: Well, no, yeah. Yeah. So, anyway, I wanted to leave something permanent behind. So, when I started writing it, when I started editing these articles and put them together, it’s the writer in me took over, and I ended up writing half of the book. It was supposed to be just collection of the articles ended up– That’s what it is about. It’s just basically about life advice kind of by the guy who should not be giving life advice, basically.
[laughter]Vitaliy: Yeah. But that’s still in the game. Yeah.
===
The Dichotomy of Control: A Stoic Approach to Investing
Tobias: To what extent is it influenced by your investment career or the way that you invest your philosophy?
Jake: Or, how bad value was there for a five-year stretch? [laughs]
Vitaliy: Oh, okay. Actually, I think that Jake just nailed it. There were some influences there of pain, and a lot less about me being a value investor. I guess maybe it’s both. There was a chapter there where I talk about very painful period in 2015, 2016 where I went through very difficult investment strategy and how I dealt with pain. So, that chapter was influenced. Other chapters really only related to investing. Toby, I think you’re working on the book of Stoic philosophy, right?
Tobias: Ah, yes.
Jake: What are you doing there?
Tobias: I’ve finished it. I’ve got it out. I’ve given it a copy to Guy Spier. He’s having a look at it for me, and he’s going to pass it on to somebody. But if that doesn’t come out through an agent, I’ll just self-publish. It’s ready to go. I can just basically push the button. I’ve got the cover done, and it’s ready to go.
Vitaliy: Okay.
Tobias: But it’s more Sun Tzu than general philosophy. Sun Tzu and then associated philosophies.
Vitaliy: Gotcha. All right. Maybe one-third of the book talks about Stoic philosophy.
Tobias: Yeah, I went down a little stoicism, and then I saw your book and I thought, I’ll leave that to Vitaliy. I went– [Jake laughs]
Vitaliy: Yeah. No, I know when you talked, you said, “Listen, I’m working on the book on Stoic philosophy.” I don’t want to read it, because I don’t want to do– I get it and I respect that. No, but the point I want to make is that, one thing you can as an investor you can take away from Stoic philosophy is the dichotomy of control. Because the dichotomy of control basically says some things are up to us, some things aren’t. Well, let’s apply it to investing. What it’s up to us is basically our research, our process, which influences our behavior basically. Everything else is not up to us.
I think that’s probably like, if you ask me what’s one concept you can apply from Stoic to investing is that. And just focus on process and long-term outcome will follow. But just know that you have absolutely no control if the stock market wakes up this morning and decides to price your stocks 20% lower.
Jake: And maybe that ties into another book that you wrote, which was The Little Book of Sideways Markets.
Vitaliy: Yeah.
Tobias: And Active Value Investing before that, right?
Jake: Where are we at right now on sideways markets?
===
Vitaliy: It’s funny you can see. I got both of them right here, like this one and this one. [Tobias laughs] I don’t know how they got you.
Tobias: Hold them up, Vitaliy. Hold them up. [laughs]
Jake: Oh, boy.
Vitaliy: I don’t know. I got some props here. Okay.
Tobias: No, that’s good.
===
Sideways Market Investment Strategies: Adapting to a New Economic Reality
Vitaliy: No. So, Active Value Investing, I started working in 2005. I finished it in 2007. The thesis of the book is very simple. Historically, every single time when you had a loan loss in bull market, when price to earnings went up a lot, the market that followed was kind of a sideways market. Basically, as price to earnings went from above average to below average, it’s upset any benefits the economy got or stocks got from earnings growth. And that was my thesis.
I think it looked accurate for about maybe mid 2013, 2015. And then as interest rates went to zero, we basically went from sideways market into a new secular bull, because today, obviously, price to earnings are at historically– Toby, probably the highest level since great depression or something or the Great Depression.
Tobias: We’re in that range on a cyclically adjusted basis on a CAPE basis.
Vitaliy: Exactly. You can argue that maybe profit margins should be higher today than they were before. And directionally, that’s true. But should they be so much higher than they are before? And then also, you can argue that the profit margins historically have benefited from globalization and low interest rates. Well, now we’re going through a very painful period of de globalization. We should probably start compressing profit margins. And obviously, interest rates are going higher now than they were even a year and a half ago.
And another factor, obviously, corporate profit margins, I mean, corporate taxes. Corporate taxes, which are basically trump to come down. So, we’ll see where they’re going to be in the future. But my thesis was the environment is going to be different than via custom tool. We’re going to be in a sideways market, here’s how you invest. And that was basically my thesis in my Active Value Investing. And then Wiley came to me and said, “Vitaliy, this book has literally, I forget, 75 charts and tables. Can you please simplify it for your traditional kind of your neighborhood dentist?”
Tobias: [laughs]
===
Vitaliy: So, this is why this book came about. It’s basically, this book simplified. And this one has literally four charts and tables. That’s it. That’s the whole thing. One thing I got to tell you about writing a Little Book, it is a much better literary work than the first book, because– And you guys both wrote books. Because when you start editing down, you figure out what’s important, what’s not. It’s just an easier book to read. But there is no way I could have written the Little Book unless I wrote the Active Value Investing first.
Jake: Yeah, you need that forcing function to distill down into the core.
Vitaliy: Yeah. Also, there is one another factor which is unique to this project, confidence. Because when I make the point, “Okay, this is why we’re going to be in a sideways markets.” In the Active Value Investing, this is why I had 75 charts and tables to prove that to make my point right. When I was writing the Little Book, my internal thinking was, if somebody challenges me, I say, “Well, just read my first book.” It was really just psychological element. It just me having self-confidence to write. I could write that Little Book, because I already read in the first one, which has all the data.
