Episode #100: Elroy Dimson, “High Valuations Don’t Necessarily Mean That We’re Going to See Asset Prices Collapse”

Episode #100: “High Valuations Don’t Necessarily Mean That We’re Going to See Asset Prices Collapse”

Guest: Professor Elroy Dimson. Elroy chairs the Centre for Endowment Asset Management at Cambridge Judge Business School and is Emeritus Professor of Finance at London Business School. His research focuses on investing for the long term, and he and his co-authors have become well known for their studies of the investment performance since 1900 of financial assets in 23 countries and real assets such as wine, stamps, art and other collectibles. His publications, with several colleagues, on financial market history, endowment asset management, and responsible investing have been recognized by several awards. Books include Global Investment Returns Yearbook (2018* with Paul Marsh and Mike Staunton), Financial Market History (2017 with David Chambers), Endowment Asset Management (2007 with Shanta Acharya), and Triumph of the Optimists (2002 with Paul Marsh and Mike Staunton).

Date Recorded: 3/19/18

Run-Time: 53:36

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Summary: To celebrate the milestone of reaching 100 episodes, we’re thrilled to welcome Professor Elroy Dimson, author of Meb’s favorite investing book of all time, Triumph of the Optimists.

Per Meb’s request, Elroy starts by giving us a summation of his research history which led to Triumph of the Optimists. He had a heritage in producing indexes and began reaching out to researchers across the globe in hopes of accessing different data sets. Looking at all the aggregated data, it became clear that from a long-term perspective, people who had invested in risky securities at the beginning of the century had done very well. People who had bought bonds and T-bills had not performed as well. The optimists had triumphed.

Next, Meb brings up a quote from Elroy about a controversial finding regarding the lack of correlation between economic growth and stock market performance. If anything, the relationship was reverse. Elroy expounds upon this, telling us that if it’s obvious that a market is growing, that’s public information. You can’t trade that since everyone else knows too. So, if you investing in countries where GDP has been growing, that could mean you’re too late.

Meb steers the conversation toward valuation, market cap weightings, and home country bias. Elroy walks us through the market cap concept, touching on the historical Austrian empire as well as the Japanese bubble. This leads to a lesson in finance, which includes real yields today, the Gordon Model, the multiple people are willing to pay today (which is higher), and the takeaway that “high valuations don’t necessarily mean that we’re going to see asset prices collapse” – they’re a reflection of the low interest rates we have today.

Meb asks about bonds, and whether Elroy has seen another historical period of negative yielding sovereigns. When you look at real rates, how does it play out for future returns?

Elroy tells us that real (inflation adjusted) rates are better to consider than nominal rates. And it turns out, real rates have been lower. Negative real rates are not all that rare – what is rare is so many countries experiencing them at the same time. This dovetails into a conversation about inflation and currency hedging. Elroy provides some color on currency issues but notes that hedging is not required if you’re a long-term investor.

There’s plenty more in this centennial episode: factors… growth stocks versus value stocks… historical returns of housing… even stamps, musical instruments and the investment returns of a good Bordeaux.

How does it compare to that of equities? Find out in Episode 100.

Links from the Episode:

Transcript of Episode 100:

Welcome Message: Welcome to the “Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas, all to help you grow wealthier and wiser. Better investing starts here.

Disclaimer: Meb Faber is the co-founder and Chief Investment Officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.

Meb: Welcome, podcast listeners. Today is a big day for us as it’s our 100th episode. As Jeff and I were discussing how we might take this one, make it a little more special because of this milestone, we had the idea to see if we could grab, as a guest, the author of my single favorite investing book of all time. Fortunately, he agreed. So, today we are thrilled to feature the Chairman of the Center for Endowment Asset Management at Cambridge Business School. He’s also emeritus professor of finance at LBS. He has too many words and recognitions. Listed here is prolific writer, having written, as I mentioned, earlier my single favorite investing book with his two co-authors “Triumph of the Optimists.” Welcome to the show, Professor Elroy Dimson.

Professor Dimson: Oh, hi. Hello, everyone, who is listening in and thank you for inviting me to participate, especially on such a very special event, 100th broadcast.

Meb: As pointed out in the intro, you know, you co-wrote over a decade ago my favorite investing book. And a lot of our readers are familiar with your book because we’ve mentioned it in a lot of the podcast and blog over the years. But for those who haven’t heard of it or read, it maybe give us a brief overview of how you came up with this title and how in the world did you cobble together all this data.

Professor Dimson: Cobbling together makes it sound so easy. It was quite a lot of work. I’ll tell you how it started because it’s a curious mixture of plans and misunderstandings. For some years Thomas and I had produced a small cap index. We’ve generated that while at London Business School. It’s still produced every day. It’s the leading small cap index in the United Kingdom. We’ve done that as a follow-up to building a 100-share index which was adopted by… I should say we’ve done some of the development work on that, and that became the FTSE 100 share index. So, we had a heritage in producing indexes. But it was specifically the small cap index that we produced independently that persuaded the banks that we work with to distribute the index data to ask us to do something that was a little bit more ambitious for the turn of the millennium.

