Preston Pysh  06:59

I absolutely love how you just threw out, “Yeah, CFA  certified like, that’s no big deal.” For the people in our audience that are listening, I’m just going to throw something out there. To get your CFA is so darn hard. I don’t think people have any idea what he just threw out there. But that’s studying for years. That’s like going as deep as you can possibly go. That’s one of the hardest charters you can possibly get. Those guys are like the Jedi Knights of Finance. So, don’t let them fool you by just casually throwing that one out there.

Patrick O’Shaughnessy  07:27

I think what the CFA says about you more than anything is it’s a testament to your ability to just punish yourself. It’s just about the hours. It’s not particularly hard. You cannot pass without putting in the time. That’s probably what it certifies for more than the knowledge and finance because I’ve forgotten probably 90% of it.

Preston Pysh  07:47

Wow, that’s amazing. I wish I had my CFA. I’m going to probably work on one of those here in the future.

Stig Brodersen  07:51

Yeah, I love the metaphors to be the Jedi of something. I mean that we should always strive for those guys to be the Jedi of something within finance.

So, Patrick, when studying your research, I find it interesting that the companies that buy back their shares most aggressively outperform the market by 3.3%. You also address that many high conviction companies use excessive amounts of debt to do so. So, as a stock investor, how worried should I be about debt being the funding for share buybacks?

Patrick O’Shaughnessy  08:25

I think buybacks in general is one of the more interesting topics out there today. And it’s also become one of the main focuses of the financial media. I would say the majority of the stories are that buybacks in the aggregate are bad. There are some very famous people out there who are saying that they’re very short-term oriented, that it’s about boosting stock price, that they’re being done at the expense of research or investment, which would be better investments for the longer term.

What happens is that all these writers tend to paint all companies that are buying back their shares with one broad brush. The research that I’ve done suggests that there are a lot of different kinds of buyback programs. And that the conviction level with which companies are repurchasing their shares, the simplest way to think about that is what percent of their shares outstanding are they buying back in the last one year or two years? You’re buying back a few percents, that’s arguably not a very high conviction bet on your stock price. Whereas if you’re buying back 10%, or 20%, or 30%, that’s a pretty big bet that your share price is undervalued, hopefully. That would be the best motivation for a big buyback program.

And what you find is that these low conviction versus high conviction firms perform very differently across history. So, companies that have a combination of good cheap prices, low PE ratios, low price-sales ratios, things like that, that are buying back huge chunks of their shares, have outperformed by a pretty considerable margin, and have done so very consistently through time.

Whereas the lower conviction guys, they have outperformed a little bit. So, they’ve outperformed say growth stocks that are issuing share. Think about Facebook or something like that today. They’ve outperformed by a percent or so but not nearly to the same degree as companies with these high conviction programs.

Now, are they all good? Definitely not. There are definitely concerns about debt and the use of debt to just do a debt-equity swap. But you have to remember that debt is not always a bad thing. And what I found, in general, is that while there are certain offenders who have levered up to the hills to buy back stock, on average, companies that are buying back shares don’t look all that more levered than the rest of the overall market. So, it’s an easy narrative, because there are definitely companies that do it for the right reasons, and those companies have tended to outperform.

Stig Brodersen  10:44

Yeah, and it’s interesting what you said that the companies that, like the highest conviction companies are less levered. That was something that surprised me when I saw that because it seems counterintuitive.

But one of the things or one of the strategies that some companies might apply right now with the interest level being so low is that they would issue bonds and then they will buy them back whenever the interest rate increases. Is that a strategy you think will be applied by these companies? Like because that would signal like screwed management. Or do you think it’s a temporary thing? We’re looking at the markets at the moment.

Patrick O’Shaughnessy  11:19

I think that the last five years, or maybe my whole career, has taught me anything, it’s to not make any investment decisions based on interest rate forecasts because most everyone has been wrong and wrong for a long time.

Now, if that strategy were executed properly, and yeah that’s a brilliant strategy. Sounds good. One of the interesting things that we find historically is that if you take a simple factor like debt to equity as a measure of firm leverage, and compare debt to equity between companies and other similar companies: so, utility to a utility, or consumer stock, and so forth. The companies that do the best are ones in the middle of the distribution. So, companies that use some debt, but aren’t the most levered.

So, the worst-performing stocks are the ones that have the highest debt to equity. And the ones that use no leverage have tended to underperform as well. So, some smart mix of leverage into the capital structure has been what’s been rewarded. Now, I want to be clear that that’s not a factor that’s nearly as predictive of something like value, which I think we’ll talk about today as well. But if there’s anything to note from leverage, historically, it’s the tail ends of the distribution have tended to underperform a little bit.

Preston Pysh  12:26

So, I just want to throw something out there. Just to piggyback on this. First, the reference that Stig had for that 3.3% that Patrick had referenced in one of his blog posts, we’re going to have a link to that in our show notes so people can read that and see a little bit in more detail behind what we’re talking about.

But to throw some contrast to that argument. I just wanted to throw out that billionaire Mark Cuban absolutely hates share buybacks. I mean, hates them. He wrote this raging blog post about why he thinks share buybacks are horrible. So, I want to have a link to that as well. And I want that to be right next to each other. So, when you guys go into our show notes, you can read both sides of this argument.

Now, my personal opinion, and I like the way Patrick described this is that it’s all about the conviction. If the company’s doing share buybacks at a modest level, typically what they’re doing with those share buybacks is they’re putting them into their equity Treasury account. And what they’re then doing is they’re issuing them out to their employees as incentives, when they’re doing it at a very small and not much conviction behind it.

