We’ve launched a new investment firm called Acquirers Funds® to help you put the acquirer’s multiple into action.
Acquirers Funds®
Our investment process begins with The Acquirer’s Multiple®, the measure used by activists and buyout firms to identify potential targets. We believe deeply undervalued, and out-of-favor stocks offer asymmetric returns, with the potential for limited downside and a greater upside.
The returns to deep value are potentially realized in two ways:
First, through mean reversion in the underlying business, and
Second, through a narrowing of the discount to valuation, either through the passage of time or the intervention of activists and buy-out firms.
We take a holistic approach to valuation, examining assets, earnings, and cash flows, to understand the economic reality of each company. An important part of this process is a forensic-accounting diligence of the financial statements, particularly the notes and management’s discussion and analysis, to find information that may impact investment decisions.
We implement the strategy in a highly liquid, tax-efficient, capital-efficient structure.
We identify the 30 best deep-value opportunities right now in all US and Canadian stocks and ADRs (excluding financials and utilities) using The Acquirer’s Multiple®. Choose from four universes: Large Cap 1000 (free), All Investable, Small and Micro Cap and Canada All TSX.
Our The Acquirers Podcast we talk to value investors about how they find undervalued stocks, deep value investing, hedge funds, shareholder activism, buyouts, and special situations.
We uncover the tactics and strategies for finding good investments, managing risk, dealing with bad luck, and maximizing success.
Part of the weekly research here at The Acquirer’s Multiple features some of the top picks from our Stock Screeners and some top investors who are holding these same picks in their portfolios. Investors such as Warren Buffett, Joel Greenblatt, Carl Icahn, Jim Simons, Prem Watsa, Jeremy Grantham, Seth Klarman, Ray Dalio, and Howard Marks. The top investor data is provided from their latest 13F’s. This week we’ll take a look at:
Vishay Intertechnology (NYSE: VSH)
Vishay Intertechnology provides discrete semiconductors and passive components to original equipment manufacturers and distributors. These products are found in industrial, computing, automotive, consumer, telecommunications, power supplies, military, aerospace, and medical markets. The firm’s portfolio of products includes transistors, diodes, optoelectronic components, capacitors, inductors, and resistive products. Less than half of the firm’s revenue is generated in Asia, with the rest coming from Europe and the Americas.
A quick look at the price chart below for Vishay Intertechnology shows us that the stock is down 18% in the past twelve months. We currently have the stock trading on an Acquirer’s Multiple of 4.59 which means that it remains undervalued.
(Source: Google Finance)
Superinvestors who currently hold positions in Vishay Intertechnology include:
We’ve just been reading through the latest Graham & Doddsville Spring 2019 Newsletter which features interviews with:
Yen Liow, Founder and Managing Partner of Aravt Capital
The first interview is with Yen Liow, founder and managing partner of Aravt Capital. Yen discussed the value of having worked under a couple of investment legends, the importance he places on systems design, and why he only focuses on a specific set of investment opportunities to compound growth over a period of years. Yen shared a couple of his “horses” (i.e. durable compounders) in Black Knight (BKI), GoDaddy (GDDY), TransDigm (TDG), and Constellation Software (TSE: CSU).
Bill Stewart, Founder of both Stewart Asset Management and W.P. Stewart and Company
The second interview is with Bill Stewart, founder of both Stewart Asset Management and W.P. Stewart and Company, the latter of which was sold to AllianceBernstein in 2013. Mr. Stewart shared why he focuses on predictable earnings, how he comes up with an earnings multiple, and what he thinks of the retail industry. He also discussed his views on ADP and Disney.
John Hempton of Bronte Capital
The third interview is with John Hempton of Bronte Capital. John is well-known for his public (and accurate) calls on both Herbalife and Valeant. John discusses his approach to finding fraudulent companies, why switching costs matter, and the benefits of global scale. He specifically discussed Mattel and provided additional color on his variant perception on Valeant.
One of the best resources for investors are the publicly available 13F-HR documents that each fund is required to submit to the SEC. These documents allow investors to track their favorite superinvestors, their fund’s current holdings, plus their new buys and sold out positions. We spend a lot of time here at The Acquirer’s Multiple digging through these 13F-HR documents to find out which superinvestors hold positions in the stocks listed in our Stock Screeners.
As a new weekly feature, we’re now providing the top 10 holdings from some of our favorite superinvestors based on their latest 13F-HR documents.
This week we’ll take a look at Howard Marks (3-31-2019):
The current market value of his portfolio is $5,265,263,000.
During his recent interview with Tobias, Justin Carbonneau, a Partner at Validea Capital discusses how value investing will turn around but no-one can say when. Here’s an excerpt from the interview:
Tobias Carlisle: We’ve seen this really difficult time for value. I get the feeling that you’re not necessarily a believer that value can turn around. You don’t think it can do it again?
Justin Carbonneau: You don’t think that? No. I strongly believe, to your point earlier, I think value investing, there’s the underpinnings of what makes value stocks work. I believe very strongly in that. I just don’t believe anyone can time the turn in value or the turn in any of these factors. But, mean reversion is a very powerful thing in the market.
Looking out over the next ten years, I do think value stands a very good chance of certainly improving its relative performance. But, you also have to always question your beliefs to some extent and just try to be … That’s one thing I’ve tried to do more of and my partner, Jack, he does a really good job at it. I don’t. I tend to, on Twitter and the articles I read and stuff, I read the things I agree with. When I hear fundamental investing is dead or somebody that’s bashing Buffett for his performance over the last 15 years, I don’t agree with that stuff. But, I also want to be open-minded to that in the markets, things change and things can go on a lot longer than we think, and they have been for a couple of years now.
Tobias Carlisle: I think value investors have been doing a lot of introspection. The last decade’s been rough, but the last five years in particular. I thought five years into the underperformance was enough.
Justin Carbonneau: Yeah. I think we were writing about it five years ago. Turn in value.
Tobias Carlisle: Here it comes.
Justin Carbonneau: I think we might have been one of the earlier ones, and we were wrong. It kind of humbled us, I think, in that sense.
Tobias Carlisle: I’ve been saying, “It’s five years,” for so long that it’s longer than five years now. I’ve been saying it for six or seven years. I’m actually going to say it’s seven years. It’s so long.
Justin Carbonneau: Exactly.
Tobias Carlisle: I always think of that article that Malcolm Gladwell wrote about Nassim Taleb. Nassim Taleb used to say to his trader, “Have you introspected today? Introspect. Introspect.”
Justin Carbonneau: Yeah. Right.
Tobias Carlisle: Every value investor out there, there’s so much introspection going on. Why aren’t these strategies working? If you were a value investor who’s kept up with the market over the last decade, you’re a genius. You’re just undiscovered. Having lived through it, I remember all the… There’s a suggestion that the problem with the value strategy at the moment is it’s so focused in bad sectors. It’s focused in energy, it’s focused in financials. Having lived through it, I can point at each stage along the way. All of these disasters like Chinese reverse takeovers, they all came on. They looked pretty cheap. They all floated down into the value stuff if you bought them, you got carted out. Then there was the for-profit colleges.
Justin Carbonneau: What was the Corinthian college and-
Tobias Carlisle: I remember it well.
Justin Carbonneau: Yeah. These things were trading at PE of four or something, you know?
Tobias Carlisle: If you backed out the cash, though, free.
Justin Carbonneau: Right.
Tobias Carlisle: Then energy more recently. At every stage along the line, you’ve just walked into a value trap industry.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Here’s a great recent interview with Charles Munger and Andy Serwer at Yahoo Finance – Influencers. There’s one passage in particular in which Munger admits to being ashamed that he missed out on Google, and has the following to say about loss-making Unicorn IPO’s:
“Well, there are a whole lot of things I don’t think about. And one of them is companies that are losing $2 or $3 billion a year and going public. It’s not my scene.”
Here’s an excerpt from the interview:
ANDY SERWER: I want to ask you a little bit about some Silicon Valley stuff. I mean, you said yesterday you were ashamed of missing on Google.
CHARLIE MUNGER: Yeah, I am. We could see, if we had looked carefully at our own companies, that their advertising was working way better than other advertising. Just we weren’t paying enough attention.
ANDY SERWER: So was it too late?
CHARLIE MUNGER: I don’t know. I don’t know everything, you know?
ANDY SERWER: Well, we’ll leave that aside. But, you know, you look at these tech investments, so they’re Apple, now Amazon. Did you know about the Amazon purchase? Were you involved in that decision?
CHARLIE MUNGER: No, of course not. I have never owned a share of Amazon. I am a huge admirer of Bezos. I think he’s been sort of like Lee Kuan Yew. He’s a leader that’s all by himself. He’s been just a perfectly amazing human leader. But it’s always been too complicated and uncertain for my particular temperament.
ANDY SERWER: It’s interesting because–
CHARLIE MUNGER: And I find other things to do that’ll work fine.
ANDY SERWER: Someone was telling me the other day that they thought that you could actually sort of think of Apple and Amazon not as technology companies so much, but as big-branded growth businesses, which would be something that would be appealing to you.
CHARLIE MUNGER: Oh, I think they’re both brands and technologies. And it’s hard to separate the effect of one from the other.
ANDY SERWER: OK. And as far as what’s going on in Silicon Valley right now with IPOs, unicorns going public and not having any profitability or any prospect of profitability in the near term, what do you think of that situation?
CHARLIE MUNGER: Well, there are a whole lot of things I don’t think about. And one of them is companies that are losing $2 or $3 billion a year and going public. It’s not my scene.
ANDY SERWER: Have you looked– so, you’re not interested in Uber or companies like that necessarily?
CHARLIE MUNGER: Well, I have to be interested when they’re that important and sweep the world and change practice. But I don’t have to invest in everything I’m interested in. I’m looking for things where I think I can predict what’s going to happen with a high degree of accuracy. And I have no feeling that I have the ability to do that with Uber.
During his recent interview with Tobias, Justin Carbonneau, a Partner at Validea Capital discusses the performance of some of the greatest investors of all time, and how one investor in particular managed to out-perform Mohnish Pabrai. Here’s an excerpt from the interview:
Tobias Carlisle: Robo. When folks come to the firm, do they say, “For a managed account, I want the Buffett strategy,” or do they say, “I want you to give me the best ideas from all of the strategies for this time of the cycle?”
Justin Carbonneau: We have a set of strategies that are based on combinations of the models that we run. But, we have some clients that either we do custom development for, or if somebody feels very strongly like, “I am a Benjamin Graham disciple, and I want deep, deep value exposure,” we can do that.
It’s just, everything we’ve seen and we’ve talked about it over the last ten minutes, growth or value, any concentrated portfolio of 10 or 20, 30 securities, especially if it’s just one type of strategy, you can be all over the place. We actually try to be very careful with our investors and say, “Listen, yeah, we understand you’re a believer in value investing and the Benjamin Graham intelligent investor, defensive investor model, but you’ve got to have the thickest skin to be able to stick with that strategy.” We do have some clients that have done it. When that turn in value comes, if they’re disciplined, they’re going to get rewarded, hopefully.
Justin Carbonneau: We generally try to do blends is kind of the answer.
Tobias Carlisle: I’m always talking about my book a little bit on this, but I am a believer in value because it appeals to me intellectually, and probably it’s emotional as well, I don’t know. I think it’s a good idea if you believe in a strategy and it does ultimately end up working to stick in, to have this … I met this guy recently. He’s an investor in, he was one of Mohnish Pabrai’s early investors. He has a record that’s better than Mohnish Pabrai because every time Mohnish is down he gives him more money.
Justin Carbonneau: Oh, really. He kind of dollar cost averages it in, but when the strategy’s underperforming … Good approach.
Tobias Carlisle: Mohnish has got a phenomenal record.
Justin Carbonneau: Do you know what’s his long term? Is it in the 20’s or something in terms of return?
Tobias Carlisle: I don’t know. The sort of numbers I thought I had saw, it was thousands of percent. Maybe tens of thousands of percent over a couple of decades, something like that.
Justin Carbonneau: Yeah. The reason I … You guys, it was a chart that you put in your weekly content recap.
Tobias Carlisle: Roundup.
Justin Carbonneau: Actually last week. It’s a chart that I encourage everyone that’s watching this, which hopefully some people watch it, right? To look at, but it’s the chart of it has returns on the y-axis and the number of years on the x-axis, and it shows all these great superstar investors, and where they would be. If you have Buffett, Buffett has 65 years at basically 22% annualized return. He’s way out to the right and pretty high up in terms of the return.
Then you have even guys like Greenblatt and like Lynch. Lynch was 29%, which was phenomenal, but it was 13 years. In terms of the time frame, it’s far less, obviously, than Buffett. I find that chart really fascinating. It does go to show, and we know this, it’s obvious, but how crazy Buffett’s long term performance is. With that being said, if you take the last 20 years for Buffett, it hasn’t been anywhere close to that, but there’s a lot of factors that play into that. I find that chart very interesting. It circulates around. Once every couple years, I see that pop back up.
Tobias Carlisle: Right, I remember it. I had to put on an update because I think everybody’s seen it. There’s another version of it that has guys who aren’t necessarily value investors and there’s some absolutely phenomenal returns on that as well.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
During his recent interview with Tobias, Justin Carbonneau, a Partner at Validea Capital discusses how often the time when your investment strategy is really about to start working is right at the time you’re going to fold your hand. Here’s an excerpt from the interview:
Tobias Carlisle: I think one of the ways that folks generate very good returns is by having a strategy that starts right at the beginning of a good run for their strategy. If you’re a value guy and you get started in the early 2000’s, you get the first 7 or 8 years, you get phenomenal performance. If you even just market perform for another decade, you get a pretty good looking track record. It’s the guys who invest through multiple cycles and outperform through multiple cycles as their asset base is getting bigger and bigger.
Basically, we’re really only talking about a very small handful of guys here. It’s probably Buffett and Soros and maybe Druckenmiller and a few other guys like that who have got some genuine skill. The really hard thing is that if you underperform for a few years and you’re a manager and you don’t have enough equity in the manager to control it, you can be fired from your role. There goes your track record. 13 years is actually a pretty long track record.
Justin Carbonneau: That’s true. That’s a good point. You’re right.
Tobias Carlisle: It takes a long time to get into the seat. You might not get into the seat until you’re in your 40’s. You run it for 13 years, you’re in your late 50’s and it’s time to hand it off to some other young guy in his 40’s.
Justin Carbonneau: There’s so many things that you said that I really agree with. You don’t know, if you were a value … Even with Validea, when we launched our models initially in ’03 tracking these portfolios, that set the stage for the asset management business. The models are sound. They’re based on things that have worked over long periods of time, but we launched it in ’03. We were coming right out of that bear market, and value went on a great run. Our models were tearing it up. We definitely benefited from that. The people that were investing with us benefited from that. But, then you have the cyclicality and the underperformance of value, so now it’s like we’re not benefiting from it. That’s why it’s very important to believe and have conviction in the strategy that you’re invested in.