So, in 1999, we set about producing a project and we thought at first we would take our long-term indexes of the U.K. and add on what was already available for the U.S. and maybe a little bit more. And then we got a little bit more ambitious and we decided that for the millennium, 1000 years, we could get back 100 years for each country. And after contacting lots and lots of researchers around the world, we ended u,p including our own country, with 10 countries. And so it kind of pleased us that we have 10 countries each with a century of data and we published this book for the New Year 2000.

It was actually something which was privately published for peers in February 2000. It was called the “Millennium Book.” I don’t know whether you’re old enough to remember the millennium, but there were lots of fireworks and celebrations on January the 1st, 2000. And then some months later people started writing what would have been a terrible miscalculation. Because when you are one-year-old you celebrate your birthday at the end of a year. Well, the calendar was, one, when we recorded the new millennium, 1,999 years were behind us and we didn’t have 2000 years behind us. And so there were new arrangements put in place in London and many other cities for fireworks at the correct millennium date, which was 12 months later.

So, the idea was that at the end of 2000 we would be celebrating 2000 years of history on the current calendar. And so we had “Millennium Book 2,” which is the book which appeared 12 months after the “Millennium Book.” And it included many more countries because as we’ve gone around presenting the results in the “Millennium Book,” we discovered there were lots of researchers around the world who were doing similar things to us, that is putting together financial market histories for their own country. And they all thought that they were operating in isolation and didn’t realize that there was general interest in this. So, “Millennium Book 2,” again, was a private publication.

We offered that to Princeton University Press, which is one of the more prestigious financial book publishers, and that appeared a short while later. The question was, what do we call it? And what had become clear by then is, within our study of long-term investment returns, that people who had invested in risky securities back at the beginning of the 20th century had done very well. People had bought common stocks. Those are the optimists. Common stocks were a small part of the investment spectrum then. They had to form very well, and people had been more cautious and bought government bonds, government securities, T-bills and so forth. They’d had much worse performance. So, we saw the 20th century as the one in which the optimists triumphed, and so we called our book “Triumph of the Optimists.” And they recounted a century of stock market history, which had been very good for common stock investors, and it caught the public imagination.

Meb: That’s kind of the main takeaway of the book. And you tracked originally, I think, 17 markets. I think you’re now up to 26. And, you know, I think the challenge for a lot of investors when you look back at this past century is it’s kind of easy to, you know, think back and say, “Yeah, you know, if you just invested in 1900.” But the world looks so different then. If you look back in your book you have this great chart that shows the composition of the world market cap by country but also by sector. And the biggest sector in 1900 was rail, I believe, which is now probably less than…

Professor Dimson: Not only railroads in the U.S. but railways in Britain. Absolutely, they were bigger than all the other sectors put together in each of those two countries.

Meb: So, things look a little bit different today. Maybe talk a just briefly about some of the main takeaways. You mentioned that stocks, in general, outperform bonds, but there was also a pretty wide spectrum. Everything from South Africa that did really well, all the way down to, say, example Russia or China that shut down their markets altogether. Maybe talk just about any sort of broad takeaways and thoughts and anything that surprised you particularly in the end when you did the research and the data.

Professor Dimson: Well, many people have made the point to us that the markets then and the markets now are not the same. And, therefore, we’re not comparing like with like, and they’re right and they’re wrong. Here’s why they are right. The world changed a great deal. We document much of this markets, though they were relatively integrated at the beginning of the 20th century moved to being quite segmented from one another, and they did different sorts of things. And there were many types of businesses that exist today that didn’t exist then. We reckon that about 80% of the industries that existed in the beginning of the 20th century have disappeared today. Out of those that exist today, over two-thirds of those had not existed back in the year 1900. So, people who say that the world is different are correct. Let me take a break and talk about bonds because this will help understand equities. Bond markets in 1900 consisted of some bonds that had a maturity date which was quite short. Many countries had, as their longest bonds, a maturity of only six, seven, eight years. Other countries like Britain, long bonds all had a maturity of infinity. They were what we call consol bonds or perpetual bonds. But people nevertheless will look at a bond index and is rolled over, and the bonds you would end up with today for many countries are completely different from the ones you started wit,h and it doesn’t seem to trouble anyone. Let me give you another example which gets us halfway back to your question. If you buy a mutual fund, the composition of that mutual fund will change over time. If you buy, which you have bought any leading mutual funds 20, 30 years ago and you looked at the composition today, it would be very strange if it was barely altered because there are many industries that have come into existence, others that have declined.

And, in fact, if you look at the list of names of U.S. companies from a century ago there’s a book by Jeremy Siegel that plots through the company as a survivor. There’s very few that survive over the long-term. So, mutual funds change as, of course, indexes do as well. And so what we’re doing is we’re fostering a perfectly viable investment strategy. The same way as if you buy mutual fund, the mutual fund manager can keep changing the stocks that are in the portfolio, and the same is true of an index. In fact, unless an index changes over time it ceases to be of continuing value.

