3 February 2018

Through research and much backtesting, Dr. Gray has found that a hybrid approach of momentum investing and value investing has provided the most comprehensive returns. On today’s show, Dr. Gray explains some of the concepts behind the way he looks at both approaches.  More importantly, he teaches the audience how to combine the two approaches into a single strategy.

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  • How and why to follow a trend in the stock and the bond markets.
  • What the biggest mistake value investors make by not including momentum in their strategy.
  • Ask The Investors: How do you build your fundamental knowledge in micro and macro investing?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:03  

On today’s show, we bring back a popular guest, Dr. Wesley Gray. We first got introduced to Dr. Gray through a member of our Mastermind Group, Toby Carlisle, because they co authored a book together called “Quantitative Value.”

The book is a popular read among value investors because it takes decades of data and provides clues into the best metrics to determine when companies are oversold and potentially undervalued. This is commonly called back testing. 

The interesting thing about Dr. Gray is that he’s also conducted extensive research into momentum investing as well. And so, based on this research, both on the value investing side and on the momentum side, he has taken a really interesting way to invest, which is a hybrid approach to value and momentum. 

On today’s show, we’re talking to Dr. Gray about some of the interesting trends he’s finding in the market today. We also talk about areas where an investor can improve or challenge their current belief structure. Finally, Dr. Gray talks about the way he accounts for systematic risk and how he might hedge a market during challenging times.

Intro  1:09  

You are listening to The Investor’s Podcast where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Preston Pysh  1:32  

Wes, we always have so much fun when you come on the show and chat because you always just have a tendency to show us different ways to look at things. We are very excited to have you back on the show. Thanks for taking time out of your day to be with us.

Wesley Gray  1:46  

It’s always an honor. I’m humbled to be here again.

Preston Pysh  1:52  

I’m sure everyone wants to kind of hear Wes Gray’s opinion on where we’re at in the market because the last time I checked this thing was starting to go parabolic. I’m just kind of curious what you’re thinking. 

Wesley Gray  2:04  

Sure. There’s a difference between what I’m thinking and what I actually do because as you know, I am a quant. I’m a fundamental dude wrapped in the quants equilibrium here. 

What I think is that the markets are insanely overvalued. It’s crazy. I have been expecting to crash for five years now but that hasn’t happened. That’s why I don’t think so. I use machines. We’re big trend followers. 

Markets are moving and trending, we own it, essentially buy and hold. To the extent these markets keep trending, we’re in. Valuation isn’t relevant to how we think about owning beta-risk, basically.

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Stig Brodersen  2:53  

Wes, I guess what you are saying might come as a surprise to a lot of those who have followed your early years. I mean, you literally wrote a book about value investing. When you’re saying you’re doing trend following, is it only on value picks or is it basically on every pick out there, even though they have high multiples?

Wesley Gray  3:13  

Yep. So it’s a great distinction to make clear. aA the stock selection level, we’re buying cheap, high quality, right? Right now, in the US, the average EBIT yield on our stocks, which is kind of how we look at the market, is essentially your operating income over your enterprise value. That basket is by around 10 to 11, versus the market, which is around five. 

We’re buying cheap stocks straight up because we’re hardcore value investors, but embedded in any investment, unless you’re market neutral is the beta bet, right? If you’re long stocks, whether they’re cheap stocks, expensive stocks, or anything in between, if you have market risk embedded in there.

How we think about timing the market risk component of what we do is based on trends. For example, we buy the cheapest dirtball stocks out there that we can find. There’s plenty of them even in today’s markets, but how we think about whether we want to be long only or hedge, it has nothing to do with valuations and everything about trends. Right now, we’re long, cheap, quality stocks. We’re not in a hedge position. We’re not long, short or market neutral.

Preston Pysh  4:26  

Let me ask you this. So let’s say the trend starts to shift. Let’s say we’re three months, four months later, or a year later, whatever it is, and you start to see a statistical change in the trend. 

First of all, for you to start saying, “Hey, this trend is over” or “we think this trend is reversing,” what are some of the things that you’re looking at to be able to make that determination?