When you have them doing it at a high conviction rate, they’re saying, “You know what? We think our company’s undervalued relative to the yields. We’re going to get by maybe purchasing other equities or other operational investments within our company. And so, what we’re going to do is we’re going to buy back our own stock, because we know what we’re buying, we know what food we’re cooking for ourselves here if we repurchase these stocks.” And when they do that at a high conviction level, it’s good for the shareholders. That’s what Patrick was getting at and I completely agree with that opinion.

But I want to throw that out there that I want people to see that contrast. So, they can read and determine for themselves. And I see Toby has a comment he wants to piggyback on this as well.

Tobias Carlisle  14:05

I would just say this, sometimes it’s important to think about the mechanics of what’s occurring, versus trying to detect it as an investor. So, what Pat’s talking about is detecting a company that’s going to outperform subsequently. And that’s something that’s shown by conviction investing. But it’s also helpful to think about the nature of the buyback.

So, a buyback that’s undertaken at a premium to intrinsic value. I’d agree with Mark Cuban on that, that will destroy value, and that’s a bad thing. But a buyback undertaken at a big discount to intrinsic value does create value for the remaining shareholders. It may be that that doesn’t necessarily show up immediately in the investment results or I think… Pat, you would agree that when they’re deeply undervalued and undertaking buybacks, that’s a pretty powerful signal together?

Patrick O’Shaughnessy  14:51

It is a powerful signal and maybe just a few more points on buybacks in general because it’s such a nuanced issue. There are definitely valuable and accurate criticisms of buybacks in aggregate. In aggregate, *they’ve been this time, the dollar value of buybacks peaked in early 2008, which of course was a terrible time to be buying huge chunks of your own equity. And the dollar values are peaking again today. I think it’s crazy that people always focus on raw dollar values and not yields are percentages because the raw dollar value of the market is much bigger today. So, it’s a smaller percentage than it was in 2008. But it’s still pretty high and elevated, in terms of gross dollars being spent on buybacks.

So, in aggregate, companies don’t do a great job at timing their share repurchases. But those high conviction guys tend to do a slightly better job. And we certainly wouldn’t advocate just buying because of a buyback program. There are all sorts of other things you should look at the quality of earnings, debt levels, lots of other things that we could do valuations that we could talk about.

But it does seem like those companies with the highest conviction do buy back at cheaper relative prices than the low conviction guys out there. So, yeah, I think that it’s important to contextualize with what else is going on in the business.

The other thing that drives me nuts is you know, you’ll hear, IBM has become the popular target for a crappy company that’s falling in sales quarter after quarter, and it’s a dinosaur and buying back their shares, burning money, and so on. You have to remember that there’s not some store that these companies can go to with high return on capital projects that they can just plugin and start earning impressive rates of capital. And sometimes buyback programs show a little bit of discipline on the part of managers behind these big companies because one of the worst things you could do for shareholders is start earning money on low return projects or investments. And it’s not liked these things grow on trees. So,  IBM, just because it’s not plowing all its money into R&D, doesn’t mean that these buybacks are a bad thing.

Stig Brodersen  16:49

I love that you’re saying that, Patrick. So, if you go back to the episode where you can listen to Tren Griffin, the author of “Charlie Munger: The Complete Investor.” Preston and I were talking about how bad IBM is, *how we have been wrong and why you should never do that as a value investor. So, it’s, it’s nice to see there’s a nuance to the discussion.

Patrick O’Shaughnessy  17:09

Yeah. So, the fun thing about being a quant or systematic investor is you own a lot of stocks, right? So, I talked about I’m interested in individual stocks as a side hobby. And I think it is helpful to talk about them just to convey the principles that we’re trying to invest based upon. But if you want IBM as a quantum, it’s going to be a tiny percent of your overall portfolio. And the goal is that a basket of stocks that have that IBM-like profile: easy to hate, easy to build a negative narrative on, easy to talk about as value traps, for example, that a basket of those kinds of stocks tend to do very well. So, it’s key that you spread your bets, even though we’re talking about individual name examples. So, who the heck knows what’s going to happen with IBM, but they’re a good one to talk about?

Preston Pysh  17:52

Toby, go ahead and hit up the third question.

Tobias Carlisle  17:54

I’ll do a huge amount of backtesting. And one of the great things that I have access to is Pat because I get these ideas that it’s something odd. That is just a little bit unexpected and Pat has access to the best backtesting system probably in the world. And he’s right in the weeds, but he knows all of it in detail. And crucially, he’s very generously often available to me to answer my odd questions. So, I was just wondering, what are some of the weirdest backtest results you’ve seen? And did you subsequently think through the result, and work out why it was working, and realize that it was a genuine thing and not just a quirk of the data?

Patrick O’Shaughnessy  18:38

It’s an interesting question. Maybe I’ll use it as an opportunity to talk philosophically about backtests a little bit because they’re becoming more and more popular. You’re seeing more and more of this logarithmic growth of $1 charts that show some strategy, absolutely creaming the overall market and seem to do it with ease over many decades. And the joke always goes and in our line of asset management that no one’s ever seen a bad backtest.

Well, I’ve definitely seen a lot of bad backtests. And typically, what they have in common is that there’s something wrong with the test itself. You know, there’s now a lot of services that allow people to enter in some formula and backtest it online and there are consulting services that do this as well. And what I found is that there are generally a couple of big issues that people screw up when conducting backtests that lead to conclusions, that make a strategy look a lot better than it is.

So just to give you an example, the first would be the data itself. So, we’re very reliant on a couple of big historical data sets. And there’s just no perfect data set. So, these companies do the very best to have stripped out things like survivorship bias and making sure to include companies that have gone out of business because after all, if all you ever did was invest in stocks that kept surviving, you probably do pretty well. You didn’t ever invest in any of the losers.

So, things like survivorship bias companies’ restatements that happen in our backfield, after the fact, some statistical issue, so just the actual conducting of the test itself. And maybe finding that something works when it’s *T-stat is completely insignificant, making sure you do in and out of sample testing.