===
Tobias: Vitaliy, let me just give a shoutout to the folks, and then we’ll come back and talk about how you see the market’s right now. Santo Domingo. First in the house. What’s up, Danny? Winter Park, Florida. Valparaiso. Love it. Brandon, Mississippi. Dubai. Belfast. Sherwood, Oregon. Milwaukee.
Jake: Say hi to Robin– [crosstalk]
Tobias: Missouri City, Texas. Mendocino, California, Is that Mendocino farms? Is that where that’s from? Nijmegen, Netherlands. Milton Keynes. Savonlinna, Finland. I just jumped over a whole lot sorry. Porto de Mós, Portugal. Nice. I’m going to come visit you. Ottawa. Tallahassee. [Jake laughs] Wilmette through a VPN. London. Chapel Hill. Cleveland. Hamburg, Germany. Wyoming. Nashville.
Jake: Oh, my God.
===
Understanding Market Cycles: Despair and Bull Markets
Tobias: People want their book of veggies, Jake. Jupiter, Florida. Kennesaw. London. Bendigo. Germany. What’s up? Good to see everybody. Vitaliy, where are we in the market? We’ve taken off into a new secular bull. What do you think?
Vitaliy: Very unlikely. The historically secular bull market started when regulations were much, much lower. Because for the bull market to start, basically, this podcast has to be canceled and nobody wants–
Tobias: [coughs]
Vitaliy: No, let me put this way. You and Jake will still be doing a podcast and will be watched by a homeless guy in San Francisco or something.
Jake: We’re already there.
Vitaliy: Huh. You are already– [laughs] But basically, the fact that you have so many people from all over the world still watching this podcast, that in itself says that we are not in the beginning of the bull market. Because it’s just basically, people have to throw in the towel and say, “I don’t want to own stocks ever again.” It’s when you have this moment of despair where the stock basically gave you no returns for a long period of time, when the price to earnings basically declined. You bought a stock which you thought was cheap at 12 times earnings, and now it’s trades at 7 and you’re like, “You know what? This stocks thing is just not working.” When the despair happens, that’s when the new bull market starts, secular bull market starts.
We are so far away from the secular bull market. I would argue we are at the end. But I want to be ambiguous. I’m not saying this is the point where it ends. I’m just saying we are in the territory where it ends. But I have known you, obviously, nobody knows how long it’s going to last. Yeah.
Tobias: I was at an Easter lunch– [crosstalk]
Jake: But what inning are we in?
===
Don’t Be Fooled by Popularity: The Danger of One-Decision Stocks
Tobias: I was at an Easter lunch over the weekend, and one of the guys, they said, “I’ve traded three crypto cycles.” We’re into the degenerate phase for this crypto cycle. [laughs]
Jake: Really?
Tobias: So, that’s where we were in cryptos.
Jake: Those happened fast.
Tobias: Yeah, it was. Cryptos.
Jake: The digital [crosstalk]. Cryptos. Yes. Like, dog ears.
Tobias and Vitaliy: Yeah.
Tobias: So, I took to everybody what they were holding. Everybody’s got a big chunk of Nvidia. They were all kicking themselves, because they missed out on SMCI. Is that the Silicon–?
Jake: Yeah.
Tobias: Got the ticket wrong there. One of the hotter kind of–
Vitaliy: It’s interesting. I became analyst. I was in industry in 1995. But I joined this company in 1997, and I was analyst at the time. I observed the dot com bubble, firsthand. I was meeting with somebody, and at the time the guy said, “You can’t go wrong owning.” And he listed like a series of stocks. There was Cisco’s, Oracle’s, Dell’s. Maybe AMD was part of the pack. And like, “You can’t go wrong owning the stocks.” He was right for about maybe two years, maybe for a year. And then they all collapsed. You obviously know how the story ended. So, it’s this mentality that you can go wrong on these stocks. And by the way, you can go back to NIFTY 50s, and it’s the same thing.
Jake: One decision.
Vitaliy: No, you’re right. One decision stocks, which is a first level thinking, because you only– Actually, no, it’s not even first level thinking. It’s zero level thinking, because all you’re looking is the stock price. Nothing else, okay? And the stock price tells you any story you want to hear, like, how Nvidia. By the way, the irony of this whole thing is internet was real. Like, Cisco still probably hasn’t recovered or maybe barely recovered from what happened 25 years ago.
Jake: I think it’s still under, if I remember right. But I could be wrong.
Tobias: Cisco got cheap a few years ago though. I think Cisco was cheapish. But yeah, you’re right, it’s not in terms of the stock price.
Vitaliy: No, it’s not. I’m just talking about stock price. In other words, Cisco was a great business in– Here is the punchline, Cisco was a great business in 1999, and it’s good business today still. It was incredibly overvalued in 1999, and it took a long time for the company to grow into its earnings. So, how much you pay actually matters. When you a one-decision stock, people actually ignore how much they pay. They just look at the chart actually. Nothing else.
Tobias: Yeah. You always feel good buying those stocks right at the point that you buy them, and then you regret it down the road. Whereas value stocks are the other way around, you feel terrible when you buy value stocks, you feel like you made a terrible mistake usually when you wake up the next day and it’s down another 20%. When you get disgusted at it and you can’t check the ticker anymore, that’s when it comes back to life.