So, we use indices which are as broad as possible over the longest period possible. And so for the different countries for which we have data, some of these indices are very broad. Others are narrower because the hype of the market was a small market or because that’s the best that we can find. But we aim to have indices which cover a large proportion of each market. And they plot, therefore, the performance of common stocks just the same way as we follow over the last 118 years the performance of long government bonds, or treasury bills to the nearest equivalent, or inflation in those different countries. And we also produce some indices which are regional, for example, a Europe index or a World X U.S. index or a global index. And so those we include countries that disappeared. The two countries that are important that actually disappeared were Russia and China, where some of the assets may have survived but the ownership changed completely. So, in 1917 with the Russian assets that were held by shareholders belongs to the state but not to the original owners.

Now, for China, it was a more gradual process over the course of the 1940s, until eventually, shareholders ended up with absolutely nothing by the end of the end of the 1940s. And so when we construct a world index, for example, we bring in those countries, and there’s no survivorship bias in there. We bring them in at their original value and when they decline to zero the index declines. And when there’s an IPO in the 1990s as those two markets get to be bigger, they’re part of the world index, and so we capture those as well. So, we have histories for individual countries and for regions and for the world as a whole. It’s a fun project and it’s one that’s occupied us now getting on for two decades.

Meb: It’s awesome. So it’s funny though that you look back. You know, you originally published this the “Millennium Book” and then “Triumph of the Optismists” I think, in ’02. And then a consistent yearly update, partner deal with ABN AMRO and now Credit Suisse, which is wonderful, exceptional reading. We’ll post some show links online. And there’s a couple interesting takeaways to me. You wrote in one of the books where you said the most controversial finding in our ’02 book is probably the lack of correlation between economic growth and stock market performance. We reported that somewhat surprisingly high economic growth was not associated with high real dividend growth. If anything, the relationship was perverse with a negative correlation. Maybe talk a little bit about that finding because, I think, a lot of people listening, if you watch CBC, if you watch a lot research, so much is focused on, “Hey, China is growing at X,” or, “The U.S. is growing at this number.” And kind of talk a little bit about some of your findings there and implications.

Professor Dimson: Yeah. I mean, this was one of the bits of fun in our research. We take on different fields each year to elaborate on, but there was a big disagreement about the growth. There was the emergence of terms like BRIC, which was Brazil, Russia, India, China. And then it was BRICS because it was the South Africa belonged in there, and there were a number of other groupings. And the belief was that if you classified companies by their economic growth, that high economic growth would reveal itself in both improved standards of people that live in those growing countries, but also in wealth that was being shared amongst the onus of companies that are in those countries.

We collected data on GDP growth, gross deamostic product growth and on stock market returns. And we were actually surprised when we produced “Triumph of the Optimists” to discover that there was a negative relationship between the two. And this was picked up by a number of other writers. So, our number crunching was verified by others who picked up on our data, people such as J. Reza who you all know of probably more famous for his work on IPOs. Or Robannas who probably needs zero introduction to you or your listeners, who published in both the “Academic Press” and in the “Professional/Analysts Journal” outlets on the findings and they came up with the same sort of conclusion.

And there are two aspects of this which, I think, are important. One is if there is economic growth who benefits from it? And the answer is that gets shared out amongst the different factors of production. So, people who work are better off, all sorts of people are better off. People who produce joint ventures are better off, but it turns out that that does not leave the external shareholders better off.

And if anything, what is going on is that the benefits of economic growth are diluted. Robanna [SP] wrote about what he called the 3% dilution writing in an article by Alison Bernstein in “Financial Analysts Journal.” And this is the dilution. You think you’re going to get some economic growth and then it gets shared out and you don’t end up with quite what you were looking for. But, I think, there is a simpler interpretation, and that’s this. That if it’s obvious that a market is growing, that’s public information, and public information is not something you can trade on to make superior profits. So people know that markets are growing.

If you knew which market was growing in the future to be the one that grows the fastest, that would be the market you want to invest in because it will do well. It will do well in stock market terms. But what we can actually do is to invest in companies that are located in countries whose GDP has been growing and where we extrapolated this growth into the future. But that’s just using public information. You’re too late. It would be like buying into shares of companies that have done well in some other way. It may be profitable, but if the whole public know about that, often you’ll end up overpaying instead of getting yourself a bargain. So, it was a controversial finding. The big champions saw this view that emerging markets would be more profitable for investors, gradually pulled back. And it’s no longer much of an argument. People know that you may do well in emerging markets. They have above average risk, and you may get some of the normal rewards for risk. But in terms of getting an alpha from investing in these opportunities, I don’t think there many, many serious investors who have that expectation any longer. But it was a debate which went on, which we were a part of for quite a number of years.

Meb: Well, it’s fun to look back. You know, you guys published this kind of right after the millennium when a lot of stock markets had that massive 1990s run and got to what most would consider to be pretty expensive valuations. And then we saw sort of the two large bear markets, particularly the 2000, 2002, as well as the global financial crisis. And I was smiling when you mentioned the BRICS because a lot of those countries got pretty high valuations in the mid 2000s. And then we’ve seen this environment, particularly based here in the U.S., where the U.S. stock market has really outperformed almost everything in the world for the past nine years.