There’s just so much nuance to all of this testing that we do. And it worries me that it’s become so popular because listen, if you test enough things at random, test 300 things at random, a small handful are going to look phenomenal, just by pure chance. So, you just have to be very careful with backtests. That’s my broad opinion of them that, of course, they’re useful, and it’s a great way to test the market hypothesis. But usually, Toby, when I see weird results, it’s because I screwed something up.

Preston Pysh  20:40

All right, Patrick. So, this is piggybacking off this conversation with backtesting. But when I think about all this backtesting that people have been doing on the market over the past 50 years, I think it’s important to highlight that interest rates have been at normal levels whenever you’d be looking at those results. And as we look at the current conditions and the expectation for future movements, interest rates seem to be polarizing to zero percent.

Using Japan as an example for future performance in the debt markets, many think that those rates will continue to drop the zero or even negative, moving into the future decade. Do you ever worry about the backtesting results you’ve done in the past and that they might not necessarily correlate to the way securities will perform moving forward with that idea of this polarization towards zero percent?

Patrick O’Shaughnessy  21:25

We’re pretty lucky in that we’ve got data on just about every market and macroeconomic regime, both in the US and globally. So, we can take the core ideas that we’re all about, which is at the end of the day, it’s ideas like valuation, momentum, the return of capital to shareholders, things like that. And we can test those in the 70s, in that crazy interest rate environment which was very different from the one we’ve lived through in the last 30 plus years. We can test it in Japan since 1989. To see, okay, value works everywhere, but what about in this weird deflationary stagnant economy?

Patrick O’Shaughnessy  22:01

I think the reason why the strategies work in the first place. So, I know you had Wes Gray on the show, and I think he and I would probably agree on this being more of a behavior story than a risk story. So, that’s the big debate in our world is does value investing work because it’s some risk that you’re being compensated for that would be the Eugene Fama efficient markets, like live value stocks outperform?

And we can stress test these things and for the most part, those key core ideas, and there’s a lot of ways I know you can measure value events, etc. But those core ideas have pretty much stood up to every out of sample test, every macroeconomic environment, every different scenario we put them through. Of course, there are bad periods of underperformance, but they always survive and thrive.

And then there’s the behavioral explanation, which is that at extremes the market overdoes it. So, the market is a discounting mechanism. It’s effectively making predictions about each stock’s future until a value stock, it sounds great, but it’s a nice one. way of saying pessimistic expectations. the crappy company, bad outlook, and what we find and then the opposite for growth fantastic outlook, credible future growth rates, things like that.

What we find is that people over extrapolate and underappreciate the fact that markets are mean-reverting. So, IBM should trade a lot cheaper than Amazon, there’s no doubt in anyone’s mind. But IBM perhaps is trading too cheap. So, the market has over extrapolated its bad recent results in sales. And any little positive surprise would catalyze an upward move in IBM, and vice versa for a company like Amazon. So, I’m a subscriber to that behavioral explanation for why value works. And because of that, because people are not going to change. Human nature is not going to change.

Preston Pysh  23:44

Hey, guys, can we continue the conversation on Amazon because I just want to hear your thoughts on this? So, whenever I look at Amazon, and everyone’s trading it at ridiculous multiples, then it’s trading it off of the top-line revenue. And what they’re doing is they’re looking at that revenue growth. They’re saying, “You know what? If Amazon would choose to basically start making a 10% margin on that revenue, it would be priced at where it’s at right now.” That’s how they’re doing it. They’re basically saying that it’d be 10%. And they’re basically using a market cap off of that.

But the fact of the matter is, is they aren’t choosing to have any margin at all. There are some quarters where it comes in positive, there’s the following quarter where it comes in slightly negative. And it’s Jeff Bezos’ method to basically just keep growing his company like a weed, and you’re seeing his revenue, his top-line revenue, just growing like a weed. Now, recently, I think you’re starting to see the revenue start to taper a little bit. You’re not seeing it grow at nearly the growth rate that it has in the past. And so, my question to you guys is: what’s his end state?

You know, Mohnish Pabrai has a great explanation. He says, “Whenever you have a human being that gets so big, it starts to become unhealthy for that person because they’re so big and there’s something that biologically holds them back from basically functioning appropriately.” He says, “I feel like you see the same thing with businesses. Once they get so big, it’s like there’s this barrier or like you’re approaching the speed of light where you have to basically start slowing down.” And so, what’s the end state with Amazon? And how is the market going to treat its market cap? I think they’re going to get obliterated when we start to see their top-line revenue start to taper off.

Stig Brodersen  25:19

I’m so happy you said that Preston, because I don’t know. I’m so desperate to figure out what Amazon is doing that forced all of my grad students to make a valuation of Amazon and they come up with like 30 different results because it’s so hard to figure out. And to me, I think the whole point is that do you have any pricing power? Like the whole business model and the way that they’re scaled, they need to have some pricing power before you can start to argue for the current valuation. And I’m not sure because their competitive advantage is that they don’t have any margins. That is at least what Jeff Bezos is saying, that they have no margins. That is how we can keep competitors away. But I just can’t see how they can start making any money, like real money, compared to the current valuation, with the current model that I have right now, simply because the industry that they are operating in are just too competitive whenever they start to increase the margins.

Tobias Carlisle  26:10

I thought it’s probably not that interesting on Amazon. It’s just one of those things that I don’t think you necessarily need to have an opinion on every single stock. It’s just, if it’s not on my screen, if it’s not in these portfolios, I tend not to look at it. I don’t know with Amazon. I don’t think that to Stig’s point, I don’t think that they are trying to be, they’re never going to be the franchise style company. They’re just going to be the low-cost operator, which seems to have been a very successful strategy. They may just be able to deliver packages to homes cheaper than anybody else. And that might be their competitive advantage that’s just impossible to erode because they’ve become so well networked and so close to everybody that no one can compete with that. I don’t have any great views on the valuation. It’s just too expensive for me and I don’t short individual names.