Vitaliy: Yeah. Universal love for stocks is not cheap. When somebody hates something that hate is cheap. If everybody loves the stock, the stock is not cheap, and therefore, the returns won’t be good either in just general.
===
Defense Stock Investment Strategy: Betting Big on European Companies
Tobias: So, what do you think is interesting now? Do you talk about individual stocks or sectors? Or, how do you–?
Vitaliy: Yeah. So, let me talk about one sector. Look, it’s tricky discussion, because I own seven stocks in this sector. And most of them are not buys anymore, but we did buy few stocks in this sector. But I’m going to talk about only high-level defense stocks. Literally, one quarter of my portfolio today is in companies in the defense sector. I look at from a prolific construction perspective, to me, it makes so much sense. And 25% position, that’s a large position. Again, but it covers seven companies in four different countries, okay?
But if you look over the last 30 years, we basically were living on the peace dividend, especially European countries, because if you look at German defense spending, which is Germany’s largest economy in Europe, it’s basically declining every year. But that’s true for every single country in Europe. Maybe there’s a few exceptions. Actually, I don’t think that’s been true.
And today, we have basically two wars going on. We have war in continental Europe and we have a war in the Middle east, which could become a bigger war. Europe for a long time basically looked at the United States and said, “You know what? Yes, first of all, we don’t have to be afraid of Russia anymore.” Well, that changed. But second of all, “US will protect us.” No matter who is going to get elected in November, Europe does not look at the United States and says and thinks they will protect us. Because we become an ethical friend.
Look, when Trump comes out and says, basically– By the way, you can argue for– There was some validity to what he said that you guys did not invest. You cannot really count on us. It’s not really fair. Let me put it this way. I’m struggling here a little bit, because I really don’t want to go into politics. So, this is not what I’m trying to do. But let me put it this way. You have an alliance, and the cost of entering into alliance is that we’re going to spend on defense and you’re going to spend on defense. So, if we have to fight together, we’re going to be both strong. We’re going to be put our forces together and we’re going to fight together. If we keep spending money on defense and you are not, and if the war comes, we basically going to carry the burden of, not just financial but also our lives, okay? So, it’s on Trump’s point, actually, I agree with. What he said before, “You can’t keep relying on us and not spending on defense.”
Now, my problem is that the way he communicated it when he run for president, who basically says, “Well, if you get attacked, good luck.” I have an issue with that. But anyway, long story short, I think European government today is waking up to this, and their defense spending will skyrocket. It’s going from extremely low level and it has to stay at above average level to catch up for the last 30 years of underspending. So, when you look at earnings projections for these companies, the next three or four or five years, they’re probably too low. Because it takes a while for your willingness to increase your spending on defense to actually to materialize. Because first of all, politicians have to agree. Second of all, the bill has to be passed. Then it has to be funded. Because they’re building atoms and electrons. So, it takes stuff to build these factories.
And by the way, European companies today are still struggling from supply and chain issues. Like, I was in a BAE conference call, and they’re talking about how small defense companies, like their tiny suppliers, are still struggling from the pandemic supply chain issues. And BAE and other companies have to actually provide them infused funds for working capital, etc., to help them.
So, my point is that the demand is there, but it’s going to take a while for it to materialize in earnings. And this is why we bought these companies. Some of them appreciate a bunch, but we’re not selling them because I think the earnings going to end up being higher than we expect. One little factoid. UK used to have the largest Navy in Europe. Today, it has half as many ships than it did 20, 30 years ago. And if you think about it– [crosstalk]
Tobias: Are they twice as good, Vitaliy?
Vitaliy: Huh.
Jake: Yeah. Hedonic adjustments.
Vitaliy: They’re not twice as good. And the interesting part, it’s very age inflate. And today, they are facing not just threat from Europe, I mean not from Russia, but also threat from China, and from whole bunch of pirates or hoodies or whoever, who are basically now attacking their cargo ships.
Tobias: Yeah. Having piracy come back was not one of the things that I was expecting.
Jake: On your bingo card.
[laughter]Jake: Well, Peter Zeihan’s thesis is that the US is potentially done playing world navy police. And if everyone else then has to carry their own water a little bit there, they’re not really prepared for that.
Vitaliy: Well, exactly. They therefore safety right up there in our basic human needs in the Maslow’s hierarchy of needs, and therefore, we going to push our social security to 121 years from whatever it is today. But we’re going to keep funding our defense. And so, it is true for European countries.
===
Value Investing vs. Market Reality: Can High Valuations Persist Despite Rate Hikes?
Tobias: Vitaliy, you’re a value investor who thinks about value as a strategy. How do you feel about–? We did go through this very long period of underperformance. Maybe justified because we got too stretched in 2015, everything cheap got pushed up.
Jake: Wasn’t that cheap.
Tobias: Yeah, it wasn’t that cheap. It feels to me like we turned the corner in late 2020. But how do you feel? This year particularly has seen this resurgence of the crypto, resurgence of Nvidia and AI, which is– Clearly, there’s a lot of return there, there’s a lot of earnings there, but there’s also a lot of multiple expansion. Where do you think we are in the cycle?
Jake: What do you think about Toby’s portfolio and why is it so good?