And so talk to me a little bit about two things. One, how you guys think about valuation. I mean one of the nice charts you had in your book was country market caps over time. And looking back to say, you know, the 1980s when Japan was the largest stock market in the world, arguably one of the biggest bubbles in the world, and then now where the U.S. is half. So, maybe the two kind of are competing forces of one valuation on one hand, and then, two, sort of market cap waiting and potential home country bias on the other, and how that kind of interplay.

Professor Dimson: Well, market cap weighting is, of course, the only waiting scheme which is macro-consistent. That is, in aggregate, investors as a whole have to own assets as a whole. So, one can take a deviant position, and there are some who argue that there are various forms of risk where, if you can tolerate at risk, there will be a reward, a risk premium for doing that. And that may be something we refer back to, if you take me on to factors later on. But the market capitalization of each country can vary. And we’ve seen some very big changes over time.

When we first published our book, we didn’t have a history for us to share. That took quite a number of years to compile. But Austria used to be a country which contained Slovakia, the Czech Republic, Slovenia, parts of Italy, Hungary. I have named 5, but there are at least 10 of them. And when that empire shrank, Austria became a great deal smaller. And so the market capitalization of Austria shrank. I suppose, at the country level it was a little bit like a corporation that does a stock split, and some of that stock will have become Italian, some of it became Hungarian and ultimately ended up being in public ownership as part of the Soviet Union. So, there are different stories. And then, on the other hand, you have the terrific bubble that was experienced by Japan when Japan not only displaced the United States, but was bigger than… It was about half the world. So, it was hugely valuable, followed by grave disappointment. So we see those big changes over time. We also see big changes in valuations.

Actually what I will do is I’ll just jump forward to the 21st century now because I think to understand valuations, it’s helpful to do a little bit of Finance 101 first week on a finance MBA course. So, for those people who are listening to this conversation, now is the time to pick up the mug of coffee and listen to two minutes on a basic finance lesson. We’ve been through a period, since the beginning of the 21st century, when interest rates will come right down. They’re not quite at their lowest in the United States. There are some countries that are lowest still. So, we started with many countries having real interest rates sets, interest rates on what you would call tips, or I would call more generally inflation-linked bonds, which would give you a real yield of about 4%.

You would have got 4% promised by the government in countries which were safe, so I’m leaving out countries which had even higher promised yields, where you might have thought that there was some worry as to whether the government could afford to pay its debts. So, you can get 4%, Today, if you’re investing in an inflation-linked bond, in an inflation-protected bond, then for the average country you will get about minus a half percent, give or take a bit more. U.S. has somewhat higher real interest rates, other countries is lower.

So what the government is doing now is it promises, it absolutely promises that if you give them a dollar now in purchasing power terms, they promise to give you back something which is worth less than a dollar in a year’s time. So the world is very different, and that has had a bearing on the valuations. The way we think about valuations is that there is a formula called the golden model, which tells you that the value of a financial security is the dividend that it provides divided by the difference between the required rate of return that investors are looking for and the growth rate of cash flows. And what’s happened is that required rates of return has come write down.

What that means is that the multiple people will pay if they’re just using the same model for valuing securities is higher. We gave a small example of this when we’re presenting the work that we’re doing. So, the high valuations that we see are because real interest rates have become very low compared to one or two decades ago. And growth rates have not moved in parallel with that. So the difference between the return that shareholders are looking for and the growth rate of dividends or corporate cash flows has gone right down. So, valuations are a puzzle to people as well, and that’s something we explore over the long-term in our books and which we’ve given quite a lot of thought over the last two or three years. High valuations don’t necessarily mean that we’re going to see asset prices collapse. It’s a reflection of the low-interest rates that we have today compared to the beginning of the current. millennium.

Meb: That’s a great overview. To me this is kind of a…it’s been a big surprise. I mean, has there been a time in history where you’ve had… I know there’s been many periods of negative real interest rates, but have you seen anything where there’s been kind of this negative nominal sovereign bonds in history within any of these countries? And then two is, you know, as you’re thinking about this portfolio, like, what are kind of… Oh, you guys also did a sort based on real interest rates and future returns for both those stocks and bonds. So, maybe talk about, is there any precedent for this, and on top of that, when you look at real interest rates in sort of countries, you know, how does that play out for future returns?

Professor Dimson: You’re absolutely right to focus on real interest rates. We don’t see much point if you want to think about world issues and focusing on nominal rights because nominal interest rates embrace inflation, which can differ a great deal from country to country. So, we talk about real or inflation-adjusted interest rates. And so one level influenced by the very low level of nominal interest rates, people just refer to the world as being one with low rates. But if you focus on real rates, they have fallen since New Year 2000 dramatically. But if you were to go back to the 1970s, real interest rates were strongly negative.