Wesley Gray  4:51  

It’s very simple. So we use basically two rules. First one is just the long term moving average. For example, the current price on S&P,  if we’re talking about domestic markets, relative to the 12 month moving average. If it’s above, great, keep owning value stocks and momentum stocks. If it’s below, that signal says we need to be hedged.

The other signal is called time series momentum or absolute momentum. If you guys know Gary Antonacci, he has a great book, “Dual Momentum”, where he kind of talks about this concept.

We use one element of dual momentum, it’s just literally the current human return on S&P, relative to the cumulative turn on the T-bills, basically, if it’s positive. Otherwise, you’re hedge. 

We have those two signals. We’ll assess them every month. If both say good to go, we stay long. If they’re 50-50, we’re 50% hedge. If they’re both saying, “Hey, you know, it’s time to jump off a bridge,” and then we’ll fully hedge the portfolio, basically.

Preston Pysh  6:06  

You’re completely short at that point?

Wesley Gray  6:08  

Yeah, so we’ll be long. We’re always long value in momentum names. But we’ll start layering down passive shorts, like SPY or EFA, or we’ll use futures to kind of pull out the beta component of the bet. So essentially, market neutral.

Preston Pysh  6:24  

What are the numbers for this past month when you did the analysis, just so the audience can kind of understand what you mean by what you’re saying there in actual numbers?

Wesley Gray  6:35  

Sure. So I don’t have the exact figures at the top of my tongue here. There has not been a trend break in either international or US equity for, I think, at least a year and a half at this point, if that makes sense. Because obviously, we’ve been in a massive trend. And so, we’d have to have a fairly substantial crash. It has to happen fairly quickly and robustly that hit a trend rule, basically.

Stig Brodersen  7:03  

Now, why do you use the one year moving average? Why not 200-days, 100-day, or say 50-day moving average.

Wesley Gray  7:12  

It doesn’t really matter, out of sample, whatever we’re using currently, is almost, there’s 100% profit it’s not going to be the one we should have used. But all we know is that ex ante and all the research we’ve done on this, as long as you’re in the general genre of long term trends, you could do 200-day or 356.25-days. We don’t really care. They’re all about the same. 

There’s a lot of noise around the signal, but it is robust to the concept. We just use that because it’s simple. It’s easy to communicate and it’s in the ballpark. It’s evidence based. 

Preston Pysh  7:59  

I would think that you would get yourself into long term gains, you would limit your short term gains by going with a longer moving average, like a year long. Like if you were at a 60 day moving average, I would think that you would incur a lot of short term gains, because you’re constantly buying and selling as it would move in and out of that mat out of that average. Is that correct? 

Wesley Gray  8:20  

That’s correct. It really depends. Trend following is not an end-all-be-all. For all intents and purposes, a long term trend following metric is basically buy and hold, because it’s long trend. And so, you’re kind of a buy and holder most of the time.

If you do shorter trend models, like the time the market reaches your point, it’s much more reactive, but it’s also going to cost you a lot more in frictional costs and taxes. It’s unclear to me if it’s any better for what we’re looking at, which is tail risk protection, versus a long term one, so why not use the one that is not as crazy and causes you as much brain damage all the time you use it?

Preston Pysh  9:03  

This can be applied when you’re doing this stuff? I mean, it because you’re really talking to straight price action, is what you’re paying attention to for hedging yourself.

Wesley Gray  9:11  

Yeah, just to be clear on that, because, as I understand what I’m saying is heresy to fundamental value investors, I still am that person, that shell of a person I used to be.

What’s important to understand here is that there was between stopping using value to pick individual securities. When you’re picking individual stocks, you want to be cheap and stay cheap, right? But then when you start getting into the world of macro and timing, market risk, i.e. overall market valuations, there is no evidence that I know of that’s very robust and that suggests that just because I know today that the market is at a 99 percentile valuation metric that it can somehow tactically help. We outperform basically a generic buy and hold proposition. 

We’ve tried a million different ways to cut that cake. It’s just an empirical fact.

Here’s what we do know. The one thing that can help you improve your risk return profile relative to buy and hold is trend.