[laughter]Vitaliy: Well, so, Toby, I’ll be honest. See, okay. So, I’m going to answer it from a different perspective. So, right now, when I look at the market, the market overall is very expensive. I’m having harder time finding new stocks to buy. So, in general, in the market, there’s just very little value in the market. Now, as a value style and I think that’s what you’re referring to, you wound think when interest rates goes from 0% to 5% to 6%, value would be just absolutely– You would not see crypto bubble. Well, actually, you would just not see crypto’s. Not crypto bubbles. You would just not see crypto’s. You would not see Nvidia like– Forget about Nvidia, forget about all this stuff, like the Donald Trump’s stock, whatever the Truth Social. I looked at it and I was like, “Oh, my God, that is insane.” If I could short a stock, that would be the stock to short it.
Jake: Yeah. Was it was like in $11 billion valuation on–? Like, how much was it $50 million of revenue or something?
Vitaliy: No, you’re too generous.
Jake: I know. Yeah.
Vitaliy: $5 million of revenues. But you’re right about $50 million of losses. You put $8 billion on that and you look at this, maybe if it’s lucky, maybe it should trade, let’s say 20 times revenues. So, that $100 million, not $8 billion, okay? When interest rates went up so much, you would not expect to see this, like a lot of bubbly stocks like this developing. So, I’ll be honest. I’m very confused. If you and I had a conversation a year ago and you said, “Well, interest rates go up from zero to this, what do you think?” I would not have guessed it.
Tobias: Equity melt up was the first thing I would think of.
Jake: Yeah.
Vitaliy: Yeah.
Tobias: Crypto.
===
How Social Media Creates a Global FOMO Frenzy
Jake: Buffett did say in his last letter like, that he thinks today has more of a speculative element to the market, like more of a gambling punting mentality than 30 years ago, which is rather impressive to me.
Tobias: Do you think that’s social media? There’s this social element to investing where you see your friends getting rich and you follow them. But it was a little bit more scattered. And now it’s so easy to– Every time somebody has a big score, they get on social media and they pop some champagne and choose rich, all that sort of stuff.
Vitaliy: Oh, I think actually that is– [crosstalk]
Jake: Choose rich.
Vitaliy: Think about it.
Tobias: You know that dude? You know who I’m talking about choose rich?
Jake: No. I just imagine that being the inverse of have fun staying poor.
Tobias: I think it’s satire, but I’m not entirely sure. The guy is like, he’s doing it totally straight, that nick.eth, the ETH, yeah, I think.
Jake: Wow.
Tobias: It’s funny stuff. When value blows up, it’ll be me. I’ll be out there doing that. I couldn’t possibly.
Vitaliy: Toby, think about it. Usually, these bubbles happens because you’re competing with your neighbor, right?
Tobias: Yeah.
Vitaliy: Okay. Well, now, the only thing is you only– [crosstalk]
Tobias: You got global neighbors.
Vitaliy: But now you have your whole Facebook– [crosstalk] .
Tobias: Yeah.
Vitaliy: Yeah, I think you’re absolutely right.
Tobias: That question was from Tyler Pharris, our unofficial producer. Good one, Tyler.
Jake: Yeah.
===
Can Physics Explain Markets? A Look at EMH Through Four Forces
Tobias: What do you think, JT? You want to sneak in some vegetables before the top of the hour? There’s lots of demands for the book of vegetables. I have also been pushing JT to do this. There are transcripts of all of these interviews. If someone wants to contact us and produce the Jake’s book of veggies?
Jake: A lot of other projects going on. So, maybe let JT get to it in good time.
Tobias: Well, I’m saying we’ll find somebody who’ll put it together for you.
Jake: Maybe. All right, well, this is trying to stick the 10.0, like triple backflip here today. So, we’ll see.
Tobias: Oh. Is that getting it back to investing?
Jake: Yeah. Well, that’s not going to happen. [laughs] But I thought it would be fun with Vitaliy on, just because I know that he understands a lot of this stuff. So, I think hopefully this is a good choice of trying to match up content with the guests. But I’m going to give a little history lesson on the efficient market hypothesis.
Vitaliy: Love it.
Jake: And also try to relate that together with the four fundamental forces in physics.
Tobias: All right, then. This would be good.
Jake: Yeah.
Tobias: Well, just in–
Jake: Yeah, buckle up. This could really blow up in my face. All right. So, the EMH, the quick history lesson is like it starts really with a 1900 PhD thesis by this guy named Louis Bachelier. And it was called theory of speculation. And he suggested that stock market prices are unpredictable and follow a random path, laying the groundwork for what would later evolve into the EMH. And this is where the term random walk came from.
So, if you imagine the thought process was imagine a drunk that’s fallen asleep at a lamppost. And every now and then he wakes up and he staggers a few steps in a random direction, you don’t know which way he’s going, and then he falls back down and it takes another nap. And then after many stages of this aimless wandering, how far away is the drunk from the lamppost?
Well, we can’t really say with any one drunk how far away he’s likely to be. But if we had like a million of them, we could start to actually look for patterns of how far away would we expect them to be on average. And it would be diffused outward in all directions. The average distance from the lamppost would increase with the square root of time. And so, that’s kind of the math that would come out of that. So, that’s what people have used then to back into prices moving around in random ways.
What I mean by that square root of time thing, so if you think if it takes one hour for him to wander one block, it would take four hours on average to wander two, and then nine hours to wander three, because there’s a lot of back tracing, wandering around in circles. All right. So, fast forward to the 1950s, and we start to get more of a foundation laid for EMH. The legendary economist, Paul Samuelson, ran with this concept and suggested the stock market was a glorified casino. And people who make fortunes there are basically just lucky. They’re not that smart. They’re basically lotto winners. Funny enough, Samuelson hedged his personal bets by putting his own money in Berkshire Hathaway.
