Stig Brodersen  07:35

I have two things I’d like to discuss. The first one is about currencies. That was something that was interesting, and I think Soros definitely knows what he’s talking about. He was making this big famous bet on the British Pound where he made a billion dollars. So he definitely knows what he’s talking about.

What Soros is basically saying is that the academics are wrong whenever they discuss exchange rates, and I learned a lot from this discussion because, what he’s saying is also what I’m telling my students, when it comes to floating exchange rates. So the theory goes like this: if you have an overvalued currency, and let’s just take the US dollars as an example. I’m not saying it’s overvalued, but I’m just saying it’s expensive. So what the academics are saying is that when you have a US dollar that is strong, you would buy more international goods, and you would buy less domestic goods. So what does that mean? Well, that means that there’ll be a relatively higher demand for international currencies and a relatively lower demand for the US dollar. What that means is that the dollar will slowly depreciate toward equilibrium.

Now, the whole idea of equilibrium is this stable point, or you can also call it the fundamental value. So basically, the effect we’re talking about is that when you have a floating exchange rate, like the dollar, it depreciates, and perhaps it will be undervalued, and then it will appreciate again toward equilibrium. So that’s the theory that I’m telling my students because that’s the one that is in all the textbooks you can find out there.

09:02

Now, like all billionaires, George Soros is saying that the textbooks are wrong. And so this is how George Soros looks at floating exchange rates. He’s saying that they’re about to crash at some point in time. It’s inherent that they will crash because there is no equilibrium in understanding the fundamentals like that.

So imagine that the exchange rate is strong, and again I will use the US dollar. If that happens, it discourages inflation. Now, if that happens, the wages will be stable, and the price of imports will fall. This is interesting because we also teach that to our students.

What he’s saying is that when imports have a large import component, a country can stay competitive for a very long time. And he mentions Germany in the 1970s as a good example. So you can have a stable,  I wouldn’t call equilibrium but you could definitely have a stable point with a really, strong currency for a long time that can grow stronger and stronger, or the other way around. So he’s saying that when you’re looking at the causality, it’s not like a linear consolidate. Look at us a circle that can just compound and compound, or worsen or gets better, depending on how you look at it.

Preston Pysh  10:12

Well, you couldn’t describe our current circumstance any better, Stig.

Stig Brodersen  10:18

Well, I’m happy you said that. I’m also under the impression that the dollar is overvalued. But my immediate thinking was that since the dollar is overvalued, we’ll see depreciation soon. But apparently, according to Soros, and also when you look at the bets that he’s doing in the market, you might think that he could stay there.

Preston Pysh  10:33

Yeah, that’s an interesting point. And it’s interesting to hear that idea of it compounding and compounding until it gets to maybe a breaking point. But it’s amazing to hear the thoughts of some of the smartest people in the world on this stuff and how they’ll take something that they start with the textbook, with this equilibrium idea, and just kind of embellish on it just a bit.

All right, so going back to the book, there’s a section called, and this is in part three, “The real-time experiment.” So at this point, Soros talks about how he comes up with some of these different ideas. He talks about individual theories that he’s tested in the past and kind of what he used as benchmarks for that. But he doesn’t talk about the overall analysis of how he comes up with those theories.

So in the third part, he’s talking about real-time experiments. He uses a couple of examples to demonstrate that. Then as you move into the fourth part of the book, he talks about how he’s evaluating those theories, and how he’s basically coming up with the metrics in order to determine whether he thinks that it’s moving in the right direction or not.

Stig Brodersen  11:40

I basically have two takeaways from this book and the first one was the currencies. The other thing that was for the individual investor and that was something that surprised me a bit. When I say individual investors, I’m thinking more about micro here. Obviously, Soros is a macro guy, but he’s talking about conglomerates and how you should be very cautious whenever you are seeing conglomerates that are growing rapidly.

He has this great example. It’s a very similar example to what Warren Buffett highlights whenever he’s looking at high growth companies. He’s saying that, imagine that you have a company with a market cap of 20 million and the earnings of 1 million. So this is trading at PE of 20. Now, then imagine that that company would buy another company with similar earnings, but with a PE of 10. And sorry, I know I’m throwing in a lot of numbers here. But what he’s basically saying is that if you consolidate that, being the conglomerate now having earnings of 2 million. Then your company would suddenly be valued at 40 million and not at say 30 million, which is 20 plus 10.

So, what he’s basically saying is that when you see a growing company, you should always pay attention to whether or not they use overvalued stock to grow. Then as an investor, you should not fall into the trap of always looking at growth as something that’s good. Just keep trading that at high multiple if that growth is financed by stock issues, or even worse by debt.

I know this was kind of like out of the blue how we talked about macroeconomics, but I think also for the individual investor, that’s something you should pay attention to. So whenever you see somebody stock picks, make acquisitions, you should always look into like the size of the acquisition and how it’s financed. So that was my second takeaway.

Preston Pysh  13:30

I like that point. I also like the idea that Soros just takes this efficient market hypothesis piece and just kind of slams it and shatters it in this book, because I would argue that he has the exact… It’d be his antithesis is the efficient market hypothesis where he is the of the opinion that it’s always mispriced and that it’s just a function of how badly mispriced it is.

So, a fantastic book. I know we covered this one pretty quickly but it is kind of a short read. And the main thesis is this reflexivity part that we’ve already talked about. So instead of beating that down, we’re just going to stop that here.

If you do want to listen to this book, go to our link on our website for Audible. And you can listen to this book completely for free. Your first download, if you use our link is completely free. I know this book is available on Audibles, it’s “The Alchemy of Finance” by George Soros. So consider that as a free gift from Stig and me, if you guys want to read this book.

14:27

Okay, let’s move into the second part of the show where we answer some questions from our audience. And we love doing this. So if you’ve got a question you want to record for our show, go to asktheinvestors.com and you can record your question. Okay, so the first question we have comes from Justin Coletti. And here’s his question.

Justin  14:42

Hi, Preston and Stig. This is Justin from Brooklyn, New York. I want to ask you guys a question about valuing commodities and maybe even cash. Right now, as I read this message in January of 2016, the stock market has been going down for quite a while and like Preston, I had moved to cash up there earlier when I saw stock valuations and the CAPE ratio getting high. And it seemed like there wasn’t much upside potential, at least in domestic equities.

But my other big question is, I think now diversifying a bit more into commodities because so many of these things, oil, silver, platinum steel, copper, seem to be so much less expensive than they have been historical. I want to ask you guys a question about how do you think we can appropriately value those things on a fundamental level? How can we take say, the Graham and Dodd approach to something like commodities? Thanks again, and looking forward to hearing your answer.

Preston Pysh  15:37

Hey, Justin, what a great question. I think this is a question that is on a lot of people’s minds is how in the world do I value a currency or commodity? So this is a hard question to answer and I don’t think that you can look at it necessarily the same way that you would if you’re valuing individual stock pick where you’re basically coming up with a discount cash flow. Where do I see these is kind of going back to the Howard Marks kind of the point of view of where’s the pendulum swinging?

The pendulum has a left and right limit. And so you got to say, is the pendulum out at the extreme, or is the pendulum right smack in the middle? And the hard thing with this is you don’t necessarily know how far out the pendulum is gonna swing, especially as you get into the kind of extreme scenarios, kind of like what we’re in right now.

So whenever I look at the dollar, let’s just say the dollar, for example, the dollar gets stronger as the Fed tightens interest rates. So the question a person would have right now and the dollar is extremely strong, relative to other currencies or relative to commodities. So if we were going to take this point in time, this snapshot in time, how much more do we think that the Fed has the ability to raise interest rates moving forward? I’m of the opinion that I don’t think that they can raise rates at all. Okay, that might be a more extreme position. Other people might say they can raise it two more times and then they’re going to have to start easing because the market is going to get disgusting at that point.

And so it becomes a very qualitative discussion because now you’re coming up with a theory of when you think Janet Yellen is going to make a decision or not. But I think that you can say, at this point in time now, if we go back three or four years from now, I think that it was a much more mushy kind of conversation where you wouldn’t be able to necessarily say one way or the other.

17:27

Now, that you’re kind of testing the limits of how strong can the dollar get, I think it becomes a little bit of an easier conversation. And you can make up a little bit more of a general understanding of what’s going to happen next. That’s my personal opinion. A lot of people, especially hardcore value investors would probably strongly disagree with that opinion.

So if we’re going back to the graphic representation of what I’m talking about, which is the pendulum, and we’re saying is that pendulum completely pegged out at its left or right limit, and I would say, yeah, I think it’s getting there. Do I think the dollar could get stronger? Yeah, I could probably get a little bit stronger, but not much, not anything that I’d be too concerned about losing much money on.

So when you see it from that vantage point, that means you got to either short it or you got to do something to invest that has a total correlation to the dollar that moves in the opposite direction, i.e. probably gold. So that’s how I’m looking at it. I’m kind of looking at it in a more general term, and it’s not nearly as mathematical, if you will, than you would do for anything else.

18:31

And so the other discussion here is that commodities and currencies typically go hand in hand. So when you have commodities, let’s just speak from the dollar vantage point, when the dollar gets strong commodities are probably way down. And that’s exactly what we’re seeing right now. If the dollars were extremely weak, let’s go back to like the 2010-2011 timeframe, commodities are probably doing well. So when you look at that, you got to look at the relationship between commodities and the dollar. So that’s whenever I sent out the email notice with the executive summaries and I was telling people I’m looking for the turn in oil to occur when the Fed announces that they’re going to start easing or they start signaling that they’re going to start easing because when there are more dollars in the system, the price of a commodity has to go up.

Now, where this gets a little bit tricky when you’re talking about commodities, like oil versus gold, which kind of has a fixed unit quantity, when you’re talking about oil that’s also heavily impacted by the supply and demand piece. And so now it’s like hitting two different balls whenever you’re playing pool, where you’re looking at the monetary supply with the currency and how that relates back to the commodity and then also you’re looking at for the commodity, you’re looking at the supply and demand piece, which makes it very, very tricky.

So we’re seeing oil kind of run into trouble going much lower around the $30 price, and it’s gotten as low as $26. It’s been flapping around there at that price point from 26 to low 30s for months now. Does that mean that you hit a bottom? Maybe I don’t know. I know that you’ve seen the rig count drop off significantly, which means the supply side might be contracting, which could potentially push the price higher.

20:14

My concern at this point is not necessarily the supply side, even though that was the major issue for the last year and a half or two years. My concern at this point now is the demand side, as we’re coming out of the winter months in the Northern Hemisphere, you also have the concern that you know, the global economy is starting to slow down. And as that happens, the demand might pull back enough that it doesn’t offset the oversupply.

So that’s why I’m just continuing to sit and watch this oil thing. And I might be late for the show, and I might not be late for the show. But I’m not anxious to get into it, just because I have that concern with the supply and demand imbalance. It’s continuing to happen and my expectation for the global economy, they continue to contract more. So there are two examples of how I’m looking at oil and how I’m looking at the dollar. I can’t give you anything quantitative, which is probably gonna annoy a lot of people. But unfortunately, I think when you’re dealing with currencies and commodities, it’s much more qualitative, and you’re looking at things from left and right limit. So I’m curious to hear what Stig has to say on this one.

Stig Brodersen  21:18

Okay, so there are so many things to say about commodities, and that it’s such a great question. We haven’t been discussing too much about commodities as a group. I know we talked a lot about oil. I’ll probably be the worst one when it comes to that, but about valuing commodities, we haven’t been talking about it much. So I’m happy, Justin, that we have a chance to discuss this.

So the way I see commodities is that it’s a question of supply and demand. And if they’re in balance, or if they’re in equilibrium, usually commodity prices would move somewhat in lockstep with inflation. Now, that’s kind of like the academic explanation because when it comes to supply and demand, especially in commodities and especially in currencies, or oil for that matter, supply and demand, they’re never in balance. You have always some kind of effect that you need to figure out.

22:08

And so let’s talk about oil first. So, at the moment, you’re hearing that countries like Iran, and also the Saudis will keep producing and what you’ll see is that you have a lower oil price. Now, this is interesting, because there’s no extra supply that second when they were saying it, but there’s an expectation of more oil supply. Okay, so two different things. Do we see more oil? No, do we expect more oil? Yes, still it has an effect on the price of oil.

So basically, what this comes down to is also expectations. Now, if you expect something to happen, say that you expect 2 million barrels more a day and you only see 1 million.  Well, in relative terms you will see an increase in the oil price. And exactly the same thing with currencies. So if you are better at guessing than the common expectations, you can make a profit when it comes because it’s just supply and demand kind of thing.

Another thing we’ve talked about currencies and this was a very interesting discussion from the Davos meeting. And this is Mary Callahan, and she is the CEO of JP Morgan. She was talking about that she could see a strong dollar because she wasn’t sure that you only see two small interest rate hikes. She was talking about all this history show us, of whenever the Fed is tightening. And on average, she was mentioning 2.25% whenever they’re tightening. And that was typically within a year. If just look at the last five, I just looked it up, you see a 2.7% hike, you know it’s a lot. So if the rest of the world thinks that it will say, .5% or they might think in terms of easing, but Mary Callahan might be right then it’s about 2%. Then you will see a complete shift in the strength of the dollar because that is not priced in the dollar.

Preston Pysh  24:00

Yeah, I definitely like to say I think she’s wrong. But no, that’s a good point to show. There are some people out there looking at it from a historical standpoint. There are other people that are looking at it from maybe a bigger context of the global economy and that the Feds’ hands are pretty much tied, they’re not going to be able to raise rates. And that this time is different because you’re at the end of a long term debt cycle. There’s a lot of different opinions out there. And people are all looking at it from a different vantage point.

And so my opinion is, is if you’re the person who’s looking at it from more vantage points than the others, and your expectations are right, you can do well on the commodity. I will say this, typically, currencies and commodities move in like three-year trends. Okay, so if you think that it’s going to flip in a quick amount of time, historically, that has not been the case. Typically, you see these things move in like three-year cycles, if it’s a currency or a commodity.

24:54

Okay, so our next question is from Jeff Henchman. And here we go.

Jeff  24:58

Hey, Preston and Stig. This is Jeff Henchman. from Peoria, Illinois. I love your podcasts. It’s a great resource of information and knowledge and I love applying it to my own investing. So my question for you guys is after listening to the Meb Faber podcast, I started investigating global equities. And I am struggling to try to calculate the intrinsic value. After looking online, I’ve noticed there are several methods and models in regards to discounted cash flow, liquidity models, etc. And I’m just curious to know how you guys like to calculate the intrinsic value. Thank you very much. And I look forward to listening to you guys later. Bye.

Stig Brodersen  25:37

You know, I was psyched when we had this interview with Meb because I was surprised that I wouldn’t say that international markets are so cheap, but I had a chance to look up like the cheapest international markets. And you have international markets that were trading at a CAPE ratio below five. So an expected return above 20%. And then you were looking at the US, it was like 4%. So my immediate thought was, I need to start investing in international markets. And it kind of stopped right there. I’m not investing in international bodies even though I guess fellow Danes would say I am because I’m solely invested in the US. But when I say International, I’m just saying non-US.

Well, if you’re evaluating an international stock, in essence, it’s just the exact same process as evaluating an American stock. So you’re discounting the future cash flow, or you estimate what the future cash flow will be, and then you’re discounted back to today.

26:30

Now, where things get a bit different, is that it might not be as easy. So for international stocks, you would, especially if it’s international stock picks, it’s usually harder for you because they might not be within your circle of competence. There might also be a lot of different things that you need to be aware of. It might be the accounting that you’re looking at.

So I think for international investing, I would probably buy an index and start to be diversified into a country and a market. I might not even do one country. I think if you look at the very cheapest at the moment is countries like Brazil and Russia. I might not buy Russian ETF. I might buy, you know, an ETF tracking, you know, the five or ten cheapest based on the CAPE ratio, or buy five individual ones. So if you are going to do that, you should probably do two things. First, of al,l diversify, and then be very systematic in your approach.

Preston Pysh  27:25

So my response to this one is just quite simple. I always use an ETF, whenever I do international investing anything outside of the United States. A lot of that is because I don’t understand the accounting the same way that I understand the accounting in the US. So whenever I look at things over in Europe, or anywhere, Japan, which I don’t look there very often these days, but if I’m looking internationally, I’m looking at ETFs. And I’m looking at specific sectors. So you know, the energy sector has been just hammered. So that might be a sector that I’m looking at internationally.

I completely agree with Stig I think that when you distribute your risk across the breadth of stocks, and you’re maybe stepping into an industry that’s been pummeled, that’s probably the best approach when you’re talking international. And he’s right, some of these PE ratios and countries right now are like a five or are under ten, which is fantastic for returns.

So, you know, intrinsic value-wise, you’re taking the PE ratio for that country, and I would strongly recommend that you use a CAPE PE ratio for the country, you just take that you invert it in order to get your expected yield. So if the PE is 10, you go one divided by 10. That gives you 10%, that should be your expectation of the value that you’ll continue to get by holding that ETF.

28:40

Okay, and this is the last question we’re going to take and this one’s from Derrick Randall.

Derrick  28:45

Hi, Preston and Stig. Thank you for all you do. It’s Derrick Randall in Moncton, New Brunswick, Canada. My question is related to the current market condition and I guess how it compares historically. Warren Buffett famously wrote in 2005 Berkshire Hathaway stockholder letter that between December 31, 1899, and December 31, 1999, the Dow rose from 66 to 11,497, a gain of 5.3% compounded annually over that hundred year period.

He then points out that to achieve an equal rate of gain for the 21st century, the Dow will have to rise by December 31, 2099, to precisely 2,011,011. Using this math, if we compound the Dow figure from December 31, 1999, or the 11,497, by an average of 5.3% annually, it tells us that the Dow should have been 27,661 on December 31, 2015. But in fact, the Dow was only 17,425 With the Dow, currently at 15,914 on February 10, 2016, do you think US equities are overvalued? And the second part of this question is, is 5.3% a realistic average return moving forward for the Dow? Thanks so much for all you do. And this is a little heads up into the 2016 Berkshire Hathaway meeting. Thanks again. Bye, bye.

Preston Pysh  30:28

All right, let’s look at the intent of what Buffett was writing about. He’s basically using that, and this is my opinion, at least, he was using that exchange in his shareholder letters to highlight the fact that the market on average was moving at 5% over the last hundred years. And if it’s going to move 5%, again, this is the super high number that represents that.

I think reading into that and any more than than that piece of it, I think, is maybe reading into it too much. And I think that you can kind of use that may be as a trend line moving forward as far as maybe five percent, but to go, you know, what would it be 15 years after the start and say, “Hey, we didn’t hit the mark of where it should be on the trend line,” I think is a little bit narrow in scope. And so, for me, I’m looking at the market from this vantage point as well. I think that if you’re starting in the late 1800s, and you’re going to 1999, there’s a 30 year period there, or maybe not even 30 years, actually, there’s about 15 years where there was no Federal Reserve in the system.

The Fed had stood up in 1914. I believe that’s the year, I might be wrong, but it’s around that timeframe where the Fed was stood up. And I think that something that we isn’t necessarily accounting for, as we do this transition from the timeframes that you’re talking about, is what impact is the Fed gonna have with this long term debt cycle that was created? And what impact is that going to have in the next 10 to 20 years?

31:55

My opinion is that it’s going to handicap the performance quite significantly. I could be wrong about that. But I think that that’s a variable that we’ve got to talk about, as far as our expectation moving forward. But, you know, who knows? I think that five percent is probably a good number to kind of focus on. I think that the Dow got up to 18,300 is the highest it got. And I think that the credit cycle is now contracting, so my expectation is that it’s not going to go higher than the 18,300, at least not for quite a few years. But that’s my position. So I’m curious to hear Stig’s thoughts.

Stig Brodersen  32:30

Yeah, Derek. So I think I want to go back to your question and say why has it grown by 5.3%? And then ask that question first, or the way I look at it is that the stock market is a reflection of the earnings. So if you have a growth of 5.3%, you must also have earnings growth in a somewhat same rate. And then ask the question, so where do earnings come from? I keep going one step back. Earnings come from efficiency and productivity. Now, what has happened to the States, because in international comparison? If you look at the last century, the US has done remarkably well.

Well, there’s a lot of good things to be said about efficiency and productivity: electricity, for one thing, manufacturing railroads. There’s a lot of things to say about why things have been so good in America. So will this continue? Will you see the same growth in earnings? That’s the question that you should be asking. And not the question of whether or not the Dow would be 2 million or not, because that’s somewhat of an arbitrary number. If the earnings don’t follow, it doesn’t matter anyway.

33:33

And then, if you look at Warren Buffett’s letter from 2005, he’s saying that’s 5.3%, it’s correct. But he’s also saying you need to include dividends because whenever you’re tracking an index, usually that is without the dividend, at least in this situation here. So remember, whenever you compare international markets to the US market, does that include dividends or not? So you might even add, say 2% to that number. It might be even 7.3% you’re talking about here.

And then the final thing, as with everything, even for something like a 100-year cycle, I know 100 years is a long time. But where do you end and where do you start? And if you look at December 31, 1999, the market was very high. It was just before the burst of the dot-com bubble, right? So I definitely like that you might say 5.3% plus dividends is like a reference point, but I wouldn’t put too much into it.

Preston Pysh  34:25

All right, all fantastic questions. And for everybody that asked their question, we’re going to send you a free signed copy of our book, the Warren Buffett Accounting Book. And again, if you want to record your question and get it played on our show, go to asktheinvestors.com, and you can record your question. So we’d love to thank all of our guests for submitting those questions.

We enjoyed the book, “The Alchemy of Finance.” It’s not quite exhilarating if you will, but it’s a very good read. And I think it makes you think about commodities, currencies, this idea of reflexivity is an interesting and kind of neat idea. So fantastic. We’re just so thankful for everybody that listens to our show and submitted their questions. So that’s all we have for you. And we’ll see you guys next week.

Outro  36:58

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorspodcast.com. Submit your questions or request a guest’s appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of The Warren Buffett Accounting Book. This podcast is for entertainment purposes only. This material is copyrighted by the TIP Network and must have written approval before commercial application.