Patrick O’Shaughnessy  26:52

But it’s yet another good stock to illustrate a broader general principle behind value versus growth investing. Amazon is a lottery stock. It’s like buying a lottery ticket. There will be certain incredible growth, incredible companies’ stories, stocks that do extremely well, in the next 10 years. This past decade was Apple. And Apple earned out it’s outrageous pricing at different times, right?

So, if you do some back of the envelope stuff on Amazon, they’d have to grow it. Let’s say they just grow with the market over the next 10 years or so. They have to grow their earnings, their bottom line like 55% a year. That’s happened before. It’s about .3% of the time, which is a tiny, tiny percentage, but it has happened. And Apple is one of the companies that did it. So, there are these darling growth names that work out. They’re the winning lottery tickets, but certainly, by the same logic, I wouldn’t suggest you go buy a lottery ticket. We know that that’s a bad idea.

In general, through history, buying stocks, like Amazon has been a bad idea. But of course, we just don’t know whether this will be the one stock that proves to be the exception, that keeps people playing this game, because now everyone wants the next Apple. And it seems as though Amazon might be that stock. It’s an amazing company that we all use and all love. It’s just priced outrageously.

Preston Pysh  28:11

I love that metaphor that you used because there are so many people that say, “If I would have just bought Microsoft back in 1990.” And you might as well just say, “I wish I would have gone out and bought that lottery ticket that won,” because that’s what’s what you’re saying is, as far as probabilities go like, Patrick, throughout the odds, 0.3% was that correct points?

Patrick O’Shaughnessy  28:33

Yeah. So, that’s a perspective, that’s like nine times rarer than hitting a single number.

Stig Brodersen  28:42

So, for the next question, we’re going to talk about Wes Gray. I think people in the podcast know when we had him on and this is starting to become a family podcast, and I’m saying that because we had Patrick on, we had his dad on, now we’re talking about Wes whom Toby wrote a book with. And Patrick, before the show, just told us that he went out with two weekends ago in Vegas. So, this has turned into a family podcast.

But Preston, I come from a foundation of value investing. And we had Wesley Gray on the show the other day, and he started to talk about momentum investing, which was something that was not on our radar, which is basically the principle of buying stocks whenever they have soared, and then hope that they will continue to increase in price. And it might seem like the opposite of value investing. It might seem like something you shouldn’t do if you’re a value investor. But I’ve seen in your research, Patrick, that you found that if you have a portfolio with 70% in value stocks and 30% momentum stocks, it’s the most optimal portfolio mix you can have. Could you please elaborate on your findings?

Patrick O’Shaughnessy  29:56

Sure. So, first, I use the word optimal very delicately. Optimal in the sense that in the sample of data with which we have to work, that blend of 70% value, 30% momentum, in a very simple test produced the best Sharpe ratio. I can all but guarantee that in the next five to 10 years, it will be some other mix other than 70-30, which proves to be best. Who knows what it’s going to be?

The broader point, though, is that there does seem to be some advantage of mixing these ideas of value and momentum, which on the face of it seemed like opposite things. So, value stocks often have gone down. have bad momentum. And growth stocks often have good momentum, right? So, it almost seems like you’re talking out both sides of your mouth.

But it’s important to know that they’re very different strategies. And the difference is about the time horizon. So, when you buy value stocks, that’s a strategy that works for a very long time. If you buy a basket of 100 value stocks today, on average, historically, that group of 100 companies will keep outperforming for five years or longer. It’s a very low turnover strategy value is, overall.

Momentum, in contrast, is a much higher turnover strategy. So, the idea is like value and you buy something because it’s cheap. With momentum, you buy something because it’s gone up a lot in the last three to 12 months. That’s typically the window that people look at. But the difference is that you need to trade that a lot. So, tax-sensitive investors, people worried about capital gains, that thing. Momentum is not probably nearly as helpful. But it has been a strategy that’s worked very, very well just like value has, so long as you’re rebalancing at least annually, typically more often than annual. Say, every six months, or even more frequently. But momentum does work well. And that works well in combination with value.

And your worst-case scenarios historically would have been much better than if you had been 100% value or 100% momentum, but you’ve had some blend. 70-30 works great, 50-50 works great, 40-60 works great. I think the exact blend is less important. The more important idea is that you can use more than just one factor to create a better overall strategy.

Preston Pysh  32:00

So, Patrick, I think it’s important for us to highlight and tell the listeners, we’re going to have a link in the show notes to the article that Stig’s referencing for this 70-30 split. So, you guys can read more about this. I’m curious because I don’t study anything to do with momentum investing. I’m typically just straight value. And so, I’m very curious to talk about this a little bit more and I think a lot of the people in the audience would be as well. When you say you’re looking at these three months to 12-month horizon, and you’re talking about price basically going up, what else are you looking at? Are you looking at the revenue? Are you looking at the net income? What other factors are you looking at, in addition to that price? And how is it correlated to price? I guess, is where I’m interested to know more.

Patrick O’Shaughnessy  32:41

So, we focus pretty exclusively on price momentum on the total return of the stock. There are other versions of momentum, short term earnings sales. So, sometimes you can even look at the revisions of analysts, *sell-side analysts estimate on stocks or something I’ve seen people do when talking about momentum.

There’s some efficacy to all of them. What we find is the most predictive or most successful at picking stocks that go on to win in the next year or so, is that strict price movement over the last three to nine months, it sounds pathetically simple. And we all know that chasing performance, in general, is a bad idea. But the chasing of performance that usually happens is people chasing some asset class or some strategy that’s worked over the last three to five years, not over the last three to five months. So, momentum is a much shorter-term signal. You certainly don’t chase a five-year winner because those tend to mean revert. But that shorter-term momentum does seem to be predictive.