Tobias: [laughs]
Jake: Fast forward, and then we have Harry Markowitz introduced the modern portfolio theory in 1952, and there he emphasized diversification and the relationship between risk and return, which set the stage even more for discussions on market efficiency.
1953, an economist named Maurice Kendall gave a talk indicating that wheat prices move around randomly supporting the notion that markets are unpredictable and by extension then efficient. And it was, of course, wheat and stocks. There’s not that much of a difference when you’re looking at the squiggly lines.
1960s, we get a much more formal introduction and development with Eugene Fama in his PhD thesis at the University of Chicago, 1965, formal introduction of the EMH. He defined efficient markets as one where prices are always the fully reflect available information. And it really categorized into three forms, okay? Weak, semi-strong and strong. So, let’s look at each one.
The weak version is you can’t beat the market by predicting a stock’s future prices just from knowing its past prices. It’s basically destroys all technical analysis as worthless at that point, when you say that the past is not prologue for the future. Semi strong is you say you can’t beat the market with any publicly available information. So, every past price, every press release, every filing, Bloomberg story, whatever, and however good you are at interpreting these things, there’s no room left over. It’s already all baked into the price, okay? And fundamental analysis then is completely worthless.
Tobias: I agree there.
Jake: Yeah, [chuckles] that’s been the lesson for the last seven years.
Tobias: [laughs]
Jake: It does leave room for private information in the semi-strong version. And then you have the strong form, which is private, is also then included in the mix. And basically, you can’t beat the market. Every piece of information, public and private, is already baked into the price. The implication is that basically insider trading is completely worthless.
Fast forward 1970s, more studies are done to validate with mixed results. The markets seem to reflect public information quickly, which might support the semi-strong version, but you can never really get all the way to fully strong version.
1980s, then we have a lot more challenges. You have anomalies such as the January effect. You end up with market crashes like 1987 that completely challenge EMH. Like, really, everything’s worth 22% less from a Friday to a Monday suggesting that maybe markets aren’t perfectly efficient. You get the rise of behavioral finance, led by psychologists Daniel Kahneman and Amos Tversky, which RIP Mr. Kahneman last week. Unfortunately, we lost a giant. And all that introduces this idea of cognitive biases which affect investor decisions, which lead to potential inefficiencies.
And then, of course, 1984, Buffett wrote The Superinvestors of Graham and Doddsville, which is a direct parry against the challenges of EMH. Then, of course, in the 1990s, you get technology, which this goes to what you guys were talking about with the diffusion of information. Now that we’re all connected on the internet, maybe markets are even more efficient. And yet, squared against that, we have the dotcom bubble in the 1990s, which companies you throw a dotcom on the end of the name, and it adds a billion dollars of market cap. Does that really make that much sense?
Late 2000s, some of the same problems. The GFC brings significant challenges to EMH. Failure to predict and prevent a bubble suggests that there’s limitations in this efficiency. So, anyway, like systematic mispricing of a lot of risk at that point. Since then, despite the criticism, EMH still remains a fundamental part of financial theory. It’s taught in every business school still, although there’s still a little bit more room now for behavioral finance.
Anyway, so, analogously now, we’re going to try to bring EMH together with the fundamental four forces in physics, which to remind you of your classes from back in the day. Number one is the strong nuclear force. Number two is the electromagnetic force. Number three is the weak nuclear force. And then number four is gravity, all right?
So, the first one, the strong nuclear force, let’s connect that together with market fundamentals. This strong nuclear force is the most powerful of the forces, and it acts as the glue that will hold nuclei of atoms together. Similarly, market fundamentals, earnings, debt levels, economic indicators, whatever, are kind of the glue that underpins the intrinsic value of securities. And just as a strong nuclear force operates at the smallest scales but with the most intensity, bundle and minimal analysis is at the core of the financial health of the company, and often revealing the most potential indicators of long-term value. It’s very powerful and up close, but it’s also short range.
So, then the next one is electromagnetic force. Maybe we can liken this one to the information spread like we were talking about. And this is like attraction and repulsion, is basically EMF. So, imagine it governs how particles are either attracted or repelled from each other. And in markets, information acts similarly, where investors can be attracted to a stock or repelled from it based on the nature of the news. You see everybody’s making money on Nvidia. You get attracted to it. Everyone hates oil companies. You would never buy that. You get repelled from it and you get these dislocations.
And then it influences over a distance. Unlike the strong nuclear force, which is very up close, electromagnetic force works over vast distances. And this mirrors how information, especially in the age of the Internet, can spread globally in an instant and affect markets worldwide.
Next up, weak nuclear force. Maybe this relates to market anomalies. So, the weak nuclear force is essentially the process of changing one particle into another. So, imagine radioactive decay. Analogously, like market anomalies, bubbles, flash crashes, things like that can be seen as markets radioactive decay, where the usual rules stop applying temporarily and challenging, I think, EMH’s notion of a perfectly always efficient market. They’re rare and unpredictable. The weak nuclear forces responsible phenomena that are really pretty uncommon and very unpredictable compared to gravity, and these other things, which are much more regular. And similarly, market anomalies are pretty rare and often unpredictable.
And then the last one is gravity, I would say, and interest rates. So, gravity is the force of attraction between all masses in the universe. And much like interest rates, it acts like the gravity of the financial universe, like, everyone. Buffett said that a million times that gravity is the– Or, sorry, interest rates are the gravity of the financial universe.