Justin Carbonneau: From my experience, and I’ve worked with hundreds of investors at this point, we’re human. It’s how we’re wired. There’s a lot of things that play into it, but as soon as you lose conviction or doubt starts to creep into your mind about, “Is this strategy the one that I believe in,” pretty much it’s over. I’ve almost never been able to convince, if a client or an investor starts to doubt and not believe in what we’re doing, then they’re probably not going to be a client for the long run. That’s going to happen. That’s part of running money and being an active manager is you hope to get the right people on the bus. You won’t all the time. You try to educate along the way. Some people will listen, and some people won’t. You know that.
Tobias Carlisle: I absolutely do, which is why all of the books that I have written have focused on the behavioral elements of it. I do think it is crucial to outperforming. It’s often that it’s tried, and it’s sort of a cliché to say it, but it is darkest before the dawn. The time when your strategy is really about to start working is right at the time you’re going to fold your hand. Often it’s because the other people with less conviction are folding their hands. All of a sudden, the capital drains away from the strategy, and that sets it up for a really good return.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
In this episode of The Acquirer’s Podcast Tobias chats with Justin Carbonneau, a Partner at Validea Capital Management. Validea replicate guru strategies and track some other strategies. They have a money management firm, and an ETF. During the interview Justin provides some great insights into:
– How Can Investors Replicate Guru Strategies
– What Is The Best Guru Strategy Over The Past 5 Years
– The Time When Your Strategy Is Really About To Start Working Is Right At The Time You’re Going To Fold Your Hand
– What Can You Do To Avoid Most Value Traps?
– Value Investing Will Turn Around But No-One Can Say When
– Why Is Factor Timing So Difficult
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias Carlisle: Hi. I’m Tobias Carlisle. This is the Acquirers Podcast. My special guest today is Justin Carbonneau of Validea and Validea Capital Management. Validea replicate guru strategies and track some other strategies. They have a money management firm, an ETF. We’re going to talk to Justin right after this.
Speaker 2: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinion of Acquirers Funds or affiliates. For more information, visit Acquirersfunds.com.
Tobias Carlisle: Hi Justin.
Justin Carbonneau: Hey, Toby. How are you?
Tobias Carlisle: I’m really well. We met face to face for the first time. We’ve known each other for a little over a year, but we met face to face for the first time in Hollywood, Florida at the Inside ETS conference where it turns out, you’re the fastest man in ETS.
Justin Carbonneau: The fastest man that no one knows about, apparently. Yeah, that was actually kind of a funny story. They do this fun run down there. It was Tuesday morning. It was 6:30. There was 100 people there, which was cool they organized it. Anytime there’s a run … I ran in college, so anytime there’s a run like that, I’m going to put my feet on the ground and try to work hard.
Justin Carbonneau: Anyway, the run starts and actually they have a celebrity runner there. His name’s Meb. He won the Boston Marathon maybe in 2016.
Tobias Carlisle: Meb Faber. Not Med Faber.
Justin Carbonneau: No, not Meb Faber. They had this celebrity runner. This group of people starts. I went out kind of hard, but I wasn’t running race pace. Anyway, at the two mile mark I’m out in the lead and I’m with the police escort. It’s just me and the police escort, and we get back to the Delmonte, which is the hotel, and no one’s there. The race just ends. I’m looking around saying, “Usually there’s somebody at the finish line to greet you or say, ‘This is the finish line.'” I go up to get my stuff, like the bag and my water bottle or whatever, and then I walk back down and I see people finishing. Then Johnson from Morningstar is finishing and walks by me. He’s like, “Did you see that Meb guy? He was flying. I don’t think anybody caught him.” I’m thinking to myself, “No one even knows that I finished first,” and it doesn’t matter because it wasn’t a race, but it was kind of hilarious.
Justin Carbonneau: Then I texted you and actually texted my wife when the race was done. “The race is done.” She’s like, “How’d you do?” I’m like, “Yeah, I kind of finished first.” She’s like, “Congratulations,” or whatever. I’m like, “Thanks, but no one really even knows.”
Tobias Carlisle: You were too far out in front, but it shouldn’t be any surprise. You’re a division one collegiate athlete at the University of Connecticut. What did you run there?
Justin Carbonneau: I ran middle distance. I ran the 400 and 800 outdoor, and then the 1000 indoor, basically.
Tobias Carlisle: That doesn’t really translate that well to a 5K.
Justin Carbonneau: No, but middle distance runners, you have to have quite a bit of endurance. I still run. I still run maybe a couple times a week, get out there. I did some hill work last night, so that was painful.
Tobias Carlisle: Maybe you should get in contact with Mike, tell him you need to go and run a marathon. You’re going to get Meb. You’re at business school, you did your MBA at the University of Connecticut, and it turns out you’re in the business school hall of fame. How does that happen?
Justin Carbonneau: Yeah, so at UConn in the full time MBA program, which I was very fortunate to attend, I had actually a graduate assistantship, so my tuition was waved and I did work with the marketing department while at UConn. This was 2002-04, so the internet was just, it was there, but schools were trying to figure out how to better utilize the web with their own marketing positioning. I worked with the marketing department on building out some of that as part of my graduate assistantship, and then I think it was a combination of students and faculty that voted for the one business school student that exemplified the characteristics that they wanted to see. I was the one that was selected. It was pretty cool.
Tobias Carlisle: That’s incredible. Now you’re a managing partner at Validea, and there are two parts to the business. One is a website that tracks gurus and also, not factors, but different investment strategies. Then you have a money management firm. Let’s talk about the website first. What does the website do, and what’s the focus?
Justin Carbonneau: The core of the website is basically running a series of strategies or models based on legendary investors, so people like Warren Buffet, Peter Lynch, Benjamin Graham, and in addition to that, we’ve actually rolled out a second set of strategies based on academic papers and books. What we basically do is, in some cases the strategies are very clear. It’s very clear what the actual underlying investment criteria and the factors are. In other cases there had to be some level of interpretation that goes into it. With Buffet for example, Buffet’s never really disclosed his exact stock picking strategy, and he probably doesn’t have an exact stock picking strategy, so we base our Buffet model off the book Buffetology. We can maybe to into that in a little bit.
Justin Carbonneau: But, basically what we do is we computerize these investment strategies, and then on Validea, you can do … That’s the underlying core foundation is these computerized models, and then it’s building things on top of those. Imagine for a minute you have a strategy, let’s say the Peter Lynch model. There’s certain fundamental criteria that goes into that. On Validea, you can type in a ticker symbol and you can see, step by step, how the Lynch method looks at over 6,000 securities. We do that for 22 different models. There’s a lot of what I would call fundamental analysis, but it’s not just lists and screens and portfolios. It’s actually the ability to look inside or look under the hood of a stock and see why a stock passes or fails a particular model. That’s something we call our guru analysis, or that’s an analysis engine if you want to see how your stock stacks up.
Justin Carbonneau: The other side of what I would say we do is running model portfolios and screens. Sticking with the Lynch method for a minute, if you want to see the top names according to our interpretation of the Peter Lynch strategy, we run model portfolios based on that, and then we also run stock screens. There’s a difference between those two things. A model portfolio, we’re sort of tracking the performance, we’re limiting the portfolio to 10 or 20 securities. We follow different rebalancing frequencies. I’ll come back to the portfolios in a minute if we talk about it. The screens are just really an idea generation list. Show me the top stocks today according to the Lynch model, and then you can combine that with other fundamental factors if you want to narrow the list down further. That’s a subscription-based product. People subscribe to that.
Tobias Carlisle: Let’s dig into the different gurus and strategies. Let’s start with Warren Buffet, because there are lots of magic formulas, is a quantitative expression of Buffet’s strategy. The magic formula is return on invested capital on the one hand, and then enterprise value on operating in [inaudible 00:08:35] or operating. How do you guys classify Buffet?
Justin Carbonne: Our Buffet model is based on the book Buffetology. There’s probably been hundreds of books written about Buffet’s approach, but that’s the one that we honed in on as having the clearest set of criteria that we could extract and be computerized. The first step is it starts with looking at trying to determine if earnings are predictable. What our Buffet model does is it looks at ten years worth of earnings, and it says, “Are earnings in this company predictable?” In the book, and I think we we know this to be true, Buffet doesn’t like volatile earnings. The more predictable the earnings are, sort of, in his mind, I think the better. That allows, in our model, that actually comes back full circle when we go to estimate the expected return, which I’ll get to. The first criteria is are earnings predictable.
Justin Carbonneau: The next criteria is, we look at ten years of earnings. The next criteria is does the company have a higher than average long term return on capital and return on total capital? Our strategy looks at 10 years of ROE and ROTC. That’s trying to express if a company has a competitive advantage or a mote around their profitability. When you look at ten years, in the last ten years, most companies … I shouldn’t say most. Many companies have sort of steady ROE or return on capital, but when you get these cycles in the business cycle, most ten year periods, you get to see where the weaknesses are in companies. The profitability dips. Our model doesn’t like to see that. Our model rewards companies that are maintaining that higher degree of profitability over long periods of time.
Justin Carbonneau: Then there’s a whole other set of factors like does the company have the ability to pay off its debt given the earnings its generating? Is management using … Are they generating a solid return on the retained earnings that they’re retaining as a company? Is the company buying back stock? These are all factors that are incorporated in the model, and companies are basically, they basically pass or fail each particular criteria. Only the ones that get passes are the ones that actually score best according to the Buffet model.
Justin Carbonne: In conclusion, there’s a part of the strategy that tries to estimate the expected return for the stock, and it does that using two different methods, the ROE and the EPS method. Our model basically likes to see stocks that have an expected return of at least 15% per year looking out. That’s the Buffet strategy. It’s obviously much more granular and maybe detailed than something like the Greenblat model, which he’s trying to get at some of that.
Tobias Carlisle: That’s where I was going to go next. You track the Greenblat model as well. Do you know how the two have compared?
Justin Carbonneau: Yes. The Greenblat strategy has been very volatile.
Tobias Carlisle: It’s very volatile.
Justin Carbonneau: Yeah, very volatile. It tends to bring us into what we would mostly call the small cap value area. The Buffett strategy tends to, given those criteria, tends to select larger, more quality type companies that tend to exhibit less volatility. One of the interesting things just to note, we also run this system on Canadian equities and South African stocks. We do those with partners in those countries, but the Buffett strategy, interestingly enough, in those separate markets, actually is in the top performing 25% of strategies that we run. It is interesting. That’s not true of the US strategies, but in those other markets, it tends to be a really good performer.
Tobias Carlisle: I watch the Australian market reasonably closely, and a lot of the other stock markets around the world, excluding the US, haven’t crested their 2007 peak. They’re still trailing. They all got very cheap, and then that’s kind of what, if you’re a value guy, that’s what you want to see. It increases the size of your universe and you should do fairly well. The US got back over it in about 2012, got over its 2007 peak in 2012 and has powered on from there.
Justin Carbonneau: I saw a chart yesterday. We’ve talked about this, this under performance of value, but this is kind of amazing. It was talking about, it was either, what was it, Deutsche Bank or one of the big European banks or managers that are basically saying value is finally set to turn. This has been a couple years we’ve been hearing this, waiting for it?
Tobias Carlisle: Five years.
Justin Carbonneau: Right, exactly. But, what it showed, this kind of blew my mind, and I may have even tweeted it, I’m not sure, but the MSCI value index over the past ten years has a negative return.
Tobias Carlisle: No kidding, yeah.
Justin Carbonneau: Think about that for a second. Ten years in international markets, developed international markets of negative performance. Then it was comparing, the chart was comparing the MSCI growth index, which was up like 60 or 70%. That wasn’t that great either, but I was like holy smokes, this is crazy.
Tobias Carlisle: It’s a phenomenon that I have … I look at the MSCI occasionally, too, just to see how it’s doing. It’s only recently, I think it was MSCI developed market, which is about 22 of the biggest developed markets around the world, has only just recently got over its 2007 peak. It’s still not particularly cheap, where it is. That’s true of some of these other countries as well. I think Australia and Canada in particular, I don’t know the South African market as well, but I imagine it’s pretty similar. Australia and Canada are dominated by big financial institutions and basic materials, which is mining, as you’d expect. They’re very cyclical. They really get beaten up.
Justin Carbonneau: That’s true. Yep. Sorry, we got off the guru strategies there for a sec.
Tobias Carlisle: We can go wherever we want. There’s no set agenda. How many guru strategies do you track?
Justin Carbonneau: We have 22 now.
Tobias Carlisle: What are the best performers? What’s done the best over the last, say, decade?
Justin Carbonneau: It’s the growth and momentum stuff for the most part. One of the extremely, and we would have never been able to predict this, and it’s not to say the next ten years are going to be like the last ten, but one of the strategies that has really stood out is it’s called the small cap growth investor strategy, and we base it off a model that was outlined by the Motley Fool. We based it off the Motley Fool investor guide. It is what it is. It’s a small cap growth investor strategy, and it has a very strong momentum criteria. Stocks that only have a relative strength of 90% or better are the ones that score highest in the model along with these other growth statistics that it looks at.
Justin Carbonneau: That, surprisingly, it’s been a great performer. This is model portfolio performance. This isn’t actual money management performance. These are model portfolios that are run and tracked on the site. I want to be careful not to say that this is actual money management performance. That’s been a really impressive one. We recently rolled out a whole new set. Of the 22, 12 of them have been on Validea basically since the 2003-2004 timeframe. Just recently we rolled out the ten new models, the Acquirers Multiple based on your book, actually, is one of them, so congratulations.
Tobias Carlisle: Thank you.
Justin Carbonneau: In that set, there’s this twin momentum strategy that has very good performance. That’s basically looking at fundamental momentum, and then it’s looking at price momentum. It’s trying to couple those two things. Companies that are exhibiting and upward trending improvement in various fundamentals and then that are also exhibiting price strength, and selecting the top 10 or 20 stocks based on that. That’s been a very good performer. It’s those types of strategies.
Tobias Carlisle: It’s been a momentum-growth market, I think, for the last decade. When you were talking about the bank, the European bank that had released the MSCI values showing it was down over the decade, I was thinking about the Rob [Annot 00:18:03] of the research affiliates, Meb Faber tweeted out some of his slides from a recent presentation which showed the dominance of growth over value. I think it’s a 20 year chart and I tweeted it out just because I was so blown away by how dominant growth had been over value. It showed that we’re sort of at the levels that we were at in the late 1990’s of this extended decade, and now leading to, I think it’s two or three standard deviations. Having lived through it, it wasn’t fun, but I’m excited for the future because I think that what has happened in the past, assuming that the world is going to look more like it did in the past in the future, and I think it tends to do that, we’re going to see some mean reversion. Hopefully we’ll see some return to value.
Justin Carbonneau: I actually saw that presentation. I downloaded those slides. There’s a lot of good stuff in there. To your point, if you looked at, at least with research affiliates, the expected returns of asset classes, or using categories of stocks, I think it was, the value was where the excess returns are likely to come from given crappy performance.
Tobias Carlisle: We’re at that part in the cycle where everybody’s making fun of value investors because value investors have had such a bad ten years of performance. How do you justify charging a higher fee for active management when you can get basis points for the SNP 500 and ETF that tracks that index and it out performs? It generates these risk-adjusted measures, these Sharpe and Sortino ratios that any kind of hitch front would be happy to have.