Preston Pysh  33:38

Now, do you get better results depending on where you’re at in the credit cycle? So, let’s say 2008-2009  that you’re in the depths of a very deep recession at that point. And basically, you’re starting over with the credit expansion at that point. Does this momentum strategy work better during that time, versus where we’re at today where you’re basically topped out at the end of this credit cycle, you’re basically chasing something that might end badly? Is there a timing in that credit cycle that this strategy works better than other times?

Patrick O’Shaughnessy  34:11

It’s easier to answer in terms of market cycles than credit cycles, just because the answer is a little bit more consistent. So, when momentum tends to do well is in the rising bowl trending markets. So, periods have established and rotating trends, where it tends to do badly. And this is one of the great difficulties with being a momentum investor is in the initial period following a severe bear market bottom.

So, if you think back to March 2009, this happened in the early 2000s, in the 1970s, and 1937, 1932. Coming out of the initial part of a bear market bottom, so go back to March 2009. What happens with momentum is what we call a factor crash. You can think about a market crash when the market goes down. A factor crash is where what normally works completely gets inverted. So, now all of a sudden, it’s the low momentum stocks that are killing the market behind momentum stocks that are going nowhere.

A value factor crash would be expensive stocks like what we’ve seen this year, and its expensive stocks outperforming cheap stocks underperforming, that would be a value crash. So, momentum has this factor crashes coming out of bear markets, and they’re extreme. They can take years for the momentum strategy to work its way back into positive excess return territory. So, it’s not for the faint of heart. And you have to understand that while that has been pretty consistent, meaning you want to be out of momentum at bottoms, we know that it’s impossible to time these things. So, sometimes you have to stick with it through a couple of cycles for you to be rewarded. But it does badly come out of a bad bear market.

Stig Brodersen  35:46

I’m going to shamelessly advertise myself here because I’ve written a few blog posts about momentum investing and value investing and why I am still a value investor and not a momentum investor. So, I would make sure to link that in the show notes. But the thing is interesting because if you’re into quant investing, you might also come to a point where you don’t care if it’s because of a value factor or if it’s because of that momentum factor that you outperform the market.

Now, I’m curious to hear your take, Toby, because you’re, first of all, you’re smarter than I am. And you’ve been studying momentum a lot more than me. So, being 100% value guys, in my opinion, like, have you changed your approach to quantum investing, and include momentum investing?

Tobias Carlisle  36:28

Thanks to God, I don’t think that I’m smarter than you at all, but I’ll tell you what I’ve had a little bit of an evolution, mainly from spending time with Pat, Wes, and Meb Faber as well. The thing that you find when you’re running a value portfolio is that it does have these periods of underperformance and this is a good year to illustrate that where the market is very strong. I say it’s the tail end of a bull market, but there’s no evidence yet that is, in fact, the case. It’s just a market that’s gone up a lot and has seemed to slow down.

I think you see value starting to sell off so badly. So, it started selling off six to 12 months ago. And I attribute that to *early guys serve this mean reversion function where they buy the stocks that have been up. But there’s a point where the market just gets too expensive, individual stocks become too expensive. And they don’t perform that mean reversion function because they don’t buy those stocks. After all, for them, they’re still not sufficiently cheap. And so, I think that’s why you see the drop in the value stocks. And so, it’s very helpful to a pure value strategy to have some momentum in it in a period like this because the momentum stocks have worked over the last six to 12 months. So, is that right, Pat? Have you seen that?

Patrick O’Shaughnessy  37:35

Yeah, for sure. I mean, it’s been like now a lot of is concentrated in just a handful of names: Facebook, Netflix, Amazon, and so on. But definitely, value has gotten crushed. And the more valuable your portfolio, the worse you’ve likely done. The more trend-following momentum, your portfolio, the better you’ve probably done. So, this has been one of the starker years since the late 90s for that inversion.

Tobias Carlisle  37:56

It’s a phenomenon that happens regularly enough that a portfolio that has that *planted in it, that particular article that Stig was talking about of yours. That was long only right. That wasn’t long-short?

Patrick O’Shaughnessy  38:05

Yeah. Just long.

Tobias Carlisle  38:06

So just being long-only and using, I don’t think you’re necessarily taking 70% stocks, you’re just using 70% factor blend versus value versus momentum, right? 30% momentum. It was the one that gave you the best Sharpe ratio. But it also had this effect that where value did *inaudible in the late 1990s. The momentum picked up that blend, so it didn’t crash as badly. And similarly, when late 2009, when momentum had the big crash, momentum underperformed. Value picked it up. And so, it doesn’t ever seem to win, but it doesn’t ever lose by much either. And it’s always in the best-performed group. So, over a period of time, it works best.

Patrick O’Shaughnessy  38:44

Yeah, I mean, the basic idea here is as investors what we’re trying to do is find stuff that works that has low correlations with one another, right? If you can find two things that work at different times. And that seems to be the case for value momentum that they are negatively correlated, meaning on a rolling three-year basis when one’s working odds are the other one is not.

Tobias Carlisle  39:06

That tends to be long-short run.

Patrick O’Shaughnessy  39:07

It works, if you have just an excess return of like a top… if you bought just the top 10% of the market by value of the top 10% by momentum. Just went long-only those two strategies, the excess return would have a negative correlation typically on a rolling through your basis. So, they’re dissimilar strategies. When you can find a stock that has good valuations, but it also has decent recent trends. So, a cheap stock that the market is just beginning to notice some catalyst, that’s tended to work pretty well in combination.

Preston Pysh  39:38

And I just want to highlight one other thing here, Patrick. So, what I find fascinating about what you guys are talking about is right now where we’re at in the cycle, momentum is doing well. Value is not doing nearly as well, but we’re now where maybe you could have this market completely changed around very quickly, and you could see those two strategies flip very quickly and very drastically.

So, for that person who’s listening and hearing momentum is doing good. And you’re late to the game and you start jumping on that bandwagon, you have to realize this is the point where cycles can potentially shift very drastically. And what could turn out to be the strategy that works well could be the strategy that you get punished with, if you get into it too late. And it comes down to this timing piece.

So, where I think, and this goes at the heart of Stig’s original question when you’re combining these two strategies, and you’re just doing it from a quant, and you’re doing this across a multitude of different picks, and you’re not trying to time it, you’re just saying, “Whatever happens, I’m going to, I’m going to stick with this strategy.” That’s how you can implement it successfully, but not picking one or the other trying to do this timing piece. That’s where I think people can get themselves in a lot of trouble as they’re hearing this conversation.

So, I just love that exchange. It’s the first time I’ve dove into any of this before and I’m assuming a lot of people in our audience have never heard this either, but just an amazing amount of information. So, with that said, Toby, go ahead with your next question.

Tobias Carlisle  41:08

Back to the, I think, Stig, you had a great quote yesterday, it was a Henry Ford quote, where it’s something like imagination without execution is a hallucination, something like that? like that’s backtesting is just pure sandbox toy playing, and the rubber only hits the road when you start implementing the strategy.

So, the question that I had is, did you have any backtest that you’re confident in that when you tried them, they didn’t work? And did it reveal something about either the backtest or the factor or that it’s interesting?

Patrick O’Shaughnessy  41:44

Yeah, so there are a few things and it’s a great quote that well describes backtesting because maybe the worst sin of backtesting is the false sense of security that imparts on potential investors. You see one of these four- or five-decades tests that shows 5% of your outperformance and consistent win rates and all these great stats. And it just makes it seem easy, right? And markets are just way too impatient for that. None of this is easy. It takes a tremendous amount of discipline and mettle for any of this stuff to work. And you know, a three-year period or a five-year period of underperformance seems like nothing if it’s you know, between 1980 and 1985. And it’s in your backtest.

But having now been doing this for you know, almost a decade and having lived through myself, a lot of money professionally managed in these strategies and having lived through periods of underperformance, I can tell you it is extremely difficult to stick to your strategy when it’s not working.

 

And because there’s more and more backtesting coming on, and more and more strategies that seem like they work historically, it’s going to be easy for investors to hear the hot new backtest. Now it’s not going to be the hot new stock. It’s going to be the hot new backtested strategy that people will jump between and over train and do all the same since they did it in individual stocks.

So, for anyone listening, I would urge you to use backtesting as a useful tool. And it’s a great way to find good strategies. But the more important thing is to come up with a basic strategy that you can stick with and believe in, and then just never change it, because I guarantee in three years, a guy like me is going to publish some great new factor or some great new strategy. And it’s going to be tempting to say, “Well  I liked the value and momentum combo, but it hasn’t worked for the last five years. And this seems more interesting. So, let’s go into that.” And I guarantee it’ll be missed time.

So backtesting is useful. But just be careful. It’s more about finding something that makes sense and that’s worked historically, and then just sticking to your guns for 20 years. So, just that that big caveat, because I think that’s so important for potential investors in these strategies, in terms of stuff that hasn’t worked when we’ve expected it to.

43:49

I think a lot of quants would give a similar answer even though it’s become a popular new category, and I’ll call it broadly quality factors. So, things like return on capital or return on assets return on equity, different measures of margin. You know, there’s a lot of different ways of looking at quality, low volatility of earnings, things like that. And what we find is that these factors are somewhat useful, but they’re not useful in the way that sounds good.

So, you often hear people say, like the Warren Buffett your guys’ expertise is around famous billionaires who have been successful investors. So, Warren Buffett’s mantra is to buy good companies at good prices, and or at least the major stage of his investing strategy after he got over the early Ben Graham stuff. And it doesn’t work as well as just pure value or momentum type investing quality.

What we find useful is to avoid the absolute worst stuff out there. So, companies who have horrendously suspicious cash flows, they’ve got you know, say great earnings, huge earnings growth, but no cash flow growth. So, it’s all coming from accruals or something like that. Weird stuff going on with their investors. There are all sorts of these little earnings quality things you can screen for that it’s helpful to avoid a very small group of stocks. But it’s not helpful, historically, or hasn’t been to buy the absolute best balance sheet,  the absolute best return on capital companies, the absolute best earnings quality. That sounds like a good strategy and you hear a million value investors say but good companies at good prices, but it would probably be better served just going with the part of the good prices.

Preston Pysh  44:46

Hey, so Patrick, you have this fantastic blog called The Investor’s Field Guide. And for anybody that wants to look this up, it’s the InvestorsFieldGuide.com. The site is 100% free and full of comprehensive ideas and thoughts on quantum investing among many other topics that you cover. Tell our audience about your site, but more importantly, why do you do it for free? I mean, why do you put all this information out there and share everything that you know and just to help people out? I’m just curious about what motivated you and what put this passion that you have for investing in this website.

Patrick O’Shaughnessy  46:01

Well, people learn a lot of different ways. I happen to learn by writing, some passion is reading, I love to read. I’m a huge reader, like, we’ll talk about books in a few minutes here. They always do it on your show, which is great. But where I learned something, and it can get a concept or an idea down is by reading a lot, and are doing a lot of hands-on research, and then trying to put it into a cohesive, comprehensive, and understandable narrative.

And so, it’s just like an outlet for me to do that in public. And it creates a fun interaction with other smart, interested investors who want to talk about these ideas because it creates a forum for engaging with other smart people. So, I just think about it as like my learning in public. And sure, it’s all free, but I’m getting a lot out of it. And I also don’t publish everything you know. So, there’s certainly, with more and more people doing these kinds of strategies. I don’t want to say that value has become a commodity because it’s hasn’t. There are a lot of nuances to value investing.

But with more and more people doing plain vanilla value investing you don’t want that as a value investor, you want as few people doing your strategy as possible. So, I’m not published, I say me, this is me and this is our whole firm, it’s a big firm, and I’m guilty of using the word I too often. But our firm, in general, is going to keep some stuff close to the vest. But I think that sharing information and educating investors is a good thing because we’ve also learned that no one is going to be able to stick with these kinds of strategies unless they know a lot about them and are well informed.

And that’s our responsibility as asset managers are not just to pitch a track record, many of which are good, but to say, “Here’s why it’s going to keep working. Here’s what we’re thinking about. Here’s all this psychology behind why this stuff works.” So, I think to share all that is self-serving is a way for us to learn, and it’s a way for investors in these kinds of strategies, to build the confidence to stick with them when they bandwidth and this year is a great example.

Tobias Carlisle  48:03

It’s very Buffett like. Buffett has said about his end of the year his shareholder letters that he doesn’t know what he thinks until he writes it down, which I always found interesting, because it is so insightful, that he doesn’t order his thoughts until he puts them down on paper.

Stig Brodersen  48:17

Yeah, we are the enemy of Patrick here. Like the three of us, we promote value investing and tell everyone to start their own value investing career. So, we’re not good friends of Patrick, I’m sure.

So, Patrick speaking about books. We’d love to provide great book recommendations to an audience and if you could recommend one or perhaps more books to audience that is not your own, “Millennial Money” or your dad’s “What Works on Wall Street.” Do you have any great book recommendations?

Patrick O’Shaughnessy  48:47

So, this is a hard question for me because what may be the most successful part of the whole website that I started was a little side project within the website. That’s called the Book Club and I’ve always read probably  I have a one and a half kids now. But before I had kids, I probably read 150 books a year, and even now I probably read  80, 90, 100. So, I’ve always read a lot. And people have always asked me for book recommendations. And so, I figured that I would create like an email list and just once a month, send out three, four or five different books that I liked, and some reasons why and build a little narrative around it. And it’s become interesting because it’s about 5000 people now. And whereas it started with me pushing recommendations, it’s now become my main source of getting recommendations for books myself. So, it’s completely inverted where I don’t have to search for books anymore, because every month I ask if you’re reading something good, let’s email about it. So, it’s very hard for me to pick just one.

So maybe what I’ll do is I’ll cheat a little bit and inspire to do so based on something that Toby just said or Buffett. And so, what I recommend is a group of essays by a guy named Paul Graham. So, Paul Graham is an entrepreneur philosopher and started a company called Y Combinator, earlier in the 90s, a company that helped businesses put their businesses online, like early e-commerce stuff. All of these essays are free. And a small portion of them is collected in a book that’s called “Hackers and Painters.” So, he’s been doing this for a long time. And he is probably my favorite writer, over the at least of people that I’ve discovered in the last three or four years.

And the reason is that he’s a philosopher. He’s teaching people how to think about business about competitive advantage. Probably, the best essay to get people started to see if they like his style is one called “What you can’t say.” So, it’s like him walking you through basically a way to find contrarian ideas. So, this whole thing about Peter Thiel’s “Zero to One,” which is another good book, is you want to find a contrarian idea. Same thing with investing, you want to find a strategy that nobody else is doing. How do you do that?

Preston Pysh  51:00

You know, Patrick, it’s funny because I think it was in Tren Griffin’s book on Charlie Munger that I read this. They were talking about how profound Charlie Munger is and his ability to just dissect things and just intuitively understand how things function and work. And they attributed to this idea that you’re talking about where Charlie studies so many other things outside of value investing, in finance and things like that. And so, he studies physics, he studies all these other things. And a lot of people would tribute his ability to understand how finance and business work so well because he’s ventured out and thought about things in that same exact manner. So, I love those book recommendations. I’m excited that your first recommendation is for free online. So, just go to our show notes, you can click on that link, and we’ll have exactly what Patrick was talking about so people can go directly to that.

Preston Pysh  52:22

So, at this point, we want to go ahead and transition into the question from our audience. This week’s question comes from Hugh.

Hugh  52:29

Good morning, Preston and Stig. This is Hugh Nguyen, a second-year mathematics student at the University of Waterloo, Canada. Thank you so very much for providing such high-quality information about the investment world. I truly appreciate your work. Today, my question is about the importance of the interest rate in the current economic condition. According to what I read in the Bloomberg lab in my school, the US inflation rate is struggling to meet the 1% range which is abnormal compared to the ideal inflation rate of two to 3% annually. What is the reason for the Fed to raise or not to raise the interest rate at this point? How does it affect businesses within a country as well as the global economy? Can you also explain why the dollar will get stronger as the Fed hike the interest rate? Thank you so very much for your time, and I look forward to hearing your answer.

Preston Pysh  53:26

All right, Hugh. This is a fantastic question. And I’ll tell you, you got the smartest people in the world trying to figure out the answer to it.

Preston Pysh  53:32

I can tell you this, this is my concern. If rates continue to get polarized to zero, my concern is that you have a total manipulation in the markets for basically accounting for risk and paying a premium for risk. So, as that continues to happen, and you look over Japan is a perfect example of rates that have literally been at zero percent for a decade at this point. How are people able to lend money and assume what risk is occurring appropriately whenever you have so much government interaction, manipulating the markets? That’s my concern. I don’t know what the right answer is. And I know that if the Fed would start raising rates, because you don’t have much growth, and you don’t have much investment coming from… Basically, you don’t have that growth percent occurring within the country. If you do raise rates above that growth rate, you’re going to cause a major downturn in the market. And that’s the big concern at this point. And that’s why the Fed is so hesitant to raise rates, but I do know that you can’t let it continue to go to zero because you’re throwing things completely out of whack. And this is a concern that everyone has in the world. And I don’t know if we have a good answer for you. But I want to hear Toby, Stig, and Patrick’s comments. And we’ll start off with Patrick.

Patrick O’Shaughnessy  54:43

Sure. So, this is the topic that we get asked about the most. And it’s probably the one that we have the least to say about because I think it’s very difficult to predict what’s going to happen. So, all we can do is position ourselves to be diversified in our portfolios in a way that will react well to a steadily rising rate environment, or to one that just is the status quo that continues to look like what we’ve seen.

I think one of the dangers with debt being as cheaper, money being as cheap as it is, is *inaudible reversals in the kinds of companies that do well in terms of how they use debt. So, over the longer term, companies that are aggressively using debt, issuing a ton of net new debt in the market relative to their cash from operations and other cash flows, have tended to underperform pretty badly. That has gone away in the last five years. So, those companies have outperformed because money has been so cheap. It’s been smart to aggressively use very low-interest rates from a company standpoint. We don’t think that that means you should go buy high levered companies, but it does show that different strategies work at different times and you should be diversified.

The good thing to know is that in let’s say we get one of those rising rates environments, we have 17 or so of them that we can study back to the 1930s. In across those 17, the way we defined it was a move of 1% up or more by the change in the yield on the 10-year Treasury, US 10-year Treasury. And so, during those 17 periods, how often did value investing do well? Value just simply defined as the cheapest 10% of stocks versus the market. And it outperformed in about 14 of those 17 periods by an average of about 4% or so annualized. So, pretty consistent with its long term, outperformance numbers, but quite consistent numbers. 14 out of 17 is pretty good. The major one where it was a loss was the period ending 1999. And we all know what was happening then with value investing.

So, I think having some value in your portfolio would be smart. And I think that momentum which has done well in this lower interest rate, recent market past. Momentum has done well in the opposite scenario would be a great balance.

Tobias Carlisle  56:56

This is just my personal opinion. I think macro is hard. And there are two reasons why it’s hard one is I think it’s  … it reveals politics more than anything else. Its politics dressed up with numbers dressed up as math and made to appear more rigorous than it is. But some guys are still trying to invest based on macroeconomics. And so best interested in the politics of it and looking at what the data underlying reveal, and you have to get so many things right in theories, that if you get nine of these difficult questions right, and you get the 10th one wrong, then you still end up being wrong on a trade like that.

And you can look at lots of examples. So, Kyle Bass with Japan has this phenomenal analysis a few years ago, where he worked out that the BOJ would have to stop *dissaving. The Japanese household would stop saving and buying Bank of Japan notes until it starts selling at that stage, it would cause weakness for the yen. And he came up with this great theory for shorting the yen at that stage and it didn’t work. And the reason is that the BOJ stepped in and started buying Bank of Japan notes at that stage. So, that reveals the difficulty of it, but most people in positions of power, politicians and central bankers don’t just stand there and let these things happen.

Concerning the US interest rates are close to zero. The question is, is the data correct? Is the data correct? Is the inflation rate being that low? Perhaps the way that the CPI is measured, the CPI is just a measure of inflation. It’s not inflation itself. Inflation is a much broader measure than that. I have no idea what they’re going to do or how they’re going to do it or what the impacts will be if it occurs. And I just think sometimes time spent worrying about it is time that you could be better served, trying to work out undervalued stocks or finding a strategy that you can stick to, my two cents.

Stig Brodersen  58:43

My take is not so much about whether or not the Fed will hike rates or not. They must do it at some point in time. I don’t know if it’ll be December or whenever that will be. But I think I will respond to the last question you have about why the dollar would get stronger if the Fed started to hike rates. And it’s a question about like, where can people get the highest return if everything else equal. People would be able to get a higher return if there was a higher interest rate in America. And the way to think about this is that the demand for the dollar will increase and the currency is just a supply and demand thing. So, if there’s a higher demand, then the price, which will be the exchange rate, will increase as well.

But again, that’s something we teach in macroeconomics. A lot of things can happen so you won’t necessarily see that the dollar will strengthen. You might as well argue that if it didn’t, the economy would be better off which will also increase the demand for dollars, and then you will have a stronger currency. So, there are so many things happening but everything else equal, yes, you’re right. The dollar should get stronger if the hike rates.

Preston Pysh  59:47

All right guys, that’s all we have for this question here. Hugh, we’re going to send you a free signed copy of our book, the Warren Buffett Accounting Book. And for anybody else out there, if you want to get your question played on our show, go to asktheinvestors.com and you can record questions there. And for anybody who gets their question played on the air, we’ll send you a free signed copy of our book. So, we want to thank Patrick for coming on the show.

Patrick, if people want to learn more about you or dig into some of the things you’ve done, how can they reach out to you and find you on the net?

Patrick O’Shaughnessy  60:14

Probably the easiest way is to go to investorsfieldguide.com or just search for Investor’s Field Guide. It’s should be you know, one of the first couple of hits on Google. That will have a lot of writing links to that book club I was talking about, links to the book, and I think I even had my email address on there, someone, so if people want to get in touch with me, that’s the best way.

Preston Pysh  60:33

And Toby, how about yourself?

Tobias Carlisle  60:36

The best way is either through https://greenbackd.com/ or acquirersmultiple.com. There are forums on Acquirer’s Multiple that I weighed into and chat about individual names, strategies, and other things like that.

Preston Pysh  60:47

Fantastic. That’s all we have for you guys. And we’ll see you guys next week.

Outro  62:45

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.