So, on an interest rates, they may seem weak and irrational on an individual company basis. Of course, interest expense makes sense. But on a macro scale, they have very profound and far-reaching impact. Like, they get into every little nook and cranny of the economy. So, the gravitational pull, it decays much faster the further you get away, and so the same kind of idea. Anyway, all of this is like the interplay of these forces. The universe operates under the influence of all four of these fundamental forces. And financial markets are shaped by complexity and the interplay of factors from hardcore fundamentals to market sentiment to these other things.
So, anyway, hopefully, maybe we got a little bit of EMH background that was interesting, the history of it, and then the four forces and tried to weave those together to talk about the interplay. I would give this a 6 out of 10 landing. I don’t know, we have a Russian judge on. [Tobias laughs] What’s the Russian judge put it at?
Vitaliy: Oh, nice. I like that. Okay. [Jake chuckles] Jake, your ability to come up with this mental models is just incredible.
Jake: Thank you. I appreciate that.
===
Gravity vs. The Market: How Interest Rates Can Upend Investment Strategies
Vitaliy: You should write a book. [Jake laughs] I always thought of, like the reason EMH was taught, because it was– You can basically take any physics teacher, give him a textbook and in three hours, he can teach the lessons.
Jake: Right.
Vitaliy: Teaching value investing is a lot more difficult.
Jake: And the math is so elegant on the EMH, right?
Vitaliy: It’s the elegance in formulas. And it’s so addictive, because it’s so– When I took my undergraduate classes in the finance, I remember how I was blown away by brilliance, the simplicity of this. And then the irony of this, I showed up at this office and I was prepared, and nobody cared.
Jake: Yeah. Where’s our efficient frontier, guys? [crosstalk] [laughs]
Vitaliy: Yeah. Exactly. I think if applying your frameworks. Yeah, so when you look at Nvidia today or forget about it. If look at, what is it, Truth Social. Is that price to reflect all the correct information right now? Let’s find of when it’s going to be 90% in six months. So, to me, I look at this just because– well, first of all, just because something is easy to teach doesn’t mean it should be thought. [chuckles] But I like this frameworks you did come up with and how they interact with one each other. Because at some point in time, one framework dominates. And at another point of time, another one dominates. When interest rates are low, then probably the– What was the framework that–? The gravity framework probably becomes– [crosstalk]
Jake: You’re on the moon– [crosstalk]
Tobias: It’s like switching off gravity. Yeah.
Vitaliy: Yeah. So it’s like, it doesn’t matter, right? When interest rates go up, suddenly, that’s all that matters.
Jake: Yeah. [crosstalk]
Vitaliy: I think this is actually an important point, which is– By the way, I’m really changing topic just slightly, but I’m just really surprised how well our economy is doing so far with high interest rates. Because I would have thought that when interest rates went up, as they did, basically, all the capital budgets would be reflect new high interest rates, and a lot of them would have been canceled. I think it just maybe takes time for the interest rates to impact to get– [crosstalk]
Jake: Corporate America, the S&P 500, did a really good job of locking in low and long. So, I think so far, they went from, last I saw, it was like 3.2 to like 3.9. It’s like, they’ve barely noticed that rates went up.
Vitaliy: You see a lot of companies, right? A lot of them– We own charter. Well, actually, I think a better case, enterprise products, which is a pipeline company. I think they have a huge amount of debt, but they also have a very stable cash flows. But if you look at their debt, it’s spread out like maturing $1 billion a year or something over 40 years. So, interest rates could quadruple tomorrow, and it’s not going to matter for them. So, I think Corporate America, you’re right, I think adapted that a lot better, unlike our very smart government, which actually I think went the other way. So, we’re going to probably see the impact in our money printing a lot sooner that we would have liked.
Jake: You know, who else borrowed short and variable?
Vitaliy: I’m sorry.
Jake: I said, do you know who else borrowed short and variable?
Vitaliy: Who?
Jake: Private equity.
Vitaliy: Yeah. No, and we haven’t found that yet.
===
Pain vs. Gain: The Price of Value Investing in Inefficient Markets
Tobias: Vitaliy, how do you square the idea that markets aren’t efficient in the academic version of efficient markets? But clearly, we do rely on some efficiency in markets, because we all buy things that are undervalued with the expectation that they will be fairly valued at some point in the future, which means that we also think that there’s some efficiency in the markets. We wouldn’t expect most of the things that we look at to be undervalued. We would expect most things to be fairly valued in a very wide range, and then there’s some that are overvalued, because they’re hot or popular and then there are some that are undervalued because they’re neglected or scary. So, how do you square that non-academic version of efficiency with the academic ones taught in all the universities?
Vitaliy: When the new information comes out, a lot of times it’s a properly reflected in the stock. A lot of times it gets– You have a time arbitrage. So, I like to call it pain arbitrage, who is willing to suffer the uncertainty you have over the next two years, where the older comes for in five years. So, I think markets are efficient. What I mean by this reflect available information most of the time, not all the time. I think what you and I bet in Toby is that when we buy in stocks, we are buying them at a point where they’re inefficient. But at some point, they’ll get to that efficiency.