What’s really important is that trend is what you want to pay attention to, especially when valuations are top heavy. You don’t want to time your allocations based on valuation alone. But to the extent that the trend sucks, and valuations are high, that’s when you definitely want to get the hell away from the market. If you want to take the risk of market timing, which I’m not saying it’s perfect, but if you wanted to do it, that would be the recipe for success, at least historically.

Preston Pysh  10:53  

Do you find yourself participating in other markets, so we’ve seen that commodities have just been crushed for the last three or four years? That’s had a very bottoming effect over the last year where they’ve been really flat and you’ve seen oil come back quite a bit recently. 

I’m curious, are you seeing a reversal? First of all, do you participate in other markets outside of equities, call it commodities? If so, I’m kind of curious to hear your thoughts on that trend reversing at this point, because it appears a lot when you talk to a lot of macro people, they’re all saying that they’re seeing a reversal in the commodities sector?

Wesley Gray  11:30  

Sure. So yes, we basically trade or have traded anything that you can possibly trade. Besides our equity business, we are a CPA and a CPO would trade man’s future. So we trade every future on the planet, basically. 

Again,  we are focused on trend and then the *inaudible* trade. So looking at backwardation and contango… Obviously, the trend was kind of mixed and all over the place. 

Recently, you’re pretty much long the commodity complex, especially in energy in the metals. It’s also backwards in the energy complex, which hasn’t happened in god knows how long.

From a quantum perspective, it’s great. Even from a qualitative perspective, if I can own trending contracts that also tend to be backwards versus contango so I capture role yield. The wind is back finally, but it has been in the past.

Preston Pysh  12:32  

Explain to the audience, the backwardation piece here, because some people might not be familiar with what you’re saying there.

Wesley Gray  12:39  

In futures contracts, essentially a return is determined, not really just necessarily by the spot movement, but also by what they call the term structure of the future. To the extent that the spot price is above the future price, that means the future is in backwardation, so what’s going to happen is over time, the future is going to roll up to the spot price. It’s called capturing kind of the role yield. 

Whereas if the current spot is below the future price, and you buy in the future, that future price will slowly kind of decay down to the spot price, which means you have a negative role historically at least in oil futures. 

For example, like last 10 to 15 years, because you don’t own a barrel of oil, you own a future in oil, typically, right? When you buy that sort of product out there… So you kind of own obviously the risk of the spot price that comes into play.

Like I say, our last recent memory, oil contracts have always been contango. You not only need oil prices to move up when you also need to overcome the negative role yield that you’ve been facing recently. 

But now, let’s just say the spot price stays the same, you’re still going to have a positive return on that investment, because now you’re capturing *inaudible*. That’s positive, which is cool.

Preston Pysh  14:08  

Awesome. Would you say that there’s statistical significance behind the momentum changing in commodities in general or would you just say that you’re starting to see it break through some of the moving averages that you track?

Wesley Gray  14:20  

Yeah, so for sure. We run both long trend models, which are basically like 12 month type ideas. We also run like a short term one that’s much more high frequency. It’s a 10-100 crossover type model. So it’s easier to compare 10 day versus 100 day.

However, if you look at the energy sector, for example, it’s pretty much raging on everything. I don’t even know its price. it really bugs 65 bucks right now or something, depending on which contract to look at. 

All signs are green, from a trend perspective. Right now on a carrier perspective, the same thing with equity like valuation based timing on commodities is a noisy, tough game. 

If you put a gun to my head and said, “Hey, are our commodities a better bet now than they were three or four years ago, when they were the coolest thing since sliced bread?” I’d say probably better now, because everyone hates them. Also, they got trend and they’re backwards. Being a contrarian in me, you know, I’d say commodities seem to be an interesting place to be.

Preston Pysh  15:30  

Yeah, Jeff Gundlach is really tooting that horn. He’s screaming, that’s the play of 2018, commodities.

Wesley Gray  15:40  

In our managed futures program, again, it’s just a quantum system, but this thing’s kind of built for crisis alpha. So it’s kind of saying, we’re probably moving to an inflation world by saying we’re short, the entire sovereign bond complex. We’re kind of long, a lot of the metals and energy sector, there’s a mixed signal in kind of like the weeds in the sauce right now. 