Justin Carbonneau: Yeah, for sure.
Tobias Carlisle: What value strategies do you track? You track Buffet, you track Graham, you track Greenblat.
Justin Carbonneau: Yeah, let’s go down the list. Buffet, Graham, a strategy based on Ken Fisher, which is used as a price to sales and has a strong value tilt. O’Shaughnessy’s corner stone value strategy, which he published in What Works on Wallstreet-
Tobias Carlisle: That’s the blend.
Justin Carbonneau: That’s not the blend. That’s just the large cap value strategy. The blend is the … Depends. There’s multiple. What he did in What Works on Wallstreet is he did, basically in the first addition it was a small cap growth momentum model, and then the large cap value. Then he combined the two for the blended, combined optimal portfolio. Since that first edition, he’s come out with different iterations of what looks to work best over time, but we track the cornerstone growth and value models on Validea. One of the new models is also using his value composite model from his book, which looks at five different value metrics and then looks to identify the top stocks according to that. That’s on Validea.
Justin Carbonneau: The John Neff strategy, strategy based on David Dreman, which is a large cap deep value [crosstalk 00:21:15] strategy.
Tobias Carlisle: Let’s dive into Dreman’s for a moment.
Justin Carbonneau: Okay.
Tobias Carlisle: How is his characterized?
Justin Carbonneau: His starts out by … It’s a deep value strategy. Interestingly enough, one of the things that is crazy with the Dreman strategy is from ’03 to ’07, the thing was by far, absolutely our best performer, significantly. It tends to pick up a lot of international stocks, and it always has historically. There’s always been a lot of financials also in there. As you can imagine, since basically the financial crisis, that thing has been in the tank.
Justin Carbonneau: The strategy starts out by looking at the largest 1500 stocks in the market. Oops, sorry. The largest 1500 stocks in the market, and then it looks at four different valuation metrics. It looks at, I think it’s price … PE, price to cash to flow, price to dividend, and another one, and it wants the stock to at least be in two of the four value. It wants the stock to pass at least two of the four value criteria, and then it looks at a series of the current ratio and improvement in underlying financials. That’s essentially what the strategy is in a nutshell.
Tobias Carlisle: Is that from his Contrarian?
Justin Carbonneau: Yep. It’s actually Contrarian Investment Strategies is the book.
Tobias Carlisle: It’s closely tied to the value factor because it is a combination of value ratios, so when the value factor is doing very well, which it did from the early 2000’s to 2007 it did very well, and when the value factor, not necessarily pressed, just any kind of ratio has struggled over the last mid 2010 to date, it’s been a very rough period.
Justin Carbonneau: Right. Yep.
Tobias Carlisle: You have this choice of all these different strategies that you can use, and then you have this money management firm. That’s managed accounts, and an ETF. Is there anything else in there?
Justin Carbonneau: We threw our hat in the ring in the robo-advisory business, too.
Tobias Carlisle: Robo. When folks come to the firm, do they say, “For a managed account, I want the Buffet strategy,” or do they say, “I want you to give me the best ideas from all of the strategies for this time of the cycle?”
Justin Carbonneau: We have a set of strategies that are based on combinations of the models that we run. But, we have some clients that either we do custom development for, or if somebody feels very strongly like, “I am a Benjamin Graham disciple, and I want deep, deep value exposure,” we can do that. It’s just, everything we’ve seen and we’ve talked about it over the last ten minutes, growth or value, any concentrated portfolio of 10 or 20, 30 securities, especially if it’s just one type of strategy, you can be all over the place. We actually try to be very careful with our investors and say, “Listen, yeah, we understand you’re a believer in value investing and the Benjamin Graham intelligent investor, defensive investor model, but you’ve got to have the thickest skin to be able to stick with that strategy.” We do have some clients that have done it. When that turn in value comes, if they’re disciplined, they’re going to get rewarded, hopefully.
Justin Carbonneau: We generally try to do blends is kind of the answer.
Tobias Carlisle: I’m always talking about my book a little bit on this, but I am a believer in value because it appeals to me intellectually, and probably it’s emotional as well, I don’t know. I think it’s a good idea if you believe in a strategy and it does ultimately end up working to stick in, to have this … I met this guy recently. He’s an investor in, he was one of Monish Pabrai’s early investors. He has a record that’s better than Monish Pabrai because every time Monish is down he gives him more money.
Justin Carbonneau: Oh, really. He kind of dollar cost averages it in, but when the strategy’s underperforming … Good approach.
Tobias Carlisle: Monish has got a phenomenal record.
Justin Carbonneau: Do you know what’s his long term? Is it in the 20’s or something in terms of return?
Tobias Carlisle: I don’t know. The sort of numbers I thought I had saw, it was thousands of percent. Maybe tens of thousands of percent over a couple of decades, something like that.
Justin Carbonneau: Yeah. The reason I … You guys, it was a chart that you put in your weekly content recap.
Tobias Carlisle: Roundup.
Justin Carbonneau: Actually last week. It’s a chart that I encourage everyone that’s watching this, which hopefully some people watch it, right? To look at, but it’s the chart of it has returns on the y-axis and the number of years on the x-axis, and it shows all these great superstar investors, and where they would be. If you have Buffett, Buffett has 65 years at basically 22% annualized return. He’s way out to the right and pretty high up in terms of the return. Then you have even guys like Greenblat and like Lynch. Lynch was 29%, which was phenomenal, but it was 13 years. In terms of the time frame, it’s far less, obviously, than Buffett. I find that chart really fascinating. It does go to show, and we know this, it’s obvious, but how crazy Buffett’s long term performance is. With that being said, if you take the last 20 years for Buffett, it hasn’t been anywhere close to that, but there’s a lot of factors that play into that. I find that chart very interesting. It circulates around. Once every couple years, I see that pop back up.
Tobias Carlisle: Right, I remember it. I had to put on an update because I think everybody’s seen it. There’s another version of it that has guys who aren’t necessarily value investors and there’s some absolutely phenomenal returns on that as well.
Justin Carbonneau: I would be curious to see Jim … I don’t think Jim Simons from Renaissance was on there.
Tobias Carlisle: I think one of the ways that folks generate very good returns is by having a strategy that starts right at the beginning of a good run for their strategy. If you’re a value guy and you get started in the early 2000’s, you get the first 7 or 8 years, you get phenomenal performance. If you even just market perform for another decade, you get a pretty good looking track record. It’s the guys who invest through multiple cycles and out perform through multiple cycles as their asset base is getting bigger and bigger. Basically, we’re really only talking about a very small handful of guys here. It’s probably Buffett and Soros and maybe [inaudible 00:28:47] and a few other guys like that who have got some genuine skill. The really hard thing is that if you underperform for a few years and you’re a manager and you don’t have enough equity in the manager to control it, you can be fired from your role. There goes your track record. 13 years is actually a pretty long track record.
Justin Carbonneau: That’s true. That’s a good point. You’re right.
Tobias Carlisle: It takes a long time to get into the seat. You might not get into the seat until you’re in your 40’s. You run it for 13 years, you’re in your late 50’s and it’s time to hand it off to some other young guy in his 40’s.
Justin Carbonneau: There’s so many things that you said that I really agree with. You don’t know, if you were a value … Even with Validea, when we launched our models initially in ’03 tracking these portfolios, that set the stage for the asset management business. The models are sound. They’re based on things that have worked over long periods of time, but we launched it in ’03. We were coming right out of that bare market, and value went on a great run. Our models were tearing it up. We definitely benefited from that. The people that were investing with us benefited from that. But, then you have the cyclicality and the under performance of value, so now it’s like we’re not benefiting from it. That’s why it’s very important to believe and have conviction in the strategy that you’re invested in.
Justin Carbonneau: From my experience, and I’ve worked with hundreds of investors at this point, we’re human. It’s how we’re wired. There’s a lot of things that play into it, but as soon as you lose conviction or doubt starts to creep into your mind about, “Is this strategy the one that I believe in,” pretty much it’s over. I’ve almost never been able to convince, if a client or an investor starts to doubt and not believe in what we’re doing, then they’re probably not going to be a client for the long run. That’s going to happen. That’s part of running money and being an active manager is you hope to get the right people on the bus. You won’t all the time. You try to educate along the way. Some people will listen, and some people won’t. You know that.
Tobias Carlisle: I absolutely do, which is why all of the books that I have written have focused on the behavioral elements of it. I do think it is crucial to out performing. It’s often that it’s tried, and it’s sort of a cliché to say it, but it is darkest before the dawn. The time when your strategy is really about to start working is right at the time you’re going to fold your hand. Often it’s because the other people with less conviction are folding their hands. All of a sudden, the capital drains away from the strategy, and that sets it up for a really good return.
Justin Carbonneau: One thing that sort of, that I wonder is you have, obviously with ETFs and quantitative strategies, I think Black Rock is … Vanguard has their value ETF now. This capitulation in the value investing arena, I don’t know if just given the proliferation of these value strategies if you’re going to get as much as you would have when maybe those didn’t exist. It’s just a question I have in my mind. We talk about everyone folding. Clearly, if growth continues to outperform, more and more people will gravitate and assets will follow the performance. At some point, you like to think there’s this tipping point where that changes and the regime changes, but I almost feel like you need some, and maybe this will happen. Maybe there will be consolidation, some of these value strategies won’t be around in five years because value will continue to underperform and firms will shut down those strategies. Maybe that’s how it will play out. I don’t know.
Tobias Carlisle: There’s lots of data to suggest that ratio values is potentially going to struggle for that reason, that there’s a lot of money in it. The only thing that I would say is when you look at any list of the flows to ETFs, for example, I think it might have even been Ben Johnson from Morningstar, or it could have been Eric Balchunas from Bloomberg had tweeted this out, but it showed the top 10, the flows to the top 10 ETFs that have launched in 2019. The top ETF was an ESG. That’s environment/government focused ETF. It raised $850 million since the start of 2019. Phenomenal performance. Then if you go down that list, number 10 on that list was a focus value ETF, which is somebody’s doing a little play on [inaudible 00:33:48], I think, which has done fairly well. It had $30 million in it.
Justin Carbonneau: That was number 10.
Tobias Carlisle: Right. I don’t know that there’s that much money chasing. I don’t talk to anybody who’s just chomping at the bit to get into a value fund because it’s so hot right now. [crosstalk 00:34:08]
Justin Carbonneau: It just goes to show if you can raise $30 million in an ETF, you’ll be a top ten.
Tobias Carlisle: Since the start of 2019. It’s a short period of time.
Justin Carbonneau: Right. Yeah.
Tobias Carlisle: That’s good performance, but it demonstrates to me that I think that there are a lot of folks who see that value has had that very extended period of under performance. It’s underperforming by so much now that if you’re a [inaudible 00:34:35], it is a good start to allocating to value strategies. I think there’s a lot of people who know that intellectually, but really, on an emotional level, they’re like maybe St. Augustine give me chastity and give me whatever it is, whatever else, but not yet. I just want to see a little upturn in value before I start allocating to it.
Justin Carbonneau: There’s so many different ways that you can define and express value. You have your Acquirers multiple. All the strategies we’ve talked about, they’re different. They’re all getting the value, they’re all getting their value tilt or their value bias through a different set of criteria. If you’re running a very focused value strategy, I think that it’s … I just think that you can get really, really strong returns when the reversion happens.
Tobias Carlisle: Even if if you’re a value investor who’s more like Buffett who’s looking at the individual businesses and not caring so much about the ratios, and Buffett’s explicitly saying that low P and low price to [inaudible 00:35:47], that can be associated with a value buy, but it’s not necessarily associated with a value buy. Even those guys who do that sort of stuff look at the growth, try to find the steady growth rate, they are still tied to the value factor in some way. They’re not spending this last decade massively outperforming by mere virtue of the fact that they’re doing a DCF.
Justin Carbonneau: Right.
Tobias Carlisle: That’s one of the things that I always think is most telling, that a lot of guys who are my vantage, who have been in the markets for the last 10 years running value strategies for the last 10 years, nobody’s particularly well know. Maybe Allan Mecham at Arlington, but there’s nobody else. Even Allan’s not particularly well known. There are lots of guys who are out there who are running strategies, but it’s just because everybody has struggled to keep up with the market, even doing that additional work and the list of private equity. You can do a whole lot of work to make sure that each, polish each stone before we put it up on the shelf, but it doesn’t help anymore than the guys like me who are just shoveling all of the rubble into it and hoping that there’s a gem in there.
Justin Carbonneau: Doesn’t matter. For sure. Yep.
Tobias Carlisle: In your ETF, how’s the ETF constructed? What’s the process for selecting the strategy or stocks, or how does that work?
Justin Carbonneau: Yeah. I guess I can talk mostly about the index. We’re the passive fund. The way our index is constructed is we select ten different investment strategies and allow each strategy to select the top ten stocks. Our index is 100 securities, 10 different models selecting the 10 top scoring issues. There’s a review proceeds at the end of every year where we look at our model lineup and we look at what we know about the performance and correlation of the various models, and select the models that we feel like are best positioned when combined together as these ten different strategies. The way right now, the index is certainly a … It is effectively a small cap value fund if you were to put us in Morningstar style and size box. Our index is actually rebalanced monthly.
Justin Carbonneau: One of the things with managed accounts or with an ETF, the turnover, you don’t want to be turning 50% of the portfolio every month, which some of these models, if you just let them run, you need a way to manage that turnover. The way we do it is we layer in an additional component, and we call it our intelligent tax management system. Hopefully it’s intelligent, but basically about 10% of the index is changing on a monthly basis. The way it works is we’re holding … It’s the same process for the index and also the managed accounts. We’re holding our winning positions until at least 12 months, and our losing positions that don’t meet the models, that have fallen in score, are the ones that are removed from the model or from the index. What that translates into our strategy that still follow this rules-based systematic sense of strategies, and they still hold true to following and selecting the stocks that pass the gurus, but we’re harvesting losing positions and we’re holding on to winning positions. It creates a much lower turnover strategy and it becomes much more tax efficient.
Justin Carbonneau: Obviously with the passive vehicle, passive ETF, the custom create and redeem process allows you to forgo capital gains, but with managed accounts, obviously with taxable money, it’s important. Trying to figure out a way to manage that turnover without giving up too much performance is what that tax system is effectively trying to do. Did that answer your question?
Tobias Carlisle: Yeah. Do you find this overlap between the strategies, do they try to buy the same stocks sometimes?
Justin Carbonneau: We don’t allow it, but there will be. We just go down to the next. Baked into the system is if we’re already holding the stock, it’ll go down to the next highest scoring security to fill the portfolio.
Tobias Carlisle: It’s possible that one strategy could be selling and one strategy could be buying, in which case you just don’t move the position.
Justin Carbonneau: Let me think about that. One strategy … Well-
Tobias Carlisle: The very deep value guy, I see this happening all the time, particularly in the early … In 2008 and 9, I’d buy all of this junk and I was buying it because at that time I was only doing net-nets. I would buy these things that were … For people who don’t know, net-net is you’re looking at the most liquid portion of the balance sheet, net current asset value. It’s just the cash in [inaudible 00:41:05] and receivables. Then you’re discounting all of the liabilities, deducting the liabilities from them. Then you’re trying to find stuff that’s trying to get a discount to that. This stuff is really, really cheap. The reason it’s cheap is because they’ve got terrible businesses, or the businesses look terrible at that time. They look like they’re going out of business, often. I would buy these things.
Tobias Carlisle: It’s just the way that deep value works. The management team doesn’t want to go out of business, so they start doing whatever they’re supposed to be doing, or competitors leave and the business improves a little bit. When that business improves, all of a sudden it starts popping up on other value investors’ screens because these earnings are, now you’ve got one or two or three years of good earnings in a row. It’s possible that a very deep value investor can buy something and flip it somebody who’s a more franchised or earnings power style investor. Do you see that?
Justin Carbonneau: Yes. It certainly can happen. I think it does happen. What you’re really getting at, at least in our world, is the intricacy of running these models, which is, on the surface, these things seem very easy. You have a screen, you have a set of criteria. You find the stocks. How do you manage turnover? How do you manage the situations that you’re talking about where you’re selling a stock and then buying it right back? How do you break ties? Do you have a stop loss procedure in place? What happens if the fundamentals are fraudulent or there’s some type of fraud? What is your … What sort of rules do you have in place to actually take a quantitative strategy and implement it in an actual money management portfolio?
Justin Carbonneau: What I’m really trying to say is that there’s a lot more that goes into that and that needs to be thought about. Then you get into how is our investment process different from your investment process, and how is your investment process different than the other quantitative guy down the street that’s running … In all of that, we like to think ours makes sense. It doesn’t always mean it’s the best or it’s perfect, but it is the reality of running models. We’ve kind of learned a lot over the years about what needs to go into that, what needs to go into actually implementing a quantitative strategy in the real world.
Tobias Carlisle: Do you do any additional fraud, financial distress type screens on top of the hundred, or do you rely on the individual strategy to do that?
Justin Carbonneau: We have something similar to … One of my partners, Jack, wrote a good article. We have a quality composite score. There’s four different things that goes into it. We were just talking about it, too. Do you have show notes that we can post or whatever? Links?
Tobias Carlisle: Yeah.
Justin Carbonneau: I can post it afterward. We’ll post the article. It’s really good. It’s how we actually implement our quality score. What we’re doing there, and I think you might do this with Acquirers multiple, we don’t use short interest. We use a couple of other factors. We’re just removing the bottom five percent of those quality … We want to make sure that we’re not missing something huge. For example, I know one of the things is current year earnings versus analyst 12 month earnings. Let’s take energy. The price of crude fell from whatever, 100 to 30, analysts were quickly cutting their earning estimates. Probably not even fast enough, but you would have caught really hard with value traps because the prices were moving so quickly and the earnings weren’t reflective of the decline and the commodity.
Justin Carbonneau: What our quality thing is trying to do, and it wouldn’t have protected us that well, honestly, in that, because we held a lot of energy in late 2015, early 2016. It’s just a lot of our value strategies were bringing us there. I think it would have saved some of the pain in that. The quality measure that we’re implementing, this quality component, is a little bit of a newer integration into our models, I’d say, in the last year or so. We’re just really cutting off the bottom, the very worst scores, on the quality. My partner, Jack, would say, what it’s trying to do is avoid value traps. There’s no way you can ever avoid all value traps. It’s impossible.
Tobias Carlisle: I was going to say, you don’t know it’s a value trap until after you’ve bought it and you’ve held it for two years and it’s not up.
Justin Carbonneau: Right. That’s true. The only way you know is after the fact.
Tobias Carlisle: It’s very hard. In quantitative value, we talked about some of the hygiene of the universe that you’re going to draw from. We excluded things that have got financial distress risk, which is sort of … Bankruptcy is something that it’s an event that it happens or it doesn’t happen, but financial distress risk is a continuum. As they get riskier and riskier, they get more likely to be in bankruptcy, so you want to exclude them. You want to exclude earnings manipulation because it gives you a misleading picture about what the company’s actually doing, and it’s also a gateway drug into fraud. Fraud is the thing that we’re trying to avoid. Statistical fraud measures as well.
Tobias Carlisle: The funny thing that I always find is when I look at the … That does great things for the entire universe of stocks. If you look at whatever universe it is, say the Russell 1000, if you exclude the 5% that score worst on those, that universe does then do better. You can improve the performance of the Russ 1000 doing that. It doesn’t actually do much for the portfolios because the Venn Diagram of the stocks that are ultimately selected and the stocks that are going to be excluded anyway, they don’t overlap.
Justin Carbonneau: Okay.
Tobias Carlisle: Do you know what I mean? It’s already looking for it. It wants a cash rich balance sheet. It wants cash flow earnings.
Justin Carbonneau: Those kinds of factors are you’re not really excluding the companies that would be in the portfolio.
Tobias Carlisle: You wouldn’t buy them anyway.
Justin Carbonneau: Right. Right.
Tobias Carlisle: The sort of stuff that gets picked up by those things is the stuff that you would expect. Most of the time you can eyeball them. They tend to be companies that are quite expensive anyway because they have to create that illusion. The only way they’re going to survive is raising capital. They’ve got to sell shares. They’ve got to sell some debt, and that’s where the fraud comes in. I think they really work best all together because often you find when it scores badly on one, it scores badly on all three. They all go hand in hand.
Tobias Carlisle: We’ve seen this really difficult time for value. I get the feeling that you’re not necessarily a believer that value can turn around. You don’t think it can do it again?
Justin Carbonneau: You don’t think that? No. I strongly believe, to your point earlier, I think value investing, there’s the underpinnings of what makes value stocks work. I believe very strongly in that. I just don’t believe anyone can time the turn in value or the turn in any of these factors. But, mean reversion is a very powerful thing in the market. Looking out over the next ten years, I do think value stands a very good chance of certainly improving its relative performance. But, you also have to always question your beliefs to some extent and just try to be … That’s one thing I’ve tried to do more of and my partner, Jack, he does a really good job at it. I don’t. I tend to, on Twitter and the articles I read and stuff, I read the things I agree with. When I hear fundamental investing is dead or somebody that’s bashing Buffett for his performance over the last 15 years, I don’t agree with that stuff. But, I also want to be open minded to that in the markets, things change and things can go on a lot longer than we think, and they have been for a couple years now.
Tobias Carlisle: I think value investors have been doing a lot of introspection. The last decade’s been rough, but the last five years in particular. I thought five years into the under performance was enough.
Justin Carbonneau: Yeah. I think we were writing about it five years ago. Turn in value.
Tobias Carlisle: Here it comes.
Justin Carbonneau: I think we might have been one of the earlier ones, and we were wrong. It kind of humbled us, I think, in that sense.
Tobias Carlisle: I’ve been saying, “It’s five years,” for so long that it’s longer than five years now. I’ve been saying it for six or seven years. I’m actually going to say it’s seven years. It’s so long.
Justin Carbonneau: Exactly.
Tobias Carlisle: I always think of that article that Malcolm Gladwell wrote about Nassim Taleb. Nassim Tableb used to say used to say to his trader, “Have you introspected today? Introspect. Introspect.”
Justin Carbonneau: Yeah. Right.
Tobias Carlisle: Every value investor out there, there’s so much introspect going on. Why aren’t these strategies working? If you were a value investor who’s kept up with the market over the last decade, you’re a genius. You’re just undiscovered. Having lived through it, I remember all the … There’s a suggestion that the problem with the value strategy at the moment is it’s so focused in bad sectors. It’s focused in energy, it’s focused in financials. Having lived through it, I can point at each stage along the way. All of these disasters like Chinese reverse takeovers, they all came on. They looked pretty cheap. They all floated down into the value stuff if you bought them, you got carted out. Then there was the for-profit colleges.
Justin Carbonneau: What was the Corinthian college and-
Tobias Carlisle: I remember it well.
Justin Carbonneau: Yeah. These things were trading at PE of four or something, you know?
Tobias Carlisle: You backed out the cash, though, free.
Justin Carbonneau: Right.
Tobias Carlisle: Then energy more recently. At every stage along the line, you’ve just walked into a value trap industry.
Justin Carbonneau: I sort of feel like we’ve had these little bumps. What was it, was it 2017 that value had pretty decent performance?
Tobias Carlisle: 2016. 2015 it sold off really hard at the end of the year, and then it bounced at the start of 2016.
Justin Carbonneau: We’ve gotten these little bursts of strong performance out of value, and you think it’s like, okay, now we’re set up for the run, right? Then the next month, it’s like, look at this year. It started off decent. January was good. Now look. Apple, Microsoft, it’s the big mega tech names that are driving a lot of the market performance.
Tobias Carlisle: There’s an enormous amount of timing luck in all these strategies. I think about 2012 in particular. That was one I remember fairly vividly, but at the beginning of 2012, value got hosed, and then midway through 2012, it did start working. In 2013, the market had a very good year. The market was up 30% with very little volatility. I forget which is the last … Chris [Call 00:52:30], who I’ve had on the show and is a buddy of mine, he tracked these and we used to talk about this a little bit. He’d show me these periods of time in the market where the market just goes up at a 45 degree angle without any volatility. You get these incredible risk-adjusted … 2013 was one of those years where the market was just straight up with no wobble through the year. I think it was one of the best on record in risk adjusted terms, and one of the more recent years beat it again. I don’t know which year. Maybe it was 2015, or 2016 beat it. It was just a better year again.
Justin Carbonneau: Right. Most stocks were participating, I think. When you have your average stock doing well, just statistically the odds, these more concentrated value strategies I think have a chance to really perform well. One of the things, I don’t know what you feel about this, but I almost feel like it might be, a bare market might be what we need to change the psyche of investors for this style to come back into favor. If you go back to the 2000 to 2002 bare market, that was obviously … There was craze evaluations and a lot of those companies, that’s when you saw value. I don’t think we’re at, it’s not the similar type of story from that point in the sense that you don’t have as much overvaluation, let’s say, but maybe the bare market will get some of the flow that has gone into all these large megacaps and growthy like names, and you’ll see a reversion in value. I don’t know.
Justin Carbonneau: I just think it’s kind of interesting to think about that way. The turn might not come until you have pain at the market level, like a bare market type environment, maybe. But with that being said, look, we’ve had, even though we talk about it and the [inaudible 00:54:32] guy has talked about this recently, there has been three mild bare markets in this since the end of, beginning of ’09. Really 2011.
Tobias Carlisle: Right.
Justin Carbonneau: ’15, and then the end of last year. If you look at something like the Russell 2000 or any of these equally weighted, stuff was down more than 20%. [crosstalk 00:55:00]
Tobias Carlisle: The question is is that enough of a market clearing? One of the things that I always say is you have to understand where your strategy is going to work well. I think this is a bit of a myth about value that people think it does better in a draw down. I’m not entirely dissuaded that that’s the case. I think that’s only I the strategy itself is under valued. One of the things that it does do very well is it recovers before the bottom in the rest of the market. It should bounce fairly hard out of the bottom, whereas momentum, it works hard at the end of the cycle. It’ll always be running very strongly. In the draw down, the last time that we had a big draw down, 2007, 2009, momentum was down 90% [crosstalk 00:55:47].
Justin Carbonneau: Was it really? 90%? Wow.
Tobias Carlisle: It takes 12 months for the signal to even start working. For that 12 months, you can’t use the signal. Momentum, that’s a really tough one. You’ve got to be in it up to the end of the cycle. Somehow you’ve got to pull your chestnuts out of the fire just as it tips over, and then you’ve got to stay out for a while.
Justin Carbonneau: Yeah. I think it’s called crash risk with momentum. Once it’s done, it’s done. It just completely collapses.
Tobias Carlisle: At that stage, you switch into value and you ride that for the next decade, or the next month as it happens.
Justin Carbonneau: The factor timing. Maybe next time I come on, we’ll do the factor timing discussion.
Tobias Carlisle: What’s your intuition without having tested it? Have you tested it?
Justin Carbonneau: Factor timing?
Tobias Carlisle: Yeah.
Justin Carbonneau: Yeah, we’ve looked at it. I think generally we still think it’s extremely difficult to do successfully. I don’t think we’ve … We tend to think tilting towards a factor is better than a light switch going on and off. Let’s just take the Validea models, for example. If we combine 10 of them and let’s say if you wanted to have a blend of value of growth, let’s just say 50/50, the longer value under performs, the more you want to try to more tilt towards value. You want to start sprinkling, go stronger towards value. But, with that being said, it doesn’t necessarily mean, like I mentioned earlier, that’s sort of making a call that value’s going to turn, and it might not in the short run.
Tobias Carlisle: Right.
Tobias Carlisle: The problem that I have seen when I look at the, if you look at growth versus value, for example, when value’s out performing, they get this sort of expen- Expense is probably the wrong word, but it’s this cascading. When value’s underperforming, the bulk of the under performance happens right at the end. The most rapid portion of the under performance happens right at the very end. Same when it’s the other way. The biggest chunk of the up performance happens right at the very end. It’s very hard to time it because as you’re slowly switching into it, you’re getting this worse and worse performance. For one thing, it makes you think that you’re doing the wrong thing. Particularly in a period where it’s extended like this, the more value exposure you have, the more risk adjusted, risk hedged or risk managed exposure you have, the worse you’re doing relative to the market.
Tobias Carlisle: I think we’re coming right up to the very end of our time. It’s flown by. If folks want to get in contact with you, what’s the best way to do that?
Justin Carbonneau: Follow me on twitter at JJCarbonneau. That’s my twitter handle. Obviously you can come to Validea and look at the research and the models that we’re running there. From there, if anybody wanted to ever just have a call with us and learn more about what we’re doing, we’re always available. Pretty responsive. Like you, probably, we’re working seven days a week most of the time.
Tobias Carlisle: I don’t regard it as work, I love it.
Justin Carbonneau: Exactly. That’s a great way to really end it, though, is I feel really lucky to do what I’ve done and have this opportunity at Validea. We sit here and work hard day in and day out. I have one foot in this internet company and the other foot in an asset management company, and I get to meet cool guys like you and do podcasts like this, videocasts. What are we calling this, actually?
Tobias Carlisle: A vlog, maybe. Vlog Acquirers podcast.
Justin Carbonneau: Nice. There you go.
Tobias Carlisle: There is a video component to it. For people who don’t know. If you’re listening to this on the audio version, you can go to YouTube and you can see Justin and I talking and see the hilarious facial expressions we make at each other.
Justin Carbonneau: Yeah, exactly. I think that’s a great way to … I appreciate you having me on. This has been really fun. Hopefully we can do it again soon. Let’s hope for the turn in value.
Tobias Carlisle: Yeah, for sure. Justin Carbonneau:, Validea. Thank you very much.
Part of the weekly research here at The Acquirer’s Multiple features some of the top picks from our Stock Screeners and some top investors who are holding these same picks in their portfolios. Investors such as Warren Buffett, Joel Greenblatt, Carl Icahn, Jim Simons, Prem Watsa, Jeremy Grantham, Seth Klarman, Ray Dalio, and Howard Marks. The top investor data is provided from their latest 13F’s (dated 2018‑12‑31). This week we’ll take a look at:
Western Digital Corp (NASDAQ: WDC)
Western Digital is a global leader in the hard disk drive market. The company develops, manufactures, and provides data storage solutions to consumers, businesses, and governments. The company’s product portfolio includes hard disk drives, solid-state drives, and public and private cloud data center storage solutions. Western Digital’s SanDisk acquisition positions the company as a broad-based provider of media-agnostic storage solutions.
A quick look at the price chart below for Western Digital shows us that the stock is down 35% in the past twelve months. We currently have the stock trading on an Acquirer’s Multiple of 7.59 which means that it remains undervalued.
(Source: Google Finance)
Superinvestors who currently hold positions in Western Digital include:
One of the best resources for investors are the publicly available 13F-HR documents that each fund is required to submit to the SEC. These documents allow investors to track their favorite superinvestors, their fund’s current holdings, plus their new buys and sold out positions. We spend a lot of time here at The Acquirer’s Multiple digging through these 13F-HR documents to find out which superinvestors hold positions in the stocks listed in our Stock Screeners.
As a new weekly feature, we’re now providing the top 10 holdings from some of our favorite superinvestors based on their latest 13F-HR documents.
This week we’ll take a look at Joel Greenblatt’s Gotham Asset Management, (12-31-2018):
The current market value of his portfolio is $6,435,198,000
During his recent interview with Tobias, Jesse Felder, hedge fund manager and Founder of The Felder Report Newsletter discusses how breadth and risk appetites provide investors with great timing tools. Here’s an excerpt from the interview:
Jesse Felder: You’re absolutely right. It’s become a mantra of the bulls, which is valuation is not a good timing tool. That’s absolutely true. I think what are good timing tools are breadth and risk appetites. So those are two things I watch very carefully. Late last year in September, I was writing about how many Hindenburg omens were being triggered on the NYSE and the NASDAQ. Absolutely astounding, more than we ever saw in history. And you see these bursts of Hindenburg.
Jesse Felder: A Hindenburg omen is essentially alerting you to great disparity in the market. So when the market is strong, it should be powered by most of the stocks in the market. You get a Hindenburg omen triggered when the market is rising, but fewer and fewer stocks are actually pushing it higher. So it’s essentially a breadth warning. I don’t use it as one Hindenburg omen is going to signal a crash like some people talk about. I want to see how man Hindenburg omens are triggered in a period of time and that tells me that breadth disparity’s widening.
Jesse Felder: In that fall of last year, we saw record numbers of Hindenburg omens triggered on the NYSE and the NASDAQ that told me there’s huge breadth disparity in the market right now. It might be powering higher to new highs, but the NYSE didn’t make new highs, even while the NASDAQ did, and the S&P did. That was kind of another sign.
Jesse Felder: Breadth can be an important warning, and then risk appetites also. So you want to see the right sectors powering the market higher. Today in this rally, we’re seeing the utility stocks do phenomenally well. That tells me that investors aren’t really keen on taking risk, they’re acting much more defensive.
Jesse Felder: When you see staples and utilities and these things doing really well and you see consumer discretionary and technology and these things doing relatively poorly, that’s a clear sign that investor risk appetites are shifting. They’re not embracing risk like they should be at that point in the cycle. So to me, when you have the breadth and the risk appetites both pointing or kind of diverging from price, that’s a pretty good timing tool that the market is pretty close to reversal. You can use those on multiple time frames, too.
Jesse Felder: But that’s also one of the reasons why I’ve said the market is in a topping process, is because we’ve seen these massive number of breadth warnings over the past year. We have also seen risk appetites shifting pretty dramatically, like we’ve seen at past market peaks. Now for me in my own portfolio, things I look at for value and I think where the greatest value us to be found are in things that are outside. So these owner-operated companies that are systematically under weighted by the indexes. So much money is flown into passive and flown out of active that these stocks have been essentially enforced to be sold by active managers and they’re not being bought by passive because they’re low float.
Jesse Felder: So that’s, I think, kind of systematically one area where you can find value. But to me, there are pockets of companies too. I look for a situation where there is massive and predictive insider buying. So you see … have an executive who has a good track record of buying their own stock, and they’re buying a significant amount. That to me will hopefully confirm my idea that the stock is already cheap, and in terms of cheap I use a variety of different measures.
Jesse Felder: Basically a look at the valuation history of the company. I look at it’s valuation relative to its peers, and I’ll also do usually a discounted cash flow model, basically just to try and confirm my idea of what fair value is or even just to see what is the stock price discounting right now. So I don’t use the cash flow model as a primary valuation tool.
Jesse Felder: And then I’ll use technicals to see what is the trend, what is the strength, what is momentum. Usually I use technicals mainly for momentum. I don’t want to buy something that has strong downside momentum. I want, if it is still falling, I want to see waning momentum that shows me signs that sellers are running out of steam. So there are things, I think one of my favorite ideas that I’ve had over the past few months has been post. Bill Stewart is maybe the most successful insider I’ve ever seen in my career. The guy, when he took over Ball Corp in the late 90s and bought, 40, 50, $60 million worth of stock with his own money, brought in his own management team, they all bought as much stock as they could afford. Ball Corp’s up 40-fold in the last 20 years.
Jesse Felder: Bill Stewarts also turned me onto Herbalife a couple years ago. I bought a big slug of Herbalife in early 2015 when he had nothing to do with the company. I really think that’s part of the thesis behind Post today is he saw a company like Herbalife. If you have 80% growth margins, you can’t go out of business, right? If I have 80% growth margins and I have no debt, I literally can’t go out of business. I can have idiots running the company like Buffet says, and it’s really hard to hurt the business.
Jesse Felder: So Post recently has started selling their own kind of a protein powder shake type of a thing, with their access to grocery store shelves and that type of thing. I think Stearets said, “Wait a second, 80% growth margin, that’s awesome. Why don’t we come up with something at Post?” It’s not Post branded, but I do think he owns a ton of stock and was buying more last year. The stock is still cheap relative to its own history, relative to its peers.
Jesse Felder: That’s the kind of thing that I look for. And then because of my concerns about the overall market, I’ll look to hedge that in some way against general market risk.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
We’ve just been reading through a great interview that Walter and Edwin Schloss did with OID back in 1989. During the interview Walter Schloss explains one of the reasons why he always kept the holdings in his portfolio a secret, saying:
Walter Schloss: Apropos of that, while I was at Graham-Newman, a man called up and said he’d like to speak to Mr. Graham. Because he was out of town that day, I asked if there was anything I could do in his stead. He said, “I just wanted to thank him. Every 6 months Graham-Newman publishes their portfolio holdings. And I’ve made so much money on the stocks that he had in his portfolio, I just wanted to come by and thank him.
That was one of the reasons I decided never to publish our holdings. We work hard to find our stocks. We don’t want to just give them away. It’s not fair to our partners.
During his recent interview with Tobias, Jesse Felder, hedge fund manager and Founder of The Felder Report Newsletter discusses the philosophical problem with passive investing whereby indexes systematically underweight owner-operated companies and systematically overweight companies. Here’s an excerpt from the interview:
Jesse Felder: It’s interesting to me that these indexes now, that they’re float adjusted, systematically underweight owner-operated companies and systematically overweight companies that are not owner-operated. To me, that’s a potential problem with passive investing today. Also, people don’t necessarily appreciate.
Tobias Carlisle: That’s a very interesting point, I hadn’t thought about that before. But that’s a fascinating point.
Jesse Felder: Something that Steve Bregman, I had on my podcast a couple years ago, and he was … I don’t think people appreciate the fact that it was 2004 or five when they actually changed the index methodology from just cap-weighted to float-adjusted cap-weighting. Still they use the track record of the S&P 500, as if it was just cap-weighted prior. But today it’s not cap-weighted. It’s float-adjusted cap, and so … To me, philosophically too, that goes exactly opposite of what I’m trying to do. So you have companies where there’s massive insider buying and they’re reducing the float, so the index has to underweight those companies to some degree.
Jesse Felder: And companies with massive insider selling, they’re expanding the float and so the index is now saying, “We’re going to buy more of these where there’s insider selling, and we’re going to buy less of these where there’s insider buying.” The greatest example of this is probably Intel.
Jesse Felder: Go look at Intel, a stock chart of Intel. You look at the chart from when it went public, when Andy Grove was running it and had a third of the shares personally, to 2000. The stock went up 30% a year for that period. Andy Grove retires as chairman and CEO, sells all of his stock, and Intel today is still down 30% from its 2000 high.
Jesse Felder: So you look at that period of the mid-80s or whatever it is to 2000, and you go, “Okay, this is what an owner-operated company does.” Right? This is going to make me 30% a year, and I’ve lost money in the 20 years since it’s been a non owner-operated company. The way the passive methodology now works is that entire time Andy Grove owned a 30% of the shares, we’re going to underweight Intel, because of the float.
Jesse Felder: Soon as Andy Grove goes and sells all of his stock, boom. Now we’re going to overweight Intel, because the float just went up a ton. So to me, it’s a philosophical problem with passive that a lot of people don’t appreciate.
Tobias Carlisle: It’s a perverse incentive. You’re incentivized to issue more stock that’s not held by the owner.
Jesse Felder: Right.
Tobias Carlisle: Held by the main shareholder.
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
During his recent interview with Tobias, Jesse Felder, hedge fund manager and Founder of The Felder Report Newsletter discusses why ‘Margins’ are the most important thing for investors to focus on right now – not earnings. Here’s an excerpt from the interview:
Tobias Carlisle: This market seems to be, it’s supported on … The multiple is very high, but earnings have also been very high for the S&P 500. Margins have been very high. It’s sort of at every part of it that you might want to look at, it all seems fairly extended. If any of that came back a little bit, you see some pretty substantial draw down in the market at least.
Jesse Felder: Well, I think you hit on it, that the number one thing that I’m paying most attention to right now is margins, because by earnings-based measures, stocks don’t look extremely overvalued. But on sales-based measures they do, and the difference is profit margins. So I think a lot of people who are using earnings-based measures don’t really understand this that well, that if you’re using an earnings-based PE to ratio, what have you, you have the embedded assumption that profit margins are going to remain at record highs indefinitely, that there will not be any reversion in those.
Jesse Felder: Historically, Jeremy Grantham has said that’s the most mean reverting series in finance. Warren Buffet wrote about it in ’99, in one of his articles for Fortune where he talked about, he said something along the lines of, “You have to be crazy to think that corporate profits can remain over six percent of GDP for any extended period of time.” And he goes, “If …” And so he was wrong about that, because profits have remained higher than that. But he was right in the fact that he said, “If you were to see a situation like that, it would create all kinds of political problems.”
Jesse Felder: I think that’s exactly what we’re seeing right now. With global populism on the rise, this is the labor share of corporate profits is at record lows. That’s the inverse of corporate profit margins. So corporate profits margins are only so high because labor has been getting a much smaller share than they ever have historically. So now labor is essentially revolting, through politics.
Jesse Felder: So you have Ray Dalio’s partner at Bridgewater, I’m spacing on his name right now, said that there’s all these forces right now that are working against corporate profits. I think if you look at what’s going on politically in that light, then you start to see the risk to profit margins and the risk to valuations over the next several years. People don’t understand the risk. If profit margins revert to historical norms, then you’re looking at an S&P 500 today that’s at a 40 PE, higher than the dot-com mania.
Jesse Felder: So that’s why my friend John Hussman has come up with one of my favorite valuation measures, is a margin-adjusted cape ratio, essentially. When you adjust for profit margins, stocks today are higher than they were in 2000, higher than they were at the peak in 1929. So I think investors who are using earnings-based measures need to be really really careful about profit margins. What is the embedded assumption that I’m making in profit margins today, and is that a safe assumption to make?
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
In this episode of The Acquirer’s Podcast Tobias chats with Jesse Felder, who is the Founder of the popular U.S newsletter – The Felder Report, and is the co-founder of a multi-billion dollar hedge fund. During the interview Jesse provides some great insights into:
– The Current Market Environment
– There’s A 97% Correlation Between Today And 1937
– The Most Important Thing For Investors To Focus On Right Now Is Not Earnings – It’s Margins
– Investors Can Combine ‘Good’ Buy-Backs and Insider Activity To Find Great Buying Opportunities
– The Perverse Incentive Of Passive Investing
– Why I Love The Acquirer’s Multiple
– Semiconductors Are The Canary In The Economic Coal Mine
– If You Don’t Own Gold You Don’t Know History
– Breadth And Risk Appetites Provide Investors With Great Timing Tools
The Acquirers Podcast
You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:
Tobias Carlisle: Hi, I’m Tobias Carlisle! This is the Acquirers podcast. My special guest today is Jesse Felder. He runs the Felder Report, which is a U.S. stock market-centric but macro newsletter. He’s co-founder of a multi-billion dollar hedge fund, and he’s got some very interesting thoughts about market. So we’re going to explore those right after this.
Speaker 3: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinion of Acquirers Funds or affiliates. For more information, visit acquirersfunds.com.
Tobias Carlisle: Hi Jesse, how you doing?
Jesse Felder: Good Toby, thanks for having me on.
Tobias Carlisle: My pleasure. Let’s get right into it. What do you think about the U.S. stock market?
Jesse Felder: Well, I think we’re in the midst of a topping process, and I think we have been since the last ’17 run up, strong run up late ’17, early ’18. It was probably pretty clearly a blow-off top. I think, valuations that are most valuable in a long-term time-frame all suggest that we’re near the highest valuations in history, if not at all-time high valuations. But you combine that with, over the past six or 12 months we’ve seen changing risk appetites. Investors shifting away from risk and to me, the combination of those two things suggests that we probably entered a new bear market late last year, and this rally we’ve seen so far this year is a … I mean, I can’t call it a typical bear market rally, but it does what bear market rallies are supposed to do, which make you believe that there is no bear market.
Jesse Felder: So I think that’s where we’re at today.
Tobias Carlisle: Why do you think it’s atypical?
Jesse Felder: I think it’s just because it’s in such a strong v-bottom. I was looking at rallies in past bear markets, especially early on in bear markets and I was using kind of an early 2001 analog for a while. And also kind of in early 2008. For a while we looked really similar to that, the early 2001 period. But this rally’s been stronger than your typical bear market rally. Not in terms of the percentage gained, but in terms of how much of the losses have been recouped.
Tobias Carlisle: So the market sort of topped out about September last year, and so now we’re six or seven months into it, which is pretty typical behavior that there’s often that little initial selloff, there’s a rally, and then it sort of seems to drift sideways for up to a year or more before you really start seeing the carnage. Is that what your expecting to see? And what would cause you to think that it was back on?
Jesse Felder: Well, the analog that I’m using right now, price analogs are one thing that I like to use. And actually this is one that Ray Dalio brought up three years ago. It was the 1937 analog, and the historical parallels are just fascinating. But the price analog is actually very close, too. You look at the past one year and three year price patterns, and there’s like a 97% correlation between today and 1937.
Jesse Felder: That would suggest if that price analog is valid, that prices should return to the lows pretty quickly here. So that’s one thing that I’m looking at. But I really do think what the market’s trying to price in right now, or what investors are counting on, is the second half rebound in earnings. I think as we start seeing this first quarter numbers come out and start hearing more guidance from companies, if that second quarter, or the second half rally in earnings or rebound in earnings doesn’t materialize, it looks like it’s not going to materialize, that’s probably what the market’s going to have to start pricing in again if it looks like that.
Jesse Felder: And the companies that have come out recently, especially on the semiconductor side, it doesn’t look like there’s any second half rebound on the horizon. So I think once the market starts beginning to price that in, that’s the catalyst for a return to the lows, and kind of see how the market behaves there.
Tobias Carlisle: What was the final result in ’37? How far was it down from the peak?
Jesse Felder: You know, it was … gosh. It was another 50, 60% decline back then. The price analog that I’m looking, when you line them up it doesn’t suggest that much of a decline. It suggests we take out the lows from last year. But it goes more back to the ’15-’16 highs would be the extent of that if the price analog is valid.
Tobias Carlisle: That’s an interesting time period and I’m glad you brought that one up, because that was … I think I had been following you for a little while, but that was when in 2014, you started your 10% draw down beard.
Jesse Felder: That’s right.
Tobias Carlisle: And that was reaching sort of ZZ Top proportions before we finally got that draw down. Take us through that. That was a fun period.
Jesse Felder: Well yeah. So that was, it was actually August or September of ’14. We hadn’t had a 10% correction, right? Since what was, 2011 or something like that. It had been a … Typically the market has one every year, and it hadn’t had one for a number of years. So I thought, “We’re getting close. We have to.” For a number of reasons, I was expecting the breadth warnings in the market.
Jesse Felder: So I said, “Hey, I’m not shaving until we get a 10% correction.” And then in September of ’14, the market went down 9.8%. Literally right after, and people were telling me, “Jesse, okay. Go ahead and round up, shave it off.”
Tobias Carlisle: You can take it.
Jesse Felder: I said, “No, no. That’s not it. That’s not it.” So it wasn’t until August of ’15 when the market actually had it’s … That was a steep sell off. So it was 11 months of beard growth, and it was, yeah. It was definitely ZZ Top at that point. My wife was very happy.
Tobias Carlisle: To the great relief of your wife.
Jesse Felder: Right.
Tobias Carlisle: So you proposed to her the 10% draw down beard and she said, “No chance.”
Jesse Felder: That’s right, exactly right. I did that what, last year or something. She goes, “Nope. That’s not happening.”
Tobias Carlisle: I know this … She knows the market too well.
Jesse Felder: Yeah, yep.
Tobias Carlisle: So the thing that has been most amazing about this market, would you have thought at that time that we’d be this far into it without really seeing that deck clearing crash or decline? Would you have thought that would have taken this much longer or we still wouldn’t have seen it?
Jesse Felder: No, and I thought that ’15-’16, the late ’15, early ’16 correction was probably the beginning of a new bear market. There’s been a lot of speculation of what prevented a bear market at that time. Clearly, it wasn’t. We did have an earnings recession, and some people even believe we probably had a mild economic recession. It was mainly an oil-focused thing at the time.
Jesse Felder: But yeah, I was surprised. But then when you look at Trump getting elected and the deregulation and tax cuts that went along with that, that essentially extended the cycle. That’s the thing with the famous thing everybody says about markets is they go a lot longer, bull markets. Trends, in both direction, go longer than you would ever imagine they could. So, yeah.
Tobias Carlisle: This market seems to be, it’s supported on … The multiple is very high, but earnings have also been very high for the S&P 500. Margins have been very high. It’s sort of at every part of it that you might want to look at, it all seems fairly extended. If any of that came back a little bit, you see some pretty substantial draw down in the market at least.
Jesse Felder: Well, I think you hit on it, that the number one thing that I’m paying most attention to right now is margins, because by earnings-based measures, stocks don’t look extremely overvalued. But on sales-based measures they do, and the difference is profit margins. So I think a lot of people who are using earnings-based measures don’t really understand this that well, that if you’re using an earnings-based PE to ratio, what have you, you have the embedded assumption that profit margins are going to remain at record highs indefinitely, that there will not be any reversion in those.
Jesse Felder: Historically, Jeremy Grantham has said that’s the most mean averting series in finance. Warren Buffet wrote about it in ’99, in one of his articles for Fortune where he talked about, he said something along the lines of, “You have to be crazy to think that corporate profits can remain over six percentage ADP for any extended period of time.” And he goes, “If …” And so he was wrong about that, because profits have remained higher than that. But he was right in the fact that he said, “If you were to see a situation like that, it would create all kinds of political problems.”
Jesse Felder: I think that’s exactly what we’re seeing right now. With global populism on the rise, this is the labor share of corporate profits is at record lows. That’s the inverse of corporate profit margins. So corporate profits margins are only so high because labor has been getting a much smaller share than they ever have historically. So now labor is essentially revolting, through politics.
Jesse Felder: So you have Ray Dalio’s partner at Bridgewater, I’m spacing on his name right now, said that there’s all these forces right now that are working against corporate profits. I think if you look at what’s going on politically in that light, then you start to see the risk to profit margins and the risk to evaluations over the next several years. People don’t understand the risk. If profit margins revert to historical norms, then you’re looking at an S&P 500 today that’s at a 40 PE, higher than the dot-com mania.
Jesse Felder: So that’s why my friend John Huspin has come up with one of my favorite valuation measures, is a margin-adjusted cape ratio, essentially. When you adjust for profit margins, stocks today are higher than they were in 2000, higher than they were at the peak in 1929. So I think investors who are using earnings-based measures need to be really really careful about profit margins. What is the embedded assumption that I’m making in profit margins today, and is that a safe assumption to make?
Tobias Carlisle: The bulls would say to that, there are two arguments for the higher than usual profit margins and sustainably higher than usual profit margins. One is that we’re transitioning to a more asset-light economy and that might warrant higher margins, so they’re able to generate higher margins. And the other one is that it’s a global world and the profits that U.S. companies are earning are typically foreign. There’s a lot of foreign profits in that mix, and so there’s no reason why it should be constrained by those old labor profit margin ratios.
Jesse Felder: I think the real way to explain it is the change in the anti-trust framework over the last 25-30 years. We’ve had this rise of oligopolies that have essentially colluded to set pricing whether it’s in airline industry or what have you. I had Jonathon Tepper on my podcast, his book The Myth of Capitalism is fantastic on this topic. I really think that is probably the main driving force that has led to these winner-take-all type of profit margins. But that’s exactly what we’re seeing in this political backlash right now, is a direct attack on that framework.
Jesse Felder: So we’re seeing a total rethinking of the anti-trust framework. You have Elizabeth Warren talking about breaking up big tech, and that becoming the foundation for a political platform. It’s not just her. In fact, there’s a .. To me, it’s fascinating to watch the bipartisan support for this anti-tech movement, because those are really the companies that have the biggest profit margins and cash piles and those kinds of things.
Jesse Felder: So to me, I think this is what Bridgewater’s talking about when they say, “All of the forces that are working against corporate profits.” It’s really a groundswell of political movement that’s moving to take back on behalf of labor what they’ve lost over the last 20 years.
Tobias Carlisle: Your Twitter account, you do have a theme of some distrust of some of the social networks. Facebook and Google and so on. What’s the impetus for that, and what’s the solution? Is it breaking them up?
Jesse Felder: You know, for me it was … I got off Facebook years ago when I just started realizing it didn’t make me feel good to be on there. And Twitter, you can get the same feeling being on Twitter too. But I find Twitter immensely valuable from the standpoint of being able to follow people like you, Toby, and I follow about 100 accounts. To me, the information that those accounts provide me with is invaluable.
Jesse Felder: But I do think the problem with social media is that it’s become far, far too powerful. I think we underestimate social media’s ability to get our attention whenever they want, and then manipulate our attention in ways that … Everybody says no, this is not happening to me, right? I’m invulnerable to this kind of stuff.
Jesse Felder: But all the studies show that whether it’s manipulating people to vote a certain way or to buy a certain product or what have you, the data collection and then the use of it to manipulate peoples essentially free will is gone way too far. That needs to be reined in, and so I think … I don’t know if it’s breaking up these companies, but I had Roger Macnamy on my podcast a couple years ago, and we talked about this when this was first breaking with Facebook.
Tobias Carlisle: It’s a great podcast.
Jesse Felder: Yeah. He’s an amazing guy, and it was really, really fun to do that. But he was … eh thinks the business model just needs to be changed. I do agree. I think when you have such powerful platforms as YouTube and Google Search and Facebook, Instagram, and their ability to manipulate people, and there’s a profit motive behind it, the problems that can arise are unimaginable and very very serious.
Tobias Carlisle: Just returning to U.S. equities. Are there any industries or sectors in U.S. equities that you like? I know I saw you Tweet out that bank stocks are at relative, the PEs of bank stocks relative to the market are as low as they’ve ever been.
Jesse Felder: Yeah, I think it was Dry House Chart that they shared, and I thought that was interesting. In some ways, I feel like this current situation we’re in in terms of valuation is very similar to the dot-com mania. Back then, there were a handful of stocks that I was finding … I mean, value, I think the similarities, growth was so popular, value was left for dead. I think we’re seeing something very similar right now where there is some true value out there, and it’s just being left for dead.
Jesse Felder: For me, financials … A stock that I bought in late ’90s, 2000, was Washington Mutual when it was just a simple thrift and the stock was trading five times earnings. Financials have been crushed them because of the same situation that’s going now, which is that the flattening yield curve, net interest margins are squeezed. So that hurts earnings, and financials get hurt, stock prices.
Jesse Felder: To me, that was a very easy investment to make because Washington Mutual was literally just taking in deposits and lending it on home loans. They hadn’t gotten into any of the other types of interest rate hedging or things that they got into later on when they hired one of the top guys from GE. That’s when I sold the stock.
Jesse Felder: When they created this derivatives portfolio and it grew into tens of billions of dollars, I said, “I don’t understand this, I have to sell this stock.” But it was a good investment for a period of years. Today, to me one of the lessons I learned in the financial crisis was a lot of these banks are black boxes that not even the top executives at those companies really understand the risks their taking and that sort of thing.
Jesse Felder: So it’s really hard for me to invest in bank stocks today, when the business is so complex that not even they understand what’s going on. I mean, even for years after the crisis, I remember these companies would announce earnings and then have to restate them a month or two later because, “Whoops, we miscalculated this and we didn’t understand that.” If you guys don’t even know what’s going on with your books, how can I have any confidence?
Jesse Felder: It’s interesting, financials might be cheap right now in the banks. I think if you have a well-run bank that’s cheap, it’s probably a good opportunity today, especially … Usually in this situation, my experience when the yield curve flattens to the extent that these companies get hammered, it’s usually an opportunity. But I have a hard time with those companies for those reasons.
Tobias Carlisle: I’ve noticed that there are a number of commercial banks that have come into my screens recently, they’re sort of taking up 15-20% of the slots in the screen. So that leads me to think that they might be something investigating, but I haven’t look at them in any great detail. So I tend to agree with you.
Jesse Felder: One other point I’d make is one of the things that I follow, since the start of my career, is insider activity. I haven’t seen any significant insider buying at any of these things yet. One of my favorite books is Reminiscence of A Stock Operator, and in that Jesse Livermore says, “When a stock gets cheap, the top management will never fail to buy because they know that it’s a great opportunity. They know they’re going to make a ton of money.”
Jesse Felder: So when I find a value opportunity and there isn’t insider buying, to me that’s kind of a red flag. Why are these guys not putting their mouths where … their money where their mouths are?
Tobias Carlisle: Or buy-backs, which is another favorite topic of yours. So let’s talk about good buy-backs and bad buy-backs.
Jesse Felder: Right, yeah. There’s good buy-backs. For me that was something that I followed for a long time through my career, because I remember Devon Energy during 2001, 2002, natural gas prices were super cheap. The top execs started buying stock themselves, and announced they’re going to buy back 20% of the outstanding shares.
Jesse Felder: To me that was a great confirmation of this stock is cheap, and they’re bullish on natural gas prices and all that. But today what you see a lot more often is buy-backs announced, and then as soon as the company starts buying back, top execs just start dumping stock right at the same time. And so to me, that’s not so much of a bullish signal as it is, we need a buyer so we can sell.
Jesse Felder: It’s interesting to me too, that’s another one that congress is looking into, because studies show statistically, insider selling goes up five-fold during buy-back periods. To me, that’s just a clear sign that these companies are, the executives are using the buy-backs to help prop up stock prices so that they can cash out. Which is, to me, if that’s a company I’m invested in, I would not be too happy about that.
Tobias Carlisle: They have some restrictions and some limited windows where they’re able to trade. So you would hope that when the company’s doing the buy-back that any market moving information has been properly disclosed. So that might describe the reason for it. I think buy-backs in aggregate, tend to be value-destroying because the bulk of the buy-backs happen when stocks are expensive, and then they disappear when stocks are cheap. When ideally you want it around the other way.
Tobias Carlisle: So if you can find that rare management that buys stock back when it’s cheap, and issues it or doesn’t buy it back when it’s expensive, that’s a good opportunity and that’s a management worth following. But in the aggregate, I think they’re probably not good for investors.
Jesse Felder: You want your management to be good capital allocators. You don’t want them to be burning cash by buying back stock at top valuations. Which is, that’s one of the things that we’re seeing with companies today. I look at some of these stocks and the DOW. I wrote about the McBam stocks that McDonald’s, Caterpillar, Boeing, and 3M, and this was a year ago. Back then, each one of these stocks on a price to sales basis or enterprise value to revenues, was trading at the highest valuation in the company’s history. Some of them, twice as high as they’d ever traded in their history.
Jesse Felder: You look at the buy-back activity and you go, “How did they get that expensive?” Well, they’re buying back more stock than they’ve ever bought back in their history, too. So it’s, to me that’s representative of what’s going on across corporate America in many ways. So yeah, it’s rare to find those companies that do the right thing at the right time, on behalf of shareholders.
Jesse Felder: To me, where you find that usually is where you have owner-operated companies. You have guys that have a large equity stake in the company, and their interests are truly aligned with shareholders, not just through option compensation, which they want to offload at some point. It’s the owner operators that seem to make the right choice, and it’s interesting to me that these indexes now, that they’re float adjusted, systematically underweight owner-operated companies and systematically overweight companies that are not owner-operated.
Jesse Felder: To me, that’s a potential problem with passive investing today. Also, people don’t necessarily appreciate.
Tobias Carlisle: That’s a very interesting point, I hadn’t thought about that before. But that’s a fascinating point.
Jesse Felder: Something that Steve Bregman, I had on my podcast a couple years ago, and he was … I don’t think people appreciate the fact that it was 2004 or five when they actually changed the index methodology from just cap-weighted to float-adjusted cap-weighting. Still they use the track record of the S&P 500, as if it was just cap-weighted prior. But today it’s not cap-weighted. It’s float-adjusted cap, and so … To me, philosophically too, that goes exactly opposite of what I’m trying to do. So you have companies where there’s massive insider buying and they’re reducing the float, so the index has to underweight those companies to some degree.
Jesse Felder: And companies with massive insider selling, they’re expanding the float and so the index is now saying, “We’re going to buy more of these where there’s insider selling, and we’re going to buy less of these where there’s insider buying.” The greatest example of this is probably Intel.
Jesse Felder: Go look at Intel, a stock chart of Intel. You look at the chart from when it went public, when Andy Grove was running it and had a third of the shares personally, to 2000. The stock went up 30% a year for that period. Andy Grove retires as chairman and CEO, sells all of his stock, and Intel today is still down 30% from its 2000 high.
Jesse Felder: So you look at that period of the mid-80s or whatever it is to 2000, and you go, “Okay, this is what an owner-operated company does.” Right? This is going to make me 30% a year, and I’ve lost money in the 20 years since it’s been a non owner-operated company. The way the passive methodology now works is that entire time Andy Grove owned a 30% of the shares, we’re going to underweight Intel, because of the float.
Jesse Felder: Soon as Andy Grove goes and sells all of his stock, boom. Now we’re going to overweight Intel, because the float just went up a ton. So to me, it’s a philosophical problem with passive that a lot of people don’t appreciate.
Tobias Carlisle: It’s a perverse incentive. You’re incentivized to issue more stock that’s not held by the owner.
Jesse Felder: Right.
Tobias Carlisle: Held by the main shareholder. You and I were both tagged in a question about Boeing, where Boeing’s off a little bit because it had the two plan crashes. Both of us sort of agree that it was extremely overvalued. I was looking at my favorite metric which is the Acquirers multiple. And then you said you agreed on the basis of revenues to enterprise value.
Tobias Carlisle: So I looked at that chart and that was a striking chart that a few years ago, Boeing sort of took off in terms of that enterprise value to revenue metric. I’ve looked at several other companies and that’s common to a lot of companies that they’ve all got extremely expensive on an enterprise value to revenue basis. How do you account for that? Is it just the margins or what’s going on there?
Jesse Felder: I think in some cases it’s the margins, but the reason I like to look at that metric is because I’ve talked with Eric Synamont a ton about this and he’s another fantastic investor, very successful guy who normalizes profit margins in his valuation process. Because if you look at a company that’s … maybe looks cheap but profit margins are at all-time highs for whatever reason, you have to make a decision on are those profit margins going to normalize or have they literally entered a new era?
Jesse Felder: Nine times out of ten, profit margins will normalize over time. It’s just the nature of competition. And so I see that with a lot of companies, and that’s why I’m using enterprise value to revenues a lot more these days, is because I want to see … that’s basically just the easiest way for me to normalize for profit margins.
Jesse Felder: I think in a lot of cases, it’s growing profit margins, but in a lot more cases, this is another thing I think equity investors don’t appreciate. There’s been this huge debt-for-equity swap where companies have been issuing tons of debt to buy back stock. It makes the stock potentially look cheaper, but when you look at something like enterprise value, you go, “Okay wow, but the debt has gone through the roof.”
Jesse Felder: That’s why I love the Acquirers multiple. If you think of a company as an Acquirer does, and I think you have to to be successful over a longer period of time, you have to take the debt into the equation. So when you’re not doing that, by just looking at just the simple price to earnings ratio or that sort of thing, you’re completely missing this dynamic that’s happened which tons of companies, especially small cap companies, this has really been more of an important dynamic where companies have just issued tons of stock, or tons of debt, I’m sorry, to buy back stock. It makes the stock look cheap, but in terms of the holistic valuation, the debt has gone through the roof.
Jesse Felder: So the valuation of the whole enterprise has gone very very high. But the simple fact that I think equity investors aren’t paying attention to the debt side of the equation.
Tobias Carlisle: That was another Tweet of yours that I remember looking at, was looking at the Russell 2000 in terms of enterprise value to eBit. I think that was the metric, or it could have been eBitter. And that’s been … I think it’s traded around sort of maybe a dozen … a multiple of 12-15, something like that. Over the last few years, it looks like it’s at 35 times now, which looks like it was unprecedented in the data or in that chart, which I don’t recall how far back it went but it was 20 or so years.
Jesse Felder: Right. And I think that was the chart from Eric Synamont. It’s fascinating, when you look at … That’s similar to looking at the median price to sales ratio, and these types of things. They all show smaller companies especially, are extremely overvalued and perhaps more overvalued than they’ve ever been in history.
Jesse Felder: This has got to be the passive dynamic. So you have big big companies that can absorb flows, passive flows. Then when you have passive flows going into a small-cap index, those companies can’t absorb the flows without pushing prices higher. So this dynamic of so much money flowing into passive I think is directly responsible for the valuations we’ve never seen before in these smaller companies.
Tobias Carlisle: It’s one of the things that I certainly didn’t realize until I saw the statistic, but of the top three thousand companies, the Russell three thousand, so the Russell two thousand is the smallest two thousand of that top three thousand. The total market capitalization of those two thousand companies is 6% of the three thousand. So the Russell one thousand is 94% of the capitalization. The two thousand is 6%, which is why if they get a little bit of flow it makes them go haywire.
Jesse Felder: Right. Yeah. The other thing about those companies too is they’re so highly indebted too. So the equity valuation has gone so high, and they’ve also piled on all this debt. That’s why when you look at things like enterprise value it’s like, “Oh my…” It’s off the chart.
Tobias Carlisle: So that makes … the debt makes them susceptible to a recession. What sort of indicators do you look at to determine if we’re in a recession or whether one is approaching? And what do you think about our prospects?
Jesse Felder: It’s so tough to try and game whether recession is coming or not. To me, I think some of the work that Robert Schiller has done is really really interesting, and it kind of relates back to Soro’s reflexivity theory which is, all of these things are interrelated and recession is as much a psychological phenomenon as anything else. So following … I think a lot of people say, “Well, that’s fine. I’ll just be super long overweight equities until we get a recession.” Which they don’t necessarily appreciate that. Failing equity prices can actually precipitate a recession.
Jesse Felder: When you look at the correlation between equity prices and consumer confidence, it’s one for one. So I think that’s one of the things that Schiller’s been talking about recently which is, we can talk ourself into a recession pretty quickly. If people just start … We have an earnings recession, I believe. We’re already going to have negative earnings growth in the first quarter, probably carried through to the second quarter.
Jesse Felder: That sort of thing, if it really results in falling equity prices and falling consumer confidence, it kind of can snowball into a recession pretty quickly. Especially 10 years into an economic expansion. So yeah, it’s not something that I try and game necessarily, but I do very closely watch the semiconductors and I think they are, because semi’s going to everything now. They go into autos, they go into all kinds of things. And so semiconductor sales now are falling 20, 30% year over year.
Jesse Felder: To me, that hasn’t happened since the last recession. They’re kind of the canary in the economic coal mine, or at least the earnings growth coal mine for me. The last earnings recession was really just oil driven and relegated to that sector. This one, we’re now seeing technology stocks are leading the earnings recession. It’s much more broad-based and so I do think that creates it’s own risk of a self-fulfilling prophecy of recession.
Tobias Carlisle: Just to go back, there’s something that you said earlier. Just eyeballing it, I’ve never done the work to determine if this is the case or not, but just eyeballing it, it seems to me that equity prices seem to lead recessions. You get the fall off and the crash happens before we’re officially recognized as being in a recession. It happens the other way too, we seem to recover in the markets before the recession is officially ended.
Jesse Felder: Well yeah, and I think people wonder why the Fed is so focused on stock prices. It’s for that very reason. They know that falling stock prices can hurt consumer confidence and create a recession. So it’s kind of the tail wagging the dog. You think stock prices should, but this is Soro’s reflexivity theory that not only does what’s going on in the economy affect stock prices, what stock prices do can affect the economy.
Jesse Felder: So I think that it’s a very good point. People who say, “I’m waiting for a recession to back off my equity exposure,” are …
Tobias Carlisle: Too late.
Jesse Felder: Right. And evidence of that was the last two recessions, where stock prices were discounting it well in advance and even probably exacerbated the consumer confidence that really led to the recession. So yeah, it’s stuff to pay attention to, but it’s really kind of all you can do is really pay attention to how those things develop through time rather trying to forecast them.
Tobias Carlisle: What about something like the yield curve? That’s recently flipped and it flip-flopped a little bit. Is that a near-term indicator or is it something that’s worth paying attention to?
Jesse Felder: So many people talk about it as just an indicator. To me, I always want to find why should this make intuitive sense? Why should I use this as an indicator? I think I wrote about it maybe a year ago when we first started getting pretty flat on the yield curve. It makes sense. I mean, we talked about squeezing net interest margins. If you think about it in terms of that, a flat yield curve, it’s banks why should we lend long when we can just buy short-term debt and make just as much money with less risk?
Jesse Felder: I think it really … The yield curve probably is indicative of what’s going on in the credit cycle. A flat curve is going to lead to a lot less interest on behalf of lenders to lend. So that creates a tightening of credit on it’s own. So I think it’s probably valuable as an economic indicator for the fact that it is going to determine what’s going on in the credit cycle.
Jesse Felder: So to me, yes. I think that’s important but also these effects take a long time to work through. So if lenders now that the yield curve is inverted and some levels are saying, “Okay, it doesn’t make sense for us to really expand our loan book,” that’s going to have ripple effects over the next three to six months.
Jesse Felder: I do think it’s valuable, but for the standpoint of it kind of helping tell you where you are in the credit cycle.
Tobias Carlisle: The Fed seems to, last year it looked like it had this longer term plan to very modestly raise interest rates over an extended period of time, and then when the market sold off last year, I think we were only down something like 20% at the lowest point. It looked like the rhetoric changed and possibly the behaviors changed. Do you have any view on whether they’re … how they’re managing the economy and where the [inaudible 00:36:54] doing a good job?
Jesse Felder: Yeah, I think … What I come back to is right after the financial crisis, before Janet Yellen became FedShare, a few years before the became FedShare, she was interviewed for the … what was it? Money for Nothing was the documentary. Great documentary on the Fed and their role during the financial crisis. I think Michael Lewis’s book was fantastic in discussing the dynamics of what led to the housing bust.
Jesse Felder: But he leaves out the role of the Fed. Money for Nothing is a very important film, I think, in detailing the role of the Fed in that. Janet Yellen right after said, “We need to find a way to get our economy growing naturally and not be so reliant on financial bubbles.” So I think she was right then, just honest, because she was in a position where she could be honest about it in saying that we had the dot-com mania, yes, and that was great for the economy until it bust. And then we had to engineer a housing bubble to try and rescue us from this dot-com mania bust. And then when she became FedShare, obviously she did her best to create a wealth effect and try to engineer higher asset price.
Jesse Felder: I think the Fed is very well aware of the fact that they … because they have talked so much about a wealth effect, they’re very well aware of the fact of asset prices on consumer sentiment. So I do think that it seemed like Jay Pal, when he first took over, was set on trying to normalize monetary policy from something that’s been abnormal for a decade and extremely abnormal for a decade.
Jesse Felder: And then when he saw what it was going to do to asset prices he said, “Wait a second, I can’t do this. I can’t do this.” Because … But I do think we’re moving towards a time, and Alan Greenspan has said this recently, that we are staring stagflation right now in the face. We’re headed to a time of higher inflation, of weaker growth. If that’s the case, and I do believe that’s the case, that we’re seeing a new inflation framework that’s very long-term in nature but it’s just kind of growing now, then the Fed is going to be forced to either start fighting inflation, or trying to prop up the market and they won’t be able to do both.
Jesse Felder: So with this talk of modern monetary theory and these types of things, the Fed has come out and I think they’re deathly afraid of this, because it’s essentially fiscal dominance. It’s essentially, “You guys can’t pursue the policies you want anymore because the fiscal authorities are going to go nuts and force your hand. Your going to have to monetize this debt and fight inflation and do these things,” and they’re not going to be able to pursue their own agenda anymore.
Jesse Felder: I think if that’s the direction that we’re headed, then this idea the Fed put is going to go away. Right now, Jay Pal is trying to have his cake and eat it too, which is, “I’m trying to preserve the FedPut, and I’m also trying to let people think that I’m going to keep inflation in check.” Right now, with the oil price being down, that’s giving him some cover to allow inflation to try and pick up. But if inflation does start picking up, that could be what leads to the expiration of the FedPut.
Tobias Carlisle: If we go into that 70s-style stagflationary environment, it becomes extremely difficult to find good place to put your money. That period, I was going to say I remember. I don’t remember it. I was alive, but I wasn’t investing. Terrible for equities, equities got destroyed on some of the nastiest bear markets that we’ve ever seen. Terrible for bonds, too. Really the only place to hide was precious metals and commodities that did seem to perform fairly well through this.
Tobias Carlisle: And through that period, no lesser investor than Buffet could only just keep up with gold. So how do you feel about the prospects for gold and other precious metals and commodities in general?
Jesse Felder: I’m very bullish on gold. Not necessarily because of inflation, but because of the fiscal situation. We’re already running trillion-dollar deficits, and there’s talk about expanding those. I think we’re headed toward five to six percentage UDP on the annual budget deficit. The dollar is very highly correlated with the budget deficit, so the dollar was very very strong in the dot-com mania. We had actually a fiscal surplus.
Jesse Felder: And then during the recession we started getting deficits, the dollar turned down. Obviously we had massive deficits after the financial crisis. The dollar tanked and gold did really well until bout 2011, when the deficit started narrowing again. But right now, this is one of the first times, one of the rare times in history where we have a widening fiscal deficit during an economic expansion.
Jesse Felder: We’re already plus trillion dollars on this thing annually, and if we get another recession, we’re going to see $2 trillion deficit pretty quickly. That’s even without even more fiscal stimulus. We have talk about the Green New Deal and these kinds of things which are massive spending programs. If we get these, we’re going to just see this widening deficit, and it’s very bearish for the dollar longer term.
Jesse Felder: I think the only way, if you are a dollar-based investor, to protect yourself is to have some kind of allocation to gold. I think Ray Dalio has said, “If you don’t own gold, you don’t know history.” I think that’s really important that right now, a lot of the talk in Washington … I think for the first time maybe in my lifetime, you have bipartisan support for expanding the fiscal stimulus and not any worry about the debt. You don’t even have people talking about how worrisome the debt is.
Jesse Felder: And so, throughout my entire lifetime, people have been worrying about debt, worrying about debt, the debt’s too big. And now all of a sudden, that worry is gone. To me, that’s troubling.
Jesse Felder: So I think that you have to have some kind of a gold allocation to protect yourself in that environment.
Tobias Carlisle: Gold seems to have struggled through a period where there has been an enormous amount of money printing and not just from the U.S. From every other central bank around the world. The debt which, I think it should matter, but it doesn’t seem to have had … it doesn’t seem to have impacted the economy, it doesn’t seem to have … None of the risks that people said were out there seem to have manifest. And that might be why it’s gone away.
Tobias Carlisle: But is it just that it hasn’t happened yet and that it’s something that we’re still to see?
Jesse Felder: Yeah. I think it’s we’ve had this disinflationary environment for 30 years. And it’s a combination of things. I think it’s demographics. You have the Baby Boomers coming into the workforce which is an increase in the supply of labor. At the same time, we have globalization and offshoring of labor. So this is how companies have been able to take down labor share, is a combination of the demographics and then globalization and offshoring of labor.
Jesse Felder: Those have been two big forces in, I think, this disinflationary environment. But demographics are now shifting, Baby Boomers are retiring, and we’re seeing these political forces I talked about, nationalism and you’re even hearing talk about deglobalization. So to the extent that those trends continue to gain traction, with Baby Boomers retiring and these things, that brings back an inflationary impulse.
Jesse Felder: Right at the time when 30 years of disinflation or whatever has lulled people into thinking debt is not problematic, we’re potentially seeing those forces reverse into more of an inflationary dynamic and that’s the one thing that could make debt really problematic is that interest rates start rising and interest expense to the government goes through the roof.
Jesse Felder: So yeah, to me all those things together means you should definitely have some gold in the portfolio.
Tobias Carlisle: What do you see as the catalyst or tipping point for something like that? And how near-term is something like that?
Jesse Felder: To me, I have a longer-term time frame than most people. Most of my investments are equity investments that are one to three year type of things. But a lot of the stuff I’m looking at is more like three to five to 10 year type of trends. I think this is something to pay attention to. It’s a very long-term dynamic, right?
Jesse Felder: I’ve actually been short-term bullish on bonds just because of what’s going on in the economy and the oil prices come down. But longer-term I’m bearish on bonds. When I say longer-term, I’m saying over the next three to five years. So I think this is something that will take some time to play out, this inflationary dynamic. Its very, very long-term in nature. It might be a 20-year, 10 to 20-year type of dynamic.
Jesse Felder: But really I think it all depends too on how much debt we start to issue, how much fiscal stimulus we start to see, and what goes on in terms of risk appetites around the world, too. So all those things are unknowable until we see how they play out.
Tobias Carlisle: One of the indicators that you watch, the M1, seems to be at the lowest level since the last great recession. What is the M1 and why do you pay attention to it?
Jesse Felder: Well, the money supply is something to pay attention to. It’s not something I pay super close attention to. The rate of change is important for various reasons. But yeah, it’s actually not something that I pay a ton of attention to, to be honest. I like indicators that are much more tactile, I guess, things that have a direct bearing on investments on a day-to-day basis. So a lot of the macro economic stuff to me is not as valuable as where’s the dollar going and that type of thing.
Tobias Carlisle: What are your preferred indicators? What are you looking at? We know the market’s expensive because we can look at, say, any … you can look at Cape which is just an inflation adjusted earnings to the price. So you can look at Toben’s Q, which is replacement value of assets against their market value. Or you can look at even Buffet’s favorite measure, which is just total market capitalization against gross national product, I think, which is just the size of the stock market relative to the size of the economy. All of those look at three different, very different aspects of the market and they basically all give you the same answer, that the market’s extremely overvalued.
Tobias Carlisle: But it’s been that way for an extended period of time. It’s been that way, maybe it’s sort of left the long-term averages in 1996 or the late 1990’s, and then at various points through there we might have touched long-term averages in 2009. I don’t know if we got that cheap in the 2002 recession, or the 2002 decline. It’s one of those things that I’m … I believe that the market is extremely expensive, but I’m also a value investor so I’m less interested in where the market is. I’m more interested in what the value stocks are doing.
Tobias Carlisle: You mentioned this a little bit earlier that it was an analog to 2000 where the market was expensive, value stocks were cheap. I think we’re in a situation now where the most expensive stocks are at extreme levels of … they’re as expensive as they’ve ever been. The median may be not as expensive as it was in 2000, but on some measures, using sales for example, it is extremely expensive. The value stocks aren’t that cheap on historical measures. They’re still at a premium to where the are on average, but they are cheap relative to expensive stocks.
Tobias Carlisle: So I just … my question is what are the indicators that you like to look at for your own portfolio? And those are valuation indicators. And then what indicators are you looking at from a when or a momentum time? What’s your timing indicator?
Jesse Felder: You’re absolutely right. It’s become a mantra of the bulls, which is valuation is not a good timing tool. That’s absolutely true. I think what are good timing tools are breadth and risk appetites. So those are two things I watch very carefully. Late last year in September, I was writing about how many Hindenburg omens were being triggered on the NYSE and the NASDAQ. Absolutely astounding, more than we ever saw in history. And you see these bursts of Hindenburg.
Jesse Felder: A Hindenburg omen is essentially alerting you to great disparity in the market. So when the market is strong, it should be powered by most of the stocks in the market. You get a Hindenburg omen triggered when the market is rising, but fewer and fewer stocks are actually pushing it higher. So it’s essentially a breadth warning. I don’t use it as one Hindenburg omen is going to signal a crash like some people talk about. I want to see how man Hindenburg omens are triggered in a period of time and that tells me that breadth disparity’s widening.
Jesse Felder: In that fall of last year, we saw record numbers of Hindenburg omens triggered on the NYSE and the NASDAQ that told me there’s huge breadth disparity in the market right now. It might be powering higher to new highs, but the NYSE didn’t make new highs, even while the NASDAQ did, and the S&P did. That was kind of another sign.
Jesse Felder: Breadth can be an important warning, and then risk appetites also. So you want to see the right sectors powering the market higher. Today in this rally, we’re seeing the utility stocks do phenomenally well. That tells me that investors aren’t really keen on taking risk, they’re acting much more defensive.
Jesse Felder: When you see staples and utilities and these things doing really well and you see consumer discretionary and technology and these things doing relatively poorly, that’s a clear sign that investor risk appetites are shifting. They’re not embracing risk like they should be at that point in the cycle. So to me, when you have the breadth and the risk appetites both pointing or kind of diverging from price, that’s a pretty good timing tool that the market is pretty close to reversal. You can use those on multiple time frames, too.
Jesse Felder: But that’s also one of the reasons why I’ve said the market is in a topping process, is because we’ve seen these massive number of breadth warnings over the past year. We have also seen risk appetites shifting pretty dramatically, like we’ve seen at past market peaks. Now for me in my own portfolio, things I look at for value and I think where the greatest value us to be found are in things that are outside. So these owner-operated companies that are systematically under weighted by the indexes. So much money is flown into passive and flown out of active that these stocks have been essentially enforced to be sold by active managers and they’re not being bought by passive because they’re low float.
Jesse Felder: So that’s, I think, kind of systematically one area where you can find value. But to me, there are pockets of companies too. I look for a situation where there is massive and predictive insider buying. So you see … have an executive who has a good track record of buying their own stock, and they’re buying a significant amount. That to me will hopefully confirm my idea that the stock is already cheap, and in terms of cheap I use a variety of different measures.
Jesse Felder: Basically a look at the valuation history of the company. I look at it’s valuation relative to its peers, and I’ll also do usually a discounted cash flow model, basically just to try and confirm my idea of what fair value is or even just to see what is the stock price discounting right now. So I don’t use the cash flow model as a primary valuation tool.
Jesse Felder: And then I’ll use technicals to see what is the trend, what is the strength, what is momentum. Usually I use technicals mainly for momentum. I don’t want to buy something that has strong downside momentum. I want, if it is still falling, I want to see waning momentum that shows me signs that sellers are running out of steam. So there are things, I think one of my favorite ideas that I’ve had over the past few months has been post. Bill Stearets is maybe the most successful insider I’ve ever seen in my career. The guy, when he took over Ball Corp in the late 90s and bought, 40, 50, $60 million worth of stock with his own money, brought in his own management team, they all bought as much stock as they could afford. Ball Corp’s up 40-fold in the last 20 years.
Jesse Felder: Bill Stearets also turned me onto Herbalife a couple years ago. I bought a big slug of Herbalife in early 2015 when he had nothing to do with the company. I really think that’s part of the thesis behind Post today is he saw a company like Herbalife. If you have 80% growth margins, you can’t go out of business, right? If I have 80% growth margins and I have no debt, I literally can’t go out of business. I can have idiots running the company like Buffet says, and it’s really hard to hurt the business.
Jesse Felder: So Post recently has started selling their own kind of a protein powder shake type of a thing, with their access to grocery store shelves and that type of thing. I think Stearets said, “Wait a second, 80% growth margin, that’s awesome. Why don’t we come up with something at Post?” It’s not Post branded, but I do think he owns a ton of stock and was buying more last year. The stock is still cheap relative to its own history, relative to its peers.
Jesse Felder: That’s the kind of thing that I look for. And then because of my concerns about the overall market, I’ll look to hedge that in some way against general market risk.
Tobias Carlisle: How are you hedging? Just for the … How are you hedging?
Jesse Felder: Well, I’m short … I usually short individual stocks but in very very small size. I don’t like to short individual stocks. I’m not as aggressive as I am on the long side in that respect. I usually just kind of short the broad indexes and sometimes sectors. So I am short the semiconductors pretty heavily today right now, because talk about companies that are trading at the highest valuations in their history. A lot of these stocks are trading … Nvidia for example. I was short Nvidia last year. I’m still short it, with trading at twice it’s valuation from the peak of the dot-com mania, which is hard to believe. It’s trading 15 times sales when it only got up to seven, eight, nine times sales in the peak of the dot-com mania.
Jesse Felder: So what is that stock discounting? It’s discounting that that company’s going to take over every self-driving car, every AI application. I mean, they’re literally going to own it all and be able to keep incredible margins in the process. Really what was driving a lot of their sales, I think, over the past couple years is Bitcoin mining rigs. So when the Bitcoin price collapsed, a lot of that chip shortages turned into chip oversupply. So they weren’t talking about that very much in terms of their earnings calls. But that was the extra factor to demand factor that really pushed the results over the top.
Jesse Felder: Now we have this massive chip oversupply and sales are plummeting. So I want to be short. I’m short the semiconductor ETF against some of my long ideas. But I do think for the average investor, you and I have talked about this, there’s simple tail hedging methodologies that people can use. To me, when I suggest that and people say, “Oh god, that’s so bearish. Why don’t you just buy and hold for long periods of time?” I go, “Well, you buy auto insurance, right? You buy homeowners insurance. You protect yourselves in the case of an adverse event in those areas. With equities at the highest valuations in history, it makes sense to me to buy some insurance against my investment portfolio, just like I would with anything else.”
Jesse Felder: That’s how I look at tail hedging. I think it makes a ton of sense today. Maybe more sense than it’s ever made before. So yeah, there’s simple tail hedging strategies you can use. Buy deep out of money puts on a monthly basis, and it’s just look at it as an insurance policy.
Tobias Carlisle: One of the things I like about tail hedging is often it gets cheapest right at the moment that you really want it. So it’s often the best bang for the buck. I’ve done various things. I had HYG, which is the junk bond ETF. I had puts on that last year that were up a lot when the market was off but I wanted to hold them through to expiration in January 20, and of course they were 83. They were struck at 83, and I bought it at 85, something like that. And then by the time they expired Jan 20, they were out of the money even though they were up like 350% plus on December 24. That was a rapid rally. I was sad to see them go.
Jesse Felder: Right, yeah. I mean it’s funny, every time I’ve made a decision based on whatever tax thing, I don’t want to pay taxes with it, it’s been the wrong decision. You have to do it on the investment merits first. I’ve done that ton of times, and I’ve learned you know what? Take the gain, pay the taxes, or whatever. You’re better off in that respect. But yeah, it was interesting too, with that selloff and I think you and Chris Cole talked about this a little bit. I was surprised that volatility remained so subdued during that selloff last year.
Jesse Felder: For that reason, people who were tail hedging were probably disappointed a little bit to the extent of it didn’t really protect them as much as they would have liked. But that was very interesting to see volatility remain subdued even though it was a waterfall decline in December.
Tobias Carlisle: Chris … I was speaking to Chris as that was happening, and he was pretty … he didn’t seem to think that that was the real thing which I was surprised about, because I certainly thought it was the real thing. But he was pretty calm through the whole thing and he didn’t expect to see anything, and it was showing up in the volatility as well. It wasn’t taking off, and I don’t know why that was.
Jesse Felder: Yeah, it was the exact opposite of what we saw earlier in the year where you had the volatility implosion and there was just tons of short covering vol. Maybe it just was the fact that there wasn’t that much of a big short position vol. I am just amazed at how resilient a lot of these volatility short sellers are. They get crushed, and then they come right back in and start selling it at the lows. Maybe they were just comfortable in continuing to sell vol into that decline, which to me would be … I’m not willing to step in front of that steamroller.
Tobias Carlisle: But they’re right over and over again. But none of them have read Filled by Randomness evidently.
Jesse Felder: Right, right.
Tobias Carlisle: I think that that’s coming up on our time. It’s been a really fascinating discussion Jesse, I really do appreciate you giving me some of your time. If folks want to get in contact with you, what’s the best way of doing that?
Jesse Felder: At thefelderreport.com, I write a blog and there’s a little contact us there that I reply to personally. I’m pretty active on Twitter also. I don’t look at the ats, so don’t at me on Twitter because I literally just don’t look at them. But you can direct message me on Twitter if there’s things people want to discuss, too.
Tobias Carlisle: You just can’t be a bear on Twitter. Bears are excluded from the body somehow. They’re forced out. I’ve discovered that too. Anything that’s bearish gets a lot of hate.
Jesse Felder: Yeah, and so I think Twitter added a feature, maybe it was like a year ago or something, where you can literally just turn off your ats. I only see the ones from the people I follow, and I feel like that keeps me sane.
Tobias Carlisle: That’s smart. That’s a smart approach. Jesse Felder of The Felder Report, thank you very much.
Jesse Felder: It was my honor. Thanks Toby for having me on. I’m really excited to be on your new show and I’m a fan. I was really excited to hear that you were doing this, and so I’m eager to hear where you go with with and yeah. Best of luck with it.
Part of the weekly research here at The Acquirer’s Multiple features some of the top picks from our Stock Screeners and some top investors who are holding these same picks in their portfolios. Investors such as Warren Buffett, Joel Greenblatt, Carl Icahn, Jim Simons, Prem Watsa, Jeremy Grantham, Seth Klarman, Ray Dalio, and Howard Marks. The top investor data is provided from their latest 13F’s. This week we’ll take a look at:
Verso Corp (NYSE: VRS)
Verso Corp is a North American producer of printing papers, specialty papers, and pulp. The company produces a wide range of paper products, including coated freesheet, coated groundwood, coated digital, inkjet, supercalendered, and uncoated freesheet. These paper products are used primarily in media and marketing applications, such as catalogs, magazines, advertising brochures, and annual reports. The company also sells kraft pulp, which is used to manufacture tissue products and printing and writing grade paper; however, the group derives the majority of its revenue from its paper products.
A quick look at the price chart below for Verso Corp shows us that the stock is up 26% in the past twelve months. We currently have the stock trading on an Acquirer’s Multiple of 4.96 which means that it remains undervalued.
(Source: Morningstar)
Superinvestors who currently hold positions in Verso Corp include:
Breaker
Overcast
RadioPublic
Stitcher