Where in other words, Seneca has the saying which I love, “Time discovers truth.” So, when you and I do research and Jake too, we want to discover truth before time does. So, if you think the company is going to earn $5 in five years or whatever that number is, and right now the company is earning lot less for whatever random reasons, if you think you’re right about $5 of earnings and then 10 times multiples, it’s worth 50, at some point, market will get to this equilibrium state where it’s going to value company fairly. It usually does. Historically, you almost have to have faith that in the long run, if you’re right about your thesis, then the company market will value it right. I think it’s just the journey to that could be extremely painful. I don’t know if I’m doing a good job answering this.
Tobias: Well, there’s also the dividing line that the efficient market guys think that there’s a risk element to– That’s their explanation for the reason that these stocks are, they generate higher returns is because it’s compensation for additional risk. They’re talking about operating risk in that context, but there’s also a financial risk component to it. And then the behavioral guys would say, “Well, no, we make these mistakes. We extrapolate earnings, and they either go to zero or they go to infinity, we decide on that basis rather than mean reversion.”
Vitaliy: I think this is so true. I think there are two factors here. Factor number one. Actually, as the stock price declines, it’s actually the stock becomes less risky as an investment, just because it’s actually you create high margin of safety. Everything else being constant. As the Nvidia stock price goes up, it actually becomes more riskier, because it’s more likely that the sun will not shine as bright as the stock price reflects. There was a second point I was going to make and I already forgot so. [chuckles]
===
Why Behavioral Biases Challenge Market Efficiency
Tobias: The behavioral element?
Vitaliy: Yeah. Oh, behavioral– Yes, thank you. Yes, behavioral element, exactly right, because I think Bill Miller tells this joke all the time. Every time I hear him talk, he makes the same joke. Like, somebody asks when you have 10 sheep on this side of the fence, and one sheep jumps over how many going to have left? [Tobias laughs] And the answer is zero, because they all move together. And so, it’s the same thing here. We feel more comfortable as human beings to move this crowd.
You and I experienced that too. When you buy something that’s hated, you get this feeling of unease. I think it’s an evolutionary feeling. It’s physiological feeling. So, this is why you have to do so much more work to be confident in your research, because you basically say, “I’m right and everybody else is wrong.”
Tobias: The risk is that there’s something obvious that everybody else knows that you’ve completely missed.
Vitaliy: Exactly.
Tobias: Everybody knows it, and you’re a fool when you put this thing on.
Vitaliy: Yeah.
Tobias: And then you find out something and you’re like, “Yeah, that was dumb. I shouldn’t have done that.”
Vitaliy: Yeah. But the problem is, I think the key word here is that when everybody knows, a lot of times it’s already reflected.
Tobias: It’s baked in.
Vitaliy: Yeah. It’s already baked in. Then that’s behavioral finance comes in. So, I think it’s a lot more difficult to teach what we were just discussing than to teach these very simple equations where you know that beta is 1.35, like this very precise math. It’s so much easier to teach than what we are discussing right now.
Tobias: What do you think, JT? How do you square those two?
Jake: I think that, in general, I’m of the opinion that the market’s pretty damn efficient most of the time. Over most timeframes too actually. I think it generally gets most things right. However, occasionally, it malfunctions to the upside and the downside. And if you could be patient and wait for the really obvious things to do that you understand, you don’t actually have to be all that clever in analysis understanding. Then you lean a little bit on Buffett’s observation that price is my due diligence. The cheaper it is, the less you really have to understand about the future.
If it’s fully priced, then you better be damn right about the quality of the business, about the future prospects. But if it’s cheap enough, I think if you own enough of those type of situations over a career, I think you’ll do just fine. And you don’t really have to be a towering genius to do that. And the difference between perfectly efficient like is strong form, especially EMH versus right most of the time is night and day as far as what you should be working on every day if you’re a security analyst.
Vitaliy: I think you summed up perfectly, Jake.
===
Forget Market Timing: Savvy Investors Focus on Individual Stocks
Tobias: I always thought that the reason for insisting that market prices are perfectly efficient is the other alternative was the command economy, the Russian communist style command economy, where they were working out where everything should go from a central location. They said, “No, that’s the wrong approach. You’ve got to use markets, because markets are perfectly efficient.” That’s a better way of doing it.
Jake: Like, the market for money? Oh, wait, no, we have pretty much command and control of [Vitaliy laughs] the temporal pricing of money.
Tobias: Even Western economists, it’s not heavily regulated, but yeah. I think that was it was like a philosophical argument that it had to be perfectly efficient.
Vitaliy: Jake, you could probably use this kind of framework of complex systems to talk about this as well. Because that’s another framework to look at the efficiency. Despite writing two books in the markets, I think the best way to look at this is just look at individual stocks. Like, you see, to me, it makes so much more sense because it’s s ambiguous. What is the market, right? Well, it’s really just individual stocks. When you try to time the market, I think I would agree with the official market theory, it’s incredibly difficult, because you need to get the economy right and you have to get the reaction right as well. And getting both of them right is incredibly difficult.
I’m not sure where market timing falls into this, but I would argue that’s a false error. All three of us could talk about this kind of stuff, but then I would do absolutely nothing about it. I would just go back to my balance sheets, and income statements, and building models and just keep looking at individual stocks.
===
Tesla’s Future: Beyond the Hype? A Look at Battery Tech and Infrastructure
Tobias: Vitaliy, can we talk about Tesla for a little bit, because I know that you did a write up about Tesla. Tesla is one of those interesting stocks that it was running out of money at one point. But because it had such a high stock price, Musk was able to take advantage of maybe that idea of a little bit of self reflex. It’s an example of self reflexivity in the market, where the high stock price made it possible for them to raise some money, which probably got rid of that blow up risk at that time, and it’s gone on to do very well. Your article came out at a pretty timely– That was a pretty good entry point I think for that stock. Do you still hold it? Can you talk to us a little bit about?