However, in general, I’d say if there’s going to be a crisis or surprise, it’s going to be an inflationary surprise, not a deflationary surprise. At least that’s what’s being shown and kind of managed futures land at the moment.

Stig Brodersen  16:19  

So you briefly hit on this. It really takes me to the next point that Preston and I wanted to cover, how do you look at the bond prices right now and the trend there because at least some of the billionaires that we follow have made some really crazy predictions of what’s going to happen.

Wesley Gray  16:37  

Yeah, I don’t know what the billionaires are saying but I do know that a lot of billionaires have lost a lot of money over the last four to five years because they’ve been saying that yields are going to go up forever. Now, they’ve been wrong. 

However, that’s why we don’t think we’re billionaires. We just follow models. Right now is finally a point in time where long duration, credit or not credit, the long duration, sovereign bonds, the trend sucks. And so, we’re starting to get short. 

Now it’s a situation where they’ve been overvalued forever, but as I mentioned, that’s not a great timing mechanism. It’s a sucker bet. 

However, when you have assets that have terrible trends, and you have a sense that they’re systematically overvalued, now might be the time to say, “Hey, maybe fixed income is not really a great place to be.”

Stig Brodersen  17:32  

On the short end of that. at least 10 years in *inaudible*, there might be a reversion happening. I don’t know if you see this the same way, Wes, or if your models would tell you otherwise. I’m very curious about your opinion on this.

Wesley Gray  17:46  

Yes, we only track all the 10 year sovereign bonds across the globe and they’re literally across the board short, which means they all have terrible trend, ie, the prices have been going down because the rates have been ballooning. 

[Therefore], if you’re someone who’s a long term bond bear, the trend is kind of confirming that. I’d say if you’re going to time that bet, in and take risk out of that bucket, this would be the time where it probably makes sense versus the last few years where it’s been getting in front of a steamroller.

Preston Pysh  18:22  

So if all that money’s coming out of the bond market, let’s just say that theory is true, and that that trend persists, and it moves forward for the next six months, and all that money comes out of the bond market?

Wesley Gray  18:33  

Well, I mean, in general, there’s always equilibrium, right? So even when bonds are getting sold, someone’s buying them. So the money’s still there, it’s just someone else’s owning it. It sounds like a simple question but that’s actually a really tough question. Frankly, I don’t know,

Preston Pysh  18:51  

The thing I like to ask really smart people like yourself, every time I get a chance to talk with you is, at least for the last quarter has been commodities because they’ve been just punished so badly over the last three years, where everything else has just performed so well. 

Then we’re seeing the bond market start to turn itself inside out. When you see the equity market going parabolic, you’re exactly right, this trend has not been broken whatsoever. This thing is still going strong and it might keep going strong.

Wesley Gray  19:22  

Yeah, you got it and you’ve kind of hit on what I call poor man’s managed futures. What  I recommend is if I wasn’t going to do a 60-40 because my advisor is just telling me that and charge me 1% to do that, even though it’s bad advice for my 40m I would say “Listen, I don’t know if we’re going hyperinflation or hyper deflation, but I do know that commodities and long duration bonds are kind of the barbell trade amongst those. I’m just going to follow.”

So commodities start getting picked up by a trend in treasuries or not. I’m going to start moving commodities for my diversification away from duration bonds. And in vice versa, if the trend tends to drift the other way, that right there is kind of a…

If you wanted to have a simple 60-40 that has protection in that 40, that’s not just deflation asset protection. You’d want to use commodities and bonds and just trend follow them across whatever one’s working best.

Stig Brodersen  20:21  

So how does the tax cut play into this? I mean, is giving the stocks, it seems like a lot of momentum? Is the market so much in momentum that it doesn’t really add anything or how do you guys look at it?

Wesley Gray  20:35  

When we’re talking about macro level stuff, we focus on trend exclusively. Obviously, it’s in the price, like the market is telling you this is worth a lot, which is why prices keep moving up. 

What does *inaudible* in that trend, because it’s probably the case, I imagine the markets don’t even fully appreciate just how big that could be. Now, that’s just also pontificating there and that we’re just focused on momentum. 

At the individual stock level, like in value land, the reason you buy cheap with margin of safety, is you bought cheap with margin of safety. Anything that could potentially be good has a huge spike. So that tax bill was great for value people, because value guys are buying dirt ball retailers. Then people that tend to pay a lot of high marginal tax rates and they just basically got their net income doubled, as they go from whatever a 40% marginal to 20. 

That’s a big deal, which is why like a lot of kinds of securities we’ve owned, which have been sucked. They’re on a ripping tear. But that’s more a function of if you buy cheap a margin of safety in the wind shifts, and you get lucky when they bounce back with that news, which in this case was favorable, they go rip it. 

However, I could have never predicted that and I did it. My only thing is just buy cheap and that works. So other networks, we don’t really incorporate it into our thought processes that much to be honest.

Preston Pysh  22:07  

Wes, I want to talk about one of your ETFs. Wes’ company has an ETF. It’s QVAL. And this is correct if I’m wrong, if I’m explaining this wrong, but this ETF is basically purely based off of your book quantitative value that you did with Toby Carlisle, as far as EBIT-to-enterprise value is how this is making its selections. Is that correct?

Wesley Gray  22:32  

Yeah, for all intents and purposes of the big muscle movements, you got it. It’s by the cheapest, highest quality stocks. Hold with conviction, don’t close the index. The cheapest is your point, enterprise multiples. That’s kind of a core driver of what we do. 

Then within the cheapest dirt balls, we obviously won’t identify the highest quality of the cheapest. So yes, this is an area where I think there’s a little bit of disagreement, probably with Toby. We kind of like cheap, but we also want to have an element of quality in there. 

Preston Pysh  23:23  

It’s interesting, because whenever I look at the performance of this, compared to the S&P for the last year, you guys have outperformed the S&P 500 with this thing. However, if I go back to inception, from whenever it first started, you guys are underperforming, because you went through this period in 2015 that it was really strange. Like, you can see that everything is very closely correlated, for the most part to the S&P 500, except for this one little tiny spot in 2015 through really kind of the second half of 2015. If it wasn’t for that you guys would be you guys would be beating it since inception. 

I’m just curious: is there a way that you can explain what happened during that six month period of time or is that just how the numbers shake out sometimes?

Wesley Gray  24:26  

Yeah. Again, a little further history. So that QE strategy we’ve actually been running for five years, because because we got that *inaudible* amazing in 2012. We’ve always done this concentrated value strategy. We launched that at the end of 2012. Like all deep value guys, it went on an epic ranger, right? We were amazing. 

Then we got this bright idea for tax reasons like, “Hey, we should launch this whole ETF deal?” Of course, with perfect timing in my life, I launched the hedge fund back today, September 2008. We launched this ETF in late 2014. About five months before one of the most epic drawdowns ever in the EBIT, a factor killed by a lot of just… in the path of Amazon’s war war machine. We’re just being in bad retail bets, what have you…

But it just so happens that the ETF came up and a track record has started at kind of the pinnacle, right before it collapsed. 

Then, to your point, like the right last year, it’s been on an epic rage. It destroyed the S&P, but that’s just the nature of value. You’re going to look like a total genius. Sometimes you look like the biggest idiot on the planet. 

The only thing we know is you have to just hold her long haul, and be willing to be very different, if you plan on having even a chance of winning over the long haul and you’ve seen that empirically and the QE system.

Preston Pysh  26:03  

I’m curious if you have an ETF that you’d be looking for that would do kind of a hedging strategy. Is that something that you can even do with an ETF?

Wesley Gray  26:12  

You can. We run one that has a trend following component to it, where it’s long, the securities, but the extent the trend starts is not doing great. We’ll start layering in hedge. It’ll kind of move towards a market neutral stance. It’s kind of like a hedge fund strategy basically in an ETF wrapper, which, again, we do that for tax reasons.

Preston Pysh  26:38  

But it doesn’t do inverses at that point? 

Wesley Gray  26:40  

Not inverses. It literally shorts, because inverses are basically too expensive, capital efficient. Frankly, my opinion it is stupid. 

I understand why people sometimes do it in an IRA, because you’re not really allowed to short, but it’s much more cost effective if you want to hedge to either short… Sell a future or sell like SPY short, as opposed to buying an inverse, because that’s what they’re basically doing.

However, they’re charging you every 10%. It’s just not a smart idea. It’s much better to do it directly. 

There’s a few others like Pacer ETFs. It has some pretty cool products that can go to hedge status. I think you’re going to start seeing that. That’s going to be a new frontier where right now in ETF land, kind of the product innovations always have been, originally just closet index things. Then they had a little small, smart beta factor.. but basically closet indexing.

We kind of led the frontier on doing concentrated factors. I think the next frontier is going to be kind of basically moving all the hedge fund type strategies in their kind of unique risk profiles into the ETF wrapper, which is going to be great because it will be tax efficient and more accessible at a cheaper cost for a broader base of investors out there.

Stig Brodersen  28:02  

Let’s take a step back from the big markets and the big movements in the madness that we’re seeing right now. Talk about the individual investor, and perhaps they are just starting to get their feet wet. What do you think, Wes, with your experience, the two biggest mistakes that you typically see are best to conduct? What can they do to correct them?

Wesley Gray  28:21  

The biggest one is just the too good to be true problem is a lot of people that get into investing, they get real excited. Bitcoin is a great example. They’re like, “Oh, this is easy. You just buy this thing, it goes up 1,000%.”

So just the number one mistake is just not understanding that when you go into a market, you are fighting with grizzly bears and 200 IQ people. They’re trying to feed their kids. So it’s super competitive, super hardcore. Going in with the expectation it’s going to be easy, or there’s some kind of magic free lunch out there, I think is the number one mistake. 

It is kind of on the flip side of that. The number two mistake is that if you want to be disciplined if you’ve got the right temperament, and if you’ve got the kind of emotional capability to not succumb to crazy behavioral biases, to assume that you can’t beat the market. 

So it’s kind of an irony like on one hand, assuming you can beat the market. It’s easy money and everything’s too good to be true. Let’s just do it. That’s one problem. 

But on the flip side, if you do have the temperament just assuming that the markets perfectly efficient and what’s the point, it is also kind of stupid. If you have the temperament so those are kind of flip sides of the same coin, but they represent two mistakes that a lot of people just get into business or just starting succumb to I think

Stig Brodersen  29:57  

To take this discussion further, you have this camp of hardcore value investors, like the Warren Buffett investing philosophy type and you’re looking straight at the fundamentals like what Preston and I are doing. Perhaps not looking too much at the momentum, the trend and what’s happening in your alley. What is our biggest mistake in that considering your vantage point?

Wesley Gray  30:25  

Well, first off, I just want to clarify that just because I personally believe in momentum and trend, that’s something that I understand. I have confidence in it. Because I have the confidence in it, I personally have the emotional ability to stick to it.

However, it is totally inappropriate for people that just think it’s total baloney. So that’s cool. It’s not me telling that’s what people should do. It’s just that what I do may not be appropriate for everyone. 

It’s kind of a tough question because if you’re a value investor that thinks that everything I just mentioned about trend and momentum is total horse manure, that’s totally fine. 

In some sense, you could argue it’s a mistake, because based on the evidence, it’s very clear that these are probably… I guess, ideas that are just as well evidence based and ingrained in the marketplace is deep value investing is.

However, on the flip side of that, because you’re not confident because you think it’s baloney, it also would be a mistake to do it. It’s kind of like this weird irony where on one hand, they’re wrong, because it’s just the facts of life on their hand, because you think it’s wrong. It would also be wrong to actually do the strategy because the minute they started doing it, they’d be like, “See, it stopped working.” 

It really all boils down to your temperament for the process that you’re following. If you can’t stick to it, then just don’t do it. 

Preston Pysh  32:07  

It’s interesting, because I was going to ask you what the mistake of a lot of momentum guys that are just strictly momentum traders, what would be their mistake? I’d imagine you’d answer the exact same way that they don’t have fundamentals into their approach, but it’s also the irony involved with that. Would you agree? It’s just the inverse of what you just said?

Wesley Gray  32:26  

Exactly. The bottom line is everyone’s got great ideas, but people get emotionally attached to their ideas. So it prevents them from kind of thinking outside the box.

However, once they become emotional about ideas that are outside their box, that’s also where the behavioral problems come in. This kind of circular logic where you weren’t smart enough to realize that you should be doing it, but because you’re not smart enough to realize that you should be doing it. Because you have an emotional attachment to some other religion, if you were to go do it, you would actually end up screwing yourself up anyway. 

It’s kind of what they call a second best equilibrium outcome, where first best would just be purely evidence based: do what the data say, do what gives you the best chance of you know, long run after tax after fee compounding. But that’s not reality for most people. So then it’s the second best solution of giving your behavioral problems, what optimizes? That’s what most people do, which is cool.

Preston Pysh  33:32  

Awesome. Hey, I was looking around on your site recently. I see that you have a new tool platform where people can filter results based off of EBIT-to-enterprise value, which I know is a very useful metric for trying to find undervalued companies, but it seems like your filter does this for ETFs. Is that correct or does it do it for individual companies as well?

Wesley Gray  33:55  

This tool is in beta right now. If you go to newtools.alphaarchitect.com, you can sign up. You have to verify your financial professional. And so, to the extent you deem that you have that label and go for it’s free, but what we’re trying to solve for there is making sure that people understand what they’re buying and why they’re buying it. 

It basically gives you deep X ray, look into the underlying holdings of ETFs, where you can like if someone says, “Hey, I’m a value fund,” well, let’s go source your securities and look at how every individual security maps out on value, like did you actually buy cheap stuff or do you just cause indexing? 

This tool will be able to directly analyze that. I don’t know if you even had a chance to look at it, but if you can click on individual securities in an ETF portfolio, it’ll drill down to the stock level. It will give you all the factor analysis, but if you’re an individual stock person, you can look at an ETF. If it owns a security you are interested in, click on it. It’ll drill down to that level of detail.

Preston Pysh  35:12  

What I like about this Wes is when you go and you do research on Yahoo Finance or a lot of these different platforms, and you’re looking specifically at an ETF, it’s really kind of hard to maybe find some of the information on even a PE ratio. Sometimes you can’t even find out what the PE ratio is for an ETF, but looking at your tool here, this is incredible, because you guys have a lot of data.

Wesley Gray  35:36  

Yeah, we think it’s going to be kind of life changing. From a transparency standpoint, and we’re trying to keep its architecture open, were you looking at tools like we don’t care if you are a Vault investor momentum investor. We have like 20 or 30 different characteristics that you can analyze, based on the holdings. All the data is there.

Preston Pysh  36:26  

Wes, last time we had you on we played a question from the audience when we got your feedback from the question, or you answered the question. So today, we’re going to do that again. This question comes from Nate. He’s out in Silicon Valley. 

Sender  36:41  

Hi, this is Nate. First, I just wanted to say thank you so much for putting on this podcast. I’ve learned a ton from listening to you guys. Thank you very much for putting this up every week. 

I found that when learning something new, you need to start by building a foundational knowledge base, a strong basal understanding of how the fundamentals work, then as you learn new things, because you already have this foundation, you know exactly where to put any new knowledge. You can see how it relates to everything else. 

As someone who’s fairly new to investing, I’ve learned a lot of things that are point learnings, but I haven’t yet formed a foundational knowledge base upon which to build and place each of these point learnings. What would you recommend as the best way aside from your podcast, to build that initial foundational knowledge base, both for investing knowledge and for broader macro economic knowledge?

Preston Pysh  37:32  

Fantastic question. By the way, I really liked this question, but I want to hear what you think, Wes.

Wesley Gray  37:38  

Yeah, I concur. It’s a great question. I don’t think it has a simple answer, because you could take it many different ways, but I’d say if you want to get in the weeds on the micro components of fundamental valuation or stock selection, unfortunately, you have to go to the well. Stick to things like Security Analysis, Intelligent Investor, even though I know they seem like old books.

However, I think that’s just a great baseline fundamental framework for figuring out how to value a stock, like the classic methods. Now, if you move beyond the micro on valuation, if you google around, there are like 100 resources like Khan Academy who almost certainly has great resources. There’s this good old thing called Google. 

Preston Pysh  38:50  

So I completely agree with Wes on the Security Analysis, Benjamin Graham, all that kind of stuff is really good for the micro level. However, for a person who’s coming into this fairly new, Security Analysis is probably going to be a little difficult to go through, depending on if you’ve had business classes or what like how much accounting experience you have might make it difficult.

Wesley Gray  39:12  

Yeah, you need an accounting background. Well, here’s another thing if you’re coming in new to investing, I mean, frankly, it probably means you’re not going to be like a stock picker. Like that means you’re a recovering professional. 

So if you’re coming in new, it’s really about more high level frameworks. We have the facts and framework like know your liquidity, know the complexity, the taxes, because you’re probably going to end up just buying a Vanguard fund anyways.

So really, if you’re going to get into the micro weeds, the reality is it’s painful and it requires you to basically read that kind of stuff a lot of you so it just is what it is. I mean,  if you don’t want to be a professional for someone who dedicated their life to the trade, and you really are just kind of someone who wants to learn about investing and how you’re going allocate your portfolio down the road, you may not even want to go into that level of detail, because it’s just going to make your head spin and it’s not going to be worth it.

Preston Pysh  40:12  

I’m curious about this Wes and I know I’m changing gears away from the question, but we were talking with Shane Parrish. I asked Shane if he had a choice between the Intelligent Investor or Margin of Safety. If he had to pick one or the other, which one would he pick, he said, Margin of Safety. I tend to agree with him. I’m kind of curious if you enjoyed that book as much as we liked it.

Wesley Gray  40:34  

Yeah. I mean, I agree, but the problem is to buy that book for like 1000 bucks. That one’s more like the access. But yeah, *inaudible* is much better at, I think exposition and kind of storyboarding it where it’s more tangible. Whereas Intelligent Investor is boring as hell, frankly, but it’s like eating your brussel sprouts. 

Sometimes the things that are good for you aren’t exactly easy or fun, but they’re still good for you because I’m a big fan of it. But you’re right Margin of Safety is also a great resource to the extent you can access the manuscript somehow.

Stig Brodersen  41:11  

I guess for me when it comes to micro, I mean, obviously, you can have and find books that are very quantitative. You have a lot of key ratios to look at and a lot of accounting to look at. 

One of the most recent books that we read was called “How the Mighty Fall” by Jim Collins. I wouldn’t say it’s the complete opposite of what you suggested. There are a few key riches in there, but it’s a very different approach to understanding why companies fail with this, at least in my opinion, one of the best approaches is to understand.

On the flip side, why companies are successful and why you want to invest in them. Not only in terms of making the decision on the stock, but also to follow the progress and not just look at the numbers, but also look much behind the numbers, and perhaps consider when you should sell.

Preston Pysh  41:57  

To answer his question about macro. I think that one of the most profound reads that I’ve ever had on macro came off of Ray Dalio’s website. I’ll put a link to it in the show notes. But Ray lays out his principles for basically macro and the way that he thinks about it. 

A lot of it is based off of the video that I’m sure most people know about by now, there’s a 30 minute video that he has on YouTube about how the economic machine works. I would highly recommend you watch that. We’ll put the video into the show notes as well. The PDF that goes along with that, I want to say it’s like a 250 page, white paper, on his opinion on how macro works and how it all fits together. That is hands down the best thing that I’ve ever read on macro that’s out there. 

Wesley Gray  42:48  

I’ll second that motion because I agree that guy’s obviously a genius.

Preston Pysh  43:00  

Yeah. So Nate, thank you so much for this really awesome question. We really enjoyed talking about this one. 

Wes, thanks for coming on the show. I always have so much fun and you know what I want to thank you so much. 

Wesley Gray  45:46  

Always, always enjoy it.

Outro  47:06  

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