So, in the U.K., for example, the yearly inflation rate peaked in the middle of the 1970s at 25%. The rolling 12 months rate, if you chose your 12 months rates very carefully, it peaked at 27% inflation. And only a few years before it had been at six. So, inflation had quadrupled from 6 to round about 25 or 27%. And at the time we didn’t even know that it would get worse. Maybe there was the possibility that it would quadruple again and we’d be at 100% per year inflation. So, inflation rates are very high. What did you get on government bonds at that time, you got about 15% or 16% is the best you could do. So, inflation is running at 27%, you’re getting 15% and 16%, the real interest rate was about minus 10% or worse.

So, although we say that interest rates are low today, nominal interest rates are low but real interest rates which are the thing that really matters, they have been lower. And so when we’ve tried to interrogate history to look at what happens to different securities in different interest rate regimes, what we do is we take the 118 years of data that we have for all of the countries that we cover, and we multiply it by the number of countries, and we have between 2000 and 3000 country-years of data. And of those, round about a third of them are real interest rates, which we define simply as the treasury bill rate, be it the short-term interest rate minus inflation.

The real interest rates and about a third of all the country-year combinations is negative, and in 2000 years it’s positive. So, negative real interest rates are not that rare. What is rare is a world in which we’ve got low real interest rates because inflation is low and nominal interest rates are low all at the same time. So, it’s not driven by the high inflation of the mid-1970s that we in Britain experienced and which we shared a little bit with the United States. But it’s a case that we can look through history and find opportunities to answer questions that people are asking at the current time, that by using the last century or more of data to provide insights on those questions.

Meb: You know. it’s interesting. I did a Twitter poll this past…last few days and, I think, you’ll appreciate this, but I was asking my followers, I said, “Just a quick quiz. Can you tell me what the historical in the last 120 years real drawdown was for long-term U.S. government bonds?” Eighty percent got it wrong. And so I did it in buckets, 0 to 20, 20 to 40, 40 to 60, and then over 60% real drawdown. And the vast majority of people said, “Under 20%.” And these, mind you, most likely my followers, obviously, very smarter than the average listener and most of them professionals.

Professor Dimson: Oh, of course. I know very well they’ve been educated to be super smart over the years.

Meb: But mostly professionals. And it just kind of goes to show that people always think about investments in nominal terms when really all that matters is real returns. And so I love your chart and tables in the book that talk about real returns after inflation for equities globally, which is around five and a half, bonds is rounding up call at two, 1.7, and bill’s about one. And to me I always just round and say that’s the old five-two-one rule is what we talk about on the podcast, is to try to give just a general perspective for real returns historically.

But what I did want to talk about because this… I thought it was pretty interesting to me, we may need a second cup of coffee for listeners on this one, but talk to me a little bit about inflation. Because particularly with currencies, because we have a lot of investors that call in or probably number one asked question is, “Should I be hedging my foreign investment? Should I be hedging my foreign bonds? I see the Japanese yen did minus 20% and da-da-da.” Talk to us a little bit about how you think about inflation. Can we predicted at all, and what sort of general takeaways can we have thinking about inflation and also currencies as well?

Professor Dimson: Well, that’s very important. And our focus isn’t limited to 100 years or 118 years. We look at short periods as well. But having a lot of data enables us to get a good idea as to what things might look like over periods of varying duration. But in terms of investment horizon, we’re usually thinking not about people who are dipping in and out of the market. We’re certainly are not talking today traders in terms of our research. We’re talking about long-term investors.

I’m phoning you from Cambridge, England, and starting tomorrow morning we have a conference for sovereign wealth fund and undamaged [SP] investors. So, we’ll peek at it together for a three-day educational experience with chief executives and chief investment officers and other senior staff from the world’s leading sovereign funds and from very large endowments. And these funds, in the main, are there forever. And many of your listeners will also be thinking very long-term ways. Some of them will be thinking about spending some of their money on cruising when they are retired or marrying off a son or having a [inaudible 00:29:59] or whatever. But many of them will be saying to themselves, “I don’t actually want to spend everything I’ve got by the day that my life comes to an end. I want to leave something behind.” And they may not know quite whether it’s a charity or for the next generation. They’re also long-term investors.

Their real-time horizon will be long indeed. And so our focus in a lot of what we do is the long-term. When it comes to currency exposure, it’s definitely possible for somebody to find a stock market which they successfully predicted under-priced. And then to discover that at the end of the year they may have got things right in terms with the stock market, but they get things wrong in terms of the currency. And so it’s quite understandable that they don’t like the idea that they may get the market right and get the currency wrong. And they want to bring the currency back into their local home currency, in your case mostly U.S. dollars.

So, that is the dilemma. I think one has to present two facts. The first one is that when we look at the long-term, most of what happens to currencies is driven by relative inflation. Currencies appreciate or depreciate to the extent that the currency is debased by inflation in that country compared to the United States, which is one of the stronger currencies in our data set. So, if you are a long-term investor the currency exposure that is being in a foreign currency protects you, although if you’re a short-term investor, if you’re investing a year ahead or three years ahead, the currency exposure may hurt you. So, we’re not in favor of moving the currency exposure into domestic currency while investing overseas. We think in general international investment does not require hedging if you are a long-term investor. So, that is one part of the story. Of course, you can hedge. Some investors and some people will have liabilities that are expressed in particular currencies, and those people may hedge.

They may be selling out of the Pound Sterling that they had acquired when they invested in British securities to get dollars. And there will be some people in Britain who, on the other side of that transaction, who want to remain in their home currency. And that, you know, we’re not against that. But nevertheless most of what happens, most of the differences in performance between one country and another are to do what really happens in the stock market in that country and what really happens in the bond market in that country, and the impact of exchange rates is small.

Meb: That this is one of my favorite takeaways from your book, by the way. Listeners, you may have to read this chapter a few times on currencies, but it definitely profoundly changed the way I thought about currencies prior to reading it. I want to talk about two more things while we still have time. Briefly, you mentioned factors and you guys have done a lot of work on this, including one of the if not largest, longest momentum studies I’ve ever seen. But you guys have talked about starting to tilt away from market cap waiting with a traditional size, value, momentum. What’s evidence look like in the world? Are these type of factor exposures you think that makes sense, but how do they show up in the data outside of just the traditional U.S. market? Any brief thoughts?

Professor Dimson: Well, for those who are not regular listeners, factors measure exposure to attributes of companies, such as the relative size of the company or the relative growth orientation of the company, which differ from the country in which the company is traded or the industry in which it’s being classified. And particularly over the last decade or so since a study that was undertaken for the Norwegian Sovereign Wealth Fund, which I chaired the strategy council until 2016, that’s influenced people a great deal to think about factors exposure, and not just national exposure or industry exposure.

Some factors appear to have a reward. In fact, almost always, they are expressed in such a way that they have rewards. As you might have thought the growth companies would do well, you would no longer talk about a premium for growth companies once you discover that it’s a value company, once that has lower growth prospects and sell at low prices rather than high stock prices, which have provided a reward. I think what I want to be very careful is this, that these rewards for exposure to a particular factor which we can see quite clearly with hindsight, those rewards may not be sustained in a marked way in the future. For everybody that receives the reward for investing, for example, in a value-oriented company, then it has to be somebody who has taken on a lower return because they were in a growth-orientated company since you add all the value stocks and all the growth stocks together, it adds up to the market. So sometimes this is referred to as smart beta.

The beta is a measure of the reward to risk, and that’s smart. But looking on the other side of this, it’s difficult to believe that there are dumb investors in large numbers time after time, month after month, year after year, decade after decade who are content with inferior returns. And I think a better assumption is that either these things are a fluke and you shouldn’t extrapolate them, or that there are exposures that some people wish to protect themselves against.

So, let’s take the five factor. The five-factor used to be the premier example of where there was a reward for factor exposure where you expected to get a larger return from a small-cap stock from some large stocks. It’s plausible to believe that other things equal, people would rather have a liquid common stock than an illiquid stock.

So, those people, for example, they might be managing a mutual fund, would like liquidity and they will accept a lower expected return in exchange for being able to get out of a position when part of the fund is liquidated. So, it’s smart to have fair liquid and small-cap stocks, as well as smart to have some of those same stocks if you are a long-term investor that doesn’t require marketability in the portfolio. So, my view of it is that smart data factors need to have a sense of check. If you can see that on the other side of this exposure, there is a sensible reason for other people to want to hedge out some risks to reduce their exposure to unmarketable stocks or to reduce their exposure to value stocks and so forth, then there may be a reward that you can anticipate.

But some of the rewards that people are extrapolating are just too large, and that’s why in our work we go back as far as we can in terms of history, sometimes being able to go all the way back to 1900 using our long-term database of the United Kingdom.

Meb: I love it. Yeah, I mean, it’s funny as working in our industry there’s so much sizzle with the steak, as you would say, about coming up with some of these factors. But there’s so many that you look at and scratch your heads and say, “I don’t even know how they came up with that.” All right. So, we’re gonna take a sideway step. I want to hear kind of some quick thoughts you’ve written about more recently in the last few years. I mean, there’s a few areas of investment that if you, I think, this is from… it might have been this year’s GIRY, “Global Investment Returns Yearbook,” where I looked kind of the allocations of ultra high net worth investors.

And on a couple areas, we haven’t even really touched on today, one being this kind of housing broad category which probably more listeners right now have exposure to that than probably any other asset. And then we can segue into a few other fun areas of collectibles and gold, but we would love to hear your take first on housing historical returns and then we can segue into the collectible world.

Professor Dimson: Well, okay. You’ve just given a lightweight plug and I’m very happy that it’s lightweight. Our annual update is called the “Global Investment Returns Yearbook.” So, the “Global Investment Returns Yearbook” 2018 came out recently. There is the freebie summary volume which you can get as a PDF. It’s all over the web. It’s a taster, and the full book is just a rather heavy 220-page hard copy only volume. But if you want details, search for Elroy Dimson on the web and send me an email. And I don’t hide on the web.

What we did this year was we introduced a new chapter into the book, which is not simply updating and extending previous work, but it’s totally new. And we’re looking at that and what one might call durable or tangible assets rather than financial securities. Real estate is the bigger collectibles, some are smaller, but we’ll talk about real estate first. The aggregate value of domestic real estate is similar to the aggregate value worldwide of stocks and bonds.

And if you added in commercial real estate, you’re adding even a little bit more on real estate. What we’ve done is we’ve gathered together industries to extend the study we had first produced six years ago looking at the long-term returns from housing. And some people say that housing is a particularly good financial security. And periodically researchers are focusing on a somewhat misleading interpretation of the data. To measure housing, there are a limited number of indices that one can use country by country. We focus on 11, which we think are particularly good. There are probably one or two more that one could add in but it is important to focus on the series which are as well constructured as you can manage and series which don’t pop in and pop out of the database, depending on whether you’ve got data or whether there’s no data because no data for real estate usually means that the city got bombed, that it’s London after the blitz. Or Germany after the end… during and after the end of the Second World War. So, we use a series where there’s a history going all the way from 1900 without any breaks.

What you find when you do that is that a real capital gain we don’t really know what the income is. There’s a real capital gain from houses which looks like it’s a view of [inaudible 00:41:01] 1%, one and a half percent per year. That is a number which we quantify in our book but if that would will give equal weight to tiny countries in the Nordic region, Sweden, or Norway, or Belgium, or whatever to large countries like the United States.

And so what we also do is we look at what the average house price gain is adjusted for population size. So, it’s a weighted average giving a weight to each country according to its population. So, we can capture what the story is on housing gains for the average person. And that brings gains down to a little below 1% in real terms. Then we look at the indices that we have and the indices that are available have a strong bias towards what are sometimes called “Super Cities: London, Amsterdam, New York, and so forth.”

So some of those are dominated by cities which are important but have grown at a much faster rate than the growth in value of rural locations or other distant locations. And so we adjust to that in returns down a bit and then there’s maintenance and insurance costs, which we had asked for.

And finally, when you look at housing, housing is very different now from the way it was in 1900. Bathrooms didn’t exist then, toilets were outside if you were lucky, central heating, well, only for royalty and so forth. So, they were asked to adjust for quality, and that brings the financial appreciation of housing down to much lower levels on average.

Another error that people make is to look at measures of the volatility of house prices, but house price indices are very poor from that point of view. They are assessed. They’re not actually transaction prices like common stocks. And anyway, it’s very difficult for ordinary people to have a diversified portfolio of housing. Typically people buy one home, maybe two or three homes, but they don’t have homes all over the place. So that added risk which in the common stock world you don’t have because it’s normal to buy a diversified portfolio of stocks.

So, as we see it the expected return on housing is somewhere in-between the financial return you’d get on long-term government bonds and the financial return you’d expect on equities. And the volatility in financial investment terms of homes is somewhere between the volatility of bonds and the volatility of common stocks. So, we try to quantify this and we should require quite a bit of evidence there. Some of it, and that’s a little sample that you can get on the web, and some it limited to the main book.

Meb: What’s been your main reaction from particular investors about this? Because I feel like a lot of the individual investors I talk to, and not necessarily, but often professionals, too, when you mention that housing, you know, I feel like so many people in their mind have this almost nominal Mirage where they look and say. “Well, I know so and so who bought this house for $50,000 and now it’s worth $400,000.” You know, and then you go back and so you do the math. You know, it only appreciated along with kind of like T-bills like returns. What’s been the reaction from most people? Was it surprise? Is it kind of general understanding?

Professor Dimson: You know, I think, the people I talk to know that it costs a lot to maintain their homes. And they know that they pour money into it and they also know that the house that they live in, I’m talking now as a Brit rather than an American. So the house will stood there typically for quite a long time but they know it’s quite different from the way it was 50 or 100 years ago.

So, we have a little cottage up in the Lake District in the northwest of the country, which we go to from time to time. It’s very small. It was a miner’s cottage for miners who, 300 years ago, were digging lead and zinc out of the hills in the Lake District. And it’s just rocks with no cavity walls or anything like that. The floor is much covered with some slabs. We’ve since modernized this a bit. We’ve had it in the family since the 1950s. Very little has done to it. It had been modernized once about 100 years ago where it got an outside toilet but that was it. Inside the set the outside toilets, where will you place this relatively recently. There was a washing machine. This washing machine with a lot of [inaudible 00:45:48]. On the top, there was a larger sheet of asbestos, and in the asbestos, there was suspended a large copper cauldron.

And underneath the surface, there was a large area which was like an oven and you would put logs into that. That would heat the water up. There was a solid state washing machine, I suppose, and they then put the miners clonthig in that so then it could then be washed and ready for the next day. So that it was some modernization of 100…150 years ago.

Houses like that have been dealt with the same way as we dealt with it once they moved on from the older generation to us. When my late mother in law had it…when they’d acquired it in the 1950s, they installed a power socket for electricity. So, in the whole house, they had one power socket. They had electric lighting when they got it. That place just as you can imagine it’s not quite like that now.

So when you look at these indeces, it’s the improvement in quality which is huge. And when you talk to people my experience is they know what they’ve poured into their homes. They can’t give you the exact amount but they know that they are forever redecorating and renovating but they also know that everybody is building like mad. And so the footprint of the plots may be the same, but the amount of accommodation, as well as its quality, has improved over time.

So, I don’t think anybody apart from some misconceived economists would have believed that it’s a better investment in pure financial terms to be buying your own home. What I think they would subscribe to is that it was buying your own home is a tremendous emotional investment. And that there’s a great deal of psychic pleasure, that the dividends are not in dollars and cents. But aren’t just in feeling good owning your own home and being able to improve it for the benefit of yourself and your family rather than just living with what a landlord happened to provide you with. So, it’s an emotional investment that’s important, and that’s the segue for you into the other half of my study.

Meb: Yeah. And just real quick question comment. I think it’s really funny, but my grandfather inside of the family grew up on a farm in rural Nebraska. And when they famously moved into town and town was like 100 people from the farm they moved from outhouse to indoor plumbing. And he thought it was the most barbaric thing he had ever experienced of why anyone would want to go to the bathroom in their own house. He thought it was backwards. Really funny. So, segue, we only have for about two more questions, but to talk to me about collectibles. So, maybe the takeaway recent issues. I should just go put all my money into a wine cellar in the bottom of my house and just buy a bunch of old Bordeaux.

Professor Dimson: Oh, okay. Well, you talked about your father and your great-grandfather, is it? And he’s like for outside toilets. My grandmother had a wine shop, and as I was brought up, my father took it over. So, I worked in the wine business. And so I’ve done a number of studies of the long-time investment returns from various kinds of things. I talked to something on the investment returns over the period from 1900 from investing in postage stamps, but it’s wine which has been the most fun.

And as I mentioned to you, starting tomorrow morning we have a program for people who are long-term investors and we have a few very short optional sessions. And I’ll be talking about the wine business. The family wine business suffered some recollections and I’ve brought along some bottles of wine and gift packs that my grandmother had bought in just after the Second World War. So, we got gifts packs to celebrate the coronation and the wedding of Queen Elizabeth. We’ll open a few of them and taste some of them.

After the Second World War, it was whatever you could get hold of, usually from British colonists. But my study of long-term investment returns focused on the very finest wines which, curiously, she managed to keep selling through the war. So theses are what you would call in the United States First Growth Bordeaux, First Growth fine wines from France, and what we would call Premier Cru. We don’t see much French here but its Premier Cru Bordeaux. In fact, when you’re in a Cambridge College, the best Bordeaux is called Claret. So, that’s what we will probably be having with dinner once this program gets underway. And what I’ve done is I have worked with a co-author collecting the prices of this fine Claret from two sources going, again, from 1900 to the present day.

One source is a very old wine shop, in other words, a customer facing dealer that’s been in business for between 350 and 400 years. It’s in St. James, which is where the royal household lives, and the company is called Berry Brothers. They have a very strong sense of history. And so we’ve gone through their price lists from 1900 to date and then we went to Christie’s, the auctioneers, and we went through their data.

Long story short, although investing in wine is not as profitable as common stocks, it’s a great deal better than investing in long-term government bonds or in treasury bills. It’s also better than post systems, better than art, better than musical instruments, where we’ve also got a series that begins in 1900. So, we had a lot of fun, and tomorrow evening is just the right time. We will be opening some bottles of wine from the 1940s, and sipping that while I recount something about investment returns from wine. A fun evening that I’m looking forward to.

Meb: Professor, we always ask our guests one question at the end, which is, if they have a most memorable investment. It can be personal, it can be good, it can be bad, it can be shorting Amazon’s. It could be wine from the ’40s. Anything that comes to mind?

Professor Dimson: Well, you know, I’m an academic, as you know, and so the most valuable investment to me is one which comes with very few strings attached. It’s investing in education. So, for me, the best investment was not anything which I purchased in the stock market. It wasn’t to buy my home. It was my education. So, I did my PhD at London Business School. I’m here at Cambridge. Those are the two institutions that I earned mental state [SP]. And I’d urge anybody to invest in educating the next generation before they start thinking about any other forms of investment.

Meb: I love it. Professor, where can people track your writing, your updates if they want to get in touch with you? Where is the best places?

Professor Dimson: Well, Meb, you and I share something which is an unusual name. So, if you google “Sir Elroy Dimson,” you’ll find that that brings up a great deal of material. And if you’ve discovered my email, then send me many junk mails that if somebody wants to be put in touch with what I’ve written or be sent details on how to get hold of the “Global Investment Returns Yearbook,” they’ve only got to ask and give me 24 hours and I’ll reply.

Meb: Professor, it’s been a blast. Thanks so much for taking the time out today.

Professor Dimson: Right. Thanks a lot. Thanks for the conversation.

Meb: Listeners, you can always find the show notes and links at mebfaber.com/podcast. We’ll add links to all the professor’s writings, papers on Norway, stuff we didn’t even get into today. I mean if you like the show, if you hate it, please leave us a review, and you can always subscribe on iTunes or the various platforms. Thanks for listening, friends, and good investing.