Vitaliy: Okay, let me embarrass myself that I literally wrote a little booklet, which I don’t have a prob, but you can actually get an Amazon for $3 or something. [Jake chuckles] In that 2018, but basically, literally writing 7,000 worth resource paper on Tesla.
Jake: But came out in 2018.
Vitaliy: Yeah, 2018.
Jake: Wow. It feels like it was like two years ago.
Tobias: Yeah, I would have said much more recent than that.
Jake: [laughs]
Vitaliy: Yeah. Basically, my argument was, I saw a lot of positive in Tesla and also saw a lot of risks. And my conclusion was it was pretty path-dependent company. I was right in the sense that the path dependency was, if they can get to escape velocity, then they were going to be incredibly successful. And escape velocity in this case meant, they have to get to the cash flow positive without going bankrupt, or diluting the hell out of the shareholders.
This is where Musk’s magic comes in. He basically creates a religion behind it. And Jeremy Grantham described that part brilliantly. So, basically, Musk come out and said, “We’re going to issue shares.” If it was any other company, the stock price would have declined. In this case, the stock price actually went up, because the cult basically says, “Oh, this is great, we’re going to issue shares, the company is going to survive. Let’s buy more shares.”
I don’t think it ever has ever happened in history, though I’m sure there are exceptions, but that’s exactly what happened. And then they did get to escape velocity. So, I never owned the stock. I own two cars, I never owned the stock. It’s one of those things where instead of buying the first iPhone, you should have bought the stock. I’m sorry, it’s the same thing, you would have a lot more money to buy hundred more iPhones. Well, I should have bought the stock instead of buying a car, I guess.
Today, I just actually wrote about this and maybe that’s what you’re referring to. Like, a few months ago, I wrote about this that I think today, we reached the point where peak electric cars. Let me qualify this. This is very important. Today, electric cars are basically about 15% to 20% of new car sales. I would argue that everybody who wanted to buy an electric car already owns one. And let me explain you. This is very important point. Basically, people who bought the car, people like me, who like the electric car, and I really do. I like how it drives. But for me, it’s one of two–
I also have IC car as a backup if I need to do long distance travel. I live in a house, so therefore, I have a gas station basically in my garage. I commute mostly locally. Because today they’re basically three things that works against electric cars, probably more than that. It’s range anxiety, because today have 300 miles if you’re lucky on an electric car. If it’s too hot, it’s going to get to 200. But if it’s too cold, it gets to 200. It takes a long time to charge it, so it’s still not great for long-distance commute. And finally, the infrastructure sucks.
Tesla has the best infrastructure. But if you buy a car from General Motors or somebody else, well, now you can use Tesla’s infrastructure. But the infrastructure outside of Tesla is not very good. So, my argument is this. Unless we have a technological shift in battery technology, in charging and infrastructure, this is where the market share will stay. Toyota talks about how by 2027, they’re going to have a car that’s going to have 600 miles range. And then by 2030, like 900 miles range. Who knows if it’s true or not. But my point is, once we get to these kind of levels, this is where the adoption will increase tremendously. If at this level of technology, we basically at 15% or 20% of new car sales, and it’s going to stay here for a long time, basically, if that doesn’t change.
Tobias: I don’t want to make you feel bad, Vitaliy, but Tesla was about $20 in 2018. Funnily enough, it’s $166 today. It’s off 5% today. So, you would have missed out on that 5% drop today.
Jake: I [crosstalk] would have dodged that bullet.
Vitaliy: Think about this. I could have basically bought eight cars. I would have had eight cars instead of one. Yeah, it’s just– Yeah.
Tobias: Yeah, it’s down 30% for the year. It hasn’t had much of a year so far this year.
Vitaliy: I think the stock price is overvalued. It was overvalued 50% higher still overall today. There will be time when I made my own Tesla stock, it’s going to be at a very different price.
Jake: Five times PE.
Vitaliy: Yeah, maybe a little bit higher than that. By the way, Tesla does– [crosstalk]
Jake: It is a car company. I don’t know, if you’ve looked at other PEs in the auto industry.
Tobias: It’s got a robot and roof tiles.
Jake: Oh, sorry. My bad.
Vitaliy: Yeah.
Tobias: Vitaliy, this is coming up on time. If folks want to get in contact with you or follow along with what you’re doing, how do they do that?
Vitaliy: Very simple. I have a very simple website, investor.fm, like FM radio. Just go there, you can subscribe to my articles. So, next time, when I write about Tesla and I don’t buy the stock, you’ll find out about it.
Tobias: That’s great. Thanks, Vitaliy. Thanks, JT.
Vitaliy: Guys, you’re so much fun. And by the way, I got to tell you, this podcast is incredible. You guys doing a great job. And, Jake, seriously, veggies, it got to be a book, maybe different title.
Tobias: We’ll get the forward out of it, Vitaliy.
Jake: Yeah, there you go.
Vitaliy: I would be delighted to.
Tobias: Thanks, folks. We’ll be back next week. Same bat time, same bat channel.
For all the latest news and podcasts, join our free newsletter here.
Don’t forget to check out our FREE Large Cap 1000 – Stock Screener, here at The Acquirer’s Multiple:
